Exchange Rate Politics In Latin America

Journal of Development Economics Vol. 66 Ž2001. 337–341 www.elsevier.comrlocatereconbase Book review Exchange Rate Politics In Latin America Carol Wise and Riordan Roett ŽEds.., Brookings, Washington, D.C., 2000, 178 pp. Latin America’s economic history has been replete with extreme macroeconomic experiences. When one reflects on the Southern Cone policy experiments of the late 1970s, the debt crisis of the early 1980s, and the heterodox stabilization programs of the mid to late 1980s, it becomes evident that the region has contributed more than its share of material for the ruminations of macroeconomists and students of political economy. The decade of the 1990s has not proven to be an exception. The market-oriented reforms that many countries in Latin America undertook during the late 1980s and early 1990s were followed by a wave of capital inflows into the region. These proved to be the harbingers of a new area of integration by Latin American countries with international capital markets. This enhanced level of financial integration represented a change in circumstances that redefined the macroeconomic playing field for Latin American countries. Its key features were more or less complete Afirst generationB reforms Žmacroeconomic stabilization, privatization, and trade liberalization. associated with the AWashington consensusB, as well as partial Asecond generationB Žinstitutional. reforms. These have been combined with enhanced openness to international capital movements. Among the most critical challenges posed for macroeconomic policy formulation by this new set of circumstances has been the formulation of an exchange rate policy. In the wake of the ERM crisis of 1992, the Mexican crisis of 1994, and the Asian crisis of 1997, a new view has begun to emerge about the exchange rate policy under circumstances such as those that currently characterize most Latin American economies. The new conventional wisdom is that developing countries characterized by a high degree of integration with world capital markets have a restricted menu of exchange rate regimes from which to choose. In its most extreme form, this view suggests that along a spectrum of exchange rate regimes ranging from clean floats to the abandonment of the domestic currency, such countries must now opt for one of the corner solutions. The argument is essentially that high capital mobility, coupled with domestic policy weaknesses will interact to make any intermediate regime vulnerable to successful speculative attacks, implying that if the value of the currency is to be managed, only very AhardB pegs, in the form of currency boards or dollarization, can be sustained. 0304-3878r01r$ - see front matter q 2001 Elsevier Science B.V. All rights reserved. PII: S 0 3 0 4 - 3 8 7 8 Ž 0 1 . 0 0 1 5 0 - X 338 Book reÕiew Typically, Latin American countries provide fertile grounds for investigating this Anew viewB on an exchange rate policy. The countries in the region have displayed a variety of exchange rate experiences in the post-reform era, ranging from floating rates adopted after a crisis in Mexico and Brazil, to a floating rate adopted without a currency crisis trigger in Chile, to a crawling peg within a band in Venezuela, to a currency board in Argentina. Some of the smaller countries ŽEcuador, El Salvador, and Guatemala. have opted for full dollarization, while Panama has long been dollarized. These recent macroeconomic experiences, encompassing widespread marketoriented reforms accompanied by very different exchange regime choices, raise a host of political–economic questions. The most basic one, of course, is how to explain the breadth and depth of market-oriented reforms in the region, as well as why the reform process has remained incomplete in many countries. But beyond this general issue, there are a variety of more specific ones which are relevant to an evaluation of the Anew viewB on exchange rate policy. For example, Ža. Why have reforming countries opted for such a wide variety of exchange rate regimes? Can this be explained by economic Žoptimal currency area. considerations, or is it the product of a purely political equilibrium? Žb. Are managed exchange rates inevitably badly managed? That is, are the authorities typically poorly informed about how to avoid misalignment, or are they simply unable to do what they know to be the right thing for political–economic reasons? What are these reasons? Do they tend to be common across countries, or do they tend to be country-specific? Žc. Related to this, why has the adoption of floating rates apparently required a crisis in some countries ŽMexico and Brazil., but not in others ŽChile.? Why did the political process resist a change in the parity in the former countries until a crisis forced it on the authorities? Žd. How were some countries ŽArgentina and Venezuela. able to sustain their parities in the face of strong speculative attacks, while others were unable to do so? Že. What is the link between the reform process and the exchange rate regime? Does the adoption of market-oriented reforms bias the regime choice, as the new conventional wisdom would predict? How has the reform process itself been affected when regime changes have occurred mid-course? Žf. What is the constellation of political forces that will determine how many countries in the region ultimately opt for full dollarization? The current relevance of these questions and many others like them make Exchange Rate Politics In Latin America, edited by Carol Wise and Riordan Roett, a very topical book. The heart of this book is a collection of case studies of the recent exchange rate experience of four important Latin American countries: Mexico, Argentina, Brazil and Venezuela. These are preceded by overview chapters on political issues by Carol Wise and on economic issues by Max Corden, and are followed by a summary chapter by Riordan Roett. Book reÕiew 339 The countries included in the volume are not only important because of their economic weight in the region, but also, as suggested above, because of the variety of exchange rate experiences that they represent. Thus, it is reasonable to expect this collection to offer some answers to the questions posed above. Does it succeed in doing so? From my perspective, the answer is that it does in part, though not always to the extent that one might have hoped. The reason is that, despite its title, the case studies in this collection do a better job of describing the sequence of events surrounding major exchange rate crises in the four countries considered than they do in shedding new light on the political–economic questions posed above. To explain, consider the questions raised above in sequence. The observation is made at various points in the book that market-oriented reforms in Latin America have tended to be imposed from above by somewhat autocratic governments, rather than as the result of the democratic election of candidates running on reform platforms Žthe PRI in Mexico, Fujimori in Peru, Menem in Argentina.. But why should this have been so? Is it because candidates running on stabilization-cum-reform platforms could not have been elected in the region, or because democracy itself tends to be one of the products of market-oriented reform? If the former, why would reform platforms have failed electorally, if stabilization-cum-reform often turned out to generate so much popular support ex post? Unfortunately, the observation about the association between autocracy and reform is made, but not explained. On the variety of exchange rate regimes, Max Corden argues explicitly Žand reasonably. that Argentina is not a good candidate for a AhardB peg to the dollar on optimal-currency-area grounds, and Carol Wise maintains, again quite reasonably, that Argentina’s extremely poor post-war economic performance and repeated high-inflation crises prepared the way for a drastic exchange rate experiment. But this would appear to raise questions about the sustainability of the regime in Argentina once price stability comes to be accepted as the norm. Should Argentina’s currency board be expected to be no more than a transition phenomenon? And what about other countries in the region? While Brazil and Mexico may have been forced to float by currency crises, would it be optimal for them to limit exchange rate flexibility under the floating regime? Have they indeed done so? Are there political forces pushing them in that direction? If so, what are these forces, and if not, why not, in light of their pre-crisis adherence to an officially determined exchange rate? None of these questions are explicitly addressed in the case studies. As to the questions concerning whether managed rates are invariably badly managed and why exchange rate adjustment was resisted in Mexico and Brazil until such adjustments were made inevitable by crises, there is more on these issues than on the previous ones, but the analysis does not always seem complete. Timothy Kessler provides an extensive list of the political players that favored sustaining the value of the peso before the crisis in Mexico, with the implication 340 Book reÕiew that an obvious overvaluation was not resolved through a devaluation because of political constraints. But this leaves the question of where the voices of the potential winners from devaluation were in pre-crisis Mexico. After all, if an orderly devaluation would have been welfare-enhancing in the aggregate, there must have been winners. Were they too diffuse to matter politically? And what happened to these political forces after the exchange rate was floated? Similarly, Javier Corrales describes the reasoning behind the apparent view of the authorities in Venezuela that a devaluation might not have done much good. He cites the weakening of the fiscal benefits of devaluation Žbecause of the accumulation of dollar-denominated public debt. and the fear that once the exchange rate moved, currency depreciation might have gotten out of hand. But both of these reasons seem dubious, and raise the possibility that the authorities may simply have been misinformed in sticking with the announced parity. Concerning the first, whatever its fiscal effects, the primary role of devaluation would have been to realign relative prices, which had apparently gotten out of kilter in Venezuela. Was a severe recession really the consciously preferred option to correct misaligned relative prices? As to the second, if a devaluation would have been a move toward equilibrium, why would an overshooting have been expected, especially with a respected central bank willing and able to use restrictive monetary policy to prevent it? Overall, it seems that in the Venezuelan case, a misdiagnosis of the situation may have played a role, though the author of the country study does not draw this conclusion. Concerning the role of crises in causing regime changes, three of the four countries in the book ŽMexico, Argentina, and Brazil.opted for exchange-rate-based stabilization after high-inflation crises, and two of them ŽMexico and Brazil. subsequently switched to floating rates in the wake of currency crises. Unfortunately, the book does not contain case studies of countries that switched regimes without crises Žsuch as Chile., but it does consider two circumstances in which crises were not accompanied by changes in regime ŽArgentina and Venezuela.. What were the differences in domestic political circumstances that determined these differences in outcomes? This is a critical question in evaluating the Anew viewB of exchange regime choices because it speaks directly to the sustainability of currency pegs, and thus, to the likelihood of a speculative attack. However, while there are specific explanations offered for successful defenses Žthe experience of low growth and repeated high inflation in Argentina, and the prestige of the Central Bank in Venezuela., there are no broad general lessons drawn from this diversity of experience in this book about the domestic political factors that make an attack on a currency likely or not likely to succeed. The authors of the book appear to take the perspective, consistent with the Anew viewB on exchange rate regimes, that a switch to a pro-market orientation in economic policy does not bias the choice of regime toward the fixed or flexible end of the spectrum, but the authors of the case studies do not directly address another aspect of this view—the role of enhanced capital mobility in determining Book reÕiew 341 the sustainability of AsoftB pegs. A possible explanation is that all four countries were completely open to capital movements. Nonetheless, it would have been useful to address this issue directly, especially in the case of Venezuela, which presents an example of a successful defense of a AsoftB peg. Finally, with regard to the dollarization debate, while the material in the book is fairly recent Žessentially through mid-1999., it is not recent enough to encompass the dollarization experiences of Ecuador, El Salvador, or Guatemala. Debates on dollarization in Argentina and Mexico are mentioned, but their political economy is not analyzed in the chapters on those countries. In short, a reader who looks to this collection for answers to the types of questions I have raised above will probably not come away fully satisfied. But that should not discourage students of Latin American political economy from reading this book. Its overview chapters provide thoughtful and comprehensive overviews of the political–economic and more narrowly economic issues involved in the formulation of exchange rate policies in Latin America, and the four country case studies contain excellent descriptions of recent currency crisis episodes in some of the most important countries in the region. If all of the political–economic questions relevant to the Anew viewB on exchange rate policy are not answered here, that is a reflection of the profession’s state of knowledge on these matters, rather than on the quality of the contributions to this collection. Peter J. Montiel Williams College, Williamstown, MA 01267, USA E-mail address: Peter.J.Montiel@williams.edu