The Currency War: Risks for Latin America and the Role of Central Banks

During the 13th and 16th of November, the Latin American Shadow Financial Regulatory Committee (CLAAF) held their second meeting of the year in Lima with the purpose of discussing the effect of the currency wars on the Latin American region. As a result of the meeting, we presented the 23rd CLAAF statement. The statement has been extremely well received and broadly covered by the Peruvian press. The members of CLAAF that participated in the meetings were:

• Guillermo Calvo, Professor, Columbia University; Former Chief Economist, Inter-American Development Bank
• Pedro Carvalho de Mello, Professor, ESALQ, Universidade de São Paulo; Former Commissioner of Comissão de Valores Mobiliários, Brazil
• Guillermo Chapman, Chairman & CEO, INDESA; Former Minister of Planning and Economic Policy, Panama
• Pablo Guidotti, Dean, School of Government and Professor, Universidad Torcuato di Tella; Former Vice-Minister of Finance, Argentina
• Alberto Carrasquilla, Executive Director of Konfigura Capitales; Former Minister of Finance, Colombia
• Roque Fernandez, Professor, Universidad del CEMA; Former Minister of Finance, Argentina

In what follows, I describe the problem that we addressed during the meeting and the Committee’s proposed recommendations.The ProblemWe discussed the challenges Latin America will be facing in the near future, resulting from strong capital inflows, a weakening dollar, and an undervalued yuan.Since the international financial crisis started, there have been two significant changes in the international economy. On the one hand, firms and households in the United States as well as European governments have started to deleverage. On the other hand, the use of fiscal policy to revive economic growth in the US is running up against several economic and political constraints. As a result, to restore growth many developed countries support the idea of rebalancing aggregate demand in emerging economies through changes in foreign exchange policies, especially in China.In the view of the Committee, focusing on exchange rate policies to deal with global imbalances misses a central point: the key problem in the US and other advanced economies is the lack of a definite resolution to problems in the financial system. In the US in particular, credit will not revive until banks’ balance sheets are cleaned-up, especially from the large stock of impaired mortgage loans. In this context, the Fed’s recently announced expansionary monetary policy through QE2 (Quantitative Easing 2) cannot be effective. Further increases in liquidity cannot encourage a credit expansion when the banking system suffers from a bad loans problem.QE2, however, encourages a significant increase in capital flows towards emerging markets with good prospects in terms of assets’ returns. A number of Latin American countries belong to that category. The problem for the region is that the large inflows are pushing upwards the price of local assets creating the potential for bubbles. Moreover, the inflows are leading to appreciation of several Latin American currencies. This is complicating the conduct of monetary policies by central bankers who, based on previous episodes, fear that a sudden stop of the inflows could materialize creating significant disturbances in local financial markets.In order to prevent excessive currency appreciation, some central banks are intervening in the foreign exchange markets and some others, like Brazil and Colombia have introduced some forms of capital controls. In what follows I present the Committee’s views regarding the adequate response by Latin America’s central banks.How Should Latin America Respond?: The Committee’s recommendationsGiven the external context, our recommendations to Latin American countries are:

1. Explore an agreement with China to establish some degree of exchange rate policy coordination. In fact, possible negotiation forums include the G-20, BRIC-countries meetings, and APEC.
2. If coordination with China is not possible, it is appropriate that Latin America’s central banks intervene in foreign exchange markets to help reduce the risk of a sudden appreciation of the region’s currencies.Regarding the exchange rate interventions:
   1. Central banks should consider a greater role for the yuan as benchmark currency.
   2. Unsterilized intervention is preferable to sterilized intervention. If sterilized intervention is to be used, it should not be used systematically since it leads to increases in interest rates and, therefore, to further capital inflows. In the case of unsterilized interventions we recommend they be complemented with additional fiscal tightening. To make this fiscal policy more effective, we recommend redirecting public consumption to public investment.
   3. Recognizing that currency appreciation could affect wages in tradable sectors, we recommend either greater flexibility in wage contracts or a greater compensatory mechanism (to deal with higher payroll costs derived from real exchange rate changes) should be introduced.
3. Central banks could also use macro-prudential policies to strengthen capital and liquidity requirements in the financial system, and adopt counter-cyclical financial regulations.
4. Some countries have complemented exchange rate intervention with capital controls. Even though capital controls can attenuate exchange rate pressures in some countries, we emphasize that they could also lead to protectionism and to a reversal of the financial and commercial progress achieved in recent years.
5. The problems generated by the capital inflows cannot be managed at a country level. It is important to ensure that the investment supported by the capital inflows is of high quality. Therefore, we recommend that the international community further strengthen multilateral development institutions that can actively support Private-Public partnerships that better channel resources towards priority infrastructure projects.

We believe that the US and other developed economies are not doing enough to address the problems in their banking sectors. Specifically, the second round of quantitative easing is not effectively addressing problems in this area. We recommended that the US focus on establishing a realistic valuation of banking sector assets and address the current situation of mortgage.