Latin America has a history of recurrent financial crises that took a large toll on economic growth and fuelled social unrest. Frequently, these crises were triggered by exogenous shocks, which unveiled macroeconomic and/or financial weaknesses, leading to simultaneous banking and currency crises. Financial crises, thus, became a primary source of macroeconomic instability and a reason for social frustration, as vast groups of the population, in particular the poorest, often lost their jobs, real income, and savings.
Fortunately, politicians and policymakers learned from previous mistakes and, consequently, Latin America is today better prepared to cope with real and financial shocks. Over a number of years, most countries strengthened their macroeconomic fundamentals and built up buffer mechanisms to mitigate the negative effects of frequent exogenous shocks. In particular, they significantly increased their international reserves, shifted to flexible exchange regimes, and improved public debt profiles, while financial systems were recapitalised and restructured and better regulated and supervised. Against this background, most countries in the region have achieved lower inflation and have kept fiscal and external imbalances in check.
Central banks’ reactions to the crisis
Latin American central banks reacted swiftly and decisively using a range of policy instruments, many of which were developed over the last decade. Initially, they raised interest rates in the wake of rising inflation fuelled by the surge in food and energy prices and allowed the nominal exchange rate to appreciate with the aim of limiting the pass-through from imported inflation. Countries like Colombia and Peru also tightened monetary policy by increasing reserve requirements on external liabilities to curb capital inflows attracted by higher interest rates.
Central banks’ policy reaction changed from September 2008 onwards when Lehman Brothers collapsed and the costs of international financing swelled, restricting access to it. In an environment of global economic contraction and declining inflation, most central banks have reduced interest rates – some more aggressively than others – to moderate recessionary trends (Figure 1). The Central Bank of Chile has been the most aggressive, slashing its policy rate by 600 basis points, to 2.25% during January-April 2009 and then to 0.50% in July 2009. Other countries, like Brazil and Mexico, followed a more gradual approach. The Central Bank of Brazil reduced its policy rate 350 basis points to 10.25% and then to 8.75% during the same time span, probably with the intention of precluding an increase in market uncertainty, given the country’s history of high nominal and real interest rates. In turn, the Bank of Mexico has followed an even more conservative approach due to its still relatively high inflation rate.
Figure 1. Central bank policy rates in Latin America
Source: IMF, International Financial Statistics
To address tensions in domestic financial markets, central banks have used a consistent menu of monetary and exchange rate policy actions. Central banks have enhanced liquidity management in domestic currency as a first line of defence. To this end, Brazil, Colombia, and Peru reduced their reserve requirements. In addition, repos have been used under various modalities, broadening collateral (Chile, Mexico) and expanding maturities (Chile, Peru). Peru has also set up foreign exchange swaps to inject liquidity in domestic currency. Some central banks have also used derivatives to complement transactions in both domestic and foreign currencies. In particular, Mexico has used interest rate swaps to alleviate pressures on commercial banks’ balance sheets.
To cope with capital outflows, most countries have allowed the currency to depreciate sharply but without triggering a surge in inflation as in the past. For instance, currency depreciation in Brazil and Mexico was near 50% from end-August 2008 to end-February 2009 and yet inflation continued declining. Central banks have also intervened selling dollars in the spot market. In addition, they have used other foreign exchange operations such as swaps (Brazil and Chile), reduced reserve requirements for dollar deposits (Peru), and allowing banks to fulfil the reserve requirement on dollar bank deposits in pesos (Chile). In Mexico, because of a long period of foreign exchange rate stability, firms used derivatives without tackling risks appropriately and, hence, the Bank of Mexico has had to sell large amounts of dollars through direct and auction mechanisms. The Central Bank of Brazil, in turn, has employed non-deliverable currency swaps to supplement direct intervention in the spot foreign exchange market.
While decisive, Latin American central banks’ policy responses have been less expansionary than those in most industrial countries, particularly the US and the UK (Figure 2). Except for Brazil, Latin American central banks’ balance sheets less than doubled from early 2006 to June 2009. Therefore, the lively discussion in developed countries about exit strategies – when to start shrinking central banks’ balance sheets, under what modality, and at what pace – is less relevant in Latin America.
Figure 2. Central banks’ balance sheets
Note: Total assets normalised to 100 in 2006M1. Source: IMF – International Financial Statistics, Bank of England.
As financial uncertainty in mature markets fades away, the worst of the financial shock seems to be over. Capital outflows show signs of abating in the region and elsewhere and, hence, depreciation trends have reversed and international reserves rebounded. Moreover, the first symptom of economic recovery has already appeared, as Brazil posted positive economic growth in the second quarter of 2009 – compared to the first quarter – and other countries are starting to exhibit a marked slowdown of output contraction.
The role of stronger institutional foundations
Central banks’ success in weathering the financial storm cannot be attributed solely to their short-term policy response and to more solid macroeconomic and financial fundamentals. It is also important to factor in the strong institutional foundations and the changes introduced to the conduct of monetary policy during recent years, which together have allowed central banks to enjoy an enhanced reputation and credibility as institutions committed to maintain low and stable inflation.
During the last two decades, all Latin American countries approved new legislation to grant central banks enhanced autonomy to defeat inflation – which in 1990 had reached on average more than 500% year-on-year – and preserve price stability. In most countries, the legal reform entailed primarily
(i) a clear mandate to pursue price stability as the main policy objective,
(ii) political autonomy to formulate monetary policy to achieve their mandate,
(iii) operational autonomy to conduct monetary policy without restrictions, introducing limitations and even prohibitions to central banks lending to the government, and granting central banks independence to set interest rates, and
(iv) accountability in achieving inflation targets, and in disclosing and explaining central bank policies and goals.
Building on their newfound autonomy, central banks shifted to more effective and sustainable monetary policy regimes and modernised their operational settings. Key central banks in the region (Brazil, Chile, Colombia, Mexico, and Peru) have introduced inflation targeting as a more effective policy regime to guide inflation expectations and have maintained exchange rate flexibility as a buffer to cope with exogenous shocks – like those that recently hit Latin America. On the operational front, central banks stopped targeting money base or other quantitative variables and, instead started targeting a price variable, typically the overnight interest rate in the money market. Changing this “policy rate” has effectively influenced other market interest rates and aggregate demand and signalled the monetary policy stance to the markets.
The monetary policy regime and the associated operational framework established by many central banks in Latin America have been instrumental at this critical juncture. It has enabled them not only to respond to capital outflows but also to better communicate to market participants the specific role played by monetary policy to alleviate economic recession without disrupting the pursuit of the objective of preserving price stability. As a result, central banks have mitigated the uncertainty associated with the global crisis and have kept market expectations aligned with central banks’ long-term inflation targets, despite the simultaneous loosening of monetary policy.