Exchange Rate Policy and Inflation Targeting in Colombia

Hernando VargasBanco de la República

May 2005

Exchange Rate Policy and Inflation Targeting in Colombia

Main ideas

I. Inflation Targeting (IT) has worked well in Colombia

II. There has been an “Independent” floating exchange rate regime with two managed floating episodes …

III. 2003-I: Dealing with a sharp depreciation

IV. 2004-II – Present: Dealing with a sharp appreciation

V. Political economy issues: Political context in which monetary policy is made in Colombia

VI. Conclusions

I. IT has worked well in Colombia A. Background

• Between 1973 and 1990 Colombia experienced moderate inflation (15%-30%).

• A crawling peg regime with capital controls was in place since 1967

• In 1991 the Central Bank was granted independence with the goal of preserving the purchasing power of the currency.

• It started a process of gradual disinflation

• Some exchange rate flexibility was introduced (crawling exchange rate bands) and intermediate monetary targets were used to guide policy

• Most capital controls were removed between 1991 and 1993 .

• In the presence of large fiscal and external imbalances, the terms of trade shocks and the “sudden stop” of 1998-1999 forced the abandonment of the exchange rate bands in September 1999

• GDP fell by 4.2% in 1999 and a financial crisis ensued involving state-owned and some mortgage banks.

• A floating regime was established and monetary policy converged to an IT framework

• Initial conditions of IT:

Inflation had fallen from 16.7% in December 1998 to 9.2% in December 1999, but was still above the long run target (2%-4%)

Deep recession

The credit channel was weakened by the financial crisis

The currency depreciated by 22% in real terms between January 1998 an December 1999 within the band system

International reserves level was considered too low after the defense of the bands

Several elements of IT were already present: Explicit inflation targets (1991), forecast models (since 1995) and an early version of an Inflation Report was being published since December 1998

• In this context, the initial objectives of monetary and foreign exchange policy were:

To continue gradual disinflation towards its long term target

To restore international reserves (IR) to levels that would limit the external vulnerability of the economy

• Considering the state of the economy and the need to bring output close to its “potential” level, a gradual approach to disinflation (as opposed to an alternative “opportunistic” approach) was adopted “Flexible” IT (Svensson, 2000).

• The short term Central Bank´s REPO interest rate was identified as the main instrument of monetary policy

• The floating exchange rate regime added transparency to the strategy. Unlike the previous period, there were no explicit or implicit exchange rate targets

• So, intervention in the for-ex market was initially limited to:

Accumulate IR and restore their level (1999) Curtail excessive volatility (1999)

There was no intention to affect the exchange rate trend

• Later a facility was created to support monetary policy in case of a sharp depreciation of the currency (2001)

• Intervention was announced, rules-based and worked through auctions of options to sell/buy dollars to/from the CB

Transparency: Avoids legal risks for CB, consistency with monetary policy easily verifiable, strong signaling effect

• More recently, discretionary intervention was added to the menu (2004)

B. Performance

• Taking into account the initial state of the economy, the CB reduced its interest rates by 550 bps between 2000 and 2004…

• …Allowing 3-month CD rates (the benchmark interest rate for Colombia) to keep real values well below its historical average for the whole period

.

Central Bank Lending Rate(for overnight Repo)

0

5

10

15

20

25

Mar

-99

Jun-

99Se

p-99

Dec

-99

Mar

-00

Jun-

00Se

p-00

Dec

-00

Mar

-01

Jun-

01Se

p-01

Dec

-01

Mar

-02

Jun-

02Se

p-02

Dec

-02

Mar

-03

Jun-

03Se

p-03

Dec

-03

Mar

-04

Jun-

04Se

p-04

Dec

-04

Mar

-05

%

Real 90-day Interest Rate

(interest rate for fixed term deposits)

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0M

ar-0

0

Jun-

00

Sep-

00

Dec

-00

Mar

-01

Jun-

01

Sep-

01

Dec

-01

Mar

-02

Jun-

02

Sep-

02

Dec

-02

Mar

-03

Jun-

03

Sep-

03

Dec

-03

Mar

-04

Jun-

04

Sep-

04

Dec

-04

Mar

-05

%

Real Interest Rate Average (from 1990)

• This was consistent with the reduction of the output gap and increasing growth rates

.

Output Gap

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

1995

Q1

1996

Q1

1997

Q1

1998

Q1

1999

Q1

2000

Q1

2001

Q1

2002

Q1

2003

Q1

2004

Q1

(% of Potential GDP)

Source: DANE, Banco de la República.

Gross Domestic Product

2,4%2,9%

1,3% 1,1%

1,9%

0,9%

3,3%

2,4%

1,2%

4,4%

2,2%

4,4%

5,1%

3,8%

4,9%

2,9%

4,3%3,2%

3,2%

1,6%

0%

1%

2%

3%

4%

5%

6%

2000

-I

2000

-II

2000

-III

2000

-IV20

01-I

2001

-II

2001

-III

2001

-IV

2002

-I

2002

-II20

02-II

I

2002

-IV

2003

-I

2003

-II

2003

-III

2003

-IV

2004

-I20

04-II

2004

-III

2004

-IVSource: DANE. Calculations Banco de la Repúlica

• …While inflation continued its decline and was on target in 2004

• Inflation expectations have also fallen, and the credibility of the inflation targets has increased

.

CPI Inflation, Core* Inflation and Inflation Targets

4.5

5.5

6.5

7.5

8.5

9.5

10.5

Jan-

00

Apr

-00

Jul-0

0

Oct

-00

Jan-

01

Apr

-01

Jul-0

1

Oct

-01

Jan-

02

Apr

-02

Jul-0

2

Oct

-02

Jan-

03

Apr

-03

Jul-0

3

Oct

-03

Jan-

04

Apr

-04

Jul-0

4

Oct

-04

Jan-

05

CPI Inflation Core* Inflation Inflation Targets* Core Inf lation: refers to inf lation excluding foodstuffs

Percentage of credibility of the inflation target

46.9

35.042.0

69.1

77.8

0

10

20

30

40

50

60

70

80

90

2001 2002 2003 2004 2005

According to the Quarterly Survey of Inflation Expectations of the Central Bank

%

• International reserves reached comfortable levels, as reflected in several indicators of external liquidity

.

1998 1999 2000 2001 2002 2003 2004

STOCK OF GROSS INTERNATIONAL RESERVES (GIR) (Million dollars) 8.740 8.103 9.006 10.245 10.844 10.921 13.540

M3 / ( GIR ) 4,2 4,0 3,1 2,9 2,4 2,7 3,0

GIR / (Capital payments of current external debt + Current account deficit ) 0,6 1,0 1,1 1,1 0,9 1,0 1,4

GIR / (Capital payments of current external debt ) 1,0 0,9 1,0 1,3 1,1 1,1 1,5

Source: Banco de la República.

Indicators of vulnerability 1998 - 2004

Overall it can be concluded that IT has worked well in Colombia

II. “Independent” Floating

• The exchange rate regime between 2000 and 2005 may be characterized as “Independent Floating” (Bofinger and Wollmerhäuser, 2003)

.

Nominal Exchange Rate Index -NERI- and Real Exchange Rate Index -RERI- (1994 = 100)

180

230

280

330

380

Mar

-99

Jul-9

9

Nov

-99

Mar

-00

Jul-0

0

Nov

-00

Mar

-01

Jul-0

1

Nov

-01

Mar

-02

Jul-0

2

Nov

-02

Mar

-03

Jul-0

3

Nov

-03

Mar

-04

Jul-0

4

Nov

-04

Mar

-05 80

90

100

110

120

130

140

150

NERI RERI based on PPI

• The degree of exchange rate flexibility has been similar (even higher) than in other countries in the region with similar regimes

.

Colombia Mexico Brazil Chile Colombia Mexico Brazil Chile

2000 1,9% 1,3% 2,0% 1,5% 2000 45,7% 84,0% 62,1% 62,5%2001 1,1% 1,3% 3,9% 2,4% 2001 79,2% 81,8% 67,8% 74,8%2002 2,5% 1,0% 5,6% 2,1% 2002 76,9% 113,1% 69,4% 59,0%2003 1,5% 1,9% 3,4% 2,3% 2003 67,8% 67,6% 74,7% 61,9%2004 1,6% 1,1% 2,1% 2,5% 2004 45,5% 77,9% 82,7% 58,2%

1Average of the monthly variation of the exchange rate. 2 Coefficient of variation of the monthly exchange rate changes

For references about this index see Levy-Yeyati, Eduardo andSturzenegger, Federico, "Classifying Exchange Rate Regimes:Deeds vs. Words" . European Economic Review, Forthcoming

Exchange rate volatility1 CV of monthly exchange rate changes2

Colombia Mexico Brazil Chile Colombia Mexico Brazil Chile

2000 2,1% 6,3% 28,6% 6,3% 2000 3,4% 29,2% 8,5% 3,5%2001 4,6% 9,9% 22,9% 6,9% 2001 3,2% 39,0% 7,9% 2,3%2002 2,3% 6,0% 23,5% 10,9% 2002 2,0% 15,9% 19,4% 3,6%2003 3,5% 7,5% 10,5% 9,1% 2003 2,0% 5,7% 20,4% 2,0%2004 2,9% 8,0% 11,0% 8,3% 2004 4,9% 6,9% 6,8% 2,9%

4 Average of monthly change in r , where r is defined as 5 Coefficient of variation of international reserves

R represents the International Assets and B is the Monetary base in US dollars.

CV of international reserves5Monthly Intervention in the Foreign Market4

For references about this index see Levy-Yeyati, Eduardo and Sturzenegger, Federico,"Classifying Exchange Rate Regimes: Deeds vs. Words" . European Economic Review,Forthcoming http://ssrn.com/abstract=214428.

1

1

t

ttt B

RRr

1

1

t

ttt B

RRr

• For-ex intervention has not been inconsistent with monetary policy…

NET QUARTERLY INTERVENTION AND EXPANSION REPO RATE

-400

-200

-

200

400

600

800

1,000

1,200

1,400

1,600

US

$ M

illio

ns

5%

6%

7%

8%

9%

10%

11%

12%

13%

Rat

e %

NET QUARTERLY INTERVENTION EXPANSION REPO RATE

… Capital controls have not been used: There has not been “Impossible Trinity” problems

However there have been two episodes that may be characterized as managed floating periods:

2003-I Semester2004-II Semester – Present

III. 2003-I: Dealing with a sharp depreciation

• In 2002-I, inflation was declining, after two years of achieving the targets,• Output gap was negative and…• The Col peso had been appreciating since mid 2001

• In these circumstances, two external shocks hit the Colombian economy…• Risk premia increased in most countries in the region due to political

uncertainty in Brazil …

Embi+ (January 2002=100)

50

90

130

170

210

250

290

Feb-

02

Apr

-02

Jun-

02

Aug

-02

Oct

-02

Dec

-02

Feb-

03

Apr

-03

Jun-

03

Aug

-03

Oct

-03

Dec

-03

Colombia Brazil EMBI+ Adjusted for Argentina

• … Economic problems and foreign exchange restrictions in Venezuela caused a reduction in export revenues

Non-Traditional Exports to Venezuela (Last 12 Months)

400

800

1200

1600

2000

Dec

-01

Feb-

02

Apr

-02

Jun-

02

Aug

-02

Oct

-02

Dec

-02

Feb-

03

Apr

-03

Jun-

03

Aug

-03

Oct

-03

Dec

-03

Source: DANE

Mill of US$

-80%

-60%

-40%

-20%

0%

20%

40%

AnnualGrowh

ExportsGrowth Rate

• As a result, the Col peso depreciated by more than 30% between April 2002 and February 2003.

• The effect of this depreciation on the prices of imported and tradable goods was clear:

PPI*: inflation for imported goods and nominal annual

depreciation

-5

0

5

10

15

20

25

Mar

-01

May

-01

Jul-0

1

Sep-

01

Nov

-01

Jan-

02

Mar

-02

May

-02

Jul-0

2

Sep-

02

Nov

-02

Jan-

03

Mar

-03

May

-03

Jul-0

3

Sep-

03

Nov

-03

Jan-

04

Mar

-04

May

-04

Jul-0

4

Sep-

04

Nov

-04

Jan-

05

Mar

-05

-15

-10

-5

0

5

10

15

20

25

30

35

PPI Imported Goods Depreciation* PPI corresponds to Producer Price IndexSource: Central Bank

% %

CPI inflation for tradable goods and nominal annual depreciation

4

5

6

7

8

9

10

Jan-

02

Apr

-02

Jul-0

2

Oct

-02

Jan-

03

Apr

-03

Jul-0

3

Oct

-03

Jan-

04

Apr

-04

Jul-0

4

Oct

-04

Jan-

05

Apr

-05

-15

-10

-5

0

5

10

15

20

25

30

Tradable goods DepreciationSource: Central Bank, DANE

% %

• Although “pass through” is low in Colombia, the size of the depreciation threatened the achievement of the inflation targets

• Shocks to food prices by the end of 2002 increased such a risk

CPI Inflation, Core* Inflation and Inflation Targets

4.5

5.5

6.5

7.5

8.5

9.5

10.5

Jan-

00

Apr

-00

Jul-0

0

Oct

-00

Jan-

01

Apr

-01

Jul-0

1

Oct

-01

Jan-

02

Apr

-02

Jul-0

2

Oct

-02

Jan-

03

Apr

-03

Jul-0

3

Oct

-03

Jan-

04

Apr

-04

Jul-0

4

Oct

-04

Jan-

05

CPI Inflation Core* Inflation Inflation Targets* Core Inflation: refers to inf lation excluding foodstuffs

• Monetary authorities were aware that the shocks were transitory, but:

They were uncertain about the persistence of the external shocks,

Inflation expectations rose to levels deemed as inconsistent with the targets and inflation forecasts were also above the targets

(*) Calculated from the differential of rates of TES UVR and fixed-rates TES (for contracts of under two years)Source: Banco de la República.

Inflation Expectations Derived from Col. Treasury Bonds (TES)*

4

5

6

7

8

9

10

May

-02

Jul-0

2

Sep

-02

Nov

-02

Ene

-03

Mar

-03

May

-03

Jul-0

3

Sep

-03

Nov

-03

Ene

-04

Mar

-04

May

-04

Jul-0

4

Sep

-04

Nov

-04

Ene

-05

Mar

-05

%

Less than two years contracts

Inflation Expectations (Quarterly Survey)

5.50

6.00

6.50

7.00

7.50

8.00

8.50

9.00

Ene

-01

Mar

-01

May

-01

Jul-0

1

Sep

-01

Nov

-01

Ene

-02

Mar

-02

May

-02

Jul-0

2

Sep

-02

Nov

-02

Ene

-03

Mar

-03

May

-03

Jul-0

3

Sep

-03

Nov

-03

Ene

-04

Mar

-04

May

-04

Jul-0

4

Sep

-04

Observed Survey, Apr-01 Survey, Jan-02 Survey, Apr-02Survey,Oct-02 Survey,Dic-02 Survey, Apr-03 Survey, Oct-03

• Therefore, the CB policy response was particularly strong: CB REPO interest rates were raised by 200 bps between January and April 2003

• The idea was to send a clear signal about CB´s commitment to the inflation targets

• However,

The presence of a negative output gap and

The uncertainty about the connection between CB interest rates and the exchange rate…

Induced the CB to complement its monetary policy decisions with for-ex policy actions…

• … In February 2003 the CB announced that it was willing to sell up to US$ 1000 m through July, by means of auctions of call options

• The peso stopped depreciating in April and the CB sold US$ 345 m out of the maximum of US$ 1000 m that it had announced.

• The peso started to appreciate slowly in October and inflation ended the year above the range target, but with a clear declining trend

Lessons:

• The announcement and the intervention in the for-ex market were useful to complement the monetary policy decisions

• Exclusive reliance on interest rates to moderate the depreciation and inflation expectations would have probably implied larger increases in interest rates and inefficiently higher volatility of output.

• The intervention announcement was useful because it was credible. And it was credible because:

(i) It came with changes in the stance of monetary policy

(ii) It came after a substantial depreciation

(iii) It was not excessive, given the initial level of IR (US$ 11.100 m or 1.1 times external debt payments).

Nominal Exchange Rate (Index) (January 2003=100)

Jan-

03

Apr

-03

Jul-0

3

Oct

-03

Jan-

04

Apr

-04

Jul-0

4

Oct

-04

Jan-

05

Apr

-05

Source: Datastream

67727782879297102

COLOMBIA BRAZILCHILE ARGENTINA

IV. 2004-II - Present: Dealing with a sharp appreciation

• In 2003 the Col peso appreciated less than other Latin American currencies (due to the fall in exports to Venezuela)

• In 2004 the peso caught up

• Reasons behind the appreciation:

Low international interest rates and spreads (depreciation of the dollar) Higher portfolio and short term debt net inflows

Increasing FDI (higher oil and coal prices)

Capital account rose from 1% of GDP in 2003 to 3.5% of GDP in 2004

Higher world growth and growth of trade partners (especially Venezuela) Larger export volumes and prices (TOT).

• Although some of these factors have persisted in 2005 (e.g. high oil and coffeeprices), ….

• Others are more uncertain (capital flows)

• Others might not be permanent (TOT, oil export volumes?)

• Thus, part of the appreciation might not be permanent

At the same time, the IT analysis showed:

• A continuous reduction of core and tradable inflation throughout 2004

• Significant reductions of inflation expectations and record high credibility of the inflation targets

• A stabilization of non-tradable

inflation and, later, convergence to the inflation target….

• …Which is a signal of a slowly closing output gap

• Higher probability of inflation being below target at relevant horizons

Non Tradable CPI Core* Inflation

3.50

4.00

4.50

5.00

5.50

Jan-

03

Apr-

03

Jul-0

3

Oct

-03

Jan-

04

Apr-

04

Jul-0

4

Oct

-04

*Core Inflation refers to CPI without foodstuffs

Source: Banco de la República, DANE

Non Tradable CPI Core* Inflation

3.50

4.00

4.50

5.00

5.50

Jan-

03

Apr-

03

Jul-0

3

Oct

-03

Jan-

04

Apr-

04

Jul-0

4

Oct

-04

*Core Inflation refers to CPI without foodstuffs

Source: Banco de la República, DANE

Distribución de Probabilidades del Pronóstico de Inflación

2.0

3.0

4.0

5.0

6.0

7.0

8.0

I trim. 03 I trim. 04 I trim. 05 I trim. 06

(Porcentaje)

2.0

3.0

4.0

5.0

6.0

7.0

8.0

(Porcentaje)

• Thus, the IT analysis suggested that it was feasible to reach the inflation targets with a looser stance of monetary policy

• The CB decided to relax monetary policy by means of two coherent instruments:

Reduction in CB REPO expansion interest rates (25 bps in February and December) and closing of REPO contraction facilities (December)

Partially sterilized intervention in the for-ex market

• The use of the second instrument was justified on the grounds of the temporary nature of part of the appreciation The conclusions of IT allowed the use of foreign exchange to:

Restore IR level (after the sales of 2002 and 2003) Avoid large reductions of interest rates (curtailing output or inflation volatility) Protect tradable sector against a sharp, temporary appreciation (Hysteresis

hypothesis)…

Consistent with the achievement of inflation targets

• CB bought US$ 2.900 m in the for-ex market in 2004 (about 26% of the initial level of IR)

• US$ 1.577 m were purchased through the put-option system, mainly between January and August

• The remainder (US$ 1.323 m) was purchased through discretionary intervention, introduced in September of 2004

• Discretionary intervention was regarded as more effective than the put-option mechanism under the conditions of a sharp appreciation and expectations of a rapid appreciation

• The effectiveness of discretionary intervention increased since December 2004, when:

Monetary policy was relaxed (interest rates were reduced and the contraction REPO facilities were closed)

No announcement on the size or the horizon of intervention was made

• This is the prevailing intervention system

Lessons and challenges:

• For-ex intervention became more effective when accompanied by changes in monetary policy in the same direction.

• Intervention has limits and challenges:

If IT indicates the need to tighten monetary policy, intervention will have to be reduced or eliminated…

…Otherwise, the CB could incur in credibility and cuasi-fiscal costs. CB has publicly stated this possibility

With intervention, larger efforts are required to communicate policy and emphasize consistency

Too large an intervention may change the position of the CB from creditor to debtor of the financial system. This change is considered inconvenient for reasons of monetary control

V. Political Economy Issues

• The Government regards the RER as a key element in its security strategy

Could requests from the Government for a depreciated RER weaken the credibility of monetary policy?

• Domestic public bond market is relatively large (outstanding stock is 23% of GDP) and central Government deficits persist at 5%-6% of GDP.

Is it possible to have a conflict between the sterilization of intervention and the cost of Government financing? Could this conflict compromise CB credibility?

• Could CB losses resulting from excessive sterilized intervention weaken its position against the Government or Congress?

• Some sectors in Congress have requested the use of IR to reduce public external indebtedness. Do these actions hamper CB independence and credibility?

VI. Conclusions

• Since September of 1999 monetary policy in Colombia has converged to a full-fledged IT strategy with an “independent” floating regime.

• The performance of the strategy has been satisfactory overall. Starting from a deep recession, the policy stance has been expansionary. Inflation has declined along decreasing targets, output has recovered and international reserves have reached levels that limit the external vulnerability of the economy.

• Intervention in the for-ex market has been consistent with the stance of monetary policy. As a result, capital controls have not been used by the central bank since 1999.

• There have been two episodes of managed floating characterized by strong shifts in the exchange rate.

• They have taught us that intervention in the for-ex market could be a useful complement of monetary policy actions. I.e. that relying only on the interest rates to deal with shocks to the capital account of the balance of payments may lead to inefficient volatility in inflation or output.

• We have also learned that intervention without consistent movements in monetary policy has not been very effective to modify the trend of the exchange rate.

• The CB is aware of the possibility of conflicts between IT policy recommendations and intervention. It has publicly stated that these conflicts would imply the reduction or elimination of intervention because inflation continues to be the primary goal of CB policy.

• Fiscal imbalances may pose a threat to the credibility and power of monetary policy through several “political-economy” channels.