Itaú BBA - Estimating sustainable exchange rates in Latin America

Macro Vision

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Estimating sustainable exchange rates in Latin America

noviembre 28, 2016

We have estimated the exchange rates consistent with sustainable current account deficits in the long term for Latin America

For the main countries in Latin America, we have estimated equilibrium exchange rates, by which we mean the exchange rate levels that are consistent with sustainable current account deficits in the long term. 

For each country, we used the average of the last 20 years as our assumption for a sustainable current account deficit. By this metric, the Brazilian real and the Peruvian sol throughout November 2016 are close to their respective sustainable levels. On the other hand, the Colombian, Chilean and Argentine pesos are stronger than their respective equilibrium levels. And finally, the Mexican peso seems substantially depreciated. 

A given country’s exchange rate is driven by the amount of resources available to finance its current account deficit. A decline (increase) in the availability of external funding (due to changes in the international or domestic scenario) demands a decline (increase) in the current account deficit. Hence, the exchange rate weakens (strengthens), so as to produce a current account balance that is consistent with the new external financing conditions.

We define the equilibrium exchange rate as the level that generates a current account deficit that is compatible with a sustainable volume of external financing in the long run (i.e., it does not generate excessive external liabilities or insufficient external savings). Importantly, as most of the countries in Latin America are historically net importers of capital, we do not regard a strict equilibrium in the current account (i.e., the need to generate future surpluses to amortize net external liabilities) as a relevant criterion for assessing exchange rate levels.

Methodology

In order to determine the equilibrium exchange rates for different countries across the region, we started by estimating the annual current account balance as a function of the real exchange rate, terms of trade and economic activity levels.[1],[2] 

The weaker the exchange rate, the larger the current account balance. The same is true for the terms of trade: the higher the ratio between export and import prices, the larger the current account balance. On the other hand, the more heated the economy, the larger the demand for imported goods and services and, thus, the smaller the current account balance.

The charts below compare actual and forecasted current account balances for each country. Except for Mexico, the explanatory power of regressions (measured by the adjusted R2 for each estimated equation) is high – i.e., these variables do capture a significant part of the current account dynamics.

Using the estimated coefficients generated by Equation 1, below, we obtained Equation 2, which shows the exchange rate as a function of the current account deficit, the terms of trade and the level of economic activity.

 (1)


 

 (2)

For a given level of the terms of trade, we say that the exchange rate is in equilibrium when the current account deficit and the economy are in equilibrium as well (i.e., when the current account deficit is consistent with sustainable external financing and the economy is neither operating with excess capacity nor overheated).

Determining the equilibrium exchange rate

One challenge in our approach to determining the equilibrium exchange rate is how to define the sustainable current account deficit. For the sake of simplicity, we assume that the equilibrium exchange rate is the one that drives the current account deficit to its average level over the last 20 years (a sufficiently long period to include both recession and growth phases and both highs and lows for the terms of trade). The results of this approach for each country are given in the table below.

Importantly, the equilibrium exchange rate for each country was based on the current level of the terms of trade. In the event of a positive (negative) shock in the terms of trade, the equilibrium exchange rate will be stronger (weaker).

Under this methodology, the Brazilian real and the Peruvian sol throughout November 2016 are close to their respective sustainable levels. On the other hand, the Colombian, Chilean and Argentine pesos are stronger than their respective equilibrium levels. And finally, the Mexican peso appears substantially depreciated.

The results for the Mexican peso (significantly undervalued) and the Colombian peso (overvalued) are consistent with the other methodologies for calculating equilibrium exchange rates that we have presented in past publications[3] . The Mexican peso has been penalized by the uncertainty surrounding economic policy in the United States. As the risk of protectionism recedes, we expect the currency to appreciate. In Colombia, the current account deficit is still very large (5.8% of GDP for the four quarters ended in 2Q16) and is considered an important vulnerability of the economy.

As for the Argentine and Chilean pesos, we note that the average current account deficits of the past 20 years may not be good indicators of sustainable levels in the long run, given present conditions and recent ruptures in historical patterns.

In fact, during much of the previous decade Argentina had low access to the international capital markets and experienced capital flight from residents. Given the market-friendly policies of the current administration, the country is already recovering access to external financing. For Argentina to be able to sustain current account deficits of around 2% of GDP (the average deficit level for the other five countries over the last 20 years), the exchange rate would be 13.75 pesos per U.S. dollar (with prices of October 2016). In a nutshell, if the historical pattern is any guidance, the Argentine peso is currently overvalued. But, if Argentina’s rupture with past policies is sustained, there is room for a further exchange rate strengthening.

Chile increased its savings substantially during the commodities boom, largely due to a counter-cyclical fiscal framework (in 2006, the central government’s nominal surplus reached 7.1% of GDP, and the domestic savings rate reached 35%). With the decline in copper prices in recent years, savings are now much lower. Over the longer period of the past 30 years, the average current account balance was -1.6% of GDP, which is consistent with the deficit generated by the current level of the Chilean peso.

Thus, we believe that Chile will deal with larger current account deficits than in the past 20 years. As for Argentina, the sustainable exchange rate seems closely related to whether the next administrations will continue with the current set of market-friendly economic policies.
 

Julia Gottlieb
João Pedro Bumachar

 



[1] We used the following as economic activity variables: in Brazil, capacity utilization (NUCI, published by FGV); in Colombia and Chile, the unemployment rate; and in Mexico, Peru and Argentina, the internal demand gap (calculated with an HP filter).
[2] For Argentina, the terms of trade are not significant in the estimated regression.
[3] Please refer to (Itaú Macro Vision: Assessing the undervaluation of the Mexican Peso - September 27, 2016) and (Itaú Macro Vision: COLOMBIA - How much depreciation is necessary for a faster current-account deficit adjustment?  - August 24, 2016)


 

 



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