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The Road to Monetary Union in Latin America: an EMS-Type Fixed Exchange Rate System As an Intermediate Step

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The Road to Monetary Union in Latin America: an EMS-Type Fixed Exchange Rate System As an Intermediate Step A Service of Leibniz-Informationszentrum econstor Wirtschaft Leibniz Information Centre Make Your Publications Visible. zbw for Economics Garcia Rocabado, Daniel Working Paper The road to monetary union in Latin America: An EMS-type fixed exchange rate system as an intermediate step W.E.P. - Würzburg Economic Papers, No. 85 Provided in Cooperation with: University of Würzburg, Chair for Monetary Policy and International Economics Suggested Citation: Garcia Rocabado, Daniel (2010) : The road to monetary union in Latin America: An EMS-type fixed exchange rate system as an intermediate step, W.E.P. - Würzburg Economic Papers, No. 85, University of Würzburg, Department of Economics, Würzburg This Version is available at: http://hdl.handle.net/10419/48560 Standard-Nutzungsbedingungen: Terms of use: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Documents in EconStor may be saved and copied for your Zwecken und zum Privatgebrauch gespeichert und kopiert werden. personal and scholarly purposes. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle You are not to copy documents for public or commercial Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich purposes, to exhibit the documents publicly, to make them machen, vertreiben oder anderweitig nutzen. publicly available on the internet, or to distribute or otherwise use the documents in public. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, If the documents have been made available under an Open gelten abweichend von diesen Nutzungsbedingungen die in der dort Content Licence (especially Creative Commons Licences), you genannten Lizenz gewährten Nutzungsrechte. may exercise further usage rights as specified in the indicated licence. www.econstor.eu W. E. P. Würzburg Economic Papers No. 85 The Road to Monetary Union in Latin America: An EMS-type fixed exchange rate system as an intermediate step Daniel Garcia Rocabado (a) (a) University of Würzburg, Department of Economics October 2010 Universität Würzburg Wirtschaftswissenschaftliche Fakultät Lehrstuhl VWL 1 Sanderring 2, D-97070 Würzburg [email protected] Postal Address Daniel Garcia Rocabado University of Würzburg, Department of Economics Sanderring 2, 97070 Würzburg, Germany Phone: +49/931/31-83702 Email: [email protected] II The Road to Monetary Union in Latin America: An EMS-type fixed exchange rate system as an intermediate step Daniel Garcia Rocabado ∗∗∗ October 2010 Abstract In the light of new political initiatives in Latin America, discussions of expanding the monetary cooperation in the region have intensified and the idea of monetary union is gaining popularity. Since literature on the subject widely dismisses the feasibility of Latin America adopting a single currency in the short- to medium-term, several authors have proposed to follow the European example by establishing a regional exchange rate system, similar to the European Monetary System (EMS), as an intermediate step. While these proposals usually describe the general benefits of an EMS-type system for Latin America, they rarely discuss how such a regional arrangement can institutionally be designed or what the main lessons are, that can be derived from the EMS experience, in order for a Latin American exchange rate system to be successful. Thus, it is the central aim of this paper to address these specific issues by providing a detailed look at the design and functioning of regional fixed rate systems as an intermediate step towards monetary union. For this purpose, first, an overview of the current Latin American initiatives in the field of monetary integration is given, followed by a general analysis of fixed rate systems from an institutional perspective. This analysis presents the basic design choices available to policymakers when creating such a system and describes how the decided upon rules (i.e. the institutional framework) determine the overall monetary adjustment constraints for the participating countries. Further, the paper examines the historic, political and economic rationale as well as the overall institutional design and functioning of a specific fixed rate system, namely the EMS. It is shown that the EMS did not only constitute an efficient monetary arrangement by effectively reducing both nominal and real exchange rate variability in the region, but can also be considered a successful intermediate step towards monetary union in Europe. The paper ends with a discussion of the main lessons drawn from the EMS analysis and their implications for the Latin American prospects of possibly establishing a similar regional exchange rate mechanism. Keywords : Latin American Integration, Monetary Cooperation, fixed exchange rates, European Monetary System JEL-classification: F31, F33, F55 ∗ The author thanks Peter Bofinger for his continuous guidance and encouragement. An earlier version of this paper was first presented as a final diploma thesis in economics at the University of Würzburg in June, 2010. Daniel Garcia Rocabado: University of Würzburg, Department of Economics, Chair of Money and International Affairs, Sanderring 2, 97070 Würzburg, Germany Email: [email protected], Phone: +49/931/31-83702 III TABLE OF CONTENTS List of tables and figures ..................................................................................................... VI 1 Introduction ................................................................................................................. 1 2 Developments in Latin American Integration .......................................................... 2 2.1 Monetary Integration in Latin America.................................................................. 2 2.2 Plans of Monetary Unification and Alternatives .................................................... 8 3 Fixed Exchange Rate Systems: An Institutional Analysis ..................................... 12 3.1 Overview............................................................................................................... 12 3.2 General Aspects and Policy Coordination............................................................ 13 3.3 Basic Institutional Features................................................................................... 14 3.3.1 Intervention Rules ......................................................................................... 15 3.3.1.1 Exchange Rate Standard......................................................................... 16 3.3.1.2 Central Parities....................................................................................... 18 3.3.1.3 Width of the Fluctuation Band............................................................... 19 3.3.1.4 Intervention Points ................................................................................. 20 3.3.1.5 Intramarginal Interventions.................................................................... 22 3.3.2 Intervention Financing Mechanism............................................................... 23 3.3.2.1 Credit Facilities ...................................................................................... 24 3.3.2.2 Asset Settlement Rules........................................................................... 26 3.3.3 Reserve Rules ................................................................................................ 28 3.3.4 Central Rate Adjustment Mechanism............................................................ 29 3.3.5 Short Typology of Different Configuration Alternatives.............................. 33 3.4 Size of Member Countries .................................................................................... 38 3.5 Overall Adjustment Constraints of the Fixed Exchange Rate System ................. 40 4 The European Monetary System ............................................................................. 41 4.1 Overview............................................................................................................... 41 4.2 Short Historic Background to the European Monetary System............................ 42 4.3 Reasons for the European Monetary System........................................................ 46 4.3.1 Political Reasons ........................................................................................... 47 4.3.2 Economic Reasons......................................................................................... 48 4.3.2.1 Interest in External Stability................................................................... 48 4.3.2.2 Interest in Internal Stability.................................................................... 50 IV 4.4 The Features and Mechanisms of the European Monetary System...................... 52 4.4.1 The European Currency Unit and the Central Parities .................................. 52 4.4.2 The Intervention Rules and the Exchange Rate Mechanism......................... 53 4.4.2.1 The Divergence Indicator....................................................................... 54 4.4.2.2 The Parity Grid of Exchange Rates........................................................ 55 4.4.3 The Financing Mechanism ............................................................................ 57 4.4.3.1 The Credit Facilities............................................................................... 57 4.4.3.2 Settlement Rules....................................................................................
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