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Exchange Rate Policy and Disinflation: the Spanish Experience in the ERM

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Exchange Rate Policy and Disinflation: the Spanish Experience in the ERM Exchange Rate Policy and Disinflation: The Spanish Experience in the ERM Philippe Bacchetta 1. INTRODUCTION PAIN is certainly one of the Western European countries that has experienced the most dramatic changes in the past 20 years. In addition to a political shift from dictatorship to democracy in the mid-1970s, the economic structure has been deeply reformed. These changes, including the process of European integration, have been generally beneficial to the nation. However, they have also posed important policy challenges. This has been particularly the case for monetary policy. The Spanish central bank, the Banco de Espan˜a, has been concerned with two major objectives associated with European monetary integration. The first and most important goal is nominal convergence, i.e. a reduction of inflation to reach German standards. The second objective is exchange rate stabilisation with respect to other currencies in the European Union (EU). The challenge has been to reconcile these aims with a rapidly changing economy affected in particular by trade, financial and capital account liberalisations. A specific problem has been the presence of significant capital inflows in the late 1980s. These inflows were caused by two main factors: first, the various reforms and especially EU membership in 1986; second, a tight monetary policy with high interest rates. Overall, the monetary policy challenge has been met only with mixed results. A strategy of exchange rate stabilisation was followed between 1987 and 1992, including membership in the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS) after June 1989. This strategy appeared successful in the PHILIPPE BACCHETTA is from Studienzentrum Gerzensee, Switzerland, the Institut d’Ana´lisi Econo`mica (CSIC), Barcelona and CEPR, London. This paper was presented at the CEPR Conference on Convertibility and Exchange Rate Policy in Transition Economies in Sofia. The author is grateful to Jorge Braga de Macedo, Pawel Durjasz, other conference participants and two referees for useful comments. ß Blackwell Publishers Ltd 1997, 108 Cowley Road, Oxford OX4 1JF, UK and 350 Main Street, Malden, MA 02148, USA. 221 222 PHILIPPE BACCHETTA early 1990s, as the inflation and interest differentials with Germany were declining, the credibility of the exchange rate target was increasing and international reserves were at a record high. The EMS crisis in 1992–93 and other turbulences in foreign exchange markets modified dramatically this situation, as the peseta was subsequently formally devalued four times and has depreciated by more than 30 per cent with respect to the DM between 1992 and 1995. Moreover, the inflation differential with Germany in the mid-1990s was similar to the one in 1987. The collapse of the exchange rate target has probably been influenced by the EMS crisis. However, fundamental domestic disequilibria, reflected in a strongly overvalued peseta, made the exchange rate policy clearly unsustainable. This paper examines the factors that have led to this situation and examines the macroeconomic policies implemented in democratic Spain. In the next section, a brief overview of the main developments in the Spanish economy over the last two decades is presented. Section 3 reviews the evolution of Spanish monetary and exchange rate policy during this period, with an emphasis on the stable exchange rate episode. Section 4 evaluates the policies implemented and attempts to draw lessons from the Spanish experience. It is argued that a superior policy would have been to join the ERM in 1987. Section 5 provides concluding remarks. 2. BASIC FACTS1 A period of more than 35 years of dictatorship was concluded by Franco’s death in 1975 and was followed by full democracy in 1977 with democratic elections. The Socialist Party remained in power from 1982 to 1996, with absolute parliamentary majority until 1993. One of its main policy objectives has consistently been European integration and Spain adhered to the European Community (EC) in 1986, jointly with Portugal. The actual integration with other EU countries has been progressive. For example, trade liberalisation was phased out from 1986 to 1992. This liberalisation was accompanied by a substantial increase in trade, especially with EU countries. The capital account liberalisation was also completed by 1992.2 While foreign direct investment as well as some types of capital inflows were basically free in 1986, the other categories of capital flows had to be liberalised to satisfy the EC Directive on the liberalisation of capital movements (88/361/EEC). Hence, Spanish portfolio investment abroad and various short-term capital flows were 1 Most of the description given below can be found in more detail in Vin˜als et al. (1990) and Vin˜als (1992). 2 See Bacchetta (1992b) for a discussion of this liberalisation process. ß Blackwell Publishers Ltd 1997 SPANISH EXCHANGE RATE POLICY AND DISINFLATION 223 liberalised from 1986 to 1992. At the same time, however, temporary controls on short-term inflows were introduced as a response to large capital inflows. Section 3 examines these measures in more detail. The increase in cross-border flows has been substantial in this period. In the 1980–86 period, capital inflows and outflows represented on average two per cent and 0.7 per cent of GDP, respectively. In 1992–93, they represented 10.3 and 11.1 per cent. In the 1987–91 period, capital inflows were much larger than outflows (6.3 and 1.6 per cent of GDP, respectively). This was reflected by a current account deficit. From a balanced position in 1987, the current account presented an average deficit of 3.5 per cent of GDP in the 1989–92 period. Finally, it is worth mentioning that a large proportion of the increase in capital inflows has taken the form of short- term capital, first with private securities and then, in the early 1990s, with government debt. The domestic financial sector has also experienced a serious liberalisation process. Until the early 1980s, most financial transactions were going through the banking system, which itself was strongly regulated. In addition to reserve and investment requirements, most interest rates were administered. The liberalisation implemented in Spain was in line with the various regulations and new directives of the EU. The numerous regulatory changes allowed the development of several financial markets, including the stock market and the market for public debt. Deep changes also affected the public sector.3 On the one hand, state interventionism was reduced compared to Franco’s era; on the other hand, the government budget expanded rapidly. For example, public expenditure has grown from less than 25 per cent of GDP in 1975 to about 50 per cent in 1994. Public debt has also increased dramatically from 12 per cent of GDP in 1975 to more than 60 per cent in 1994. This debt increase was particularly strong in the early years of democracy, but was stabilised in 1987 only to increase again in the early 1990s. In fact, fiscal policy became more restrictive in the period 1987–89 as the government deficit went down to about three per cent of GDP, compared to a maximum of seven per cent in 1985. While the government’s objective was to eliminate the deficit by 1992, it actually increased compared to the late 1980s (4.5 per cent of GDP in 1992 and 7.5 per cent in 1993). In other words, fiscal policy became more expansionary in the early 1990s. In terms of overall economic performance, the Spanish economy has not been outstanding under democracy and no catching up with richer European countries can be observed. From 1975 to 1994, the Spanish GDP per capita grew slower than the EU average. To assess the actual convergence process is, however, made difficult by the fact that the Spanish business cycle is more pronounced than in other countries (see Dolado, Sebastia´n and Valle´s, 1993). Growth in the late 1980s was much stronger than in the EU, while the recession in the early 1990s 3 See Bacchetta (1994b) for an analysis of public sector reform after 1975. ß Blackwell Publishers Ltd 1997 224 PHILIPPE BACCHETTA was more severe. Consequently, there is convergence in expansions and divergence in recessions. Another preoccupying aspect of the Spanish economy is its unemployment.4 Since 1979, the Spanish unemployment rate has consistently been the highest in the EU (to reach 24 per cent in 1994). The difference with other countries has been steadily growing. On the other hand, the inflation differential has been reduced over the two decades. After the first oil shock, inflation increased substantially (reaching 25 per cent in 1977) to progressively decline thereafter. In the 1980s, however, it remained at double-digit levels until 1987, where a restrictive monetary policy was implemented. Between 1987 and 1993, the inflation rate fluctuated around an average of six per cent, which was significantly higher than the average ERM countries. A similar pattern is observed with nominal wages. 3. MONETARY POLICY, EXCHANGE RATE POLICY AND CAPITAL INFLOWS The most interesting period of Spanish exchange rate policy was probably the one between June 1989 and September 1992, where the peseta remained in a stable ERM. This section provides a description of the main aspects of monetary and exchange rate policy by examining three periods: (i) before June 1989, (ii) June 1989–September 1992, and (iii) after September 1992.5 a. The Pre-ERM Period In the mid-1980s, the Banco de Espan˜a progressively decreased the attention given to monetary aggregates and started to stabilise short-term interest rates (similar to other OECD countries). At the same time, due to increased economic integration, the exchange rate was acquiring more weight in the determination of monetary policy.6 From 1986 to 1989, the value of the peseta with respect to other ERM countries was actually maintained in a 6 per cent band similar to the one adopted in June 1989.
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