How Flexible Exchange Rates Helped Latin America Adjust to Commodity Price Shocks

IMF Blog, May 25, 2017

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Canonical URL: How Flexible Exchange Rates Helped Latin America Adjust to Commodity Price Shocks

Authors: Yan Carrière-Swallow, Nicolás Magud, Juan Yépez; May 25, 2017.
Event: World prices for Latin America’s key exports—oil, metal, and agricultural products—fell from their super-cycle peak in 2011 while demand from trading partners weakened.
Impact on export revenues:
- Across most of South America, export revenues have fallen by one-third.
- In the case of Venezuela, export revenues have fallen by more than half.
Some shocks rank among the largest trade price busts faced by emerging economies around the world since 1960.
Many Latin American countries maintained flexible exchange rate regimes and allowed substantial depreciations; given the size of the shock, the currencies of Brazil, Chile, Colombia, and Mexico lost about half their value against the US dollar.

Adjustment channels described:
- Income effects: reduced purchasing power abroad leads to lower domestic demand and lower imports.
- Expenditure-switching effects: relative price movements shift consumption from foreign to domestic goods and make exports cheaper in dollar terms, potentially boosting exports and supporting domestic output.
Empirical regularity from Adler, Magud, and Werner (terms-of-trade busts in 150 emerging economies since 1960):
- Income effects tend to dominate: countries decrease imports and domestic demand sharply after such shocks.
- Boost from increased exports and domestic output typically plays a secondary role.

Sacrifice ratio of external adjustment:
- For economies with flexible exchange rate regimes, the sacrifice ratio after the recent shock has been about half the ratio observed in countries with managed exchange rates.
- Fixed exchange rates have become costlier—requiring more domestic demand compression to deliver the same adjustment—partly because currencies that remained stronger lost competitiveness versus trading partners.
Evidence of expenditure switching in flexible exchange rate countries:
- Non-commodity exports have responded positively to real depreciation following the terms-of-trade shock.
- Magnitudes: a 10 percent real depreciation increases real exports by only 2 percent in one year, while it lowers real imports by close to 7 percent.

Exchange rate flexibility has paid off by making adjustment to commodity price shocks less painful, mainly via import substitution rather than export growth.
Structural policy support:
- Exchange rate flexibility can support structural policies aimed at shifting resources to non-commodity sectors.
- Depreciations boost exports of manufactures more than for other goods, so supporting a dynamic manufacturing sector would help spur diversification and raise the region’s growth potential.

Source: How Flexible Exchange Rates Helped Latin America Adjust to Commodity Price Shocks, IMF blog, May 25, 2017.