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

_IMF Blog, May 25, 2017_

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## Bibliographic details
- Authors: Yan Carrire-Swallow, Nicols Magud, Juan Ypez
- Published: May 25, 2017

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### Overview and context
- 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.

### Adjusting to external shocks: theory and practice
- 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.

### Recent Latin American experience and key findings
- 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.

### Policy implications and recommendations
- 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.*

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## References

- [Chapter 3](http://www.imf.org/en/Publications/REO/WH/Issues/2017/05/10/wreo0517)
- [https://www.imf.org/wp-content/uploads/2017/05/ENG_May_23_WHD_REO_1.jpg](https://www.imf.org/wp-content/uploads/2017/05/ENG_May_23_WHD_REO_1.jpg)
- [study](http://www.imf.org/en/Publications/WP/Issues/2017/02/13/Terms-of-Trade-Cycles-and-External-Adjustment-44655)
- [https://www.imf.org/wp-content/uploads/2017/05/ENG_May_23_WHD_REO_2-1.jpg](https://www.imf.org/wp-content/uploads/2017/05/ENG_May_23_WHD_REO_2-1.jpg)

_Source: https://www.imf.org/en/blogs/articles/2017/05/25/how-flexible-exchange-rates-helped-latin-america-adjust-to-commodity-price-shocks_