Latin America central banks: The search for stability
After decades of trying, have LatAm’s central bankers finally steadied the ship? Mexico's Agustin Carstens, one of the monetary policy stalwarts of the region, takes stock.
Agustin Carstens, general manager of the Bank for International Settlements
When the Bank for International Settlements looked to replace outgoing general manager Jaime Caruana – a Spaniard – at the end of 2017, it decided to break with almost 88 years of tradition by handing the role to somebody who wasn’t from either Europe or Canada, namely Mexican central bank chief Agustin Carstens.
For Carstens, his appointment reflects the growing importance of emerging economies to the global financial system, with the credibility of Latin American central banks in particular receiving more recognition as efforts to maintain financial stability after years of economic turmoil have allowed the region’s banking systems to flourish at last.
“Central banks in the region have been evolving and have been adhering to better practices and, in terms of traditional mandates of central banks, they have delivered quite well during the last couple of decades,” Carstens tells Euromoney from his BIS office in Basel, Switzerland. “There are obviously exceptions here and there, but by and large, especially in terms of controlling inflation, financial stability has improved dramatically with respect to what we had in the 1980s and parts of the 1990s.”
Those debt crises in the final decades of the 20th century in Latin America were typically accompanied by repeated bouts of hyperinflation. Even today, the region is home to the country with the highest inflation in the world – Venezuela – which, according to the IMF, saw consumer prices rise by more than one million percent last year.
But while Venezuela is obviously considered an outlier – most Latin American economies experience far lower levels of inflation now than in the past – Carstens says the persistent inflationary pressure faced by Latin American central banks still sets them apart from other emerging market regions. Compare it with emerging Asia, he says, where inflation tends to be one or two points below Latin America.
“To a large extent this is attributable to the fact that there is a lot of inertial inflation, which means that if there is an inflationary shock, this tends to persist longer than in other latitudes,” he says. “Also many, if not all, of the Latin American economies are quite commodity based. Mexico, for example, is less commodity based, but still for public finance oil is very important, as is the weight of food in the CPI. This means that inflation tends to be far more sensitive to commodity prices than in other regions, and that also makes the conduct of monetary policies more complicated.”
Another challenge Latin American central banks face – albeit one they share with policymakers in other emerging market regions – has been the transition in many countries to an open economy and the subsequent impact of capital flows on exchange rates.
“Sometimes there are massive capital inflows, which implies that there can be a wide appreciation in real and nominal terms in the exchange rate,” says Carstens. “In contrast, sudden stops in capital flows can pressure the exchange rate and generate other sorts of problems, in particular in the fight against inflation. So this has called for Latin American central banks to look at the broader range of policies, how to deal with capital flow volatility and take into consideration what are generally called macro prudential policies.”
For Carstens, the experience of a sudden reversal of capital flows has personal resonance given Mexico’s tequila crisis in 1994 when foreign investors, alarmed by domestic tensions and rising interest rates in the US, started pulling money out of the country. At the time, Carstens was the chief economist at Mexico’s central bank.
Mexico had dusted itself down from the bruising experience of the 1980s debt crisis by embarking on a series of structural reforms, including opening up its economy and privatizing the banks. But the country still maintained a fixed exchange rate regime, mainly as a way to manage inflation. As capital drained away and Mexico’s international reserves depleted, it was impossible to keep parity with the dollar in place, says Carstens. Mexico had no choice but to let the peso float.
“The conventional thinking at the time was that to have flexible exchange rate regimes in small open economies was crazy, it was not advisable,” he says. “Mexico was probably the first emerging market that proved that it could manage a flexible exchange rate regime if there were appropriate fiscal, monetary and financial policies. The crisis was solved adequately and established the basis for a more solid macro framework that Mexico has enjoyed since then.”
So what did they learn?
“There were many lessons learned – one was the flexibility of the exchange rate, the others included the importance of having a well-supervised and regulated financial market and banking system, to have very prudent external and internal debt management, and it was also very important to have the autonomy of the central bank during the recovery process.”
You have to work every day to preserve your macro strength, and I think Latin American countries should not forget that - Agustin Carstens
Those lessons have now been adopted widely across the region and this is one reason why Latin America’s financial markets are more robust than they were just a quarter of a century ago.
“Back then, the main problem was to have a more predictable and more stable macro financial environment in Latin America that would allow for longer duration issuance of bonds in the domestic markets,” says Carstens.
“I remember when I was in Mexico in 1994 at the time of our crisis, the average maturity of our internal debt was seven days – now the average maturity is more in the seven to eight years range. So you can imagine the difficulties we faced in developing a medium- to long-term capital market when the government couldn’t even place debt for more than seven days.
“This progress has also been matched in other Latin American countries, so macro discipline and macro stability is deeper ingrained.”
The big test for the region’s central banks came in 2008 as the subprime mortgage blow-out and the collapse of Lehman Brothers plunged the global financial system into crisis.
By that time Carstens had become Mexico’s finance minister, but the memories of the Tequila crisis were still fresh. While many G20 finance ministers were talking about expansionary fiscal policies, Carstens was thinking the opposite: that Mexico needed to embark on a big fiscal contraction to avoid running up a large fiscal deficit and potentially scaring away investors.
“The signal of fiscal sustainability was very important so as not to induce capital outflows, in particular given that our main trading partner, the US economy, was in crisis,” he says. “I remember at the time having hearings in congress where representatives would tell me that the IMF, which traditionally calls for fiscal discipline, was saying that then it was time to spend.
“They basically were complaining that I was advocating for a tougher stance than the one the IMF was calling for. At the end of the day, it worked out well, but it was difficult to pull it off at the time.”
The guiding hand of past crises that informed Carstens’ thinking was also shared by central bankers across Latin America as they successfully responded to the fallout from the global financial crisis.
“At the time, many of these countries were either still in the recovery process or it had not been so long since they were in recovery,” he says. “Therefore, the lessons they learned from their own crises were still very ingrained in the minds of many of the policymakers.”
In January 2010, as the crisis was still resonating in many parts of the world, Carstens became governor of Banco de Mexico, or Banxico, the country’s central bank. It was an era of unprecedented global monetary stimulus and rock bottom interest rates that inflated asset prices and saw a deluge of money pouring into emerging market economies, particularly in Mexico.
“I remember very markedly during the first years after the global financial crisis, around 2010 to 2014, we were experiencing substantial capital inflows and Banco de Mexico’s board decided to have a more aggressive policy towards accumulating international reserves,” he says. “That in a way was a form of macro prudential policy, first under the anticipation that at some point the very low levels of global interest rates would be reversed, and in those circumstances we might need some of the accumulated foreign exchange to stabilize our currency market.”
For Carstens, a reversal of the expansionary monetary policies of the last decade by central banks in the developed world is one of the biggest risks Latin America’s central bankers face today.
“For the last 10 years or so Latin American economies in general have faced a relatively benign external environment from the point of view of having plenty of international liquidity,” he says. “Obviously the main central banks like the Fed, the European Central Bank, the Bank of Japan, they’re being very mindful of the spill-over effects of their actions and they have been exercising considerable forward guidance; but that doesn’t take away the fact that the higher rates in the main advanced economies might pose some pressures on some emerging economies. This requires Latin American economies to be particularly mindful about the need to have their houses in order to try to mitigate any vulnerabilities and therefore be in a position to face tighter financial conditions ahead.”
China, too, may also become an issue for those Latin American economies that depend on that country’s demand for commodities to help prop up prices.
“[Latin American] countries should feel good that so far the shock-absorbing capacity of their economies has been important, but more shocks might come in the future, and also in some cases there have been some slippages in policy conduct,” Carstens says. “You have to work every day to preserve your macro strength, and I think Latin American countries should not forget that.”