Comfort in Floating: Taking Stock of Twenty Years of Freely-Floating Exchange Rate in Chile

WP/20/100 Comfort in Floating: Taking Stock of Twenty Years of Freely-Floating Exchange Rate in Chile by Elías Albagli, Mauricio Calani, Metodij Hadzi-Vaskov, Mario Marcel and Luca Antonio Ricci IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. 2 © 2020 International Monetary Fund WP/20/100IMF Working Paper Western Hemisphere Department Comfort in Floating: Taking Stock of Twenty Years of Freely-Floating Exchange Rate in Chile1 Prepared by Elías Albagli, Mauricio Calani, Metodij Hadzi-Vaskov, Mario Marcel and Luca Antonio Ricci Authorized for distribution by Luca Antonio Ricci June 2020 Abstract Chile offers an example of a country that has overcome the fear of floating by reducing balance sheet mismatches, enhancing financial market development, as well as improving monetary, fiscal, and political institutions, and strengthening policy credibility. Under the floating regime, Chile’s economic adjustment to external shocks appears significantly improved, and its exchange rate pass-through has substantially declined. Our results reinforce the case that moving to a clear and credible floating regime can be associated with a reduction in the fear of floating via economic transformation (like smaller balance sheet mismatches, a larger hedging market, and a lower exchange rate pass-through). JEL Classification Numbers: E31, E52, F31, F33, F41, G15 Keywords: exchange rate regime, FX derivatives, hedging, exchange rate pass-through, policy credibility, central bank independence Authors’ E-Mail Addresses: MHadziVaskov@imf.org, LRicci@imf.org, MMarcel@bcentral.cl, EAlbagli@bcentral.cl, MCalani@bcentral.cl 1 We benefitted from useful comments by Guillermo Calvo, Alejandro Werner, Patricia Alonso-Gamo, Martin Cerisola and the participants at the XXIII Annual Conference of the Central Bank of Chile “Independence, Credibility, and Communication of Central Banking” and the WHD seminar at the International Monetary Fund. We thank Ivan Burgara, Isidora Lara, Emilio Guamán, and Sebastián Ramírez for excellent research assistance. We also thank Marcela Arriagada and Dagoberto Quevedo for their help in web-scrapping data, and “Comisión para el Mercado Financiero” for kindly giving us access to historic records on non-financial corporations under their supervision. The views expressed in this paper and those of the authors and do not necessarily represent the opinion of the Board of the Central Bank of Chile, or the views of the IMF, its Executive Board, or IMF Management. All errors are our own. IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. 3 Contents Abstract ___________________________________________________________________2 I. Introduction and Literature Review ____________________________________________4 II. The transition towards fearless floating: key elements ____________________________8 A. Evolution of currency exposure and the role of derivatives ______________________8 B. Evolution of the exchange rate pass-through over time ________________________21 III. Macroeconomic Adjustment: a tale of two crises _______________________________27 A. Key findings from the crisis episodes: Chile (1997–98 vs. 2008) ________________28 B. Comparing Chile with key EMEs over the two crisis episodes ___________________32 C. Financial adjustment under free floating: a less appreciated tradeoff? _____________37 IV. Conclusion ____________________________________________________________41 Figures 1. IMF exchange rate regime classification _______________________________________5 2. Evolution of balance sheet net currency exposure in supervised firms _______________10 3. Balance sheet net currency exposure in domestically and trade-oriented firms _________11 4. Cumulative reduction of initial FX exposure ___________________________________12 5. Evolution of credit supply by institutional investors _____________________________14 6. Main participants in Chile’s derivatives market _________________________________16 7. Derivatives use among groups of supervised firms ______________________________17 8. Simulated ERPT under alternative inflation expectations regimes __________________22 9. Institutions and credibility _________________________________________________23 10. ERPT rolling coefficient estimates for headline and core CPI _____________________24 11. ERPT from VAR regressions (block-bootstrap) ________________________________26 12. Chile’s macroeconomic performanc