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October 31, 2011
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December 1, 1970
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Declassified and Approved For Release 2011/10/31 : CIA-RDP85T00875R001600030172-8 r/0- /-// DIRECTORATE OF INTELLIGENCE Intelligence Memorandum Brazil, Chile, And Colombia: Experience With "Crawling Peg" Exchange Rates DOCUMENT SERVICES BACII FILE COPY d0 NOT DESTROY Confidential ER IM 70-171 December 1970 Copy No. 54 0 Declassified and Approved For Release 2011/10/31 : CIA-RDP85T00875R001600030172-8 Declassified and Approved For Release 2011/10/31 : CIA-RDP85T00875R001600030172-8 WARNING This docwnenit contains information affecting the (iationnl defense of the United States, within tl(o mcar-ing of Title 18, sections 793 and 791, of the US Code, as amended, Its transmission or revelation of its contents to or rc- eeipt by no unnnthorized person is prohibited by law, OIQUP 1 Declassified and Approved For Release 2011/10/31: CIA-RDP85T00875R001600030172-8 Declassified and Approved For Release 2011/10/31 : CIA-RDP85T00875R001600030172-8 CONFIDENTIAL CENTRAL INTELLIGENCE AGENCY Directorate of Intelligence December 1970 INTELLIGENCE MEMORANDUM Brazil Chile And Colombia: Experience With "Crawling Peg xc range Rates Introduction Brazil, Chile, and Colombia have been con- fronted in recent decades with recurrent balance- of-payments strains caused partly by currency over- valuation. This overvaluation arose because they were slow to adjust exchange rates for rapid in- flation. Inflation has continued in recent yes:s, but in order to live better with it these countries have adopted "crawling peg" adjustments, which consist of small devaluations every few weeks.* This memorandum describes tl:e new procedure and assesses its impact -- in part through comparisons with Argentina, Peru, and Uruguay, which retained more conventional adjustment procedures. Between ad,juotmente, crawling peg rates (or smoothly moving parities) are held at fixed levclc by government intervention in the exchange market. Crawling peg rates are distinct from "floating" rates, which are allowed to move more or less freely in response to supply and demand conditional with, at most, only tacit government support. Outside of South America, only South Korea has a crawling peg system. The fluctuating exchange parities currently in use in Canada and used temporarily in the Philip- pines and West Germany in recent years are proparly classified as floating rates. Note: This memorandum was produced solely by CIA. It was prepared by the Office of Economic Resecreh and wa/i coordinated with the Office of Current Intelltitgence. CONFIDENTIAL Declassified and Approved For Release 2011/10/31 : CIA-RDP85T00875R001600030172-8 Declassified and Approved For Release 2011/10/31 : CIA-RDP85T00875R001600030172-8 CONIC IDENTIAL The Problem of Currency Overvaluation 1. Exchange rate adjustment has been important in most South American countries because of rapid (in some instances, raging) inflation. Brazil, Chile, and Colombia have experienced the problem in varying de- grees, with average annual cost-of-living increases since 1958 of 45%, 26%, and 11%, respectively (see Figure 1). Their inflation primarily reflects large government deficits financed partly with r riure, central bank credit, COST-OP-LIVING INDEXES WLLJ. ` JJrvuynti Rest-ices monetary expansion. in Brazil and Chile, toeo-l1) 4000,1 _ . 1. ! _! ' /1 1 as businessmen and organized labor sought 4511. 30001 Oraril - -- ; 1 1 / ! I to maintain their real countries have repeat- uuLy initiated finan- cial stabilization pro- grams to control infla- tion and have had some '0001- ' ! f I success in recent years. .oo I So far, however, politi- moo - ; / % veloped countries im- doo portant to their trade. 2. The countries' rapid inflation called for prompt, substantial currency devaluations,, but they were delayed because of expected ad- verse p\1itical reper- cussions and the added inflationary impact. CONI''IU')ENTIAL Declassified and Approved For Release 2011/10/31 : CIA-RDP85T00875R001600030172-8 Declassified and Approved For Release 2011/10/31 : CIA-RDP85T00875R001600030172-8 CONFID, i N'i AL, ror example, from 195G until it adopted the crawling peg in 1962, Chile did not adjust the exchange rate despite a 90% cost-of-livi'ltg rise. During 1959-66, while the cost of living increased about 140%, Colombia made only four major adjustments, permitting its currency to be overvalued for extended periods. In the decade before adopting crawling pegs, Brazil devalued an average of once a year, but rampant inflation nevertheless caused substantial currency overvaluation between adjustments. 3. Currency overvaluation caused severe balance- of-payments strains by deforming trade balances and provoking capital flight. Reduced profitability of foreign sales rand inability to sell some goods) at established exchange rates restricted export ex- pansion; at the same time, import demand was greatly stimulated by making some foreign products relatively cheap. As foreign payments strains mounted, growing prospects of a large devaluation or import and ex- change controls usually prompted speculative flights of capital. Instead of devaluing frequently, the countries drew down reserves, imposed import and exchange controls, and (in some instances) subsidized major exports. 4. Currency overvaluation thus distorted re- source allocation and slowed economic growth. Ex- port diversification was discouraged (especially into manufacturing), leaving Brazil and Colombia dependent on coffee for 40%-60% of exports and Chile on copper for 65% of exports when they adopted crawling pegs. Actual or threatened exchange controls, particularly over profit and capital repatriation, at times deterred private foreign investment. Slackening exports and capital inflows and weakened foreign reserves limited import capacity and economic growth. Introduction of Crawling Peg Adjustments 5. The three countries introduced crawling peg exchange rate adjustme;,lts over a six-year period. Chile initiated them in October 1962, when the Alessandri govern nt's initially successful stabili- zation program was giving way to accelerating in- flation and when trade and exchange controls imposed the preceding January were proving ineffective. In Colombia, the'newly elected Lleras government adopted CONFIDENTIAL, Declassified and Approved For Release 2011/10/31 : CIA-RDP85T00875R001600030172-8 Declassified and Approved For Release 2011/10/31 : CIA-RDP85T00875R001600030172-8 CONFIDENTIAL the crawling peg system in March 1967, along with trade and exchange controls and sweeping financial stabilization measures. Brazil's military regime introduced the now provedure in August V.,,681 when -- after four years' stabilization efforts -- further slowing of inflation seemed problematic. 6. At the time, the three countries were losing substantial foreign reserves because of trade deficits and (in Brazil and Chile) capital flight in antici- pation of large devaluations. Brazil and Chile de- valued moderately at the outset and th(ea', sought to maintain suitable exchange rates through crawling peg adjustmPnts. Brazil devalued by 12% immediately, and Chile spiaad an initial 32% reduction over tytree months, devaluing by 18% the first month. Colombia, on the other hand, used trade and exchange controls to ease immediate paymerts difficulties and aimed at improving the exchange rate gradually, through crawling peg adjustments that would outweigh con- tinuing inflation. Bimonthly adjustments made within six months devalued Colombia's currency by 12%. For Chile and Colombia, these initial devalua- tions were grossly inadequate, compensating for only 40%-50% of inflation since the preceding devaluation. For Brazil, however, the initial adjustment accOuhted fully for the interim price increase and gave the cruzeiro a reasonable value. 7. Under the crawli"g peg system, the three countries' central banks which control nearly all foreign exchange) have fixed new buying and selling rates every few weeks.* The banks support these rates at exactly the level announced. The timing and extent of rate adjustments do not follow rigid patternn -- an apparently deliberate feature that the banks hope will minimize speculation. Changes in foreign reserves and domestic prices have been the general criteria for adjustments, but little The ci: a .Zing peg proaadure applies primarily t genercil exchange rates for trade, but the countries' other rates have b:ren adjusted commen- burately. When crawling pegs were adopted, Chile had rates for trade and capital transactions; Colombia, rates for general trade, capital (since abolished), and cc'f f e; and Brasil;, rates for coffee and all other transactions. 4 - CONFIDENTIAL Declassified and Approved For Release 2011/10/31 : CIA-RDP85T00875R001600030172-8 Declassified and Approved For Release 2011/10/31 : CIA-RDP85T00875R001600030172-8 CONI.'Ii)ENTI.'IAL, is known of how the banks data minod their precise extent and timing. The International Monetary Fund (IMF) approved crawling pegs as part of standby credit agreements with the eour,ttries, but it apparently has not tried to enforce strict rules regarding adjustments. 8. Although crawling pegs generally promised to boost export earnings, Brazil and Colombia necessarily were concerned about stimulating coffee output through increased proceeds (in domestic cur- rency) for growers. Since the countries were already fulfilling their export quotas under the International Coffee Agreement (ICA) and increased output would simply boost stocks, they limited the rise in pr'- ducer profits by raising support prices lass than devaluation raised coffee export proceeds. This step also helped to moderate inflation by limiting coffee growers' incomes and swelling government revenues, which include nearly all profits on cof- fee exports. Impact of the Crawling Peg Procedure Movement of Real Exchange Rates 9. Since adopting crawling peg adjustments, all three countries have held their real exchange rates* below earlier levels (see Figure 2). Chile has had both the most extended experience and the greatest success in maintaining the initial devalua- tion. By the end of 1963, Chile reduced its real exchange rate for general trade by 33%. In October 1963, however, following sharply rising world copper prices, it adopted a special rate for copper exports that was permitted to rise through 1964 to limit copper company profits, in terms of escudos. Chile also permitted the general rate to rise during 1964-65 but abolished the copper rate at the end of 1966 and by December 1969 had reduced the reunified rate almost to its earlier low.** 10. Both Brazil and Colombia have lost ground in holding down real exchange rates. Dy the second Defined as the nominal rates adjusted for inflation. ** Since August 1970, Chile has not made any crawling peg adjustments despite continuing rapid inflation. The Allende government, in- augurated in early November, has eeverely criti- cized the crawling peg system and indicated that it will be abando;-ed. CONFIDENTIAL Declassified and Approved For Release 2011/10/31 : CIA-RDP85T00875R001600030172-8 Declassified and Approved For Release 2011/10/31 : CIA-RDP85T00875R001600030172-8 INDEXES OF REAL EXCHANGE RATES* Chile 000- \ (nnnrnll Trndo Rate CONFIDENTIAL 91 Mar 21 Auo Brazil colomlvle I I ~ ~ I 1 , 11 , III, IV I , II, Ill, IV I , it III , Iy loge 11063 1oe4 foes foes 1oe7 loge logo 'Obtained by dividing Indexer of the currencies' external value (expressed In US $ ) by indexes of their Internal value (oxprosr ad no reciprocals of cost-of-living Indexes). A declining Index of real exchange rates Indlcntes develuntlon that more than offr,eti price Increases -generally n favorable development for the b ilanco of pnymonts. half of 19611, Brazil's rate was only 2%-3% below the earlier level. Colombia made good progress for 2 years but suffered a partial setback in 1969. Crawling peg adjustments nevertheless gave both countries more favorable Teal exchange rates than under the old procedure, under which inflation commonly offset devaluation within six months. 11. The recent movements of real exchange rates in Brazil and Colombia do not differ greatly from those experienced in Argentina, Peru, and Uruguay under more conventional procedures. In 1967 the lat- ter three countries sought to ease balance-of-payments strains by means of large devaluations and harsh anti-inflation programs. Nominally, Argentina devalued by 29% in March 1967, Peru by 31% in September 1967, and Uruguay by 50% in November 1967 and 20% in April 1968. The real devaluations of Argentina and Uruguay were considerably smaller, however, because the countries raised export taxes to capture much of the gain in exporters' profits. Peru accomplished somewhat the same result by advancing the payment schedule for corporate income - 6 - CONFIDENTIAL Declassified and Approved For Release 2011/10/31 : CIA-RDP85T00875R001600030172-8 Declassified and Approved For Release 2011/10/31 : CIA-RDP85T00875R001600030172-8 CONFIDENTIAL taxes. The return of real exchange rates to the pro-devaluation level was slowed by the three countries' considerable progress its checking inflation and, in Argentina and Uruguay, by gradual cuts in export tax rates. By the end of 1969, Argentina's and Uruguay's real exchange rates (like Brazil's) were back near where they started, since nearly all of the initial improvement in their ex- change rates had been offset by domestic price rises. Peru's real rate remained about 10% below its pre- devaluation level, however. Effects on Trade and Capital Flows 12. After Brazil, Chile, and Colombia adopted crawling pegs, growth of export earnings accelerated, capital inflows rose, and speculative capital flight generally stopped. Crawling pegs contributed to these gains but played a large part only in Brazil and Colombia. 13. Brazil's export earring from items other than coffee -- the expected bei.eficiaries of im- proved exchange rates -- rose from about $950 mil- lion (57% of exports) in 1967 to $1.4 billion (61% of exports) in 1969 (see Figure 3) and are doing well in 1970. The gain averaged 22% annually, compared with 6% during 1959-67, and was by far the largest two-year rise during the 1960s. It was paced by cotton, beef products, and cocoa, with manufactured goods remaining a very small share of sales. Apart from a reduced real exchange rate, export expansion was aided by favorable crop condi- tions, generally strong markets for coffee and other farm products, and increased government export promotion. Import growth moderated in 1969, con- tributing to the emergence of a small trade surplus. Brazil's receipts of short-term private capital accelerated further after crawling pegs were intro- duced. Growing strength in the balance of payr_,:nts boosted Brazil's foreign reserves from $200 million to $600 million during 1969 and probably was a major factor in allowing the real exchange rate to rise. 14. In Colombia, exchange rate adjustments and trade promotion have contributed to substantially increased exports of items other than coffee and petroleum. These sales -- led by cotton, textiles, CONFIDENTIAL Declassified and Approved For Release 2011/10/31 : CIA-RDP85T00875R001600030172-8 Declassified and Approved For Release 2011/10/31 : CIA-RDP85T00875R001600030172-8 CONFIDEN'J.'IAL, ides ia'as toes 1C 4 1O idea tda,- io'an loan provIslonal CONFIDENTIAL Declassified and Approved For Release 2011/10/31 : CIA-RDP85T00875R001600030172-8 Declassified and Approved For Release 2011/10/31 : CIA-RDP85T00875R001600030172-8 CONF.IDEN':CIAL and paper -- rose from $110 million (22% of exports) in 1966 to more than $205 million (34% of e::ports) in 1969. The average annual gain for these exports was 23%, compared with 13% during 1959-66. Total exports, however, have increased only moderately since 1966, because ICA quotas restricted the growth of coffee exports and declining reserves prevented expanded earnings from oil. Crawling peg adju'it- ments have been insufficient to permit import re- strictions to be removed, and export expansion has merely reduced the trade deficit somewhat from the substantial 1966 level. At the same time, the new system has strengthened business confidence and helped to attract more private capital, which -- with increased foreign aid -- has raised foreign reserves gradually. 15. Chile's initial devaluation and subsequent exchange rate adjustments were too small either to snake non-traditional exports very profitable or to permit import controls to be abolished, despite soaring copper export revenues. Exports other than copper rose only from about $165 million in 1962 to abcut $235 million in 1969. Dramatically increased world prices, however, pushed copper exports from about $325 million in 1962 to about $950 million in 1969, when they made up 80% of the total. The crawl- ing peg system, along with tight exchange controls, generally eliminated capital flight, although it revived in presidential election years. The marked improvement in foreign reserves since the mid-1960s, however, reflects mainly increased foreign aid, large US-financed copper investment, and continuing moderate trade surpluses generated by booming copper exports. 16. Argentina, Peru, and Uruguay, using con- ventional procedures, also have improved their payments positions since 15;66, but export gains have been far less striking than in Brazil, Chile, and Colombia. There was little or no growth in Peruvian exports in either 1967 or 1969, and part of Argentine and Uruguayan gains represented a recovery to earlier levels. In Argentina, trade surpluses have been shrinking, and the speculative capital movements associated with its traditional devaluation practices have continued to be a problem. Its foreign reserves rose greatly after the 1967 - 9 - CONFIDENTIAL Declassified and Approved For Release 2011/10/31 : CIA-RDP85T00875R001600030172-8 Declassified and Approved For Release 2011/10/31 : CIA-RDP85T00875R001600030172-8 CONFIDENTIAL devaluation becau;te of short-term capital inflows, increased a little in 1968, and then fell sharply in 1969 as capital flight recurred in anticipation of devaluation. Peru's trade balance improved sharply in 1968-69, largely, because imports dropped. Foreign reserves, however, registered little gain because of continuing capital flight and reduced inflows of foreign aid and long-thrm private capital, both attributable to expropriation of the US-owned international Petroleum Company properties and other government measures dampening the investment climate. Uruguay's foreign reserves rose moderately in 1S67- 69, following the devaluation, partly because sub- stantial capital flight gave way to small capital inflows. Crawling Pegs and Fiscal Irresponsibility 17. Some observers believe that a cxawling peg system may encourage fiscal irresponsibility by reducing the adverse balance-of-payments effects of inflation. Without the discipline of fixed exchange rates, they argue, governments are freer to incur budget deficits and let private credit expand unrestrainedly. Experiences in South America, though brief in Brazil and Colombia, provide little support for this fear. Colombia's average infla- tion rate amounted to only 8% during 1967-69, compared with 11/% in 1959-66. Since adopting crawling pegs, Brazil has reduced its average inflation rate to less than 25%, compared with 50% in 1959-67. Although Chile's average inflation rate of 31% since 1962 exceeds that during 1959-62, it is an improvement over the preceding decade. 16,. It is true, nevertheless, that Argentina, Peru, and Uruguay, using conventional adjustment procedures, made strikingly greater progress toward curbing inflation. Though their inflation rates rose or remained high under the initial impact of devaluations, they were cut decisively in the following years. Argentina did especially well, paring the rate from 32% annually in 1959-66 to only 7% in 19.69. The inflation rate dropped in Peru from 9% annually in 1959-66 to 6% in 1969 and in Uruguay from 42% annually in 1959-67 to 14% in 1969. Progress in this area probably depends mainly on the government's character and strength rather than on specific :evaluation practices. CONFIDENTIAL Declassified and Approved For Release 2011/10/31 : CIA-RDP85T00875R001600030172-8 Declassified and Approved For Release 2011/10/31 : CIA-RDP85T00875R001600030172-8 CONFIDENTJAL Conclusions 19. Chile, Colombia, and Brazil all benefited from adopting crawling peg exchange rate adjust- ments. But the benefits of the change (which occur- rod in 1962 in Chile, 1967 in Colombia, and 1960 in Brazil) varied widely. The proc.idure helped con- siderably in expanding exports other than coffee in Brazil and other than coffee and petroleum in Colombia. Chile's spectacular rise in export earn- ings, however, mainly refle^ted, high copper prices. Growth of non-traditional exports in Chile and (to some extent) Colombia was handicapped by inadequate devaluation when crawling pegs were introduced. Speculative capital flight was avoided by Brazil and Colombia and was eliminated by Chile in most years. Crawling peg adjustments contributed to a dramatic rise in short-term private capital inflows in Brazil and increased inflows of long-term private funds in Colombia but were outweighed in Chile by rising copper prices and by other government measures effecting foreign investors. 20. Use of crawling pegs does not seem to have encouraged fiscal irresponsibility, as some observers have feared. Both Brazil ant' Colombia reduced their average annual inflation rates, compared with earlier years, and Chile's rate (though higher than the average for the preceding four years) remained below the average for the previous decade. Nevertheless, Argentina, Peru, and Uruguay -- which retained con- ventional exchange rate procedures -- made strikingly better progress in checking inflation than did countries using crawling pegs. 21. Although South America's brief experience with crawling pegs is encouraging, experience in Argentina, Peru, and Uruguay suggests that occasional major devaluations combined with periodic changes in export taxes and import tariffs can achieve some success. Speculative capital movements, however, remain a problem under this procedure. Although these often can be minimized by devaluing before it is generally considered necessary, such an approach is unusually troublesome politically and probably cannot be indefinitely successful. The more con- ventional approach probably works best where the government has the will and power to pursue a strong - 11 - CONFIDENTIAL Declassified and Approved For Release 2011/10/31 : CIA-RDP85T00875R001600030172-8 Declassified and Approved For Release 2011/10/31 : CIA-RDP85T00875R001600030172-8 CON] 1i)EN't"fAL financial stabilization program. Crawling peg adjustments, on the other hand, seem an alternative worth consideration, most of all whore, for political and social reasons, the inflation rate in likely to remain high. 22. The experience of the throe countries using crawling pc is not particularly rolovont to developed countries. Developed countries are in a better position to control inflation and are under greater international pressure to do no rather than accommodate the exchange system to it. Adoption of crawling pegs has been discussed as one of several possible reforms of the international financial system. But the method usually proposed calls for automatic parity changes in accordance with an agreed sot of rules, not occasional changes determined independently by national governments. - 12 - CONFIDENTIAL Declassified and Approved For Release 2011/10/31 : CIA-RDP85T00875R001600030172-8