POLICY RESEARCH WORKING PAPER   I3188
Exchange-Rate-Based                                                INchangeratbased
stabilization programs
Stabilization in Argentina                                       - a- suppoJed asustained
and   Chile                                                         8<al ljusment generally
and Chile                                      ^reduced londterrn infladon.
Success was not easy,
A Fresh Look                                                     -          beSuSrgid
adherence to the exchange
rate rule many times resulted
Miguel A. Kiguel                                                 . . in strong overvaluation of the
Nisn Lvitdatn.:
s   Lurrency and balance-of-
payment problems before
-stablizaton was finally
secured.
The World Bank
Office. of thie Vice President
Development Economics
July~~~~~~~~~~~~~~~~~~~~~~~~: 1994' ,- -X    - 



POLIcy RESEARCH WORKING PAPER 1318
Summary findings
Exchange-rate-based stabilization is designed to reduce  in 1979, it was already enjoying a budget surplus.
inflation by using the exchange rate as the main nominal    Argenina in 1991 was running a small dcficit - smallcr
anchor. This does not necessarily mean a fixed exchange    than in previous years, but a deficit.
rate. A crawling peg with a low rate of depreciation or a  Perhaps a better explanation is the government's
pre-announced gradual reduction in the ratc of          perceived strong commitment to the fixed exchange rate
dcvaluation are alternativc ways to use the exchange ratc    and the potential large costs of rcncging on it. The
as a nominal anchor.                                    convertibility law made devaluation far more difficult
Exchange-rate-based stabilization (ERBS) has been     (requiring congressional approval) and reduced the
widely used in the high-inflation  wtonomies of Latin   chances of discretionary devaluations. And the
America. Argentina, Chile, and Uruguay adopted a pre-   govcrnmcnt tied its own hands further by legalizing the
announced crawling peg in the late 1970s (the famous    use of the dollar as unit of account and means of
tablitas) to bring down inflation, with mixed results. Israel    exchange. The costs of abandoning the fixed exchange
and Mexico used the exchange rate as a nominal anchor,  rate were also perceived to be greater in Argentina.
and inflation cmnc down significandy. More recently,    Devaluation was (and is) perceived as opening the door
Argentina relied on a fixed and convertible exchange ratc  for rcnewed hyperinflation, a dreadful scenario. Chile
(the convcrtibility plan) to bring to an end four decades of    did not face this tihreat so it was more difficult - and
inflation. So far, the outcomes have been good.         took longer - to convince the public that the
Kiguel and Liviatan find that ER£SS havc generally    govemment was determined to maintain the parity.
been more effective than money-bised programs in          Governmcnts tend to stick to the fixed exchange rate
bringing down inflation in the high inflation ecopwnmies.    longer than is prudent. It is now apparent that some
But when inflation was reduced gradually, the process   flexibility at an earlier stage would havc reduced the
resulted in continuous (sometimes significant) real     costs of the final failure of the tablicas. Why do
appreciation. Even fixing the exchange rate in Chile in  govcrnments find it so difficult to make exchange-rate
1979 did not reduce thc underlying rate of inflation.   policy more flexible? Why do they wait for a balance of
Argentina's recent convertibility plan has been more  payments crisis rather than anticipate it? Perhaps because
successful in bringing inflation down significantly than  they fear the public will equate flexibility with failure
previous money-based programs (from monthly rates of    and a loss of credibility.
about 10 percent to just 1.5 percent in a few months). One  Kiguel and Liviatan found, however - in the
could argue that this is a special case, since Argentina was  experiences of Israel and Mexico - that inflation does
coming from fuIll-blown hyperinflation, so Kiguel and   not necessarily go up when the exchange rate is made
Liviatan compared the fixed-exchange-race periods in    more flzxiblc. Countries must balance the necd to
Argentina and Chile, and came up with useful insights.  maintain an exchange rate rule (for credibility) with the
Argentina's greater success cannot be explained only   need to keep external balance.
by fiscal arguments. When Chile fixed its exchange rate
This paper - a product of the Office of the Vice President, Development Economics -was prepared for the seminar on
central banking organized by the International Monetary Fund and the Monetary and Exchange Affairs Department. Copies
of this paper are availablc free frosai the World Bank, 1818 H Street NW, Washington, DC 20433. Please contactMilagros
Divino, room S9-049, exrension 33739 (26 pages). July 1994.
The Polcy Research Working Paper Sries dissemiates the findwgs of ucrk in pogress to enourage the exchange of idea about
deuelopment isses. An objective of the series is to get the findrgs    quickly, even if theprentations are kss than fully polisbed The
papers anrry the names of the arhbonsad sbould be usd and citedaccordingly. The fmdings, hiterprerats. and eosions are the
a*rbo' ouw and should not be attrikaedto the World Bank its Executve Board of Directorsm or any of its mawber countr
Produced by the Policy Research Dissemination Center



ExchanIge Rate Based Stabilization in
Argentia and Chile: A Fresh Look
Miguel A. Kiguel
The World Bank
and
Nissan Liviatan
The World Bank and
Hebrew University of Jerusalem
This paper was prepared for the seminar on Central Banking organized by
the IMF Institute and the Monetary and Exchange affairs Department. The
views expressed in this paper -t. not necessarily reflect those of the World
Bank or its affiliated institutions. We are grateful to Fernando Fuentes for
research assistance.



z. Usincr the Exchancre Rate to Ficrht High Inflation
An exchange rate based stabilization is one designed to reduce
inflation by using the exchange rate as the main nominal anchor. This does
not mean necessarily a fixed exchange rate. A crawling peg with a low rate
of depreciation or a preannounced gradual reduction in the rate of
devaluation are alternative ways of using the exchange rate as a nominal
anchor.
Exchange rate based stabilizations (RBES) have been widely used in the
high inflation economies of Latin America.' Argentina, Chile and Uruguay
adopted a pre-announced crawling peg in the late seventies (the famous
tablitas) to bring down inflation with mixed results. Likewise, Mexico and
Israel used the exchange rate as a nominal anchor, but in these two episodes
inflation came down significantly. More recently, Argentina relied on a
fixed and convertible exchange rate (the convertibility plan), to bring to an
end four decades of inflation. The outcomes, so far, have been good.
There are a number of reasons that make the exchange rate an appealing
nominal anchor for disinflation in the high inflation economies. First, the
fixed exchange rate played an important role historically as a way to
mainitain price stability. Throughout the period of the gold standard the
fixed exchange rate was seen as the cornerstone to avoid inflation. Second,
the fixed exchange rate is generally recognized as one of the critical
components in those programs that stopped the hyperinflations in Europe after
World War I, making it a good candidate for dealing with high inflation as
well. Third, the exchange rate, being itself a price to which the prices of
IHigh inflation economies are those with average annual rates of
inflation between 601k and 2,0001; per year, for at least five years. They are
in betweenL moderate and hyperinflation.



2
tradeable goods are linked, was seen as having a more direct effect than
money as an anchor for inflation. Fourth, as a nominal target, the exchange
rate is a more transparent nominal anchor than money. The public can readily
monitor the evolution of the exchange rate as it is widely and frequently
quoted. In contrast, information on money supply is not readily available
and the public can not monitor it as well. In addition, a change in the
exchange rate means a change in prices (at least of tradeable goods), while
changes in the money supply are generally more difficult to interpret (as
they might reflect seasonal patterns, changes in money demand, etc.).
Besides, there is a common perception that money is not an effective
anchor to reduce high inflation.3 While there are many cases where monetary
targets have been successful in reducing inflation from moderate to low
levels (e.g. the U.S. and U.K. in the early eighties) or in blocking
hyperinflation (e.g. Chile and Argentina in the mid-seventies, and Peru in
early 1990s), there are no examples of countries that have succeeded in
reducing inflation from high to low levels relying on t:ight money. Most high
inflation countries that started stabilization programs using tight money
quickly abandoned them as they either became too costly (in terms of output
and unemployment) or they were ineffective in significantly reducing
inflation.
-Despite the attractiveness of using the exchange rate for disinflation,
theory and practice both show that fixing the exchange rate is not generally
sufficient. This is clear in an economy with tradeable and non-tradeable
2 Bruno (1990) and Fischer (1986) prcvida a more extensive discussion
of the reasons underlying the choice of the exchange rate as a nominal
anchor.
3 Bruno (L993):makes this point in evaluating the stabilization
experiences in Eastern Europe.



3
good., because the exchange rate can only anchor a subset of prices. In
addition, fixing the exchange rate is not enough to change expectationu, as
agents realize that if the program is not supported by changes in the policy
fundamentals succoes will at best be temporary. For these reasons, fiscal
support for the exchange rate based stabilization is essential. Monetary
policy is not an effective instrument in this type of programs, because it is
endogenous with capital mobility.
This paper will take a new look the Argentine and Chilean Tablitas and
compare the results to the more recent convertibility plan in Argentina.'
The objective is to illustrate three points: first, exchange rate based
stabilization programs are generally more effective in the high inflation
economies than those based on money, as they reduced inflation faster without
negative effects in the early stages on output and unemiployment. -In fact, in
these three episodes the authorities shifted to exchange rate bused
stabilizations after some disappointment with money based programs that
achieved limited results on the inflation front and were costly in terms of
output and unemployment. Despite their relatively larger success, exchange
rate based stabilizations rarely,stop high inflation in its tracks.
A second objective is to show that a sound fiscal balance is a
necessary, but not sufficient condition to bring down inflation in ERBS
programs. Programs that failed to put in place the needed fiscal adjustment
(such as the Argentine tablita) clearly failed. But the Chilean program of
the late 1970s also encountered big difficulties in bringing down inLflation
in spite of significant fiscal adjustment, suggesting that non-fiscal factors
(such as the choice of the exchange rate rule itself) also matter for
' The first two episodes have been thoroughly analyzed in the existing
literature. see for example Foxley (1993), Ramos (1996), Barletta, Blejer
and Landau (1983), etc.



4
diginflation. For example, a reduction in the rate of depreciation in is too
rapid relative to inflationary expectations would lead to a significant real
appreciation and the stabilization effort would quickly become unsustainable
because of external problems.
The third, and related point is that ERBS need to overcome two types of
credibility problems: one relates to the sustainability of the fiscal
balance, an issue that is commonly mentioned in analytical and policy
oriented papers. The other, less understood credibility problem relates to
the ability of the authorities to adhere to the announced exchange rate rule
itself. For example, the authorities might have to abandon the policy if
they face adverse external shocks and severe balance of payments problems, or
if the public does not believe that the authorities are not willing to
maintain the program if it leads to unemployment and a significant loss of
external competitiveness.
The rest of the paper will be organized as follows. Section II
describes the monetarist phase preceding the tablitas in Argentina and Chile.
It shows that tight money was useful to block incipient hyperinflations and
improve the balance of payments, but that it was less effective in stopping
high inflation. Section III takes one more look at the tablitas in these two
countries, and discusses alternative explanations for the sluggish response
of inflation and the resulting real appreciation. Based on these episodes it
provides a more positive evaluation of the usefulness of ERRS than earlier
assessments. Section IV presents the stabilization efforts of Argentina in
the 1990s, which started with a money based stabilization and ended with the
convertibility plan. We conclude in section V with a summary of the
findings.



5
II. Tight Money to Deal With Near Hvoerinflationa
The tablitas in Argentina and Chile were preceded by monuy based
stabilization programs. In this section we highlight two contrasting
features of these programs: first, the auccess of orthodox money based
stabilization programs in bringing down inflation from the heights of a
hyperinflation outburst to high levels; second, their inability to bring down
inflation from high to moderate or low levels.
i. The Chilean E=aeriWent
The Chilean Stabilization of 1974-75, following the overthrow of the
Allende regime, is one of the few episodes in which a government applied a
fairly persistent monetary crunch in the face of accelerating inflation
(exceeding 400 percent per year).  The program was a comprehensive effort
that also attempted to correct large external imbalances, raise public sector
prices to historical levels and establish a market economy following a period
of marked government intervention. The stabilization package included a
drastic cut in the budget deficit -- from 30V of GDP in 1973 to St in 1974
and 2% in 1975-- large adjustments in public sector prices and a maxi-
devaluation (see Table 1).
The results of the fiscal-monetary phase in Chile (where the exchange
rate policy was basically to maintain purchasing power parity) were quite
disappointing regarding inflation. During this phase, which lasted from
September 1973 to June 1976, the danger of hyperinflation was averted.
However, inflation which exceeded 500% per year in 1973 did nct fall below
200% till the end of this period. This sluggish reduction in inflation was



Table 1: CHILE
Indicator               1971   1972   1973   1974   1975  1971  1977   1978  1979   1980  1981  1982  1983
Percentages
GDP growth rate          9.0   -1.2   -5.8    1.0  -12.9   3.5   9.9    8.2   8.3    7.8   5.5  -14.1  -0.7
Unemployment ()          5.7    3.7    4.8    9.2   16.8  19.4  18.6   17.9  17.7   17.4  15.6  28.2  24.5
Inflation rate a/       20.0   74.9  361.5  504.7  374.7  211.8  91.9  40.1  33.4   35.1  19.7   9.9  27.3
M2 growth rate          85.1  101.3  255.4  322.3  328.1  477.7    NA    NA    NA   62.1  47.9  25.7  27.8
Nominal devaiu ()                     455.0  549.5  490.3  185.8  84.9  47.0  17.7    4.7   0.0  30.5  54.9
M2/GDP                  17.3   18.9   13.7    7.2    5.0   12.8    NA    NA   17.3   20.1  25.1  32.4  32.9
Public sector
surpluslGNP (')      -10.7  -13.0  -24.7  -10.5   -2.6  -2.3  -1.8   -0.8   1.7    3.1   1.7  -2.3  -3.8
Current Account
surpluslGDP           -1.9   -3.9   -2.7   -2.6   -6.8   1.5  -4.1   -7.1  -5.7   -7.1  -14.5  -9.5  -5.1
Indexes
Real wage Inde ()      119.3  108.2   80 c   64.8   62.1   63.0  71.1   75.7  82.0   89.4  97.5  97.1  88.8
Real effective
exchange rat ()       91.9   98.4  107.2   93.5  100.2   87.1  84.4   97.7  87.4   75.1  67.4  78.9  83.5
Terms of trade (h)      80.6   75.5   84.7  58.3   55.4   59.3  54.1   48.6  54.7   51.6  44.6  39.8  40.7
a/ Based on CPI
bl Exchange rate variations deflacted by the difference between extemal and intemal WPI.
c/ January - August.
Sources:
IFS, World Bank and () Ramos (1986)



6
accompanied by a dramatic rise in unemployment (f rom 4.6% in 1973 to 16.8t in
1975) and negative growth, including a fall in GDP of 12.9% in 1975.
Theme disappointing results generated intense debates as to whether
money warn indeed tight in this otherwise orthodox program. Harberger (1381L)
questicon whether it is possible to talk about tight money when nominal money
supply continues to grow at high rates (exceeding 300% per year). In our
view, however, the relevant question is not if money is expanding rapidly in
nominal tens, but whether monetary growth is contractionary relative to the
underlying rate of inflation. in othier words, the key issue is whether
monetary growth accommodated or fought inflation.
The data on the ratio of M2 to GNP can throw some light on this
question. Table 1 shows that this ratio fell dramatically, froM 14% of GDP
in 1973 to St of GDP in 1975. This constitutes indirect evidence of a
monetary crunch. In addition. Corbo and Soliumano (1991) found more direct
evidence of the existence of tight money during the period. They estimate a
money demand function for Chile and show that during this period there was
indeed an excess demand for money.
Thus, there can be little doubt that monetary policy was highly non-
accommodative from the start relative to the sluggish inflation. This is
also the evaluationx of Foxley (1983), who attributes the recession whichL
developed in 1974 towards the beginning of 1975 to the foregoing monetary
crunch (Focey, op. cit., p. 53), and of Edwards and Edwards, Jgp-g4it, pp.
31-33).
In spite of the monetary crunch and the reductionL in the budget
deficit, inflation stabilized in 1974 at around 45%t per quarter which is an
indication of considerable rigidity. The continued rigidity of inflation in
1975 is often attributed to the consequences of the sharp fall in the price



7
of copper in the end of 1.974 which induced large devaluations in the
beginning of 1975. But the devaluations were supported by a significant
fiscal adjustment (a reduction in the primary fiscal balance of around 30
percent of GDP). This unusually large fiscal adjustment indicates that in
principle there warn no reason for the dev&Iuations to slow down the reduction
of inflationA~
Li. Argentina 1976-78
Argentina had a brief experience with money based stabilization in the
mid-seventies, following the overthrow of the Peronist government. This was
the first phase of what was going to became a longer term stabilization
effort under economic minister Martinez de Hoz. The monetarist-fiscal stage
lasted for approximately two years, starting in April 1976.
As in Chile, the stabilization program was initiated by an
authoritarian military regime and stabilization was part of a broader
objective of reducing government intervention in the economy. in addition to
restoring price stability and improving the balance of payments, the policies
were intended to undo much of the damage on efficiency introduced during the
Peronist regime with intervention in the financial markets, trade and other
areas of the economy.
The stabilization program started on a strong foot and was aimed at
controlling a near hyperinflation in the country. The major fiscal imbalance
was addressed early on as the government reduced the budget deficit from
around 15% of GDP in 1975 to St of GDP by 1977, a cut that was mainly
The results of this case stand out in sharp contrast with the
Bolivian orthodox program that stopped hyperinflation. where in spite of the
severe external shock during the stabilization (a collapse in tin prices),
control over inflation was reestablished very rapidly.



effected through lower government expenditurem (which fell from 42% of GDP in
1975 to 33% in 1977). This was accompanied by a tightening in monetary
policy as measured by the contraction in monetary aggregate. as a share of
(OP. T'2 fill from 15% of GOP in 1975, to 11% in 1976, while domestic credit
to the privats seotor fell from 12% to at during the same period.
The fiscal-monetary stage of the M4artinez de Rom policies was quite
successful in reducing the rate of inflationL early on from 500% to around
175% (annual) with a relatively ~mnall cost in tenms of loss in GDP growth and
unemployment (see Table 3). This looks much more favorable than the Chilean
experience, which put in place a more severe fiacal adjuitment and similarly
corrective price increases for public sector prices to undo the effect. of
price controls. The more succesuful outcome in Argentina is in part
attributable to a better use of the nominal anchors C including wage controls)
applied during the early stage, chat succeeded in reducing real wage. from
the unsustainable high levels of the end of the Peronist period, a less
distorted economy at the outset, and to a more favorable external
environment.
The Argentine experience suggests that fiscal-money based programs can
be effective in arresting a near hyperinflation. On the other hand, the
success was limited in the sense that inflation camne down only to around 175%
per year, and remained entrenched at those levels. This is certainly much
less than the authorities hoped at the time they launched the program. So
why did we observe only partial success?
one possible interpretation is that the authorities were not strong
enough in pursuing orthodox policies. while the deficit was reduced from the
unsustainable levels of the Peronist period, the reduction fell short from
what was needed to restore price stability. Budget deficits indeed persisted



Table 2: ARGENTINA
IlndIcator                    1971    1972    1973    1974    1975    1 978    1977    1978    1979    198            1981a    1962    1963
Percentages
GDP growth rate                 3.5     2.1      3.7      5.4    -0.6    -0.0       6.4    -32        7.0      1-5     4.7      -5.0     29
Unemployment rate ()           6.0      6.6      5.3      3.4      2.6     4.5      2.8      2.8      2.0      2.3      4-5     4.8      4.0
Inflaton rate a/              34.5    56.4    62.3    23.2   182.0   444.2   176.0   175.5   159.5   100.8   104.5   164.8    343.8
M2 growth rate                 -0.6    25.1    109.3    74.2    73.8   297.2   251.5   211.A   181.6   127.8    93.4   140.5   297.1
Nominal devaluaton ()                           146      -5.3   311.2   282.5    191.1      952      65.5    39.5   175.0   360.3   3502
M21GDP                        22.4    16.7    20.3    25.9    15.2    11.4    14.5    18.1    18.7    21.5    21.5    192               16.5
Public sector
surpluslGNP     (4)          -3.1     -3.3    -4.7    -5.3   -10.3    -7.2    -2.8    -3.2    -2.7    -3.6    -8.1    -72    -11.0
Current Account
surpluslGDP                  -1.6    .0.6       1.0     0.1    -3.6       1.2      2.2      2.8    -0.5    -3.1      -3.8     4.1      4.8
Indexes
Real wage Index   (C)         103.4    98.3   104.4   117.9   111.1       74.7    73.6    72.3    83.0    92.8    83.0    74.1    90.8
Real effectve
exchange rate bI (C)         94.9   107.3   102.7    87.8   134.2    88.5   114.0   102.9    772            692      87.0   1129    104.1
Terms of trade   C')          108.1   117.3   141.8   128.7    97.1    93.1        88.Y    89.9    97.6   110.3   1002         89.1     86.8
aJ Based on CPI
bl Exchange rate variations deflected by the difference between extemal and intemal WPI.
Sources:
IFS . World Bank and () Ramos (1 986)



at around 4 to 5 percent per year till the end of the decade {this contrasts
with Chile where the authorities belanced the budget '.ery quickly). The
problem with this explanation is that deficits of this size were not unusual
in the past and they were associated with much lower rates of inflation.
This indicates that an additional force was keeping inflation alive.
A second possibility is that the costs of persisting with tight money
were perceived by the government as being prohibitively high. The public, as
a result, became convinced that the government *would not continue along those
lines, and that instead it would start to accommodate inflation. Once these
beliefs became widespread. :t was difficult for the government to continue
with the monetarist strategy. Basic data supports the view that there was a
relaxation in monetary policy in 1977, as money and credit increased as a
share to GDP. By 1970, for example, credit to the private sector was 14% of
GDP compared with just 8% in 1976. Thus, it is very possible that once
expectations of high inflation became entrenched, they were an unsurmountable
obstacle for the authorities, which found it easier to accommodate rather
than to fight them.
i:n. Tablitas in Araentina and Chile
The dissatisfaction with the slow pace of disinflation under the
fiscal-monetary package in the Southern Cone countries led the authorities to
switch in the later part of the 1970S to an exchange rate based stabilization
strategy. we start with the Argentine tablita, where the causes for its
eventual failure are relatively clear, and we then shift to the Chilean



10
experience with the tablita, where there is still controversy regarding its
short and long term impact on inflation.
i. araentina
On December 20, 1970 the government announced an exchange rate based
stabilization, the tablita, showing future daily exchange rates. The Tablita
embodied a decreasing rate of devaluation that was below the ongoing rate of
inflation. The objective was to influence forward looking inflation
expectations by removing uncertainty about future exchange rate policy.
The December 20 plan did not include important additional measures to
supplement the new exchange rate policy. There was no deepening of the
fiscal adjustment; in fact, the fiscal situation slightly deteriorated during
those years as the budget deficit increased from 6.5V of GDP in 1978 to 7.6%
of GDP in 1980. On the other hand, the central bank pursued a policy of
tight domestic credit which meant that most of the expansion in money supply
was driven by changes in international reserves.
The outcomes of this experiment are widely documented in the existing
literature.' Inflation fell gradually (see figure i), from 175% in 1978 to
100I in 1980. However, it did not converge fast enough to the rate of
devaluation (65% in 1979 and 40% in 1980), and as a result there was a
significant real appreciation during this period. The current account
balance, which was in surplus in 1978, reached a deficit of around 3% of GDP
in 1979 and 1980 (as shown in table 2). For a while this was not a problem,
because large capital inflows more than compensated the deficits in the
current account, and as a result the central bank accumulated international
reserves. In the end, however, these deficits became unsustainable and the
' See for example Ramos (1986).



FIGURE 1
ARGENTINA
200         -
150      .  ...
100e-H
50                   
0
76   77   78   79   80   81   82
- Domestic Inflation   l
-Devaluation + USA Inflation



-,  -                              ~~~~~~~~~~~11
program ended in a severe balance of payments crisis which was associated
with a resurgence of inflation.
Does this failure provide strong evidence against the use of the
exchange rate as nominal anchor? Probably not, because in Argentina the
tablita was not accompanied by strong fiscal discipline. As shown in
table 2, the primary fiscal balance deteriorated during the period, and the
total deficit increased to more than 7t of GDP. These large fiscal
imbalances impaired the long ternm sustainability of the program. At the
minimum, they were inconsistent with the stated objective of rates of
inflation at international levels. More importantly, they provided
aamunition to the skeptics regarding the government's commitment to
disinflation, which argued that a government that cannot eliminate the budget
deficit cannot be serious about disinflation.
The Argentine experience thus left an open question: can exchange rate
based stabilizations worked in cases where there are no fiscal imbalances?
we now turn to the Chilean program of 1978 to address this question.
ii. ChIle
While the Tablita was announced in Chile in early 1978, some authors
(e.g. Ramos (1986)1 date the beginning of the exchange rate based
stabilization period to mid-1976, coinciding with the first revaluation. The
appreciation marks the time when the authorities started to view the exchange
rate management as an important component of the stabilization strategy.
However, only once the tablita was announced it became clear the precise role
that the exchange rate played in the stabilization effort. The decreasing
crawl ended in mid-1979 when the exchange rate was fixed at 39 pesos per U.S.
dollar.



12
While quarterly data show that the policy was eventually successful
in bringing down inflation to international levels (see figure 2) it is
noteworthy that this took five years, with the decisive period (of pegging
the exchange rate) lasting two years. Inflation fell from 91% in 1977 to 33%
in 1950 and, 9.9% in 1992. The pace of the reduction of inflation, hovever,
was disappointing. In 1979 and 1980 it got stuck at around 35% percenit per
year, well above international levels. The stubbornness of inflation during
the exchange rate stabilization period in Chile was comparable with
Argentina.
The asynchironization between inflation and devaluation over the
adjustment period led to a real appreciation of over 30% with respect to 1975
and 20% with respect to 1976. Towards the end of the stabilization period
the external position deteriorated signxificantly. The current account
deficit --which averaged 7.5% of GDP during 1978-80-- reac-hed 14% of GDP in
1991. In the end, as it became clear that the policy was unsustainable
capital started to flow out and the economy faced a balance of payments
crisis which resulted in an astounding drop of 14.2% in real GDP in 19B2.~
Table 1 clearly shows that this policy was accompanied by a systematic
fiscal support. Recent studies indicate that between 1975 and 1981 the
consolidated public sector ran surpluses in the primary, operational and
overall balances, and that these were remarkably large in 1979 and 1.950 (the
overall surplus in 1.950 was 6%k of GDP) - Thus, the eventual failure to
maintain the exchange rate stabilization cannot be explained by the standard
fiscal argument along the lines; of the Kcrugman (1979) model. We shall
therefore look for alternative explanations.
7 See Edwards and Edwards (1-997) and Ramos (1986) for a complete
account of this episode.



FIGURE 2
CHILE
40
20    -.. .
10
-10~
76   77   78   79   80   81   82
D-Domestic Inflation
Devaluation + USA Inflation



13
Asi most exchange rate based staLbilizations, the Chilean program ended
in a balance of payments crisis, compounded with a financial debacle that had
serious fiscal repercussions. The external environment became hostile Cb ith
because of the debt crisis and the fall in copper prices) and the economy
faced a severe recession in 1.982 (when GDP fell by 14%). Prices did not fall
even under this extreme circumstanLces, and in the end the government wasi
forced to devalue.
iii. Are Exchancre Rzate Based Stabilizatlons Exvansionar'fl
Before discussing the reasons for the difficulties encountered in these
programs it is worth pointing out some of the ouitcomes that are common to
other exchange rate based stabilizations. As discussed in more detailed in
Kiguel and Liviatan (1992), ERBS programs tend to display the following
features:
* There is generally a business cycle which starts with an expansion in
output in the early stages and ends in a recession. The boom in Argentina
was short lived, and occurred during the first year of the program (1979) and
ended in a sharp recession in 1981. The expansion in Chile lasted longer and
was stronger, with GDP growth exceeding a8 per year on average betwees 1978
and 1980, and the recession (in 1982-83) was short but severe.
* There is a real appreciation as inflation responds sluggishly to the
new exchange rate rule.  The real exchange rate appreciated quickly (in just
two years) and significantly by around 45% in Argentina during the program,
and by 25% in Chile over a 4 year period.
* There :is a deterioration in the current account of the balance of
payments associated with the expansion in output and the real appreciation.
In Argentina, the current account deteriorated by 5 snercent of GDP between



14
1979 end 1901, while ini Chile it worsened by 10 percentage points.
culminating with a huge current account deficit amounting to 14 percent of
GDP in 1 92.
The most striking feature of these programs is that, in contrast to the
money based stabilizations, they were not recessionary and they were
associated with a deterioration of the current account of the balance of
payments. Kiguel and Liviatan (1992) discuss alternative explanations for
these outcomes, attaching particular importance to the one presented by Calvo
and Vegh (1991) who argue that in a non-credible exchange rate based
stabilization program agents anticipate consumption leading to an expansqion
early on followed by a recession at a later stage that coincides with the
collapse of the program.
iv. Why the Slu.cish-Response of Inflation?
The causes for the slow convergence of inflation to the rate of
devaluation was and continues to be a source of debate. The Argentine case
is not very controversial because there was never a serious and sustained
reduction-of the budget deficit. But Chile enjoyed a fiscal surplus durinig
most of the period, Several explanations exist, and in what follows we
examine three of them-
one explanation offered for the sluggish reaction of domestic prices to
the exchange rate stabilization in Chile was the existence of backwar-d
looking wage indexation EDornbusch (1985) and Edwards and Edwards (19873].
it is easy to explain using this type of model that indexation introduces
sluggishness in domestic inflation, and hence slow convergence to the rate of
devaluation. Along the way the real exchange rate appreciates, and thatca
explain the deterioration in the current account.



-- 0                           ~~~~~~~~~15
While this is an appealing explanation for the real appreciation in
Chile, the rise in real wages during the period casts doubt about its
significance for the real appreciation. The data on real wages shown in
table 1 implies that nominal wage increases stayed ahead of consumer prices.
Full indexation implies that real wages remain essentially constant, as
nominal wage increases accompanied inflation. So indexation could not have
been a major force for the real appreciation.
An alternative explanation for the sluggishness of inflation in Chile
is associated with the li-beralization of the capital markets which was part
of the stabilization policies in the Southern Cone. According to this view,
the opening of capital markets to foreign inflows constituted an exogenous
stimulus to investment which led to a domestic boom. This exerted pressures
on domestic prices which slowed down their convergence to the rate of
devaluation (Corbo (1983) and Edwards and Edwards (1987)].
However why should this cause an overvaluation of the currency?
Edwards and Edwards (1987) suggests that the reason is that the flow of
foreign investment takes place at a diminishing rate (as in stock adjustment
models). Therefore the initial increase in domestic prices represents an
overshooting. This leaves, however, the question of why do not domestic
prices adjust to the declining rate of foreign investment? The answer must
rely on the downward rigidity of domestic prices.
It should be noted that in principle, as in the Argentine case, part of
the capital inflows themselves can be explained endogenously. The central
bank adopted a policy of tight domestic credit which put upward pressures on
' There is a subtlety in this argument, as a falling rate of inflation
results in increasing real wages with full indexation. However, this effect
cannot explain the rise in wages in Chile between 1978 and 1980, as the rate
of inflation remained relatively constant in these years.



16
domestic interest rates. Because inflation persisted money demand increased
pari-passu with the rise in nominal GDP. Capital inflows, induced by high
interest rates, became a mechanism to accommodate the increase in money
demand.
Edwards and Edwards (1987) seems to rule out this kind of explanation
because the Chilean government did not permit short term capital inflows.
However, It is questionable whether the controls were in fact effective given
the sophistication of the financial markets and the great difficulties that
are generally observe in enforcing regulations in this area. The
considerable difference between domestic interest rate over Libor plus
devaluation provided enough incentives to find ways to sidestep the
regulations.
A third explanation-is that t-he persistence of inflation was driven by
lack of credibility about the ability or willingness of the authorities to
adhere to the exchange rate rule in the event of adverse shocks. These
credibility problems are different from those resulting from the perceived
unsustainability of fiscal policies, a notion that is much more familiar to
economists.
The non-fiscal credibility arises because under discretion a government
can deviate from the announced rule.' The basic framework is one where the
government announces an exchange rate rule, but it maintains the option (or
discretion) of reneging from it if the 'optimal" rate of inflation is
different from the announced one. The government has two objectivres,
reducing inflation and keeping external balance - Deviating from the
announced exchange rate rule involves costs (i.e. loss of reputation). The
9 For a more detailed and formal presentation of a model analyzing a
similar issue see Cukierman , Kiguel and Liviatan (1992), and Devarajan and
Rodrik (1992) amog others.



17
main benefit of adhering to the rule is that inflation comes down and their
reputation remains intact.  But when the announcements are not fully
credible, the reduction in inflation will be smaller than the reduction in
the rate of devaluation and hence there is likely to be some real
appreciation. Under good states of the world (i.e. the external environment
is favorable) the government will adhere to the rule (as the benefits
outweigh the costs).  But under bad scenarios (e.g. an adverse external
shock) the cost of the deterioration in the balance of payments could well
exceed the benefits of continuing to adhere to the rule, and hence the
authorities will renege and devalue.
The basic framework can be illustrated with the help of figure 3. There
are four stages in the decision.  In stage 1, the government announces an
excharge rate rule, which balances its desire to reduce inflation with other
objectives (such as a target for external balance or unemployment). In stage
2 the shock realizes. In stage 3 agents form expectations about inflation
based on the government's announcement, and on the realization of the shock.
But the public does not know how committed the government is to the
disinflation program, and hence a source of uncertainty remains. Finally, in
stage 4, the government sets the policy in order to maximize welfare.
Figure 3
1                2                 3                  4
Government         Shock             Public          Government
announces rule     realizes          forms           sets policy
expectations



18
The ability of the government to adhere to the rule depends or how
credible its announcement is (i.e. whether the public believes that it is
serious about stabilization) and on its luck regarding the realization of the
external shock. A more credible government is more likely to be aucceasful
in reducing inflation. What does this interpretation mean about these two
programs?
An important implication of the above discussion is that even programs
that succeed in providing fiscal support for disinflation might fail because
the public does not believe that the authorities can maintain external
balance. Some real appreciation will occur if the program is not fully
credible, and the program can be maintained only if the real appreciation is
not strong enough or if the external environment is sufficiently good.
In the case of Chile the program was not fully credible at the outset
and that led to some real appreciation. Once the government fixed the
exchange rate in 1979 the program got trapped, because prices were inflexible
downwards. The pubic realized that under the fixed exchange rate regime
there was not an automatic mechanism to generate the real depreciation to
address the increasingly larger current account deficits.  According to this
view, agents were not questioning the government's ability to maintain the
fIscal balance, they were questioning its ability to adhere to the exchange
rate rule in view of the large external deficits. This was a non-fiscal
credibility probleu. In the end, there was a severe external shock (the debt
crisis) that forced the abandonment of the regime.
v. A auick Reassessment of the Tab2itas
Early assessments of the tablitas were fairly negative, as they
emphasized the limited benefits on inflation and the large costs of the
programs.-t The early facts certainly gave room for skepticism as both
programs ended in a balance of payments crisis, and severe recessions.
'o Diaz Alejandro (1981) and Foxley (1983) were among the first ones to
question the viability of the strategy to bring down inflation-



-;-                             ~~~~~~~~~~19
Bemides, the pronounced real appreciations that the countries experionced
during this period had damaging, long term effects on the export sactor. The
real appreciation was considered an unwise coot to pay for disinflation, and
meant that exchange rate utabilizationi were a bad idea.
A new look at these episodes, with the benefit of hindsight, provides a
more positive view. The Chilean experience is the critical one to derive
lessons from ERBS, because in Argentina the tablita was never supported by
adequate fiscal policies. Such a view can argue that while there were
problems with the implementation of the ERBS program in Chile at leart the
period of the ERBS brought down inflation on a long term basis.
While most Latin American countries, and all the high inflation ones,
experienced a protracted increase in the rate of inflation in the debt crisis
of the early eighties, Chile maintained inflation in the moderate levels.
While inflation went up in Chile at the time of the maxi-devaluations of 1982
and 1983, the increase was only temporary as it is typically the case in low
inflation economies. The maintenance of the fixed exchange rate in the late
1970s under extremely adverse circumstances certainly signaled the commitment
of the authorities to low inflation. Thus, when the crisis erupted in
1982-83 the public anticipated that the government that had invested so
heavily in achieving price stability would not tolerate a rekindle of
inflation.
Of course the Chilean program could have been carried out better,
especially with the benefit of hindsight. The output losses would have
certainly been smaller if the exchange rate rule had been flexibilized
earlier. There is little debate today about this. And most agree that
automatic wage indexation was a policy mistake. But in the end, and despite
all the costs, Chile did manage to bring down inflation and it had a
remarkable growth performance in the last decade.
An interesting feature is that in spite of widespread skepticism about
ERBS, Mexico adopted an exchange rate based stabilization in the 1988 and has
essentially maintained it -with some variations till the present- and



20
Argentina once again adopted an ERBS program, this time relying on a fully
fixed exchange rate. The Argentine episode, the convertibility plan, is
probably more insightful, because the memories of the Martinez de Hoz tablita
were still fresh. We now turn to review the why's and what's of the
convertibility plan.
iv. Is History Repeating Itself? Argentina in the 1990s.
Argentina in the 1990s adopted a major program to stop inflation. This
program confronted worse initial conditions than previous stabilization
attempts, as it was fighting the first ever full blown hyperinflation. As in
the previously discussed ERBS episodes, the disinflation had two phases. It
started with a money based program, which blocked hyperinflation but failed
to bring about price stability and then shifted to an exchange rate based
stabilization, the convertibility plan. The Convertibility Program of March
1991, launched by Minister Domingo Cavallo, was the final phase of the
stabilization process under the Menem administration to bring down inflation
from hyperinflation to low or moderate levels.
i. Monetarism in the 1990s
The monetarist phase in Argentina started in March, 1990.  This program
followed two policy failures: the first one was the collapse of a short
lived, exchange rate based Bunge & Born plan. The second was the outbreak of
the second hyperinflation in December 1989, as the government rescheduled the
domestic debt and prompted a flight from domestic currency.
The March 1990 program (siso known as Decree 435) brought the
hyperinflation to an end (figure 4). The program maintained the floating
exchange rate that had been in effect since December, and relied on tight
money and a deeper fiscal adjustment (through cuts in subsidies and public
employment as well as some revenue enhancing measures) to control inflation.
The effectiveness of the tight money-fiscal combination in blocking
hyperinflation was remarkable.  Inflation came down from 95% in March 1990,



F IGRE 4
Inflation
5001        ~~Argentina
400 -
300 
200
100 
89     90      91      92      93



21
to just 11* in April. In the short run, the money-fiscal combination brought
about an important reduction in inflation, but it failed to reduce it below a
basic rate of around 10 percent per month.
During the tight money period inflation came down from the heights of
hyperinflation, but this result was associated with poor growth performance.
As shown in figure 5.a, Argentina did not grow in 1990 .
As in other money based stabilizations there was a sharp appreciation
in the real exchange rate. The real exchange rate appreciated by over 30
percent in Argentina during the monetarist phase (figure 5.b). But the
country ran a large and continuous surplus in the trade balance in spite of
the real appreciation (figure 5.c). The deep recession in economic activity
(which started at the time of the hyperinflation) can partly explain the
comfortable trade balance position.
ii. The Convertibility PrcQram: The New Twist in Exchange Rate Based
Stabilizations
In March 1991, Minister Cavallo announced the Convertibility Program a
far reaching attempt to bring down inflation. The Executive sent to Congress
and got approved the Convertibility law which fixed the exchange at 10,000
Australes per U.S- dollar, included a provision that any change in the
exchangePrate had to be authorized by law, and legislated that the central
bank could only issue domestic money to buy foreign exchange (credit to the
government was precluded in the law). A This last component was particularly
important since it eliminated, at least in principle, the option of the
central government, provinces and public sector enterprises to use the
central bank as the lender of last resort.
The circumstances in which the program was launched provided a fertile
ground for positive outcomes. The fiscal situation was probably the best
Argentina had enjoyed since the late sixties, when Krieger vassena managed to
11 There was a loophole in the law, since government dollar deno     ted
bonds --valuated at market prices-- could be counted as part of the reserves.
However, the government announced that this could only amount to 103lo?) of
total holdings



FIGURE 5
GDP Growth
Argentina
4 -------- 
-2
-4
87   88   89   90   91   92   93
(b)
Real Exchange Rate
Argentina
250
200
100
089      90      91      92      93
1-1988 =0I
(C)
Trade Balance
Argentina
3000
I   o 
-1000
2       82 
-20_2__ D_ 
Z    7'889   8 90    91    92     - 93



!                                                 22
reduce inflation to one digit. Despite many stops and goes regarding fiscal
policy since the Austral plan, much had been learned about the sources of
fiscal and quasi-fiscal imbalances, and policy makers and the public became
convinced of the need to eliminate the budget deficit. Significant
improvements in the fiscal situation occurred under Minister Erman Gonzalez,
including privatizations and other measures to reduce the size of the public
sector. Much progress was also achieved in tax administration and in raising
tax revenues. While these efforts were not enough to achieve full price
stability, they laid the ground for the more far reaching reforms that were
undertaken in 1991.
In terms of outcomes the convertibility program has been quite
successful. The strong adherence to the convertibility law (both in terms of
maintaining the fixed exchange rate and in not printing money to finance the
deficit) was a powerful policy instrument to reverse inflationary
expectations. Inflation came down one step, falling from 11* in March, to
around 15% per month from mid 1991 onwards. In 1993 inflation was only 8%,
the lowest in the last four decades.
once again we observed that inflation displayed significant
persistence, and that the convergence process to the rate of devaluation (in
this case zero) was slow fit took 2 years to reduce it to one digit). Along
the way the real exchange rate has appreciated significantly, rasing
questions about the long run sustainability of the program.
But there are some indications that this programs is enjoying more
credibility than previous ones. In contrast to most other exchange rate
based stabilizations, interest rates have been remarkably low in Argentina.
Interest rates on 7 day deposits fell to 1.5% per month in April, and by
September they were less than 1%.12  Credibility, however, was not enough to
bring inflation quickly to international levels.
As in most other ERES, we observe a strong expansion of output from the
outset and a deterioration in the trade balance and in the current account.
12 Interest rates on 30 day deposits were higher, around 1.5% per month.



23
This was accompanied by an increase in economic activity (as measured by
industrial production>, and an appreciation in the real exchange rate. In
contrast to the other episodes discussed in this chapter, the real
appreciation was not accompanied by a rise in real wages, which in fact
remained quite depressed.
The experience with the fixed exchange rate during the convertibility
plan confirmed that the exchange rate can be a powerful nominal anchor to
bring inflation down. However, it also highlighted that inflation could
still display significant persistence, though at much reduced levels, and
hence that the economy is likely to experience a real appreciation along the
way.
V. Final Remarks
The evidence an exchange rate based stabilizations presented in this
paper indicates that they were generally more effective than money based
programs in bringing down inflation. But the reductions in inflation were
usually gradual, and hence the process resulted in a continuous (and in some
case significant) real appreciation.  Even the fixing of the exchange rate in
Chile in 1979 did not succeed in achieving a discrete reduction in the
underlying rate of inflation.
The recent Argentine Convertibility plan that fixed the exchange rate
was more successful in bringing down inflation significantly (from monthly
rates of around 10% to just 1.5% in just few months).  One could argue that
this is a especial case, however, because Argentina was comriLng from a full
blown hyperinflation. The comparison of the fixed exchange rate period in
Argentina and Chile shows useful insights.
Argentina's relatively more successful experience can not be explained
on fiscal arguments. When Chile fixed the exchange rate in 1979 it was
already enjoying a budget surplus. When Argentina fixed the exchange rate in
March 1991, on the other hand, the government was running a small budget



24
deficit (of around 2% of GDP). While this represented a significant
improvement over previous years (when budget deficits were as large as St of
GDP), it certainly did not go as far as Chile.
Perhaps a better explanation is the perceived government commitment to
the fixed exchange rate and the potential costs of reneging on it. Argentina
went farther on the accompanying non-fiscal measures to support the fixed
exchange rate. The convertibility law made devaluation much more difficult,
as it required congress approval, and reduced the chances of discretionary
devaluations. Besides, the government tied its own hands further by
legalizing the use of the dollar as unit of account and means of exchange.
As a result many prices of non-tradeable goods were denominated in dollars,
hence reducing the potential effectiveness of devaluations to change relative
prices. In this respect the commitment to the exchange rate rule in
Argentina was stronger than in Chile
The costs of abandoning the fixed exchange rate were also perceived to
be larger in Argentina. The fixed exchange rate quickly became the pillar of
a program that neither the government nor the public at large were willing to
let it fail. A devaluation was (and still is) perceived as opening the door
for a renewal of hyperinflation, a dreadful scenario. The situation in Chile
was different, as the country did not face the threat of hyperinflation. As
a result it took much longer to convince the public that the government was
fully determined to maintain the parity, even if inflation continued for a
whLile.
A typical feature of exchange rate based stabilizations is that the
authorities tend to stick to the fixed exchange rate for longer than it might
be prudent. In the tablitas it is now apparent that some flexibilization in
exchange rate policy at an earlier stage would have reduced the costs of the
finLal failure. Why do governments find it so difficult to flexibilize
exchange rate policy? Why do they wait for the balance of payments crisis
rather than anticipate it? one plausible answer is that they fear that the
public will identify the flexibilization with the failure of the prcgram.



25
once the exchange rate moves, inflation will rekindle and the authorities
will lose credibility about announcements. So they don't devalue. in the
end, however, a balance of payments crisis occurs and this force. the
devaluation.
The interesting finLding is that inflation does not necessarily goes up
when the exchange rate is flrexibilized. In Chile, for instance, the maxi-
devaluations of the early eighties only had a temporary effect on inflation,
which then fell back to the moderate range. Likewise, the successful recent
ERBS programs launched in Israel (1995) and Mexico (1987-es) started with a
fixed exchange rate but later the governments adopted a crawling pe and then
an exchange rate band without facing increases in inflation. These two
recent episodes clearly learned from the experiences of the Southern cone, as
they balance the need to maintain an exchange rate rule (for credibility)
with the one to keep external balance (for external balance). 3 The key to
the success of an exchange rate based stabilization program is the ability to
combine credibility and flexibility, and on this issiue the lesson was
learned.
"3 See Cukiermtan, Kiguel and Liviatan (1992) for a more detailed
discussion on this topic.



26
Reternmcuu
Barletta, A, M. Blejer and L. Landau (1983). Economic Liberalization and
Stabilization Policies in Argentina, Chile and Uruquav, Washington,
D.C.: The World Bank.
Br-.mo, M. (1991). "High Inflation and the Nominal Anchors of an Open
Economy,n Essays ir: International Finance, Princeton University No.
183, June.
Bruno, M. (1993). Crisis, Stabilization and Economic Reform, Oxford
University Press.
Calvo G. and C. Vegh (1991). "Exchange Rate Based Stabilization under
Imperfect credibility," Working Paper 91/77, International Monetary
Fund.
Cukierman A., M. Kiguel and N. Liviatan (1992). "How Much to Commit to an
Exchange Rate Rule: Balancing Credibility and Flexibility," Revista de
Analisis Economico. June.
Corbo, V. and A. Solimano (1991). "Chile's Experience with Stabilization
Revisited," in Lessons of Economic stabilization and Its Aftermath, MIT
Press, pp. 57-91.
Devarajan, S. and D. Rodrik (1991). "Do the Benefits of Fixed Exchange Rates
outweigh Their Costs? The Franc Zone in Africa," The World Bank, PRE
Working Paper No. 777.
Diaz Alejandro, C. (1983). "Southern Cone Stabilization Plans, " in Economic
Stabilization in Developing Countries, W. Cline and S. Weintraub
editors, Washington D.C.: The Brookings Institution.
Dornbuasch, R. (1995). "Inflation, Exchange Rates and Stabilization," NEER
Working Paper No. 1739.
Edwards, S. and A. Cox Edwards (1987). Monetarism and Liberalization - The
Chilean Experience, Ballinger Publishing Company.
Fischer S. (1986). 'Exchange Rate Versus Money Targets in Disinflation', in
indexing, Inflation and Economic Policy, MIT Press.
Foxley, A. (1983), Latin American Experiments in Neoconservative Economies,
University of California Press.
Harberger, A. (1981) "Comment on Foxley," in Economic Stabilization in
Developing Countries, edited by K. Cline and S. Weintraub, pp. 226-28,
Brookings Institution.
Kiguel M. and N. Liviatan. (1992). 'The Business Cycle Associated with
Exchange-Rate-Based Stabilization', The World Bank Economic Review,
vol. 6, No. 2, pp. 279-305.
Kiguel, M and N. Liviatan. (1998). "Inflationary Rigidities and Orthodox
stabilization Policies, Lessons from Latin America," The World Bank
Economic Review, September.
Pazos, F. (1972). Chronic Inflation in Latin America. New York: Praeger.
Ramos J. (1986). Neoconservative Economics In the Southern Cone of Latin
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