Currency crisis and fiscal adjustment

ABSTRACT

We believe that the balance-of-payment crisis literature can offer the basis to understand the current economic turmoil in Brazil. According to our calculations the real exchange rate requires a 15% to 20% devaluation so as to assure that the intertemporal balance-of-payments constraint is not violated. Such appreciated currency (and the FX policy designed to reduce the appreciation) imposes a heavy burden on monetary policy: covered interest parity implies high real domestic interest rates in order to finance the current account. Eventually the defense of the exchange rate requires an additional increase in interest rates, accepted by the government, the weight of stability in the government loss function seems to be much higher than the assigned to unemployment (or growth). Yet - despite such preferences - the existence of a large budget deficit imposes objective limits on the use of interest rates as a means to defend the currency. In the absence of a sharp fiscal adjustment monetary policy will no longer be credible. In this sense, the fiscal adjustment is a crucial element to sustain the current FX policy.

KEYWORDS:
Currency crisis; capital flows; exchange rate regime; balance of payments