THE REALITIES OF MODERN HYPERINFLATION

NEETA NAINANI MMS-B 122

How different are the modern hyperinflation episodes from the one experienced after World War I?
Ans) Modern episodes of hyperinflation are different from those that followed World War I. The following points highlight the difference: The hyperinflations of the 1920s sprang up swiftly and were rapidly brought to an end, without much cost to employment and output, after governments implemented drastic fiscal and monetary reforms that restored currency convertibility and gave central banks independence to conduct monetary policy. In contrast, modern hyperinflations have not been short and swift. In most cases, they have been preceded by years of chronic high inflation. In Argentina, Brazil, and Peru, for example, year-overyear inflation remained consistently above 40 percent for 1215 years before the peak of the hyperinflation. Chronic high inflation does not necessarily degenerate into hyperinflation. But, in the five countries reviewed here, hyperinflation did ensue, triggered by an uncontrolled expansion in the money supply that was fueled by endemic fiscal imbalances. Nor has price stability been restored overnight in modern hyperinflations. It took 14 months in Bolivia and more than 3 years in Peru for inflation rates to fall below 40 percent. It took even longer to reach single-digit inflation ratesthree and a half years in Argentina and about seven and a half years in Bolivia. In Brazil, failure to put in place the needed fiscal and monetary reforms in 198990 caused the country to experience a second, borderline hyperinflation in 1994. Another difference is that full currency convertibility and strict institutional constraints on monetary policy have not characterized the end of all modern hyperinflations. Except for Argentina, which adopted a currency board in early 1991, countries have relied on hybrid monetary and exchange regimes to bring high inflation under control. Bolivia and Peru relied on money targets and heavy foreign exchange intervention (dirty floats); Brazil and Ukraine retained de jure dual exchange rates for most of the 1990s.

2. How did hyperinflation affect the Latin American economies?

Latin American countries were plagued with inflation over several decades without parallelism. There have been several episodes of extreme inflation with. Bolivian Inflation, for instance, between May and August of 1985 reached an annualized rate of 60,000 percent, the seventh worst case of hyperinflation in history. Hyperinflation reduced the size of the financial sector and gradually erodes the efficiency of the price system and the usefulness of domestic money as a store of value, unit of account, and medium of exchangetaking the economy, in the extreme, to a near state of barter. In Bolivia, bank deposits fell to a low of 2 percent of GDP the year after hyperinflation began. Although deposits and monetary aggregates do recover after hyperinflation ends, intermediation remains extremely low by international standards. For instance, the ratio of bank deposits to GDP in the four Latin American countries ranged from 9 percent to 20 percent three years after the hyperinflation, which is between one third and one-half the comparable ratio for middle-income countries with no history of high inflation. Owing to the collapse of financial intermediation, banking crises have been a feature of all modern hyperinflations. The large-scale deposit withdrawals and sharp increases in nonperforming loans that accompanied economic contraction made these banking crises extremely costly. The Latin

American countries had already defaulted on their foreign currency bank debt when hyperinflation began, and hyperinflation triggered new defaults. The run-up to hyperinflation has been characterized by a broad array of economic distortions, including capital controls, many forms of financial repression, segmented foreign exchange markets, and outright corruption. Although many of these distortions are hard to measure, the parallel exchange rate market premium has been found to be a useful proxy. The parallel market premium during the hyperinflation or the run-up to the hyperinflation has consistently remained above 50 percent, and premiums in the hundreds and even thousands have not been uncommon. The following chart represents hyperinflation occurring in various Latin American countries between 1981 to 2000.

3. Was the monetary policy effective enough to control hyperinflation? Substantiate your answer with valid reasons.
Ans) Yes. Inflation stabilization programs adopted by many Latin American countries in the early 1990s and the historically low rates of inflation attained by the region in recent years, falling from an average of over 400% in 1989 to below 10% at the beginning of the millennium. Easing or lifting capital controls and unifying exchange markets have been critical to reducing some of these distortions during stabilization. These measures together with strict fiscal policieshave usually led to dramatic declines in parallel market premiums. The following table shows the drastic decline of hyperinflation owing to the measures adopted by the government.

Evolution of the Rate of Inflation Before and After Stabilization Year 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Bolivia 24 25 296 329 2177 8170 66 11 Mexico Argentina Brazil

28 59 102 66 64 106 159 52 20 30 19 12 8

385 82 175 388 4924 1833 84 18 7 4 1,6 0,1

211 228 58 366 993 1765 2360 421 989 2086 2312 75 11 8

4. What role did the government play in controlling hyperinflation? Bolivia:

In 1985 the elected government of Victor Paz Estensoro implemented a stabilization plan (in September inflation had reached 56% per month) The government declared a moratorium of Debt Service (accepted by the IFI) The exchange rate was fixed The government implemented a deep fiscal reform (sharp increase in public sector prices, reduction of subsidies to the mining industry and public sector wage freeze) By 1986 inflation reached 66% (from 8.178% in 1985

Mexico:
In 1987 the government announced the Economic Solidarity Pact, which was followed by the Pact for Economic Stability in 1989. Strong adjustment of the peso was followed by smalls and decreasing over time adjustments in the exchange rate. Guidelines for wage and price adjustments (voluntary agreements monitored by the three parties: business, labour and the government) Tariff reduction and trade liberalization was adopted. Inflation diminished slowly and the costs in terms of output were low.

Argentina:
In 1991, the convertibility plan was launched by the government and approved by the congress. Convertibility of the peso at 1-to-1 rate with the US dollar and obligations of the monetary authority to maintain full backing of the monetary base in foreign reserves were mandatory. The law also banned any kind of automatic price adjustment linked to domestic prices and contracts in foreign currency were allowed. The programme was complemented with a massive privatisation of public utilities (which solved partially the fiscal problem). The government implemented deep trade and financial liberalization.

Brazil:
Advocated by then finance minister Fernando Henrique Cardoso, the Real Plan was launched in June 1994. It had three phases. Phase one of the plan was an attempt to secure fiscal stability through tax increases, expenditure cuts and the reduction of compulsory transfers to local administrations. Phase two, contemplated the creation of the Unit of Real Value (URV), a stable unit of account whose nominal value increase daily according to the rate of inflation (of cruzeiros reais). Phase Three, was the transformation of URV into the Real . In took place in June after relative prices were aligned.