v11_2000e - 4 THE FUTURE OF ARGENTINA’S QUASI-CURRENCY...

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Unformatted text preview: 4 THE FUTURE OF ARGENTINA’S QUASI-CURRENCY BOARD: TOWARD A MERCOSUR MONETARY UNION? Aaron Jones This paper will examine the future ofArgentina’s Convertibility Plan, a stabilization program that was adopted in 1991 in response to years of hyperinflation and turmoil within the Argentine financial markets. This program linked the value of the Argentine peso to the U.S. dollar with a quasi—currency board. The Plan achieved rapid macroeconomic stabilization and helped to reinte— grate Argentina into global markets. However, permanent com- mitment to this program will not be in Argentina’s best economic interest. After an evaluation of the advantages and disadvantages of the Convertibility Plan, I conclude that it is not the optimal arrangement for Argentina in the long run. I propose an alternate arrangement for Argentina and discuss some issues relating to a possible transition. INTRODUCTION This paper will examine the future of Argentina’s Convertibility Plan, the quasi—currency board regime adopted in 1991 as a response to years of hyperinflation and turmoil in the Argentine financial markets. It initiated drastic measures to stabilize the system of payments and restore investor confidence in the economy. The Convertibility Plan is generally hailed as an extremely successful stabilization effort, and it has helped to revive interest and support within academic and policy circles for currency boards in developing countries. While the program has achieved its Aaron Jones is a Master of Arts Candidate in International Relations at the Yale Center for International and Area Studies, Yale University. The Future of Argentina’s Quasi-Currency Board 53 m primary goals of controlling inflation, stabilizing the value of the currency, remonetizing the economy, and increasing international capital flows, I will argue that the Convertibility Plan is no longer the optimal monetary and exchange rate program for Argentina. Policy makers should actively pursue an alternate arrangement. I will propose such an alternative and discuss some issues relating to a possible transition. This paper will be divided into five sections. Section I will describe the Convertibility Plan and briefly review its evolution and performance to date. Sections II and III will discuss the Convertibility Plan in relation to the Argentine financial and trade markets, respectively. In each case, I will be raising some of the concerns that the Plan creates. Section IV will present the range of alternatives to the current quasi—currency board regime, suggest an optimal arrangement, and discuss some issues pertain— ing to a possible transition to this arrangement. Section V will conclude. BACKGROUND This section will first present the case in favor of a currency board and will then introduce Argentina’s Convertibility Plan and discuss how policy makers were forced to modify it in response to the country’s severe financial crisis in 1995. The Case for a Currency Board A currency board is a rigidly fixed exchange rate regime accompanied by strict rules governing monetary policy. More specifically, it is an institu— tional arrangement whereby the exclusive authority to print money is vested with an independent institution whose mandate is to maintain complete convertibility of the currency at a fixed price and to ensure 100 percent backing of the currency with international reserves. Any local currency received by the currency authority from the sale of foreign exchange must be removed from circulation. In this way, the supply of currency in circulation is completely determined by the market demand for the currency at the fixed price. The rationale for currency boards is quite simple. Fixed exchange rates have often been applied as an anchor to stabilize high inflation economies. Currency boards are away to increase the credibility and strength of a fixed exchange rate regime as well as monetary discipline by replacing policy makers’ discretion for monetary policy with strict monetary rules. A currency board allows a country to import monetary discipline from abroad. In other words, the goal of a currency board is to create a credible exchange rate anchor for inflation. 54________________________Aflw_bl1_€i There is a fair amount of disagreement regarding the desirability of currency boards, but recently they have been gaining favor as the debate over the optimal exchange rate regime has become increasingly polarized. Most academics and policy makers now tend to argue either for a fairly flexible exchange rate regime or for some form of currency board system (IMF 1998; Currency Board System Symposium 1997).1 Fixed rate systems not backed by the strict rules governing monetary policy have become discredited by the recent wave of currency crises associated with such systems in developing countries. All too often, when granted some discretion over monetary affairs, policy makers, who often are subjected to political forces both within and outside of the country, are unable to maintain the discipline necessary to sustain fixed exchange rate regimes. Empirical studies have concluded that, compared to other fixed rate regimes, currency boards are, in fact, generally associated with lower inflation rates While actually achieving higher rates of growth (IMF 1998). The Convertibility Plan In direct response to the years of hyperinflation and financial instability which had plagued Argentina, President Carlos Menem, Economic Min— ister Domingo Cavallo, and Central Bank President Roque Fernandez launched a comprehensive stabilization and liberalization program in April of 1991. The Convertibility Plan, the centerpiece of this program, sought to stabilize the Argentine currency, the austral, through a quasi— currency board regime that fixed it to the US. dollar. The Plan, enacted by congressional legislation in the Convertibility Act, required the central bank to maintain full convertibility of the austral at a rate of 10,000 australs per U.S. dollar and to remove from circulation the currency that it received from these transactions. The austral was soon thereafter replaced with the peso such that one peso equaled one US. dollar. The Act also mandated that international reserves of the central bank remain no less than the total monetary base, defined as “currency in circulation, plus the demand deposits of the financial institutions in the central bank, in current or special accounts” (Connolly 1995, 643). The central bank was only permitted to issue australs in exchange for hard currency, thereby prohibiting it from financing the fiscal deficit and severely limiting its powers of money creation.2 In addition, government guarantees to the financial system (deposit insurance and the central bank’s lender of last resort functions) were essentially eliminated. Subsequent laws granted dollar and local currency deposits equal treatment and permitted contracts to be denominated in either currency. These efforts established a regime The Future of Argentina’s g Zuusi-Currency Board 55 similar to a currency board, though the central bank did retain a limited capacity to control the money supply. The novelty of this stabilization effort was not the fixed exchange rate, but rather, the rigid restrictions on currency creation and the legislative foundations with which it was implemented. Because numerous past stabilization efforts based on a nominal exchange rate anchor had failed, the strict rules and legal commitment were intended to boost international and domestic credibility. The 1 995 Crisis The Convertibility Plan did achieve a remarkable degree of monetary stability in Argentina. It rapidly reduced inflation to a negligible rate and resulted in a significant remonetization of the economy and an increase in foreign capital inflows. However, it also left the country unable to insulate itself from international forces, exposed weaknesses in the financial system, and demon- strated certain contradictions in the Plan itself. In 1995, in the wake of the December 1994 Mexican default, these problems culminated in a severe financial and currency crisis. Aggregate deposits in the banking system fell from $45.6 billion on 20 December 1994 to a low of $36.8 billion on 12 May 1995 (Carrizosa et. al. 1996). The crisis proceeded in two stages. The first was marked primarily by a perception of increased exchange rate risk and investors’ withdrawal of peso assets. The second stage involved more generalized uncertainty regarding the health of the financial system and the sustainability of the overall monetary program. The result was more widespread capital flight. While the crisis began with a liquidity crunch in the banking system, the situation continued to deteriorate until a risk of widespread insolvency emerged in the financial sector and central bank assets fell to dangerously low levels. As the crisis unfolded, policy makers were forced to alter the Convert— ibilityAct in several respects, resulting in a retreat from the strict discipline of the rules governing monetary policy. Initially, the government focused on relatively minor reforms intended to bolster confidence in the continu- ity of the system. These included the elimination of the central bank’s buy- sell gap for dollars, the conversion of reserve requirements on peso deposits into dollars, and the unification of each bank’s account at the central bank into a single, U.S. dollar-denominated account. As the bank run proceeded and the banks’ liquidity shortfalls became evident, the central bank took What steps it could within the rules of the Convertibility Act to boost liquidity. Reserve requirements for demand and savings deposits, which stood at 43 percent in December 1994, were progressively lowered beginning in late December and reached 33 percent 56 Aaron ones by July 1995 and 20 percent in August (Calcagno 1997). Requirements for time deposits were even lower. The central bank orchestrated an effort by the top five banks to set up a safety net for illiquid banks of $250 million. In exchange for their contributions, these banks received lower reserve requirements. A second safety net of $790 million soon followed with contributions by 25 banks; the proceeds were transferred to the government owned Banco de la Nacién. The central bank essentially circumvented the Convertibility Act by transferring lender of last resort responsibilities to the largest public bank. Also, on 26 January the central bank allowed the trading of excess reserves and assumed the credit risk for these operations. In February 1995, as these measures proved inadequate to stem the crisis, the government amended the charter of the central bank. The central bank was permitted expand its support of the financial system, both through an increase in the maturity of its swap and rediscount operations and through an increase in the volume of those operations to levels that exceeded the net worth of the borrowing banks. In March, the central bank further loosened reserve requirements of the financial sector, and another law was passed which permitted it to provide funds even more directly and freely to illiquid banks. In this case, banks with insufficient balances in their accounts at the central bank were essentially loaned the funds necessary to reach the required level of reserves. Also, the central bank began to more directly manage the safety net by transferring loans from less liquid to more liquid banks. Nevertheless, capital flight contin— ued, and central bank losses were jeopardizing the strict limits on money creation imposed by the Convertibility Act. Authorities were forced to increase the portion of reserves that the central bankwas permitted to hold in the form of U.S. dollar denominated government debt from 20 percent to 33 percent. In the wake of the crisis, the government launched a series of efforts to privatize and restructure the financial sector, and the central bank was granted a larger role in the supervision and regulation of the country’s banks. Reserve requirements in the sector were replaced with liquidity requirements (which permitted a wider variety of assets to be held for the requirement) and the level was harmonized at 15 percent. Finally, a limited deposit insurance program was created, and the government organized a $6 billion line of credit with a group of international banks to alleviate future liquidity shortages. In sum, the crisis of 1995 forced the government to relax the initial discipline of the Convertibility Plan in several ways. The central bank’s The Future ofi Argentina ’5 g zuasi-Currengl Board 57 # capacity to create money was increased. The reserve requirements of the financial sector were substantially decreased. Lastly, the central bank reestablished various types of guarantees to the financial sector through the lender of last resort functions described above and the new deposit insurance program. Performance of the Convertibility Plan The convertibility plan is often hailed as an unequivocal success because it did help to rapidly reduce inflation, remonetize the economy, increase financial intermediation, and encourage foreign capital inflows.3 Given the country’s long history of hyperinflation and financial instability, these are considerable accomplishments. But, these factors alone are insufficient to serve as a benchmark by which to judge a monetary program. By eliminating domestic discretion over monetary policy, a currency board forces a country to accept a reduced strategy set for economic policy. An “optimal” monetary policy is not simply one that achieves a stable Currency, but one that maintains currency stability while approaching the “full employment” level of output, i.e., one that maintains sufficient monetary stability while minimizing unemployment and retaining the highest sustainable level of economic growth.4 A currency board inher— ently involves accepting a money supply that may often deviate from the optimal level. While the Convertibility Plan has clearly been a success as a stabiliza— tion effort, Argentina has been unable to alleviate double-digit unemploy— ment, currently over 14 percent, and output growth has been extremely volatile and dependent on conditions in the external account. The Convertibility Plan has also resulted in habitual overvaluation of the currency (Connolly 1995). Partly as a result of this, Argentina has maintained relatively large current account deficits that have necessitated substantial external borrowing. A strong US. dollar has arguably exacer— bated the current recession by increasing the overvaluation of the peso and creating an unnecessarily tight monetary environment. FINANCIAL MARKETS AND THE CONVERTABILITY PLAN The application of a currency board in the presence of a fractional reserve banking system necessarily introduces fundamental inconsistencies and risks. The reason is that, while under a currency board the monetary base must be completely backed by central bank reserves, the money supply can greatly exceed the monetary base. Accordingly, if the monetary base is 58 Aaron ones generally defined as M1 (currency in circulation, demand deposits, and other checkable deposits), potential claims on central bank reserves can far exceed this measure. Such claims include not only the liabilities of the central bank (local currency), but also those of the government and the private sector, including banks, businesses, and households. Any liquid asset denominated in the local currency can represent a potential claim on central bank reserves (Tobin 1998). Therefore, even complete backing of the currency according to the stipulation of the currency board does not necessarily guarantee the central bank’s ability to maintain convertibility of the currency in all cases. Reserves may still prove insufficient to completely satisfy demand for foreign exchange and fight off all financial panics or speculative attacks. This discrepancy was evidenced during the 1995 peso crisis. The central bank was required to maintain, and had basically achieved, full backing of the monetary base (roughly equal to M1 as defined by the Convertibility Act) with foreign reserves. But, as the crisis unfolded, the bulk of the flight from pesos came from time deposits at the banks and other less liquid assets, which are not included in M1 (Calcagno 1997). The relevant aggregate to capture these types of funds is M3, which at the time of the crisis amounted to roughly three times central bank reserves. So as the crisis unfolded, M3 fell dramatically, creating a large drain on central bank reserves, but the monetary base did not fall as fast. With both a currency board and fractional reserve banking, money supply will be profoundly affected by perceptions of the financial system and the preferences of domestic actors, as well as by demand for the local currency relative to foreign currencies. In other words, “if the size of the monetary base is limited to the central bank’s holdings of international reserves, the central bank has no way to compensate for increases in the public’s demand for local currency at the expense of its willingness to hold local bank deposits” (Tobin 1998). For example, assume a commercial bank’s reserve requirement is 20 percent. Also assume that an individual decides to withdraw one peso from an account at this bank in order to hold one additional peso of local currency, (in other words, to substitute one peso of hard currency for one peso in a demand deposit). This transaction would decrease overall money supply by not one but five pesos due to the multiplier effect. When the central bank is constrained in its ability to inject liquidity into the system, the result of any trouble or perception of trouble in the financial sector is an amplified contraction of the money supply and a sharp rise in interest rates. This, in turn, hurts banks’ balance sheets and can cause or exacerbate a financial panic. The Future of Argentina’s g Zuasi—Currengy Board 59 In a system such as Argentina’s, where foreign currency deposits are granted equal status as local currency deposits in the financial sector, the fixed exchange rate system can introduce other instabilities. In this case, an increase in perceptions of exchange rate risk can be a destabilizing factor in the financial system and cause liquidity risks. This is because depositors will want to withdraw peso deposits or convert them into dollar deposits, pushing up peso rates and creating a discrepancy between the banks’ portfolios (with a relatively fixed portion of peso-denominated loans) and liabilities. Without assistance or corrective measures, such a temporary liquidity shortfall can lead to insolvency. These dynamics were clearly evidenced in Argentina during the 1995 crisis, when fears about the health of the financial system and perceptions of increased exchange rate risk both contributed to a systematic solvency crisis in the financial system. As a result, the central bank was forced to utilize its limited reserves both to maintain convertibility of the currency and to support the troubled banks. When these reserves proved to be insufficient for both tasks, the government was forced to moderate the original discipline of the Convertibility Plan, as described above. It is possible that the Argentine financial sector was strengthened by government efforts at consolidation and restructuring of the sector after the crisis. Similarly, the various government guarantees to the financial sector that were reinstated as a result of the crisis may help to increase market confidence and improve perceptions of risk. But at the same time, the lower reserve requirements have left the sector more vulnerable by increasing potential claims on already scarce central bank reserves, and the various government guarantees could increase distortions in the sector by creating a moral hazard risk. Because of the dynamics described in the previous section, it is obvious that confidence in the financial sector is a critical factor to the survival of the system. But with the central bank’s ability to supply currency con- strained, it must rely on a finite supply of reserves to fulfill both its obligations to maintain convertibility of the currency as well as to guarantee convertibility of bank deposits (through lender of last resort and deposit insurance programs). As explained earlier, these reserves may not be sufficient even to back the local currency, much less to support lender of last resort or deposit insurance functions. While such government guarantees may not be explicit duties of the central bank, and in fact the Convertibility Act essentially sought to eliminate them, it is likely that some government guarantees to the financial system are unavoidable at an implicit, if not explicit, level (Miller 1996). The reason is that, simply QQ Aaron [ones stated, some banks are too big and too important economically for the government to let them fail. Argentina’s response to the 1995 crisis adds credence to this claim. Because the credibility of and confidence in the financial system are so crucial to the monetary program itself, it is quite possible that explicit guarantees should be maintained. However, govern« ment guarantees add another potential claim on the already scarce resources of the central bank, as well as adding a moral hazard in the financial sector. Sustainability of the system may therefore be contingent on high quality bank supervision and regulation. TRADE MARKETS AND THE CONVERTABILITY PLAN The Convertibility Plan has created considerable stress on Mercosur, the customs union between Argentina, Brazil, Paraguay and Uruguay (as well as Chile and Bolivia as free trade members). This union will be very difficult, if not impossible, to maintain without sufficient monetary coordination among its members. The reason is that Argentina’s overval— ued currency places its exporters at a severe disadvantage. This problem was profoundly exacerbated by the Brazilian devaluation in earlyJanuary 1999. As a result, protectionist pressures have been rapidly mounting domestically. Argentine authorities have sought to provide some relief to exporters, most recently through tax breaks, anti~dumping duties, and other non—tariff barriers on imports. Brazil claims that it should be exempt from these protectionist measures as a member of Mercosur, but Argen- tina has been unwilling to comply in this way, resulting in bitter trade disputes between the two countries. It is unclear how long Mercosur can survive such friction. Since the Brazilian devaluation, trade within Mercosur has fallen by 30 percent. Brazil has threatened to suspend all negotiations over certain particularly contentious issues and has requested the forma- tion of a WTO panel that it hopes will recommend the elimination of the restrictive measures ( TbeEconomz'st 1999) . Without protection, Argentine exporters in several sectors may not be able to survive such adverse relative prices. For this reason, Argentine policy makers must carefully consider their long-term priorities and interests. The Mercosur market probably repre- sents a more important economic partner for Argentina than the United States. Brazil alone is the recipient of over 30 percent of Argentine exports compared to just over 8 percent for the United States, and at 22.6 percent Brazil also accounts for the largest share of Argentine imports, compared to 19.4 percent from the United States (EIUl 999). While NAFTA could potentially represent an appealing opportunity forArgentina, the political The Futureo Ar entimz’s unsi—Curren Board _ 61 environment in the United States is not at all propitious for an expansion of NAFTA in the foreseeable future. Furthermore, the United States already maintains relatively low tariffs in most sectors. While The Convertibility Plan has encouraged foreign investment and capital in— flows, longer-term investments, which are most important to sustained economic strength, are influenced primarily by perceptions regarding economic stability and potential returns. The question remains; can Argentina maintain stability with a more advantageous set of policies? OPTIONS FOR ARGENTINA I will now discuss the range of alternatives to the current quasi—currency board regime. In the long run, Argentina can either maintain its current link to the U.S. dollar, in which case various options are available to minimize the risks and contradictions described above, or it can seek an alternative. These options are discussed below. Managing the Risks of the Convertibility Plan As explained above, a currency board applied to a fractional reserve banking system introduces a degree of weakness into the systeml. One obvious solution is to adopt 100 percent reserve banking, a ‘money board’ system. Under this system, banks are required to hold risk—free, liquid assets equal to the value of their deposits. While this would ensure the convertibility of deposits, it would deprive banks of their ability to perform maturity transformation and commercial lending activities. These activities would be transferred to less regulated non—bank institu— tions. This system would guarantee risk-free deposit institutions and a sound system of payments, and it would eliminate bank runs without the distortions caused by government guarantees. The longer-term lending activity, and therefore maturity and liquidity risk, would be transferred to non—bank institutions on an uninsured basis. Therefore, the central bank’s guarantee of currency convertibility would become much more credible, and exchange rate risk would fall since the Bank would no longer need to guarantee deposits. It is possible that depositors might also migrate to non- bank financial institutions if higher interest rates could be found there. It is not clear that transferring the lending and credit provision functions to less regulated and uninsured financial institutions would provide a more desirable outcome. Though this approach would stabilize the payments system, it is not certain that it would stabilize the overall system of credit provision in a crisis situation. A second option involves moving away from fixed nominal values for éL____________—IWTLM bank loans toward a variable interest rate system. Such a system, though, simply transfers the risk burden to borrowers, creating new risks and concerns within the economy. A third possible option involves reserve requirements that are high, but less than 100 percent. This compromise solution has been adopted in many developing countries, including Argentina prior to the 1995 crisis. However, since the inception of the Convertibility Plan, reserve require— ments have steadily fallen. With the strict limits on money creation, reserve requirements have become the primary tool available to the central bank to control the level of liquidity in the system. In such a context, high reserve requirements may be unsustainable. A fourth alternative is official dollarization. This alternative has recently received increased attention in academia and has been mentioned as an option by some Argentine policy makers (The Economist 1999) who View it as the natural course of evolution for the Convertibility Plan. Eliminating the Argentine currency and adopting the U.S. dollar as the official currency would essentially be an irrevocable commitment to Argentina’s monetary link to the United States. This option would end uncertainty about commitment to or sustainability of the Convertibility Plan, and therefore eliminate exchange rate risk and the instability that it creates in the financial sector. Dollarization has several drawbacks. First, it would imply a loss of seignorage revenues for the government. Moreover, while it would elimi— nate exchange rate risk as a destabilizing factor in the financial system, it does not solve the central bank’s limited capacity to provide guarantees to the financial sector. In fact, it exacerbates this problem by placing absolute constraints on the resources available to the central bank to perform its various functions. The central bank would, therefore, have less capacity to bend the rules in order to increase liquidity in the system, as it was forced to do during the 1995 crisis. It is also unlikely that the U.S. Federal Reserve Bank will assume responsibility for the Argentine financial sector. Another cost of official dollarization could arguably be a lower level of macroeconomic performance and growth in the long run. Adopting the U.S. dollar would result in a permanent monetary union with the United States, but one in which Argentina has no voice. The U.S. Federal Reserve has no reason to consider the needs of the Argentine economy when formulating monetary policy, and, as discussed above, the result could be a sub—optimal monetary policy. Furthermore, it is very unlikely that the United States andArgentina constitute an optimal currency area. Theories of optimal currency areas state that exchange rates should be fixed when The Future of Argentina’s Quasi-Curreng Board 53 factors of production are mobile (both capital and labor) and the markets for goods and services are highly integrated. As stated earlier, Argentina’s trade markets are much more integrated with the Mercosur countries than with the United States, and meaningful labor mobility would be easier to achieve with Mercosur due to both geographic and political consider— ations. Therefore, dollarization would probably imply accepting large externally induced price fluctuations and extremely volatile real interest rates. In sum, fixed exchange rates with fewer rules governing monetary policy run the risk of decreased discipline on the part of policy makers and of lower credibility. With more rules, problems stem from less autonomy over monetary policy and adjustment processes, as well as a more vulner- able financial sector. Alternatives to a Fixed Exchange Rate When considering alternatives to the Convertibility Plan, it is important to consider first the specific exchange rate regime and its implications for monetary policy, and second, the appropriate institutional arrangement. The first set of alternatives concerns the regime itself. The alternative to a fixed rate is a regime with some degree of exchange rate flexibility. Again, many specific arrangements exist, including pure floats, dirty floats, regimes with a target parity surrounded by a band, and adjustable or crawling pegs. Each of these introduces various degrees of flexibility and discretion in formulating policy. Any degree of rigidity, in the form of a band or peg, invites a risk of speculation if its sustainability is questioned. On the other hand, floating rates require a high level of prudence and discipline on the part of monetary authorities and the supporting institu- tions. With such systems, the credibility of these policy makers and institutions is a primary factor affecting the public’s willingness to hold the currency. Therefore, credibility affects the currency’s value and stability. This credibility can be extremely difficult to achieve, especially for countries, such as Argentina, with a history of instability. Currency boards and official dollarization are solutions to this credibil- ity problem, but other forms should be considered. Another potential solution to this credibility problem is a monetary union with another country or group of countries. In the case of Argentina, the likely candidates are Brazil and possibly the other Mercosur countries. This union could either chose to link its currency to the U.S. dollar or a basket of major currencies, or it could establish an independent central bank with the discretion to manage a more flexible common currency. The former would solve the problems caused by the lack of monetary coordination 64 Aaron Zones among the Mercosur countries, but would not solve the other problems presented by dollarization discussed above. With a flexible Mercosur currency, presumably each member country would have a degree of representation in the central bank and control over policy roughly proportional to its economic clout. A Mercosur common currency should be accompanied by other policies to increase labor mobility and economic integration among members in order to create a more optimal currency area, as discussed above. I argue that the optimal arrangement for Argentina is a Mercosur monetary union with an independent central bank mandated to focus on price stability holding discretion over a flexible common currency. This type of union offers several advantages. As discussed above, the Mercosur countries constitute a more optimal currency area than do Argentina and the United States. Therefore, a common monetary policy would be less problematic. The central bank would be under a mandate to balance the interests of each participating country, as in the case of the European Central Bank. Clearly, the interests of the members will at times conflict. Although, I argue that this would represent an improvement over the completely passive acceptance of monetary policy that is implied with the adoption of a foreign currency such as the U.S. dollar. This system would also alleviate the friction within Mercosur created by variations in the nominal exchange rate, and decrease transaction costs of trade within this market. It would also increase the size of the monetary base and, therefore create a stronger currency. Before such an arrangement could be implemented, the potential members would need to achieve greater convergence of certain key macroeconomic conditions, primarily fiscal discipline. Without a solid fiscal foundation, this arrangement would not succeed. Brazil’s fiscal deficit is roughly 10 percent of GDP while Argentina’s is just over 2 percent, and short-term interest rates in Brazil are 1 9 percent compared to just over 9 percent in Argentina ( TbeEconomist 1999). Clearly, aMaastricht— like convergence effort would be necessary in order to achieve monetary unification. Some Issues Regarding Transition and Implementation While the current exchange rate regime is not optimal for Argentina, certain factors would complicate a transition to an alternate arrangement. The first of these is Argentina’s large stock of external debt. A high degree of foreign indebtedness makes any policies that would result in a devalu- ation of the currency less attractive because devaluation directly increases The Future of Argentina’s Quasi—Currency Board Q5 M the foreign debt burden in local currency terms. Another complicating factor is the gradual process of dollarization that has taken place through- out much of Latin America. Across the region, local currencies have been slowly replaced with the dollar, to varying degrees both as a store of value and as a medium of exchange. In Argentina, roughly 60 percent of bank deposits are now held in dollars, and possibly close to 50 percent of transactions are conducted in dollars (IMF 1999). The high degree of substitutability between pesos and dollars would increase the volatility of the exchange rate. Demand for domestic currency would be quite volatile, as it will be affected not only by local interest rates, but also by foreign interest rates and its expected value relative to foreign currency. The widespread circulation of dollars would also complicate the execution of monetary policy because the central bank would need to focus on a monetary aggregate that takes into account this supply of foreign currency in the system when managing the money supply. These factors are substantial obstacles to any possible transition out of the Convertibility Plan. The health of any fixed rate regime is completely dependent on the credibility of the program. If the markets sensed a decrease in the government’s commitment to the fixed exchange rate or the expectation of a nominal devaluation, there would be a widespread conversion to U.S. dollars. This would create excessive claims on the central bank’s foreign currency holdings. It would ultimately cause the collapse of the system and the return of monetary and financial turmoil to Argentina. It is worth recalling that this type of exchange rate risk was a major cause of the 1995 crisis, and Argentina escaped the crisis precisely because the measures taken by the government reassured the markets of its commitment to the fixed exchange rate. Generally speaking, there would be two ways to execute a transition to monetary union with Mercosur countries: a gradual approach and a sudden approach. The former would involve focusing on the convergence criteria discussed earlier while implementing policies to decrease Argentina’s external debt load and reduce the level of dollarization of the economy, without announcing the intention to terminate the Convertibility Plan. Policies to reduce dollarization include the promotion of alternate peso- denominated financial instruments, policies that increase the peso—dollar interest rate gap, direct restrictions on foreign currency deposits or transactions, and legal or institutional measures to encourage the use of local currency. The last of these is probably the most prudent if an incremental approach is determined to be preferable (IMF 1999). Once these goals are achieved, the transition would be far less problematic. Yet fig Aaron lanes the obvious disadvantage of this approach is the long time horizon required. On the other hand, a sudden approach would essentially involve surprising the markets with an announcement of an immediate transition to a new Mercosur common currency, possibly in combination with restrictions on short-term capital flows or even forced conversion of dollar deposits. The cost of this approach in terms of market confidence and the credibility of the new currency and institutions could be severe. If Argentina can afford the time demanded by the more gradual approach, it appears to be the more prudent route to monetary union with Mercosur countries. CONCLUSION The monetary and exchange rate regime created by the ConvertibilityAct of 1991 has achieved remarkable success in stabilizing the Argentine economy and reintegrating it into global markets. Nevertheless, I believe that a permanent commitment to this program is not in Argentina’s long— term interests. It decreases the strategy set for monetary policy, creates contradictions in the financial markets, and encumbers Argentina’s com— mitment to Mercosur. My analysis has shown that a Mercosur monetary union is a more attractive alternative. Nevertheless, it is important to recognize that policy makers are in somewhat of a bind. A transition to such an arrangement could be complicated, as well as politically risky. Policy makers should consider the implications of Argentina’s substantial external debt and highly dollarized domestic market and must work to achieve greater macroeconomic convergence with other Mercosur members. Furthermore, because of the legislative foundation of the Convertibility Plan and the success that it has achieved stabilizing the economy, it will take an extremely bold politician to push for such a policy. However, opposition to the current regime has been mounting among key constituencies, so it is possible that sufficient political momentum for such an effort could be generated. Notes 1 For more on this issue, as well as the currency board vs. central bank debate and the rules vs. discretion debate, see Bery et. al. eds. (1997), Bennett (1994), Hanke and Schuler (1994), Schuler (1996), Wood (1996), and Balino and Cottarelli eds. (1994). 2 In fact, the ConvertibilityAct permitted a maximum of 20 percent of central bank reserves to be dollar denominated government obligations. This figure was expanded to 33 percent in late 1995 when the first mandate of the central bank’s The Future of Argentina's Quasi—Currency Board 67 M board of directors expired. Therefore, the central bank retained a limited capacity to finance the fiscal deficit within this restriction. 3 For example, see Nissan (1993). 4 David Felix discusses this point in his comments on Connolly (1995). References Balino, Tomas J. T. and Carlos Cottarelli, eds. 1994. Frameworks for Stability: Policy Issues and Experiences. Washington, DC: International Monetary Fund. Bennett, Adam G. G. 1994. Currency Boards: Issues and Experiences. IMF Paper on Policy Analysis and Assessment (PPAA/ 94/ 1 8). Bery, Suman K and Valeriano F. Garcia, eds. 1996. Preventing Banking Sector Distress and Crisis in Latin America. Proceedings of a Conference held in Washington, DC April 15—16, 1996. World Bank Discussion Paper 360. Calcagno, Alfredo F. Convertibility and tbe Banking System in Argentina. 1997. CEPAL Review 61 (April): 63-90. Carrizosa, Mauricio et. al.. 1996. Tbe Tequila Eflect and Argentina’s Banking Reform. Finance 86 Development (March): 22—5. Connolly, M. B. 1995. Tbe USES ofa Currency Board-Argentina'April 1,1991 to the Present. Economic Notes 24(3): 639—54. Currency Board Symposium ’97. 1997. Currency Board System: A Stop-Gap Measure or a Necessity/.9. Singapore: Board of Commissioners of Currency. Economist Intelligence Unit (EIU). 1999. Argentina. EIU Country Report 4th Quarter 1999. Hanke, Steve H. and Kurt Schuler. 1994. CurrencyBoardsforDeveloping Countries.- A Handbook. SectorStudy NumberNine. San Francisco: International Center for Economic Growth. International Monetary Fund (IMF). 1998. Currenty Boards: The Ultimate Fix? IMF Working Paper WP/98/ 8. International Monetary Fund (IMF). 1999. Monetary Policy in Dollarized Econo- mies. IMF Occasional Paper 171. Mercosur Beclamed. 1999. The Economist. 11 December, 34. Miller, Geoffrey P. 1996. Is Deposit Insurance Inevitable? Lessons fiom Argentina. International Review of Law and Economics 16: 211-232. Nissan, Liviatan, ed. 1993. Proceedings ofa Conference on Currency Substitution and Currency Boards. World Bank Discussion Paper 207. Perry, Guillermo E., ed. 1997. Currency Boards and External Sbocks: How Mucb Pain and HowMucb Gain?World Bank Latin American and Caribbean Studies: Proceedings. Work in progress for public discussion. Schuler, Kurt. 1996. Sbould Developing Countries Have Central Banks? London: Institute of Economic Affairs. Aaron ones Tobin, James. Financial Globalization: Can National Currencies Survive? 1998. Keynote Address, Annual World Bank Conference on Development Econom— ics. Washington DC, April 20—2 1. Wood, Geoffrey E., ed. 1996. Explorations in Economic Liberalism: The W/incozt Lectures. Macmillan Press Ltd. ...
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v11_2000e - 4 THE FUTURE OF ARGENTINA’S QUASI-CURRENCY...

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