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Argentine Currency Board
The Argentine Currency Board pegged the Argentine Peso to the US Dollar between 1991 and 2002 in an attempt to eliminate hyperinflation and stimulate economic growth. While it initially met with considerable success, the board's actions ultimately failed because of significant flaws in policy implementation.
For almost twenty years up to the end of the 1980s, Argentina experienced hyperinflation poor or negative GDP growth, a severe lack of confidence in the national government and the central bank, and low levels of capital investment. After eight currency crises since the early 1970s, inflation peaked in 1989, reaching 3,000 percent per annum; per capita GDP was 10 percent lower than in 1980, social indicators had deteriorated seriously, and the fiscal deficit reached 7.6 percent of GDP.
To a large extent, the main reason behind this long period of hyperinflation was unsustainable growth of the money supply in order to finance the large fiscal deficits maintained by successive governments. Since Argentina could not participate meaningfully in world capital markets given the great investment risk it posed, the only course available was the financing of these fiscal deficits by monetizing them. This meant that governments levied an inflation tax to pay for the fiscal deficits, which in turn contributed to stalling growth.
Another reason for the instability of the Argentine currency was the fragility of domestic financial institutions. The Argentine banking crisis of 1980 underlined this point, as the central bank moved to confiscate the deposits of commercial banks to overcome a liquidity crunch.
There were also external factors that further triggered the currency crisis, such as interest rate fluctuations. In the early 1980s, for example, the United States imposed tight monetary discipline, which made it more expensive to borrow money since banks had fewer reserves. At other times, easier monetary policy lowered interest rates in the developed economies, resulting in capital flows to developing countries, which produced real exchange rate appreciation, ballooning current account deficits , and – in many cases – full blown currency crises.
The currency board
In 1989, former President Raúl Alfonsín resigned, and in July of that year Carlos Menem was elected President. His early attempts to stabilize inflation failed, resulting in further devaluation of the Peso and a serious reduction in the central bank’s reserves.
In April 1991, President Menem changed back towards what was later to be called “economic neo-liberalism” . This system involved a program of massive privatization and labor-flexibility laws, which encouraged foreign investment and infused the country with cash to finance its fiscal deficits. However, the lynchpin of the new system was the introduction of the Convertibility System, or currency board system.
At the time, there was much debate in Argentina and abroad about how to control inflation and build confidence in local currencies in order to foster investment and growth. There were three options of exchange rate management available to any government: a floating exchange rate, a super-fixed exchange rate (including the possible use of a currency board), or a hybrid system. The latter, however, consisting of various levels of control over exchange rates, was discredited in the early 1990s as empirical evidence from several currency crises showed that in a world of high capital mobility, a semi-fixed exchange rate was very unstable as it allowed a country with poor monetary policy to exercise too much discretionary power. The consequence was that a government had to choose between either fixed or fully floating exchange rate systems.
Before the implementation of the currency board there had been much debate over which currency or currencies to peg the Peso against. In the view of many economists, the Peso should have been pegged to a basket of currencies from the countries that were Argentina's major trading partners . Others argued that the Peso should be pegged to the US Dollar because it would provide simplicity of understanding, the highest degree of safety, greater international credibility, and the promise of increased trade with the USA. The latter argument won the day, with both positive and negative consequences.
Argentina’s currency board established a fixed pegging of one-to-one parity between the Peso and the US Dollar. It also guaranteed full convertibility of Pesos into US Dollars. By tying the value of the Peso to the US Dollar, the government hoped to establish local and international credibility in the peg and to limit the amount of local control over monetary and fiscal policy. In essence, it was a decision to import US monetary policy rather than rely on their own abilities which had been fraught with failure after failure over the previous two decades. The currency board regime was intended to stabilize the Peso, encourage both foreign and local investment, and foster sustained economic growth.
Flaws in implementation
The main qualities of an orthodox currency board are:
- A currency board maintains absolute, unlimited convertibility between its notes and coins and the currency against which they are pegged, at a fixed rate of exchange, with no restrictions on current-account or capital-account transactions.
- A currency board's foreign currency reserves must be sufficient to ensure that all holders of its notes and coins can convert them into the reserve currency (usually 110-115 percent).
- A currency board only earns profit from interest on reserves (less the expense of note-issuing), and does not engage in forward-exchange transactions.
- A currency board has no discretionary powers to effect monetary policy and does not lend to the government. Governments cannot print money, and can only tax or borrow to meet their spending commitments.
- A currency board does not act as a lender of last resort to commercial banks, and does not regulate reserve requirements.
- A currency board does not attempt to manipulate interest rates by establishing a discount rate like a central bank. The peg with the foreign currency tends to keep interest rates and inflation very closely aligned to those in the country against whose currency the peg is fixed.
Argentina’s currency board violated all these rules at one time or another, except that of a fixed exchange rate: full convertibility with the US Dollar was jeopardized when exchange rate controls were implemented by providing a preferential exchange rate for exports; the currency board was allowed to hold up to one-third of its dollar-denominated reserves in the form of bonds issued by the government of Argentina; it acted as lender of last resort and regulated reserve requirements for commercial banks; and it engaged in certain monetary policy activities. The impact of all this was to reduce the credibility of the Argentine government's intent, and to put speculative pressure on the Peso, despite the peg.
Results of the currency board
Argentina implemented its currency board in April 1991. Its main achievement was in controlling inflation which was brought down from over 3,000 percent in 1989 to 3.4% in 1994.
Another major accomplishment of the system was renewed economic growth. Enjoying the high world prices of primary products (Argentina’s main exports), GDP grew at an annual rate of 8% between 1991 until the Tequila Effect of 1995. Even after the Mexican crisis until 1998, the annual growth rate was 6%.
Argentina’s international trade also increased dramatically, reflecting the growing degree of openness of the country. Imports increased from US$11.6 billion in 1991 to US$32.3 billion in 2000. Likewise, exports also increased from US$12.1 billion in 1991 to US$30.7 billion in 2000.
Despite these impressive results of the currency board, there were also negative side effects on the social variables, such as unemployment, income distribution, poverty levels and wage rates. Unemployment increased from 6.1% in 1991 to 15% in 2000 as the fixed exchange rate increased foreign price competition and forced local firms to invest in more advanced technologies that required less labor and increased productivity.
Income distribution also showed no improvement – indeed it moved in the wrong direction: the bottom 20% of the population decreased its participation in national income from 4.6% in 1991 to 4.1% in 2000, while the top 20% of the population increased its share of income from 50.4% to 51.4%.
Initially, the poverty rate declined as hyperinflation receded (implying that the inflation tax was primarily absorbed by low-income households), but after the Mexican crisis the trend reversed. Although overall wages increased they did not benefit all workers equally: skilled and unskilled workers lost ground in comparison to managerial and professional income groups.
Government indebtedness increased sharply: unwilling or unable to raise taxes, and precluded from printing money by the currency board system, the government's only other recourse to finance its budget deficit was through issuing debt instruments in the capital markets. Public debt increased sharply from 29.5% of GDP in 1993 to 50.3% in 1999. Moreover, this debt was in foreign currency, since the domestic private savings remained low, and it took place despite large inflows of income from the privatization of formerly state-owned companies. Associated with the increase in public debt was an increase in the debt service ratio , which increased from 22% of exports in 1993 to 35.2% in 1999, helping to exacerbate an increasing current account deficit.
Part of the Menem program included large-scale privatization of state-owned companies. Unfortunately, because of the fixed exchange rate, privatization agreements generally linked price increase flexibility to the rate of US inflation, which was often higher than that in Argentina. The relative prices of public utilities thus increased and shifted wealth from the state to the privatized firms – which, without any exchange control restraints, were free to expatriate these windfalls and invest them elsewhere.
External shocks also affected the Argentine currency board. The first was the Mexican crisis of 1994-1995, resulting in a liquidity crunch that drove interest rates sharply higher, stalling growth and spurring unemployment. In quick succession, the ensuing Asian and Russian financial crises pounded at the economy by further increasing interest rates as foreign investors became much warier of where they invested their assets, continuing to keep the cost of borrowing high for Argentina. The Brazilian crisis of 1999 probably had the most severe effect because it is Argentina’s largest trading partner, and it was coupled with an appreciating US Dollar and a slump in the world prices of primary products. Argentina’s competitiveness in world markets was severely hit given the Peso's link to the appreciating US Dollar, and weakening demand in its northern trading partner. As a result, the economy stalled and actually contracted.
These ongoing crises and the strong US Dollar in the late 1990s also put the spotlight on Argentina’s peg to the US Dollar rather than to a basket of currencies that were better aligned with its trade patterns. While Argentina was mostly trading with countries (Europe and Brazil) that did not have the US Dollar as their currency, the Peso was fluctuating against those other currencies according to the US Dollar, and not according to Argentina’s economic position. This is known as the "third currency phenomenon" . Simply put, the US Dollar peg overvalued the Peso in the rest of the world, especially against a weak Euro and Brazilian Real , reducing its competitiveness and compounding its deteriorating current account deficit.
Abandonment of the peg
During the second half of 2001, the pressure mounted on the currency board but there was no clear way out. Since most of country's debt was denominated in US Dollars, there was a huge cost to breaking the peg, not to mention the long-term damage to Argentina's credibility in world capital markets. On the other hand, allowing the market to determine the exchange rate would radically improve competitiveness, eliminate the current account deficit – and the need to borrow money to finance it. Many solutions were discussed, including changing the peg to a currency basket of US Dollars and Euros, which would have entailed an effective controlled devaluation of the Peso, and even dollarization (using US Dollars an the country’s only currency). In the end, in December 2001 Argentina suspended payments on its external debt and restricted bank deposit withdrawals. In January 2002, it abandoned its peg to the U.S. dollar and allowed the Peso to float freely, resulting in a realignment of the Peso from 1 per US Dollar to 3.
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- The Crisis that Was Not Prevented: Lessons for Argentina, the IMF, and Globalisation, Jan Joost Teunissen and Age Akkerman (eds.), Fondad, 2003, book, pdf)
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