Argentine Currency Board
Encyclopedia
The Argentine Currency Board pegged the Argentine peso
to the U.S. 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. In contrast of what most people think, this peg actually did not exist, except only in the first years of the plan. From then on, the government never needed to use the foreign exchange reserves
of the country in the maintenance of the peg, except when the recession and the massive bank withdrawals started in 2000.
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 5,000% that year. GDP was 10% lower than in 1980 and per capita GDP had fallen by over 20%. Fixed investment
fell by over half and, by 1989, could not cover yearly depreciation
- particularly in the industrial sector. Social indicators deteriorated seriously: real wages collapsed to about half of their 1974 peak and income poverty rates increased from 27% in 1980 to 47% in 1989.
To a large extent, the main reason behind this long period of hyperinflation was unsustainable growth of the money supply
to finance the large fiscal deficits maintained by successive governments. Driven by rising tax evasion and losses among state enterprises, the total public fiscal deficit reached 10% of GDP in 1983. Austerity measures pursued by President Raúl Alfonsín
trimmed this 4% in 1985, thought the 1989 crisis pushed the shortfall to 7.6% (which could only be financed by suspending debt interest payments). 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 the government 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 1990 underlined this point, as the Central Bank moved to confiscate the deposits of commercial banks to overcome a liquidity
crunch, exchanging certain types of time deposit
s for BONEX bonds. Tightening domestic credit became increasingly limited to the public sector: only US$17 billion of loans outstanding (45% of the total) were accounted for by private sector borrowers, and this declined to US$7 billion during the 1989 crisis. Accordingly, the nation's money supply (M2
) fell by nearly identical figures, while affluent Argentine nationals held over US$50 billion overseas.
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 upon its own institutions, which made it more expensive to borrow money because banks were required to keep higher reserve requirement
s. Erratic or punitive responses to global financial vagaries by the Central Bank of Argentina itself often left the Argentine economy bearing the brunt. One particularly damaging austerity policy was the Central Bank Circular 1050. Enacted in 1980, it tied monthly installment payments to the value of the U.S dollar
in Argentina, which rose over ten-fold between early 1981 and July 1982, when new Central Bank President Domingo Cavallo
rescinded the surcharge (by then, commercial banks had been writing off 5% of their loan portfolio a month). The debacle shattered credit market confidence locally for the rest of the 1980s, directly contributing to the negative economic climate in Argentina during those years.
Carlos Menem
took office six months in advance. His early attempts to stabilize inflation failed, resulting in further depreciation
of the austral
and a serious reduction in the Central Bank's foreign currency reserves.
In April 1991, Menem reverted the country's policies according to ideas of Washington Consensus
to what was later to be called economic neoliberalism
. This system involved a program of massive privatization
and labor deregulation
laws, which encouraged foreign investment and infused the country with cash to finance its fiscal deficits. However, the linchpin of the new system was the introduction of the Convertibility
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 hybrid system consisted of various levels of control over exchange rates, and it was discredited in the early 1990s when empirical evidence from several currency crises showed that, in a world of high capital mobility, a semi-fixed exchange rate was very unstable, because 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 was 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 U.S. dollar because it would provide simplicity of understanding, the highest degree of safety, greater international credibility, and the promise of increased trade with the United States. 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 U.S. dollar. It also guaranteed full convertibility of pesos into U.S. dollars. 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. The currency board regime intended to stabilize the peso, encourage both foreign and local investment, and foster sustained economic growth.
The Argentine currency board violated all these rules at one time or another, except that of a fixed exchange rate. Full convertibility with the U.S. dollar became jeopardized upon implementation of exchange rate controls that provided a preferential exchange rate for export
s. 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 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.
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%.
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, there were also negative side effects on social issues, such as increased unemployment
, unequal income distribution, increased poverty
levels and decreased 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 higher 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 compared to managerial and professional income groups.
Government debt 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 to issue 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, exacerbating an increasing current account deficit.
Part of President Menem's 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 U.S. 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 1997 Asian and 1998 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 Brazil
ian crisis of 1999 probably had the most severe effect, because Brazil is Argentina's largest trading partner, and the crisis was coupled with an appreciating U.S. 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 U.S. dollar and weakening demand in its northern trading partner. As a result, the economy stalled and subsequently contracted.
These ongoing crises and the strong U.S. dollar in the late 1990s put the spotlight on the decision to peg the peso to the U.S. 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 U.S. dollar as their currency, the peso was fluctuating according to the U.S. dollar and not according to Argentina's actual economic position (this is known as the "third currency phenomenon"). Simply put, the dollar peg overvalued the peso in the rest of the world, especially against a weak euro
and the Brazilian real
, reducing Argentina's competitiveness and compounding the account deficit.
of the peso), and dollarization (using U.S. dollars as the country's only currency).
On December 3, 2001, the minister Domingo Cavallo
restricted bank deposit withdrawals to a maximum of 1000 pesos/dollars per month until 3 March 2002. This was popularly known as Corralito
. The effect of the Corralito was so unpopular that the president de la Rúa
and Cavallo had to resign. First Ramon Puerta took the presidency and 2 days later Rodriguez Saa assume. In the week he was in charge, Argentina suspended payments on its external debt. In January 2002, the new president, Eduardo Duhalde, repealed the Convertibility Law and adopted a new, provisional fixed exchange rate of 1.4 pesos to the dollar (a 29% devaluation) and the conversion of all the bank' accounts denominated in dollars into pesos and its transformation in bonds ("Corralon"); soon afterward it completely abandoned its peg and allowed the peso to float freely, resulting in a swift depreciation
of the peso, which lost 75% of its value with respect to the U.S. dollar in a matter of months.
The reason of this incredible depreciation of the peso was not the economic crisis or the overvaluation, it was the "pesification" of all the accounts. As a consequence of the pesification of every account in Argentina, the 100 billion dollars that were in the banks were changed to 100 billion pesos. This caused an enormous demand for dollars and transformed the normal change of 1.40 pesos per dollar to 4 pesos per dollar in 5 months.
Argentine peso
The peso is the currency of Argentina, identified by the symbol $ preceding the amount in the same way as many countries using dollar currencies. It is subdivided into 100 centavos. Its ISO 4217 code is ARS...
to the U.S. dollar
United States dollar
The United States dollar , also referred to as the American dollar, is the official currency of the United States of America. It is divided into 100 smaller units called cents or pennies....
between 1991 and 2002 in an attempt to eliminate hyperinflation
Hyperinflation
In economics, hyperinflation is inflation that is very high or out of control. While the real values of the specific economic items generally stay the same in terms of relatively stable foreign currencies, in hyperinflationary conditions the general price level within a specific economy increases...
and stimulate economic growth
Economic growth
In economics, economic growth is defined as the increasing capacity of the economy to satisfy the wants of goods and services of the members of society. Economic growth is enabled by increases in productivity, which lowers the inputs for a given amount of output. Lowered costs increase demand...
. While it initially met with considerable success, the board's actions ultimately failed. In contrast of what most people think, this peg actually did not exist, except only in the first years of the plan. From then on, the government never needed to use the foreign exchange reserves
Foreign exchange reserves
Foreign-exchange reserves in a strict sense are 'only' the foreign currency deposits and bonds held by central banks and monetary authorities. However, the term in popular usage commonly includes foreign exchange and gold, Special Drawing Rights and International Monetary Fund reserve positions...
of the country in the maintenance of the peg, except when the recession and the massive bank withdrawals started in 2000.
Background
For most of the period between 1975 and 1990, Argentina experienced hyperinflation (averaging 325% a year), poor or negative GDPGross domestic product
Gross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....
growth, a severe lack of confidence in the national government
Government of Argentina
The government of Argentina, functioning within the framework of a federal system, is a presidential representative democratic republic. The President of Argentina is both head of state and head of government. Executive power is exercised by the President. Legislative power is vested in both the...
and the Central Bank
Banco Central de la República Argentina
-Overview:Established by six Acts of Congress enacted on May 28, 1935, the bank replaced Argentina's Currency board, which had been in operation since 1890...
, and low levels of capital
Capital (economics)
In economics, capital, capital goods, or real capital refers to already-produced durable goods used in production of goods or services. The capital goods are not significantly consumed, though they may depreciate in the production process...
investment
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
. After eight currency crises since the early 1970s, inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
peaked in 1989, reaching 5,000% that year. GDP was 10% lower than in 1980 and per capita GDP had fallen by over 20%. Fixed investment
Fixed investment
Fixed investment in economics refers to investment in fixed capital, i.e., tangible capital goods , or to the replacement of depreciated capital goods which have been scrapped....
fell by over half and, by 1989, could not cover yearly depreciation
Depreciation
Depreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....
- particularly in the industrial sector. Social indicators deteriorated seriously: real wages collapsed to about half of their 1974 peak and income poverty rates increased from 27% in 1980 to 47% in 1989.
To a large extent, the main reason behind this long period of hyperinflation was unsustainable growth of the money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...
to finance the large fiscal deficits maintained by successive governments. Driven by rising tax evasion and losses among state enterprises, the total public fiscal deficit reached 10% of GDP in 1983. Austerity measures pursued by President Raúl Alfonsín
Raúl Alfonsín
Raúl Ricardo Alfonsín was an Argentine lawyer, politician and statesman, who served as the President of Argentina from December 10, 1983, to July 8, 1989. Alfonsín was the first democratically-elected president of Argentina following the military government known as the National Reorganization...
trimmed this 4% in 1985, thought the 1989 crisis pushed the shortfall to 7.6% (which could only be financed by suspending debt interest payments). 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 the government levied an inflation tax
Inflation tax
Inflation tax is a term which refers to the financial loss of value suffered by holders of cash and fixed-rate bonds, as well those on fixed income , due to the effects of inflation...
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 1990 underlined this point, as the Central Bank moved to confiscate the deposits of commercial banks to overcome a liquidity
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...
crunch, exchanging certain types of time deposit
Time deposit
A time deposit is a money deposit at a banking institution that cannot be withdrawn for a certain "term" or period of time...
s for BONEX bonds. Tightening domestic credit became increasingly limited to the public sector: only US$17 billion of loans outstanding (45% of the total) were accounted for by private sector borrowers, and this declined to US$7 billion during the 1989 crisis. Accordingly, the nation's money supply (M2
M2
-In computers and electronics:*Fast Universal Digital Computer M-2, an early Russian digital computer *Memory Stick Micro , a removable flash memory card format*Modula-2 , a computer programming language...
) fell by nearly identical figures, while affluent Argentine nationals held over US$50 billion overseas.
There were also external factors that further triggered the currency crisis
Currency crisis
A currency crisis, which is also called a balance-of-payments crisis, is a sudden devaluation of a currency caused by chronic balance-of-payments deficits which usually ends in a speculative attack in the foreign exchange market. It occurs when the value of a currency changes quickly, undermining...
, such as interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
fluctuations. In the early 1980s, for example, the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
imposed tight monetary discipline upon its own institutions, which made it more expensive to borrow money because banks were required to keep higher reserve requirement
Reserve requirement
The reserve requirement is a central bank regulation that sets the minimum reserves each commercial bank must hold of customer deposits and notes...
s. Erratic or punitive responses to global financial vagaries by the Central Bank of Argentina itself often left the Argentine economy bearing the brunt. One particularly damaging austerity policy was the Central Bank Circular 1050. Enacted in 1980, it tied monthly installment payments to the value of the U.S dollar
Historical exchange rates of Argentine currency
The following table contains the monthly historical exchange rate of the different currencies of Argentina, expressed in Argentine currency units per United States dollar...
in Argentina, which rose over ten-fold between early 1981 and July 1982, when new Central Bank President Domingo Cavallo
Domingo Cavallo
Domingo Felipe "Mingo" Cavallo is an Argentine economist and politician. He has a long history of public service and is known for implementing the Convertibilidad plan, which fixed the dollar-peso exchange rate at 1:1 between 1991 and 2001, which brought the Argentine inflation rate down from over...
rescinded the surcharge (by then, commercial banks had been writing off 5% of their loan portfolio a month). The debacle shattered credit market confidence locally for the rest of the 1980s, directly contributing to the negative economic climate in Argentina during those years.
Carlos Menem
Carlos Menem
Carlos Saúl Menem is an Argentine politician who was President of Argentina from 1989 to 1999. He is currently an Argentine National Senator for La Rioja Province.-Early life:...
took office six months in advance. His early attempts to stabilize inflation failed, resulting in further depreciation
Depreciation (currency)
Currency depreciation is the loss of value of a country's currency with respect to one or more foreign reference currencies, typically in a floating exchange rate system. It is most often used for the unofficial increase of the exchange rate due to market forces, though sometimes it appears...
of the austral
Argentine austral
The austral was the currency of Argentina between June 15, 1985 and December 31, 1991. It was subdivided into 100 centavos. The symbol was an uppercase A with an extra horizontal line . This symbol appeared on all coins issued in this currency , to distinguish them from earlier currencies...
and a serious reduction in the Central Bank's foreign currency reserves.
In April 1991, Menem reverted the country's policies according to ideas of Washington Consensus
Washington Consensus
The term Washington Consensus was coined in 1989 by the economist John Williamson to describe a set of ten relatively specific economic policy prescriptions that he considered constituted the "standard" reform package promoted for crisis-wracked developing countries...
to what was later to be called economic neoliberalism
Neoliberalism
Neoliberalism is a market-driven approach to economic and social policy based on neoclassical theories of economics that emphasizes the efficiency of private enterprise, liberalized trade and relatively open markets, and therefore seeks to maximize the role of the private sector in determining the...
. This system involved a program of massive privatization
Privatization
Privatization is the incidence or process of transferring ownership of a business, enterprise, agency or public service from the public sector to the private sector or to private non-profit organizations...
and labor deregulation
Deregulation
Deregulation is the removal or simplification of government rules and regulations that constrain the operation of market forces.Deregulation is the removal or simplification of government rules and regulations that constrain the operation of market forces.Deregulation is the removal or...
laws, which encouraged foreign investment and infused the country with cash to finance its fiscal deficits. However, the linchpin of the new system was the introduction of the Convertibility
Convertibility
Convertibility is the quality that allows money or other financial instruments to be converted into other liquid stores of value. Convertibility is an important factor in international trade, where instruments valued in different currencies must be exchanged....
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
Floating exchange rate
A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime wherein a currency's value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency....
, a super-fixed exchange rate
Fixed exchange rate
A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime wherein a currency's value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold.A fixed exchange rate is usually used to...
(including the possible use of a currency board
Currency board
A currency board is a monetary authority which is required to maintain a fixed exchange rate with a foreign currency. This policy objective requires the conventional objectives of a central bank to be subordinated to the exchange rate target....
), or a hybrid system. The hybrid system consisted of various levels of control over exchange rates, and it was discredited in the early 1990s when empirical evidence from several currency crises showed that, in a world of high capital mobility, a semi-fixed exchange rate was very unstable, because 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 was 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
Currency basket
A currency basket is a portfolio of selected currencies with different weightings. A currency basket is commonly used to minimize the risk of currency fluctuations. An example of a currency basket is the European Currency Unit that was used by the European Community member states as the unit of...
from the countries that were Argentina's major trading partners. Others argued that the peso should be pegged to the U.S. dollar because it would provide simplicity of understanding, the highest degree of safety, greater international credibility, and the promise of increased trade with the United States. 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 U.S. dollar. It also guaranteed full convertibility of pesos into U.S. dollars. 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. The currency board regime 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 convertibilityConvertibilityConvertibility is the quality that allows money or other financial instruments to be converted into other liquid stores of value. Convertibility is an important factor in international trade, where instruments valued in different currencies must be exchanged....
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 currencyReserve currencyA reserve currency, or anchor currency, is a currency that is held in significant quantities by many governments and institutions as part of their foreign exchange reserves...
(usually 110–115%). - A currency board only earns profitProfit (accounting)In accounting, profit can be considered to be the difference between the purchase price and the costs of bringing to market whatever it is that is accounted as an enterprise in terms of the component costs of delivered goods and/or services and any operating or other expenses.-Definition:There are...
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 affect monetary policy and does not lend to the government. Governments cannot print money, and can only taxTaxTo tax is to impose a financial charge or other levy upon a taxpayer by a state or the functional equivalent of a state such that failure to pay is punishable by law. Taxes are also imposed by many subnational entities...
or borrow to meet their spending commitments. - A currency board does not act as a lender of last resortLender of last resortA lender of last resort is an institution willing to extend credit when no one else will. The term refers especially to a reserve financial institution, most often the central bank of a country, intended to avoid bankruptcy of banks or other institutions deemed systemically important or 'too big to...
to commercial banks, and does not regulate reserve requirementReserve requirementThe reserve requirement is a central bank regulation that sets the minimum reserves each commercial bank must hold of customer deposits and notes...
s. - A currency board does not attempt to manipulate interest rateInterest rateAn interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
s by establishing a discount rateDiscount rateThe discount rate can mean*an interest rate a central bank charges depository institutions that borrow reserves from it, for example for the use of the Federal Reserve's discount window....
like a central bankCentral bankA central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
. 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.
The Argentine currency board violated all these rules at one time or another, except that of a fixed exchange rate. Full convertibility with the U.S. dollar became jeopardized upon implementation of exchange rate controls that provided a preferential exchange rate for export
Export
The term export is derived from the conceptual meaning as to ship the goods and services out of the port of a country. The seller of such goods and services is referred to as an "exporter" who is based in the country of export whereas the overseas based buyer is referred to as an "importer"...
s. The currency board was allowed to hold up to one-third of its dollar-denominated reserves in the form of bonds
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
issued by the government of Argentina. It acted as lender of last resort and regulated reserve requirements for commercial banks. And it engaged in 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 more than 3,000% 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
1994 economic crisis in Mexico
The 1994 Economic Crisis in Mexico, widely known as the Mexican peso crisis, was caused by the sudden devaluation of the Mexican peso in December 1994....
, until 1998 the annual growth rate was 6%.
International trade
International trade
International trade is the exchange of capital, goods, and services across international borders or territories. In most countries, such trade represents a significant share of gross domestic product...
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, there were also negative side effects on social issues, such as increased unemployment
Unemployment
Unemployment , as defined by the International Labour Organization, occurs when people are without jobs and they have actively sought work within the past four weeks...
, unequal income distribution, increased poverty
Poverty
Poverty is the lack of a certain amount of material possessions or money. Absolute poverty or destitution is inability to afford basic human needs, which commonly includes clean and fresh water, nutrition, health care, education, clothing and shelter. About 1.7 billion people are estimated to live...
levels and decreased wage
Wage
A wage is a compensation, usually financial, received by workers in exchange for their labor.Compensation in terms of wages is given to workers and compensation in terms of salary is given to employees...
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 higher productivity
Productivity
Productivity is a measure of the efficiency of production. Productivity is a ratio of what is produced to what is required to produce it. Usually this ratio is in the form of an average, expressing the total output divided by the total input...
.
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 compared to managerial and professional income groups.
Government debt 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 to issue 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
Debt service ratio
In economics and government finance, debt service ratio is the ratio of debt service payments of a country to that country’s export earnings. A country's international finances are healthier when this ratio is low...
, which increased from 22% of exports in 1993 to 35.2% in 1999, exacerbating an increasing current account deficit.
Part of President Menem's 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 U.S. 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 1997 Asian and 1998 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 Brazil
Brazil
Brazil , officially the Federative Republic of Brazil , is the largest country in South America. It is the world's fifth largest country, both by geographical area and by population with over 192 million people...
ian crisis of 1999 probably had the most severe effect, because Brazil is Argentina's largest trading partner, and the crisis was coupled with an appreciating U.S. 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 U.S. dollar and weakening demand in its northern trading partner. As a result, the economy stalled and subsequently contracted.
These ongoing crises and the strong U.S. dollar in the late 1990s put the spotlight on the decision to peg the peso to the U.S. dollar rather than to a basket of currencies that were better aligned with its trade patterns. While Argentina was mostly trading with countries (Europe
Europe
Europe is, by convention, one of the world's seven continents. Comprising the westernmost peninsula of Eurasia, Europe is generally 'divided' from Asia to its east by the watershed divides of the Ural and Caucasus Mountains, the Ural River, the Caspian and Black Seas, and the waterways connecting...
and Brazil) that did not have the U.S. dollar as their currency, the peso was fluctuating according to the U.S. dollar and not according to Argentina's actual economic position (this is known as the "third currency phenomenon"). Simply put, the dollar peg overvalued the peso in the rest of the world, especially against a weak euro
Euro
The euro is the official currency of the eurozone: 17 of the 27 member states of the European Union. It is also the currency used by the Institutions of the European Union. The eurozone consists of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg,...
and the Brazilian real
Brazilian real
The real is the present-day currency of Brazil. Its sign is R$ and its ISO code is BRL. It is subdivided into 100 centavos ....
, reducing Argentina's competitiveness and compounding the 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 U.S. dollars, there would be 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 and eliminate the current account deficit along with the need to borrow money to finance it. Many solutions were considered, including changing the peg to a currency basket of U.S. dollars and euros (which would have entailed an effective and controlled devaluationDevaluation
Devaluation is a reduction in the value of a currency with respect to those goods, services or other monetary units with which that currency can be exchanged....
of the peso), and dollarization (using U.S. dollars as the country's only currency).
On December 3, 2001, the minister Domingo Cavallo
Domingo Cavallo
Domingo Felipe "Mingo" Cavallo is an Argentine economist and politician. He has a long history of public service and is known for implementing the Convertibilidad plan, which fixed the dollar-peso exchange rate at 1:1 between 1991 and 2001, which brought the Argentine inflation rate down from over...
restricted bank deposit withdrawals to a maximum of 1000 pesos/dollars per month until 3 March 2002. This was popularly known as Corralito
Corralito
Corralito was the informal name for the economic measures taken in Argentina at the end of 2001 by Minister of Economy Domingo Cavallo in order to stop a bank run, and which were fully in force for one year. The corralito almost completely froze bank accounts and forbade withdrawals from U.S...
. The effect of the Corralito was so unpopular that the president de la Rúa
Fernando de la Rúa
Fernando de la Rúa is an Argentine politician. He was president of the country from December 10, 1999 to December 21, 2001 for the Alliance for Work, Justice and Education ....
and Cavallo had to resign. First Ramon Puerta took the presidency and 2 days later Rodriguez Saa assume. In the week he was in charge, Argentina suspended payments on its external debt. In January 2002, the new president, Eduardo Duhalde, repealed the Convertibility Law and adopted a new, provisional fixed exchange rate of 1.4 pesos to the dollar (a 29% devaluation) and the conversion of all the bank' accounts denominated in dollars into pesos and its transformation in bonds ("Corralon"); soon afterward it completely abandoned its peg and allowed the peso to float freely, resulting in a swift depreciation
Depreciation (currency)
Currency depreciation is the loss of value of a country's currency with respect to one or more foreign reference currencies, typically in a floating exchange rate system. It is most often used for the unofficial increase of the exchange rate due to market forces, though sometimes it appears...
of the peso, which lost 75% of its value with respect to the U.S. dollar in a matter of months.
The reason of this incredible depreciation of the peso was not the economic crisis or the overvaluation, it was the "pesification" of all the accounts. As a consequence of the pesification of every account in Argentina, the 100 billion dollars that were in the banks were changed to 100 billion pesos. This caused an enormous demand for dollars and transformed the normal change of 1.40 pesos per dollar to 4 pesos per dollar in 5 months.
Sources
- Baer, Werner; Elosegui, Pedro & Gallo, Andrés. (2002) The Achievements and Failures of Argentina's Neo-Liberal Economic Policies, Oxford Development Studies, Vol. 30, No. 1, pp. 63-85.
- Bird, Graham. (2002) Argentina's Currency Board: Cry for Argentina - But not for its currency board, New Economy: Surrey Centre for International Economic Studies, pp. 158-165.
- Cavallo, Domingo F. & Cottani, Joaquin A. (1997) Argentina's Convertibility Plan and the IMF, AEA Papers and Proceedings, May, Vol. 87, No. 2, pp. 17-22.
- de la Torre, Augusto; Levy Yeyati, Eduardo & Schmukler, Sergio L. (2003) Living and Dying with Hard Pegs: The Rise and Fall of Argentina's Currency Board, Journal of LACEA Economia, LACEA - LATIN AMERICAN AND CARIBBEAN ECONOMIC ASSOCIATION.
- Dornbusch, Rudi. (2001) Exchange Rates and the Choice of Monetary-Policy Regimes: Fewer Monies, Better Monies, AEA Papers and Proceedings, May, Volume 91, No. 2, pp. 238-242.
- Edwards, Sebastian. (2002) The Great Exchange Rate Debate after Argentina, The North American Journal of Economics and Finance, Volume 13, Issue 3, pp. 237-252.
- Gurtner, Francois J. (2003) Currency Boards and Debt Traps: Evidence from Argentina and Relevance for Estonia, (Oxford, Blackwell Publishing Ltd.), pp. 209-228.
- Hanke, Steve H. (2002) On Dollarization and Currency Boards: Error and Deception, Policy Reform, Vol 5 (4), pp. 203-222.
- Hanke, Steve H. (2003) The Argentine Straw Man: A response to Currency Board Critics, Cato Journal, Spring/Summer, Vol. 23, No. 1, p. 47-57.
- Horn, Gustav A., Fritsche, Ulrich. (2002) Argentina in Crisis, DIW Economic Bulletin, Vol. 39, No. 4, pp. 119-126.
- Levy Yeyati, Eduardo (2006) Liquidity Insurance in a Financially Dollarized Economy, NBER Working Papers 12345, National Bureau of Economic Research, Inc.
- Schuler, Kurt. (2002) Fixing Argentina, Policy Analysis, July 16, No. 445.
See also
- Economy of ArgentinaEconomy of ArgentinaThis article provides an overview of the Economic history of Argentina.-Emergence into the world economy:Prior to the 1880s, Argentina was a relatively isolated backwater, dependent on the wool, leather and hide industry for both the greater part of its foreign exchange and the generation of...
- Argentine economic crisis (1999-2002)Argentine economic crisis (1999-2002)The Argentine economic crisis was a financial situation, tied to poilitical unrest, that affected Argentina's economy during the late 1990s and early 2000s...
- Digital gold currencyDigital gold currencyDigital gold currency is a form of electronic money based on ounces of gold. It is a kind of representative money, like a US paper gold certificate at the time that these were exchangeable for gold on demand. The typical unit of account for such currency is the gold gram or the troy ounce,...
External links
- The Crisis that Was Not Prevented: Lessons for Argentina, the IMF, and Globalisation, Jan Joost Teunissen and Age Akkerman (eds.), Fondad, 2003, book, pdf)
- Living and dying with hard pegs: the rise and fall of Argentina's currency board, De la Torre, Augusto & Levy Yeyati, Eduardo & Schmukler, Sergio L., 2003)
- Levy-Yeyati, Eduardo & Martinez Peria, Maria Soledad & Schmukler, Sergio L., 2004. Market discipline under systemic risk - evidence from bank runs in emerging economies, Policy Research Working Paper Series 3440, The World Bank)