FRBSF Economic Letter
99-29; September 24, 1999
 Economic
Letter Index
Dollarization in Argentina
Nations have long pursued exchange rate pegs to avoid wide fluctuations
in the international values of their currency. As we have seen in recent
crises in Asia and Latin America, however, when pegs are set at values
that speculators deem unsustainable, they are attacked and usually break
down during currency crises. These crises can have devastating impacts
on national economies, as countries are faced with the undesirable choice
between abandoning their exchange rate pegs and closing the channel of
speculative attack through capital controls, as Malaysia did during the
Asian currency crisis.
To enhance the credibility of their exchange rate pegs, some nations
have adopted a currency board. Under a currency board, the government
pledges to redeem its domestic currency for a foreign "hard" currency.
Nations currently pursuing currency boards include Hong Kong, Estonia,
and Argentina. Indonesia seriously considered launching a currency board
to combat its economic difficulties during the Asian crisis (Spiegel 1998).
Recently, Argentine President Carlos Menem has proposed going a step
further by changing Argentina's currency board regime to a full dollarization
regime. Put simply, dollarization implies the elimination of the Argentine
peso and the adoption of the U.S. dollar in all day-to-day Argentine transactions.
In this Economic Letter, we examine the arguments favoring and
opposing such a move by Argentina.
Argentina's currency board
To keep the implications of a move to dollarization by Argentina in perspective,
it is important to understand its current currency board regime. Under
its currency board, the Argentine peso is pegged to the dollar one for
one. Most importantly, unlike standard fixed exchange rate regimes, the
central bank under a currency board must hold liquid reserves that exceed
the value of the outstanding monetary base (Hanke and Schuler 1999). The
motivation behind this requirement is that the central bank must always
maintain adequate funds to convert outstanding pesos into dollars at the
specified exchange rate.
However, Argentina's currency board allows a share of these assets to
be held in the form of Argentine government bonds, up to a third in emergencies.
Therefore, despite the fact that the abandonment of its peg is a low-probability
event, the Argentine peso does yield an interest rate premium relative
to the U.S. dollar attributable to currency risk. Over and above currency
risk, the interest rate on peso-denominated notes is more sensitive to
increases in U.S. interest rates than yields on dollar-denominated notes.
The reason for this surprising result is that when U.S. interest rates
increase by a given amount, Argentine interest rates increase by a matching
amount to equilibrate the yields on these two assets net of any risk,
and by an additional amount to compensate the holders of peso-denominated
notes for the additional risk that Argentina may abandon its currency
board and let the peso devalue.
Loss of lender of last resort capacity
Because Argentina's central bank can hold some government bonds, it does
retain some limited flexibility under its current currency board policy.
It can use this flexibility to intervene in cases of emergency, as it
did to shore up the reserves of illiquid, but not insolvent, banks during
the 1995 Mexican peso crisis. This "lender of last resort" activity is
traditional for a central bank. It is generally acknowledged that solvent
but illiquid banks should have access to a central bank's "discount window,"
where they can obtain the funds necessary to remain in operation. This
lender of last resort policy is intended to ensure that liquidity shortages
do not lead to crises in the payments system.
Of course, such central bank discount window activity would not be possible
under full dollarization, as the central bank would be precluded from
issuing reserves to provide banks with these additional funds. In its
place, lender of last resort funds would either have to be provided by
private sources or the Argentine Treasury.
Initially, there was some discussion of the United States acting as the
lender of last resort by providing solvent but illiquid Argentine banks
access to the discount window of the Federal Reserve. However, there appears
to be little likelihood of any formal discount window access for Argentine
banks. For example, in Senate Banking Committee testimony (April 22, 1999),
Lawrence Summers, then U.S. Treasury Deputy Secretary, said, "žit would
not, in our judgment, be appropriate for United States authorities to
extend the net of bank supervision, to provide access to the Federal Reserve
discount window, or to adjust bank supervisory responsibilities or the
procedures or orientation of U.S. monetary policy in light of another
country's decision to dollarize its monetary system." In the same hearing,
Federal Reserve Chairman Alan Greenspan echoed this sentiment, saying,
"We have to be careful not to be perceived as creating a safety net,"
for banks in countries adopting dollarization.
While lender of last resort activity is widely considered consistent
with prudent lending practices, it is unsurprising that there is little
possibility that such activity would be granted to banks from another
sovereign nation. Lender of last resort activity does expose the central
bank of a nation to capital losses. Extending such support internationally
would then expose the U.S. taxpayer to losses stemming from poor performance
of Argentine loans. While the U.S. has provided international assistance
in emergency situations to other nations experiencing liquidity difficulties
in the past, these have been financed primarily by the Treasury. It seems
highly unlikely that the central bank of any nation, including the United
States, would make a formal agreement to accept such exposure.
Loss of seigniorage
The direct cost of moving to a dollarized monetary regime would be the
loss of seigniorage, the revenues a central bank earns from its issue
of currency and reserves. Because Argentine citizens would engage in transactions
using U.S. dollars, dollarization would shift the seigniorage revenue
due to Argentine transactions from the central bank of Argentina to the
United States. As in the case of the loss of lender of last resort capacity,
there has been some discussion about the possibility of the United States
compensating Argentina for its lost seigniorage revenue. However, again
there is little chance that such compensation would be politically feasible.
Even proponents of dollarization for Argentina admit that this loss is
far from trivial. Hanke and Schuler (1999) estimate annual seigniorage
revenue to be $750 million. However, they stress that this figure is only
about 0.22% of Argentina's annual GDP. The implication is that if the
move to dollarization provided significant economic benefits, these would
far outweigh any loss in seigniorage revenue.
Removal of currency risk
The primary economic benefits anticipated from a move to dollarization
would be the removal of currency risk--the risk of a loss in asset value
from depreciation in the value of the currency in which the asset is denominated--from
Argentine assets. By removing this risk component, proponents of dollarization
hope to reduce both the average magnitude and the volatility of the interest
rate premium paid by issuers of Argentine assets. Under dollarization,
holders of Argentine assets would only suffer currency risk comparable
to holders of other dollar-denominated assets, such as U.S. Treasury bills.
However, it is important to remember that the increased interest rate
spread that Argentine borrowers suffered in previous turbulent periods
stemmed only partially from currency risk. These spreads also reflected
increases in "country risk," the risk of default on assets from a given
country. In addition, in the case of Argentina, it is important to remember
that its currency board already goes a long way towards eliminating currency
risk. The net impact on interest rate premia from moving from a currency
board to full dollarization then may not be that large.
Indeed, the sensitivity of the country risk premium with respect to an
increase in U.S. interest rates may actually increase following a move
towards dollarization. If Argentine borrowers lack the safety nets associated
with lender of last resort activity and limited central bank flexibility,
the increase in the probability of default on Argentine assets stemming
from an increase in the U.S. interest rate may be larger than it was under
the currency board.
Appropriateness of a dollar peg
Under a currency board regime, the Argentine central bank can change
the currency to which it is pegged fairly easily. For example, if Argentina
chose to peg to the yen instead of the dollar, it could announce a yen
peg and exchange its dollar-denominated reserves for yen assets with limited
disruption of international capital markets. However, if the economy were
fully dollarized, "de-dollarizing" would be fairly costly, as prices and
contracts would have to be adjusted throughout the economy. The lengthy
adjustment process currently taking place as European countries move to
a single currency illustrates that this is not a trivial process
One might hope that the dollar would never cease to be an adequate currency
for an exchange rate peg. Recent price level volatility in the U.S. has
been quite limited. Nevertheless, the U.S. has had episodes of price instability,
and a nation choosing to make such a commitment to this currency would
have to consider the possibility of a recurrence of such turbulence.
More likely, the desire to de-dollarize would stem from the realization
that the dollar was not an appropriate benchmark currency for trade reasons.
The U.S. represents a fairly small share of Argentina's trade basket.
That nation's trade with the rest of the region, and its Mercosur partner
nations in particular, is much more important. It is therefore difficult
to see how a unilateral dollarization move would facilitate trade between
Argentina and its regional partners. Indeed, President Menem's initial
call was for a move towards dollarization by Argentina and its main trading
partners, particularly Brazil. It is unclear why these nations as a group
would choose a dollar peg.
The tyranny of sovereignty
By transacting completely in dollars, dollarization removes the limited
flexibility the central bank currently holds to address emergency episodes.
The hope is that by tying its hands in this manner, Argentina will become
a more attractive destination for international capital as international
investors now face one less form of risk, currency risk. The benefits
of this greater commitment to price stability would come in the form of
a reduction in interest rates paid by issuers of Argentine assets.
It should be pointed out, however, that a sovereign nation's ability
to promise not to pursue actions which it might in the future deem to
be in its own interest are limited even under a completely dollarized
regime. Take the case of a liquidity crisis in a dollarized nation's banking
sector. If that nation believed that its banking sector was threatened,
it could impose restrictions on international capital movements to keep
foreign assets in the country. Holders of these assets could well end
up experiencing capital losses due to default. To some extent, then, under
dollarization country risk would be substituted for currency risk. The
net reduction in interest rates from such a move would therefore be reduced.
Conclusion
Dollarization represents a less drastic step for Argentina than it would
for most economies because that nation already operates a currency board
with a dollar peg. As such, both the benefits and the costs of a move
towards dollarization would be limited relative to a nation under a floating
exchange rate regime. Nevertheless, a move to dollarize would be a large
commitment, as Argentina would be giving up its seigniorage revenue and
its limited current monetary policy flexibility in an effort to reduce
its currency risk. The merits of the move appear to depend on the size
of the expected reduction in the interest rate premium paid on Argentine
assets stemming from the currency risk reduction. Unfortunately, the size
of this payoff is quite uncertain.
Mark M. Spiegel
Research Officer
References
Hanke, Steven H., and Kurt Schuler. 1999. "A Dollarization Blueprint
for Argentina." Friedberg's Commodity and Currency Comments Expert's
Report (February).
Spiegel, Mark M. 1998. "A Currency Board for Indonesia?"
FRBSF Economic Letter 98-09 (March 20).
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
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