FRBSF Economic Letter
2002-25; August 23, 2002
Argentina's Currency Crisis: Lessons for Asia
This Economic Letter is based on a presentation
Mark Spiegel prepared for a panel on "Optimal Currency Arrangements
for Emerging Market Economies: The Experience of Latin America and Asia,"
organized by the Latin American and Asian Economics and Business Association
on July 15, 2002, in Tokyo, Japan.
Before Argentina's currency crisis erupted this year, renewed interest
in pegged exchange rate regimes had been gaining momentum, especially
in Asia. That region's 1997 financial crisis led many of its nations to
explore whether formal currency arrangements might forestall a repeat
of such crises. The initial efforts concentrated on developing institutions
to raise liquidity regionally, and since then the feasibility of greater
monetary policy coordination also has been considered.
Asian countries found particular inspiration from the successful launch
of the European Monetary Union (EMU). The EMU consists of 11 European
nations that adopted a single currency, the euro, and ceded monetary policy
to a single central bank authority; at the same time, however, these countries
retain a large amount of other policy independence, particularly concerning
domestic public finance. As such, the EMU provides a model of a viable
currency union that closely matches a potential ASEAN arrangement (the
ASEAN nations are Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar,
the Philippines, Singapore, Thailand, and Vietnam). The launch of the
EMU was followed by the Chiang Mai Initiative in June 2000, in which the
ASEAN nations plus Japan, China, and Korea agreed to adopt a system of
swap arrangements. There was some speculation that the successful launch
of these swap arrangements would lay the foundation for more intensive
regional monetary policy coordination.
However, the difficulties experienced by Argentina this year have slowed
much of the momentum for the adoption of formal fixed currency arrangements.
The shock of seeing Argentina's currency board regime, which had been
perceived as strong and credible despite some misgivings about the appropriateness
of its currency peg, appears to have renewed doubts about the sustainability
of any formal exchange rate arrangements.
In this Economic Letter, I review the circumstances surrounding
the collapse of Argentina's monetary regime and describe some lessons
these circumstances may provide for proposed Asian currency arrangements.
Argentina's currency board regime
Argentina maintained a currency board regime from April 1, 1991, through
January 6, 2002, under which the Argentine peso was pegged one for one
to the U.S. dollar. In several respects, the regime did not meet the criteria
of an "orthodox" currency board, as defined by Hanke and Schuler
(2002). These criteria include three key features: first, the board must
maintain a fixed exchange rate with its anchor currency; second, it must
allow for full convertibility, that is, it must allow holders of the currency
to move into or out of the anchor currency without restriction; third,
the monetary liabilities of the currency board must be fully backed in
hard—that is, foreign currency—assets.
In addition, an orthodox currency board should not participate in activities
such as purchasing government securities, regulating commercial banks,
or acting as a lender of last resort. It is easy to see how any of these
activities could undermine a currency board's primary goal of maintaining
the peg with the anchor currency.
Argentina's currency board violated all of these rules at some point
in its existence (Hanke and Schuler 2002). The charter governing Argentina's
currency board allowed it to be partially backed by domestic—rather
than hard foreign currency—assets. The currency board initially was
allowed to hold as little as 66.6% of its assets in true foreign reserves.
The remainder could be backed by Argentine government bonds. As such,
the currency board could pursue discretionary monetary policy. In 2001
alone, the foreign reserve backing for Argentina's currency board ranged
from a high of 193% to a low of 82%. In addition, the Argentine central
bank set reserve ratios and, therefore, retained some financial regulatory
power. The currency board also acted as lender of last resort, for example,
during the Mexican peso crisis of 1995, when it extended funds to illiquid
commercial banks (Spiegel 1999). Therefore, it would be more accurate
to characterize Argentina's exchange rate regime not as an orthodox currency
board but as a fixed exchange rate regime with a hard dollar peg. Nevertheless,
it must be granted that the rules faced by Argentina's currency board
exceeded those commonly found in pegged regimes.
With the appreciation of the dollar in the late 1990s, the Argentine
currency board experienced overvaluation. Argentina's exports became less
competitive on the world market. These effects spilled over to the real
side of the economy. Argentina has been in recession now for four years.
In addition, Argentina had been running massive fiscal budget deficits
for some years. In 2000, the government raised income taxes in an effort
to balance its budget, and in 2001 it levied a tax on financial transactions.
But these efforts failed as Argentina's economic recession worsened. The
climbing deficit led to an increase in devaluation concerns. Roughly $20
billion in capital fled the country in 2001. Peso interest rates climbed
to between 40% and 60%, which further weakened the government's budget
position.
At the end of 2001, Argentina moved to a dual exchange rate system, adopting
a preferential exchange rate peg for exports. This move eliminated the
characteristic of full convertibility—and with it any semblance of
a currency board. However, this failed to reassure the public. The government
then froze bank deposits, formally initiating a financial crisis, and
in January 2002 it abandoned the exchange rate regime for a floating regime.
Asian currency arrangements
The currency arrangements proposed for Asian nations vary widely in intensity,
ranging from regional insurance schemes aimed at forestalling future financial
crises to agreements that could culminate in an Asian version of the EMU
with a single currency for the region.
Japan first proposed creation of an "Asian Monetary Fund" in
1997 in the wake of Asia's financial crisis. The proposal was for an institution
that would provide a framework for financial cooperation and policy coordination.
Opposed by both the United States and the IMF, the proposal was shelved.
However, policy coordination in the region was reborn with the Chiang
Mai Initiative in 2000. This initiative would expand existing swap arrangements
to the ASEAN nations as well as to China, Japan, and Korea. The swap arrangements
are designed to provide liquidity support for member countries in distress
in an effort to prevent regional contagion and systemic risk.
A full-fledged intra-Asian currency arrangement analogous to the European
Monetary Union also has been considered (see, for example, Bayoumi and
Mauro 1999). The argument in favor of such a regime is that it would stabilize
exchange rates within the region, while allowing for flexibility against
the three major global currencies, the dollar, the euro, and the yen.
However, Ogawa and Ito (2000) have argued simply for a greater weighting
of other currencies in Asian monetary arrangements. They argue that the
excessive targeting of the dollar fueled the Asian crisis of 1997. If
Asian countries had instead adopted a currency basket with a yen weight
commensurate with Japan's share in trade, the nations would not have experienced
as significant a boom over the 1993-1995 period, as their currencies would
have appreciated with the yen. More importantly, the depreciation of their
currencies along with the yen in 1996 and 1997 would have mitigated their
recessions.
Lessons from the Argentine experience
One obvious and important lesson for the Asian countries from Argentina's
failed currency board is that an improper exchange rate peg is doomed
to failure, no matter how rigorously one imposes conditions to engender
credibility. A basket peg is likely to serve the ASEAN nations best, because
their trade volumes with the United States, Europe, and Japan are of similar
magnitudes. For example, Rajan (2002) notes that during the 1997 Asian
crises, Singapore, which pursued a flexible basket peg, outperformed Hong
Kong, which pursued a dollar peg.
Another lesson is that exchange rate arrangements are no cure for problems
in the area of macroeconomic policy. Despite the relatively strong set
of rules governing the conduct of Argentina's currency board, the regime
collapsed in relatively short order when domestic and foreign investors
determined that the Argentine government's fiscal policies were unsustainable.
One important implication for prospective Asian currency arrangements
is that the degree of disparity in development levels across these countries
is likely to prove difficult. The Asian nations as a group, particularly
if Japan is included, represent a more heterogeneous set of nations than
the EMU, making it more likely that the nations differ in their desired
macroeconomic policies.
A third lesson is that rules can go only so far in enhancing the credibility
of an exchange rate regime. It is generally understood that a nation can
buy credibility by increasing the cost of abandoning the announced peg.
In the case of Argentina, this cost was clearly very high. Nevertheless,
the collapse of the Argentine regime demonstrates the ease of circumventing
the rules of an exchange rate regime. The introduction of a dual exchange
rate system and the freezing of bank accounts were readily adopted policies
in Argentina, despite currency board rules to the contrary.
This lesson raises the question of whether dollarization would have done
much better, and the answer is, not necessarily. Under dollarization,
Argentina would have experienced the same exchange rate appreciation and
therefore the same loss of competitiveness vis-à-vis its primary
trading partners who were not tied to the dollar. Therefore, the government
probably would have ended up in a similar unsustainable fiscal situation.
Moreover, there is little reason to believe that dollarization would have
precluded the government from abandoning the peg. For example, one proposal
to deal with the current crisis that is now being circulated is the forced
conversion of asset claims into bonds, presumably at depreciated peso
prices. There is no reason that the same reduction in liabilities could
not be achieved under a dollarized regime. The government could simply
freeze all deposits and convert them to bonds with a financial haircut
in place. Once the legal protection of property claims is open to abrogation,
no exchange rate regime can ensure asset values.
Finally, many would argue that the ultimate lesson from Argentina's currency
crisis is that no fixed exchange rate regime, even one as institutionally
strong as Argentina's, is completely sound. As a result, it will sooner
or later lose its credibility. Moreover, since financial contracts will
have been written in the domestic currency, this loss of credibility will
have real effects and likely will precipitate a financial crisis, or at
least a severe disruption to the real side of the economy. As such, floating
may be a superior policy over the long run.
At the same time, floating exchange rate regimes pose important difficulties
for developing countries. First, because many of these countries are relatively
open, external shocks can do more damage to them than to most developed
nations. Second, because developing countries lack the ability to issue
debt in their own currency, depreciations immediately correspond to increases
in indebtedness in domestic currency. As a result, floating regimes may
exacerbate the potential for financial crises stemming from widespread
bankruptcies.
Finally, floating regimes place responsibility for maintaining price
stability back squarely in the hands of the national central bank. Because
developing country institutions are often less well-established, it may
be difficult for a developing nation's central bank to resist, for example,
monetizing the deficit of its treasury. As a result, price stability may
be unattainable domestically. Instead, nations may look to exchange rate
pegs as mechanisms to import developed nations' monetary policies that
are otherwise unattainable given their own level of institutional development.
Conclusion
The collapse of Argentina's currency board has had a devastating impact
on that nation. Perhaps the most important lesson from Argentina's experience
is that an exchange rate regime is only as good as its peg. No set of
rules surrounding the regime, regardless of their strength, can force
a nation to remain attached to a peg that has outlived its usefulness.
As a result, even "good" pegs are likely to be less than perfectly
credible. Despite the drawbacks outlined here, the alternative of pure
floating must be seriously considered.
Mark Spiegel
Research Advisor
References
Bayoumi, Tamim, and Paolo Mauro. 1999. "The Suitability of ASEAN
for a Regional Currency Basket." International Monetary Fund Working
Paper WP/99/162.
Hanke, Steve, and Kurt Schuler. 2002. "What Went Wrong in Argentina?"
Central Banking 12(3), pp. 43-48.
Ogawa, Eiji, and Takatoshi Ito. 2000. "On the Desirability of a Regional
Basket Currency Arrangement." NBER Working Paper 8002 (November).
Rajan, Ramkishen S. 2002. "Argentina and East Asia: The Peg Does
It Again." Mimeo, University of Adelaide.
Spiegel, Mark M. 1999. "Dollarization in Argentina." FRBSF
Economic Letter 99-29 (September 24).
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