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.
- Argentina’s currency board
- Loss of lender of last resort capacity
- Loss of seigniorage
- Removal of currency risk
- Appropriateness of a dollar peg
- The tyranny of sovereignty
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.
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.
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.
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.
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.
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.
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.
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
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).
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