Download The Function of Dollarisation

IESG: Argentina
ECONOMIC REFORM & THE RECENT CRISIS
IN ARGENTINA
 The Function of Dollarisation
 Economic Reform under Alfonsin &
Menem
 The Impact of the Currency Board
 The December 2001 Crisis
 Where To Now?
IESG: Argentina
THE FUNCTION OF DOLLARISATION
Eichengreen in the Journal of Money Credit & Banking
(2002) discusses credibility and the sequencing of
reform and Dollarisation:
 Ecuador – Dollarisation then reform. Recognition that
dollarisation necessary for domestic reform to be
credible.
 Argentina – reform then effective dollarisation. Use of
exchange rate link to ‘lock-in initial reforms.
IESG: Argentina
ECONOMIC REFORM UNDER
ALFONSIN & MEMEM
Democracy was restored in 1986 with the election of
Radical President Raul Alfonsin after a decade of
political repression and economic dislocation including
rampant hyperinflation and stagnant economic growth.
Alfonsin initiated limited structural reform and attempted
to end hyperinflation. Much of the reform programme
was undermined or blocked by the Peronists.
The failure of Alfonsin’s reforms led to the election of
Peronist Carlos Menem in 1990 (and 1994). It was
Menem who (unexpectedly) implemented significant and
far-reaching structural reforms:
IESG: Argentina
ECONOMIC REFORM UNDER MENEM
 Cuts in Federal/State expenditure and transferring
control of the money supply to the Central Bank.
 Significant trade liberalisation, including major tariff
cuts and the removal of import quotas and export
taxes.
 Exchange rate reform to introduce currency stability.
Argentina had 3 different currencies 1976-1990. The
Peso was ‘dollarised’, supported by a currency board.
 Extensive state ownership (federal and provincial) of
enterprises and military firms were privatised to cut
subsidies and raise revenues.
 The deregulation of the labour market through the
reform of contract laws so as to increase labour
market flexibility.
 The removal of price controls, including wage
indexation.
IESG: Argentina
THE ARGENTINIAN CURRENCY BOARD
The Argentinian Peso was linked to the US Dollar at par
value (1:1) from 1991 until December 2001 via a
currency board. This was effective (rather than actual)
Dollarisation with the domestic Peso money supply
restricted to the level of hard currency reserves. Ecuador
did Dollarise in 1999.
IESG: Argentina
DOLLARISATION OF THE ARGENTINIAN
PESO
Dollarisation is the substitution of a hard currency usually the $US - for a weak domestic one with the
objective of restoring economic stability and credibility. It
has several important effects:
 Strict control of the money supply (backed by
reserves). The elimination of hyperinflation.
 The significant reduction in the risk of exchange rate
devaluation.
 Interest rates determined by the US Federal Reserve
(plus a risk premium).
IESG: Argentina
ARGENTINA’S ECONOMIC PERFORMANCE
1991-98
The Argentinian economy enjoyed good growth between
1991 and 1998, averaging 6.2% - the strongest in Latin
America. The only poor year being 1995 when the
economy was affected by contagion from the Mexican
Tequila Crisis.
This was accompanied by a significant growth in
exports, from $12bn to $27bn. This would have been
even greater in the absence of agricultural protectionism
in the US and EU (grains and beef).
The continued return of capital held abroad (capital
flight) together with new inflows of international capital
(FDI and portfolio) stimulated domestic investment.
Funds invested in equities, new ventures and recent
privatisation offerings.
IESG: Argentina
THE IMPACT OF THE $US LINK
The Appreciation of the $US
The link with the $US came at the beginning of the long
economic boom of the 1990s – strong appreciation
against all international currencies.
US Productivity Growth
US
productivity also
grew substantially,
requiring
Argentina to cut prices significantly to maintain its
competitiveness in $US (as well as other currencies).
IESG: Argentina
OTHER EVENTS IN LATIN AMERICA
The Mexican Tequila Crisis
Mexico’s crisis and devaluation 1995 had contagion
effects as foreign investors (temporarily) withdrew their
funds from Latin America, including Argentina. This led
to a sharp fall in growth (-2.8%) in 1995, the collapse of
several banks and greater domestic financial regulation.
The 1999 Brazilian Devaluation
From 1991, Argentina a member of Mercosur, the South
American common market, together with Brazil and
Uruguay (now also Paraguay). In January 1999, Brazil
devalued the Real by more than 40%, making many of
Argentina’s
exports
uncompetitive
over
night.
As
Argentina’s largest trade partner, this exacerbated the
impact of the Dollar appreciation.
IESG: Argentina
THE INTERNAL IMPACT OF THE $US LINK
Declining Competitiveness & Deflation
The international strength of the US Dollar reduced the
competitiveness of Argentina’s exports in its major
markets (except the US), exacerbated by the Brazilian
devaluation. Because of the $US link, this loss of
competitiveness
could
only
be
rectified
through
deflationary price cuts – prices fell by 16.4%, November
94 to September 01.
High Real Interest Rates
Nominal interest rates were low because of the $US link
but falling prices led to higher real interest rates,
choking-off new investment.
Declining Growth
Argentina moved into recession in late 1998 as a result
of faltering exports, deflation, high real interest rates and
falling investment. Growth in 2001 is estimated at -5% or
worse and possibly the same for 2002.
IESG: Argentina
WHAT PRECIPITATED ARGENTINA’S CRISIS?
The trigger for the crisis was the limits imposed on bank
withdrawals on 1 December of $1,000 a month. This
created a liquidity crisis starving the economy of cash.
The limit aimed to prevent a banking collapse after $8bn
was withdrawn between July and November. In turn, the
run on the banks was caused by Economics Minister
Domingo Cavallo’s attempts to finance the financial
deficit, having sacked the Governor of the Central Bank.
The rigidity of the $US link left few policy instruments
available to deal with the problems of deflation, rising
unemployment, high interest rates and excessive
Government expenditure.
IESG: Argentina
WHERE TO NOW?
 Problem of incomplete reform rather than the failure of
reform.
 Restructuring the global financial architecture (IMF).
 Use of Tobin taxes a la Chile