Download Currency Board and Debt Trap: Evidence from Argentina and

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Currency Board and Debt Trap: Evidence from
Argentina and Relevance for Estonia
François J.Gurtner 1
Heriot-Watt University
February 2002
Discussion Paper 2002/04
Abstract
This paper analyses the November 2000 liquidity crisis that brought Argentina near
default on its foreign debt. The main purpose of this paper is to assess whether this crisis
may be taken as a warning signal for Estonia, given the similar exchange-rate system
shared by the two countries. It seems that with a low level of public debt and a balanced
budget, Estonia will not face a similar liquidity crisis as its Latin American counterpart,
which remained heavily reliant on foreign borrowings. But the substantial real exchangerate appreciation of the kroon under the Currency-Board Arrangement has resulted into
serious external imbalances, which will need to be corrected to avoid balance of
payments pressure and reduce Estonia’s high dependency on the level of foreign direct
investments.
Keywords: Argentina, Balance of Payments Crisis, Currency Board Arrangement,
Estonia, Transition.
JEL Classification:
1
Francois J.Gurtner is from the Centre for Economic Reform and Transformation (CERT), based at
Heriot-Watt University in Edinburgh. He wishes to thank Dr. Iannis Mourmouras, Dr. Mark Schaffer and
an anonymous referee for comments and suggestions. The usual disclaimer applies.
1. Introduction
After the Brazilian financial crisis that brought about a 30 percent devaluation of the
Brazilian Real in January 1999, the second-biggest South American economy was hit by
a liquidity crisis in November 2000 and seemed on the brink of default. Not
surprisingly, the Currency-Board Arrangement (CBA), introduced in 1991, which
linked the value of the peso to the US dollar at a one-to-one rate, came under the fire of
critics who held it responsible for Argentina’s plight. From this, two questions arise: (1)
Why and under which circumstances did Argentina decide to adopt the most extreme
form of exchange-rate peg, and (2) To what extend is Argentina’s severe liquidity crisis
relevant for other emerging market countries living under similar monetary
arrangements?
The main objective of this paper is to assess whether the experience of Argentina may
constitute a warning signal for Estonia, a country in transition which has been living
nearly a decade with a Currency Board Arrangement and which is seeking EU and
EMU membership. Is Argentina’s debt trap relevant for Estonia, or do the two countries
differ sufficiently in a number of respects to remain confident in the future of the
Estonian CBA? Through a brief retrospective, section 2 shows under which
macroeconomic conditions Argentina and Estonia decided to adopt a Currency Board
and the main reasons behind the choice of this monetary arrangement. Section 3 offers a
concise review of the theoretical background explaining the behaviour of the Real
Exchange Rate (RER) during the transition process and seek to assess whether the
continuous appreciation of Estonia’s currency is fully or only partially explained by
economic theory. Section 4 proposes an assessment of the solidity of Estonia’s currency
board in light of Argentina’s recent experience. In particular, the degree of dependency
on external financing and the stock of debt are scrutinised as high reliance on external
financing increases the vulnerability to a tightening of international liquidity and a large
debt-servicing burden is a potential danger under a CBA. Section 5 provides some
concluding remarks.
2
2. Historical Background
A Currency Board Arrangement represents the most rigid form of all fixed exchange
rate regimes. Under a CBA, the monetary authority guarantees with no restriction the
conversion of domestic currency against a well-determined reserve currency at a fixed
rate. Consequently, its liabilities are entirely backed by foreign exchange reserves. As in
other forms of fixed exchange rate regimes, the money supply becomes an endogenous
variable: a foreign exchange outflow contracts the monetary base and increases interest
rates which ensures bilateral exchange rate stability. CBAs are enacted by law and are
usually used to enhance credibility and break inflationary inertia after episodes of
currency crises.
(a) The Argentinean Case
Argentina adopted a Currency-Board in April 1991. This move followed the collapse of
another inflation stabilisation plan -BB Plan- started in July 1989 under new president
Carlos Menem and which ended after seven months only, in February 1990, with the
peso devalued by 220 percent and a Central Bank that had lost 58 percent of its
reserves. At that time, the CBA appeared like a solution of last resort to put an end to
(hyper) inflation in a country that had experienced no less than eight major currency
crises since the beginning of the 1970s (Choueiri and Kaminsky, 1999). The main factor
behind those repeated crises was excessive expansions in the money supply resulting
from large fiscal imbalances and monetary financing of these deficits. While Argentina
was absent from world capital markets, the government deficit, which at times reached
two digits as a portion of GDP, had to be monetized. And when the country re-entered
the markets, as it did in the late 1970s, external factors such as world interest rates
fluctuations played a central role in triggering currency crises. The failure of the
Alemann Plan in the early 1980s, for instance, was a direct consequence of the
monetary tightening in the United-States.
In addition, the banking crisis of 1980 and the subsequent bailout of financial
institutions by the central bank brought about a substantial increase of domestic credit
(in US dollars) in the economy. The confidence in the peso was undoubtedly seriously
undermined after episodes of strong inflation, interest rate controls on deposits and even
direct confiscation of commercial banks’ deposits. The national currency was gradually
3
being replaced by the US dollar both as bank holdings and as means of payments. In
April 1991, the Convertibility Plan introduced a CBA, tying the peso to the US dollar at
parity, in an economy that was thus largely dollarised. After the loss of fiscal and
inflation credibility, the authorities assessed that to drive inflation out of the economy,
the best (if not unique) solution was to adopt a monetary “straitjacket” and hence avoid
any further macroeconomic mismanagement. In other words, the best monetary policy
was to have no independent monetary policy, or rather to subject the monetary
authorities to the disciplines imposed by adopting the monetary policy of the US and the
Federal Reserve.2
TABLE 1
Argentina: Selected Economic Indicators (1989-1998)
Years
Inflation
, CPI
(%)
GDP
growth
(%)
1989
1990
1991 1992 1993 1994 1995 1996 1997
1998
3079.
8
2313.
9
171.
7
24.9
10.6
4.2
3.4
0.16
0.53
0.92
-7.5
-2.4
12.7
11.9
5.9
5.8
-2.8
5.5
8.1
3.9
Source: WDI-2000
Table 1 shows that the inflationary dynamics was successfully broken by the
introduction of a currency board. The rise in the Consumer Price Index (CPI) was
brought down to a single digit in 1994 and inflation disappeared entirely two years later.
Meanwhile, an impressive GDP growth took place two consecutive years after the
introduction of the CBA and the economy grew at an annual average rate of 5.7 percent
from 1991-98. Nonetheless, this remarkable achievement that has been largely driven
by a significant rise in the investment rate between 1990 and 1998 covers substantial
year-to-year GDP fluctuations. 3 In 1991-95, the Argentinean economy seems to have
reaped the full benefits of the hard peg as both nominal and real variables moved in the
desired direction. From 1995 onwards, while the inflation record continued to be
satisfactory,
economic
growth
became
2
much
more
volatile.
It is often argued that Argentina did not have a strict currency board arrangement. This argument
originates in the 1995 speculative attack on the peso, in which the Argentinean authorities have eased the
required reserve ratios of the banks in order to attenuate the effects of the sharp interest rates increase on
the banking sector. In a strict CBA, the central bank looses entirely its ability to act as a lender of last
resort because domestic credit expansion is ruled out.
4
The “disciplinary power” of the CBA and the prerequisites to its success have led the
Argentinean authorities to implement other crucial reforms in terms of competition
policy, privatisation, labour market flexibility and banking supervision and regulation.
Thus, it is arguable that without a CBA the record of the Argentinean economy over the
last decade would have been much less impressive. This assertion, however, is
questionable in light of a reversal of the causality link: the Argentinean performance
owes less to the CBA than to macroeconomic policies and structural liberalisation
policies that are consistent with the maintenance of any fixed exchange rate regime
(Roubini, 1998). In the Argentina of the early 1990s, however, it is doubtful that such
ambitious reforms would have been implemented without the binding constraints that
characterise a Currency Board.
Argentina’s experience under a CBA has led a growing number of observers to
advocate a similar super-fixed arrangement for other Latin American countries, and to
pursue the move towards outright dollarisation. The key question they address is that of
the feasibility to follow an independent monetary policy – a policy allowing for a truly
flexible exchange rate – in a situation in which the domestic currency is not the
effective standard of value. The “Original Sin” hypothesis that they put forward
emphasises the fact that in most emerging markets the domestic currency cannot be
used to borrow abroad or to borrow long term, even domestically. Hence, all domestic
investments have either a currency mismatch or a maturity mismatch. From this, they
argue that the adoption of the US dollar as legal tender for all domestic payments would
dissolve currency mismatches and attenuate maturity mismatches (Eichengreen and
Hausman, 1999).4
(b) The Estonian Case
Estonia adopted a currency board in June 1992. This move followed the collapse of the
Soviet Union that led this Baltic country to gain independence and to introduce its own
currency, the kroon. Estonia’s CBA has been introduced in a context of very high
inflation following price liberalisation, and was selected by the authorities to conduct
monetary policy throughout the transition process. Contrary to Argentina, it was not a
3
Gross domestic Investment in billion current US dollars rose from 19.8 in 1990 to 51.4 in 1994 and to
59.3 in 1998. The rise has been continuous, except for 1995 (WDI-2000).
5
case of a country that urgently needed to tie its hands as a result of a long history of
currency crises, but rather of a country which opted for an exchange rate regime that
best suited its ultimate goal of integration with a large regional economic entity. Thus,
the kroon was pegged to the German mark as Estonia traded heavily with Germany and
with other European countries whose currencies shadowed the German mark.5 Factors
supporting the adoption of this extreme fix were the need for a strong external anchor at
the outset of transition, widespread dollarisation, and the very small size of the domestic
economy which gave a very limited scope for conducting an independent monetary
policy.
TABLE 2
Consumer Price Index (CPI)
Compared to previous
quarter, %
Compared to corresponding
quarter of previous year, %
Quarter
Quarter
Year
1993
1994
1995
1996
1997
1998
1999
2000
I
11.2
16.9
7.9
8.2
3.0
4.7
1.6
1.4
II
7.0
11.9
6.2
4.6
4.4
1.6
0.9
0.8
III
5.6
5.5
5.3
1.0
2.1
0.7
0.1
1.4
IV
9.1
5.2
6.4
1.6
2.3
0.1
0.7
1.7
I
II
242.1 131.9
44.1 50.8
34.0 27.2
28.9 26.9
10.5 10.3
14.2 11.2
4.0
3.3
3.1
3.1
III
55.8
50.6
27.0
21.7
11.5
9.6
2.7
4.4
IV
37.1
45.2
28.5
16.1
12.4
7.2
3.3
5.4
Compared to
previous
year, %
1993
1994
1995
1996
1997
1998
1999
2000
89.8
47.7
29.0
23.1
11.7
8.2*
3.3
4.0
Source: Bank of Estonia (* Change of structure of basket)
At first glance, the tale of the post-communist Estonian economy looks like a success
story. Table 2 shows that inflation has been gradually reduced and eliminated. The CPI
was halved from 1993 to 1994 and from 1994 to 1995. In 1998, it had been brought
down to a single digit. Meanwhile, a quite vigorous expansion took place after 1995,
which marked the end of production decline. The historical experience of the Baltic
4
Other influential economists argue that after the recent success of several Latin American countries in
bringing down inflation, a general move towards inflation-targeting regimes could be observed (Mishkin
and Savastano, 2000).
5
The Kroon was pegged to the German Mark at: 1 DM = 8 Kr. By the Law on Security of Estonian
Kroon (1992), the issue of kroon must be fully secured by gold and convertible foreign exchange
reserves.
6
States suggests, to some observers, that the choice of Estonia to peg its currency early in
transition was wise. Latvia, which opted for a floating exchange rate regime, succeeded
in bringing down inflation but at a cost of a longer and deeper recession (Sachs, 1996).
As in the case of Argentina, the implementation of the CBA came with a number of
other key reforms that were necessary to ensure the credibility of the overall program.
As adjustments through exchange rate changes were made impossible by law, the real
sector of the economy (wages, employment…etc) had to become sufficiently flexible to
accommodate any potential shocks. Further reforms included sound fiscal and banking
practice.
In summary, Argentina opted for a currency board as it had exhausted alternative
solutions, and hence tying the hands of the monetary authority was regarded as the best
response to address the chronic inflation the country experienced and to bring
confidence in the currency on the part of the public. Estonia opted for a CBA after the
introduction of the kroon, mainly because of the strong need of an external anchor
following decades of central planning. Moreover, the very small size of its economy and
the desire to integrate rapidly with a major neighbour provided evident support in
favour of a fixed exchange rate regime rather than a flexible one.
3. Real Exchange Rate Appreciation
(a) Theoretical Issues
Measuring the degree of misalignment of a currency is not straightforward. It requires
measuring an unobserved variable: the Equilibrium Real Exchange Rate (ERER).
Because the ERER is a function of a number of real variables called the fundamentals, it
changes in response to exogenous and policy-induced shifts in those variables
(Elbadawi, 1994).6 The notion of equilibrium is that of the consistency with
macroeconomic balance, implying the simultaneous achievement of both internal and
external balance. On the one hand, internal balance is achieved when the domestic
economy has reached the highest level of output that is consistent with the control of
inflation. On the second hand, external balance is achieved as long as capital flows
6
Among the variables that are commonly admitted to have an influence on the ERER are the terms of
trade, the degree of openness, capital flows, productivity changes and foreign assets positions.
7
finance the current account deficit without drawing on international reserves
(Williamson, 1994). Thus, external balance is the sustainable desired net flow of
resources between countries when they are in internal balance (Clark and MacDonald,
1998).
In theory, the notion of sustainable current account path provides guidance to assess the
level of ERER. In practise, computing such a path is extremely difficult for economies
undertaking a complete transformation of their production structure, not least when
rapid and volatile capital inflows are accounted for. Since transition began, the
economies of Eastern Europe have been rebuilding their capital stocks, and accordingly
very large current account deficits emerged.7 External imbalances do not necessarily
mirror an alarming competitiveness problem but could largely reflect the higher
investment opportunities in transition economies and the prospect of higher economic
growth. This assumption, which is consistent with the intertemporal approach of the
current account, is reasonable provided that capital inflows are used to finance capital
accumulation rather than consumption and are mainly directed towards the traded goods
sector.8
The difficulty is to distinguish the share of the RER appreciation that is justified by
changes in fundamentals from the share that signals a competitiveness problem. On the
one hand, the RER appreciation is explained by an appreciation of the Equilibrium Rate
Exchange Rate (ERER) and by the initially strongly undervalued position of these
concerned currencies (fundamental view). On the other hand, the RER appreciation
represents a loss of competitiveness that worsens the current account balance and that
might be reversed only through a process of nominal and real depreciation of the
currency (misalignment view).9 Some authors have tried to obtain a sense of what scope,
7
This concerns mostly non-energy exporters.
The framework that links structural transformation of the economy and ERER draws from the seminal
work of B. Balassa and P. Samuelson (1964). According to the Balassa-Samuelson model, life is usually
cheaper in LDCs than in industrialised countries because productivity in the tradable goods sector is
typically lower. Consequently, the ratio of non-tradable to tradable goods price, which gives the definition
of the RER, tends to be lower. Therefore, real convergence (as measured by GDP per capita) must be
accompanied by a real appreciation of the exchange rate. As productivity gains in the tradable sector
gather momentum, the equilibrium dollar wage follows an upward trend and the RER appreciates.
Empirical studies have provided extensive evidence that the Balassa-Samuelson effect is at work in
advanced transition countries (De Broeck and Sløk, 1997). Their real exchange rate appreciates in the
face of rapid productivity gains, the fastest occurring in the traded goods sector.
9
See Roubini and Wachtel (1997).
8
8
if any, remains for further real appreciation before competitiveness becomes an issue.10
Although subject to considerable uncertainty due to measurement problems, they
conclude that for a number of countries including the Baltics this scope may be small or
nil and enhanced vigilance seems appropriate (Krajnyák and Zettelmeyer, 1997).11]
(b) Empirical Evidence
As there is no clear-cut answer at the theoretical level and no strong consensus among
observers about the underlying factors behind large current account deficits, it is
perhaps useful to bring the arguments at a more empirical level. In this respect, the
recent experience of countries that suffered severe balance of payments crisis (Mexico
in 1994-95 and Thailand in 1997) certainly bears very valuable information for the
assessment of the sustainability of Estonia’s current account deficit.
Until the early 1990s, large current account deficits were not perceived as a cause for
concern if they originated in the behaviour of private agents exclusively (Lawson
Doctrine).12 In addition, they were considered benign if the underlying factor behind
these imbalances was an increasing investment rate rather than a falling saving rate. The
occurrence of the Mexican crisis in 1994-95 seriously undermined the credibility of this
doctrine because Mexico had no fiscal accounts imbalances even if it showed a large
current account deficit – financed mostly in US dollars.13 At that time, the flow of
capital entering Mexico, and which was concentrated in short-term maturities, financed
the current account deficit and prevented the Mexican peso from depreciating in line
with the inflation differential with the United States.
Today, conventional wisdom is that a current account deficit in excess of 5 percent of
GDP is a matter of concern irrespective of the underlying factors, especially if the
deficit is financed with short-term debt (Milesi-Ferreti and Razin, 1996). But, there is
no reason for the sustainable current account deficit to be uniform at all times and for all
countries. The current account position a country can maintain over the medium run is
10
It is arguably the devaluation of the Czech koruna in May 1997 (following large external imbalances)
that caused an increase in the interest in the issue of real appreciation of currencies in transition
economies.
11
This conclusion can be made stronger because this study was conducted in 1997 and external
imbalances, in the Baltics, have remained very large afterwards.
12
The budget of the General Government is balanced or in surplus and the current account deficit is
explained by the saving/investment gap in the private sector.
13
See Edwards (2000) for a comprehensive survey on the evolving views on the current account.
9
determined by the pace at which foreigners are prepared to accumulate that country’s
financial liabilities (Edwards, 2000). If, for any reason, i.e. an increase in perceived
country risk, foreign investors loose confidence in a particular country and reallocate
their portfolio, they will modify that country’s level of sustainability of its current
account. Consequently, the sustainability of a current account deficit varies not only
across countries but is also time-varying within a particular country. A large and
persistent current account deficit need not trigger a currency crisis, at least not in all
countries, at all times.
TABLE 3
Selected Indicators of External Vulnerability
Estonia
Current Account Balance (%
of GDP)
Total External debt (% of
GDP)
Short-term debt (% of total
external debt)
Thailand
Current Account Balance (%
of GDP)
Total External debt (% of
GDP)
Short-term debt (% of total
external debt)
Mexico
Current Account Balance (%
of GDP)
Total External debt (% of
GDP)
Short-term debt (% of total
external debt)
1992
1993 1994 1995 1996 1997
0.86
0.55
4.22
-3.3
1.38
3.92
4.71
5.98
0
0.19
-5.66
-5.08
-5.6
37.6
42.1
45.4
35.18
8.06
49.4
- -9.19
9.14 11.7
9
9.29 13.4 15.02
8
26.4 47.9
39.4
5
-8.1
50.0
- 12.79
2.03
62.9 77.4
42.94 44.4 49.4 41.4 37.1
8
6
3
7
27.3
0.43
45.9
2.07
41.5
-4.06
27.52 28.0 22.3 19.0 19.0
5
5
6
9
17.2
-6.72
-5.8
30.9
32.7
21.85
4.3 10.3
7
1998
6.99
33.0
0.66
44.7
40.6
Source: WDI-2000
Table 3 indicates that Estonia’s external imbalances were minor until the mid-90s, but
rapidly widened in the following years. Interestingly, both Mexico and Thailand had
lower current account deficits when they were hit by a crisis, in 1994-95 and 1997,
respectively. This confirms that a crisis does not emerge automatically once a particular
level of current account deficit is reached. The reasons behind persistent external
10
imbalances should rather be scrutinised. After the adoption of the CBA in June 1992,
Estonia’s inflation rate has remained for several years substantially higher than that of
its main trading partners, in particular those of the Nordic countries of the European
Union. In principle, currency boards should make the inflation expectations converge to
those prevailing in the anchor country, but this does not happen instantaneously and
residual inflation remains. The appreciation of the real exchange rate (RER) is arguably
justified by the significant initial undervaluation, but continuous positive inflation
differentials have started to show their effect on the RER after the mid-90s. Estonia’s
external position deteriorated markedly between 1995 and 1997, from -3.3 to -11.8
percent of GDP and has remained significantly negative in the following years.14
FIGURE 1
Estonian kroon Real Effective Exchange Rate (REER), June 1992=1
June1992=1
REER
4.000
3.500
3.000
2.500
2.000
1.500
1.000
0.500
0.000
June 1992December2000
REER
Source: Bank of Estonia
Certainly, the large current account deficits posted by Estonia from 1995 onward are a
matter of concern if they are structural in their nature. Heavy external imbalances are
possibly the first indicators of serious RER misalignment and might no longer be
justified by the catching-up process that characterise transition.15 Estonia’s exchange
14
Although the most recent figures related to current account data show a slight improvement (deficit of
4.7 and 6.4 percent of GDP in 1999 and 2000), it is perhaps useful to recall that the largest current
account deficits posted by Thailand and Malaysia were those of 1995, that is two years before the outset
of the Asian crisis.
15
This view is reinforced by the Czech currency crisis of May 1997. The authorities argued that the
current account deficit was justified by increasing ERER. In reality, increasing ERER explained only a
portion of the RER appreciation and the value of the koruna needed to be corrected downward (after
several years of strong real appreciation).
11
rate locked to a misaligned nominal parity could eventually lead to an attack on the
kroon.16
4. An Assessment of the Solidity of Estonia’s Currency Board
(a) Recent Developments in Argentina
Argentina experienced its first recession under the currency board arrangement in 1995
but the monetary regime survived and the prevailing parity remained unchanged. Four
years later, in 1999, Argentina suffered another severe recession. This time, the crisis
was not the result of a general speculative attack on regional currencies but rather was
the outcome of a deteriorating external environment specific to Argentina: terms of
trade loss, effects of the devaluation of the Brazilian real, and strong US dollar. This
crisis had plunged Argentina into a long period of stagnation and had shaken confidence
in an exchange-rate regime, which deprived the country of a useful policy instrument.
After having successfully broken the inflationary dynamics in the early 1990s, the
currency board arrangement had, seemingly, become a trap.
Table 4 shows that between 1996 and 1998 Argentina has systematically posted current
account deficits on the verge of the 4-5 percent threshold that the new conventional
wisdom holds as alarming. As a result, the external debt rose from 42.4 percent of GDP
in 1997 to 52.7 percent in 2000. Evidently, tax revenues were hampered by the
stagnation in economic activity, at a time of an increasing demand for unemployment
benefits. In the last quarter of the year 2000, the effects of the internal political crisis
and signs of growing social unrest raised serious concerns among international lenders
and caused investors to withdraw funds, which resulted in a rapid widening of spreads
on Argentina’s sovereign bonds.17 These rising borrowing costs left the country on the
16
The speculative attack on the Argentinean peso in the aftermath of the Mexican crisis showed that
currency boards are powerless in preventing speculative attacks, especially when the parity is considered
unrealistic. The firm commitment of the Argentinean authorities to maintain the prevailing parity led to
sharp interest rate rises and the country entered a recession. The assistance provided by multilateral
institutions prevented the banking sector from collapsing. While it is true that the currency board survived
the crisis, the issue of the misalignment remained leaving wide open the door for further speculative
attacks in the future.
17
Interest rate spreads refer to the differences between yields on sovereign bonds of developing countries
and those on US Treasury securities of comparable maturities, which are a proxy for country risk.
Argentina had an average spread of 6.5 percent on its dollar borrowing between 1997 and 2000. The
premium nearly reached 10 percent in October-November 2000.
12
brink of default in November 2000, which further increased panic among investors who
feared that it would default on its $124 billion foreign debt or even that its fixed
exchange rate might collapse. Eventually, the rescue package negotiated with the
International Monetary Fund (IMF) prevented this scenario materialising.
TABLE 4
Argentina: Indicators of External Vulnerability
1996
1997
1998
1999
(Annual percentage change, unless otherwise indicated)
Terms of Trade
7.8
-1.2
-5.5
-5.9
REER appreciation (12 months basis) 1/
-1.4
4.8
0.3
12.1
(In percent of GDP, unless otherwise indicated)
Current Account balance
-2.4
-4.1
-4.8
-4.4
Total External Debt
40.3
42.4
47.1
51.0
Public Sector debt
41.1
38.1
41.3
47.3
Of which: External debt
27.0
25.5
27.6
30.0
Total external debt to exports 2/
385.5 402.0 452.1 521.4
External interest payments to exports 2/
25.6
28.3
33.0
40.4
2000
(prel.)
9.7
-0.8
-3.4
52.7
49.7
32.0
487.9
40.1
Sources: Central Bank of Argentina; Ministry of Economy; and Fund staff estimates.
1/ Based on 1996 trade weights. Increase means appreciation.
2/ In percent of exports of goods and non-factor services.
This crisis revealed the dangers of a monetary regime, which fixes permanently the peso
to the currency of a country whose business cycle does not closely correlate with its
own. The combination of (1) an appreciated value of the anchor currency, (2) a
depreciated value of the biggest regional economy’s currency and (3) terms of trade
loss, produced an overvalued peso.18 The accomplishment of labour reform and some
tax consolidation were not the sole remedy to the lack of competitiveness in the face of
a significant deterioration in the external environment. With high wages and a high
price level in US dollars, exports could not be an effective engine for growth. Certainly,
deflation had contributed to a reduction in domestic costs in 1999-2000, but the
noticeable late improvement of the trade balance was due essentially to the stagnation of
domestic demand and its impact on the current account balance had been largely offset
by the higher net interest payments abroad.19 The rise in Argentina’s borrowing costs
showed the extreme sensitivity of CBAs to confidence and was, to some extent, the
18
Brazil is Argentina’s main trading partner whereas only just over 11 percent of Argentina’s exports go
to the United-States. A good candidate for a fixed-peg exchange rate link needs to have a very high trade
share with the country to which it is pegged.
19
Interest payments in percent of GDP rose from 2.3 in 1997 to 4.0 in 2000.
13
reflection of investors’ scepticism concerning the lack of a shock absorber mechanism
capable of coping with a sudden deterioration of the external environment.
Undoubtedly, those negative developments have demonstrated that only external help
complemented by exogenous favourable developments abroad had saved Argentina
from a possible default in December 2000, following the crisis that had emerged one
month earlier. Firstly, the loan agreement with the IMF in December had guaranteed
Argentina’s government borrowing needs for most of the year 2001 and therefore had
eased fears about a liquidity crisis.20 Secondly, the monetary policy shift in the UnitedStates had provided additional breathing space by reducing debt service costs.21 Thirdly,
the relative weakening of the US dollar against the euro after a continuous appreciation
since January 1999 gave a modest boost to Argentina’s exports.22 Finally, international
prices for wheat and soya rose after a long slump, contributing to a net improvement of
Argentina’s overall terms of trade.23 Terms of trade gains contributed to the
improvement in the current account balance.24 25
But, to stabilise the external debt, the first priority was to cut public spending so as to
get the budget deficit under control. In the year 2000, Argentina had the largest external
debt of all medium-income Latin American countries. Table 5 shows that Argentina’s
external debt has been increasing continuously from 1994 to 2000, reaching 52.6
percent of GDP. As a matter of comparison, the debt of neighbouring Brazil and that of
Mexico stood at 36.3 and 30 percent, respectively.26 Between 1999-2000, Brazil and
Chile succeeded in curbing the path of their external debt but Argentina failed to
20
The loan agreement with the IMF amounted to $ 39.7 billion in total, including: 1) $13.7 billion from
the augmented Stand-By Arrangement; 2) $5 billion in new loan commitments from the IDB and the
World Bank; 3) $1 billion in a loan from Spain; and 4) $20 billion of financing from a dozen private
financial institutions.
21
The pronounced cooling of the US economy in the last quarter of the year 2000 has led the Federal
Reserve to cut its key interest rate three times in the first quarter of 2001, each time by 50 basis points. On
January 3rd (6.5 % → 6 %), on January 31st (6 % → 5.5 %) and on March 20th (5.5% → 5 %).
22
In addition, local producers, who found themselves priced out of world markets, benefited from
Argentina’s lower inflation than that prevailing in its main trading partner.
23
According to the Fund staff estimates, Argentina’s terms of trade deteriorated by 5.9 percent in 1999
and recovered by 9.7 percent the subsequent year.
24
Table 4 shows that Argentina’s current account deficit was brought down to 3.4 percent in 2000, from
4.4 percent in 1999.
25
As a result of these positive events, the spread on Argentina’s bonds fell from close to 1000 to less than
700 basis points from November 2000 to January 2001.
26
In Brazil, the budget for 2001 targeted a primary surplus of 3 percent of GDP, which was consistent
with a further decline in public debt relative to GDP. The government was committed to a primary fiscal
surplus of 3 percent of GDP for the next three years. Mexico’s debt was upgraded to Investment Grade in
March 2000, reflecting a decreasing country risk that has narrowed the spread with US Treasury bonds.
14
stabilise its own and it is worth noting that its external debt in US dollars had been
growing much before the November 2000 liquidity crisis. From $65.32 billion in 1993,
it reached $144.05 billion five years later.27
TABLE 5
External debt in selected Latin American countries
(Percent of GDP)
Country
1994
1995
1996
1997
1998
1999
2000
Argenti
na
Brazil
Chile
Colombi
a
Mexico
Venezue
la
33.3
38.2
40.3
42.6
47.1
51.1
52.6
18.2
42.2
27.4
22.6
33.3
27.9
23.2
33.5
31.6
24.9
35.6
31.5
31.2
43.6
36.0
44.6
50.4
42.6
36.3
49.8
44.2
33.9
71.3
59.0
51.0
49.6
53.1
38.2
41.1
38.4
39.3
34.6
36.7
30.0
31.8
Of which: short-term debt
Argenti
na
Brazil
Chile
Colombi
a
Mexico
Venezue
la
3.5
4.8
5.0
6.5
7.2
6.9
6.5
3.5
10.7
5.4
4.3
7.9
5.8
4.9
6.5
5.1
4.6
4.8
4.4
3.4
5.4
4.6
5.1
5.8
4.8
3.8
9.5
4.5
3.4
4.3
5.4
1.9
4.5
2.6
3.3
2.7
3.1
2.2
2.9
1.5
2.4
1.9
Source: IMF- World Economic Outlook
Argentina’s monetary regime had clearly become a trap. The Real Exchange Rate
overvaluation had led the country to a prolonged stagnation that prevented tax revenues
from increasing.28 Fiscal figures were also hurt by higher interest payments, which
Argentina’s debt was downgraded on several instances when a better rating would have been needed to
decrease its borrowing costs.
27
Interestingly, in November 2000, while Argentina had spreads on its dollar borrowing oscillating
between 8.3 and 9.9 percentage points, that of Chile was 2.3 percentage points only (Wolf, 2000). In
Argentina, inflation and currency risks had turned into credit risk (Wolf, 2001).
28
The Economist Intelligence Unit estimates that, between 1996 and 1999, the trade-weighted RER
appreciated by 15 percent. On the basis of relative unit labour costs, the RER appreciated by about a third
between early 1998 and the middle of 1999 (Wolf, 2001).
15
made the external debt inflate.29 But, given the high and still rising level of the public
debt relative to GDP, the primary balance needed to be increased. By doing so,
Argentina was willing to provide more guarantees to investors that it will have enough
revenue to meet its obligations. There was very little choice other than opting for a more
restrictive fiscal policy.30 But, by contracting internal demand while the output gap was
significant, this policy contributed to delay an early recovery and, as a consequence, the
stabilisation of the external debt. To avoid a default, Argentina needed to decrease the
spreads on its sovereign debt and sought to achieve: (1) Higher net foreign assets in
terms of GDP or imports, (2) Lower fiscal deficits, (3) Lower ratios of debt services to
export and (4) A lower ratio of debt to GDP.31 But a tougher fiscal policy was extremely
complex to put in practise as no upturn in demand had been noticed after several
previous attempts to either increase taxes or decrease spending.32 Thus, the question of
the sustainability of the CBA remained fully relevant.
The Argentinean economy was stuck in a deflationary cycle, which had negative effects
on two components of growth. Firstly, as deflation kept interest rates too high, domestic
firms had more difficulties to have access to capital. Secondly, deflation made
consumers delay spending.33 As a result, economic growth had come to a standstill and
there seemed to be no clear strategy to pull Argentina from its trap. It was of course
tempting to advocate an early move from the CBA but, unlike that of Brazil, the
domestic economy was almost entirely dollarised. Thus, few were advocating a
devaluation that would have had a major negative impact on the net worth of the private
sector, including banks.34 Rather than a harmful devaluation, the Argentinean
government considered undertaking structural reforms in the fiscal area, including
passing laws tightening tax administration, reforming the social security system and
modifying revenue sharing arrangements with provinces.
29
Argentina’s public debt was largely external, and 92 percent of it was denominated in US dollars.
In September 1999, Argentina adopted the Law on Fiscal Solvency, which stipulates that the federal
government is required to maintain a position of overall balance from 2003 onwards. However, due to the
liquidity crisis, the accomplishment of this objective had been postponed (with the agreement of the
IMF).
31
Steps in that direction had been taken by Argentina’s new Economy Minister Ricardo Lopez Murphy,
who announced plans to bring the fiscal deficit down to 6.5 billion pesos in 2001 (the target agreed with
the IMF) by combining spending cuts and the elimination of tax breaks.
32
Lopez Murphy’s plan was the fifth package of economic measures aimed at ending the recession
introduced by the Alliance during 16 months in office.
33
A third effect of deflation is that it causes the real burden of public and corporate debt to swell.
34
About two-thirds of bank loans to companies were in US dollars, along with almost all mortgage loans.
In addition, the memory of hyperinflation had not disappeared neither had the price paid for monetary
stability, so few seemed ready to give up the Convertibility Regime.
30
16
Brazil’s noticeable improvement of primary budget surplus at the provincial level was
certainly an interesting example.35 But Brazil has been able to put its fiscal accounts in
order, including at the provincial level, after the devaluation of the real, which was
followed by a buoyant growth of activity.36 Given its currency board arrangement,
Argentina could not rely on a downward correction of its nominal exchange rate to
stimulate activity. The Argentinean authorities could of course act on the fiscal side to
moderate the effects of an appreciated currency but in practise the room for further
spending cuts was very limited considering that spending decisions were partly in the
hands of provincial governors.37 Concerning the effects of a fiscal contraction, it is
important to assess whether this policy could be expansionary and whether the positive
growth rate could possibly stand above the real rates of interest so as to curb the path of
debt accumulation.38 To avoid a unilateral default, Argentina urgently needed to raise its
modest primary budget surplus to convince investors that it would be able to meet its
obligations. Alternative options, including floating the peso, appeared highly
undesirable: with almost all debts denominated in US dollars depreciation would have
increased the cost of debt service, bankrupting the government, corporations and
domestic banks.
(b) Relevance for Estonia
Like most transition countries, Estonia has had large current account deficits for several
years. The question is less the deficit itself than its sustainability over the medium-run.
35
Since early 1999, when Congress started debating the fiscal-responsibility law, the states have gone
from a primary deficit to a primary surplus; and the municipalities have stayed in primary surplus.
36
Thus, in Brazil, the chain of causality ran from growth to fiscal balance. In Argentina, this chain had to
work the other way round because of the hard peg.
37
With unemployment at 14.7 percent and the poverty rate close to 30 percent, opposition to spending
cuts was strong. Provincial governors, for instance, promised to fight any reductions in their provincial
funding, ahead of congressional elections in October 2001. The lack of political support – six senior
government officials resigned – after the announcement of Lopez Murphy’s plan to cut spending brought
Argentina’s spreads back to their levels prior to the multibillion-loan agreement with the IMF. The
political uproar that followed Lopez Murphy’s proposal to cut the education budget eventually led to his
resignation. On March 20th, Domingo Cavallo became Argentina’s third economy minister in 16 days
with the same commitment to fiscal adjustment. He backtracked on some of the spending cuts favoured
by his predecessor in a favour of an increase in tariffs on consumer goods, a reduction on those
concerning capital goods, and a new tax on financial transactions. Although, the first quarter deficit target
of $2.1bn was missed by $1bn, the government maintained its objective of a deficit of $6.5bn for 2001,
meeting the target agreed on with the IMF.
38
Experience in several countries, in particular in Italy, show that fiscal tightening can be expansionary
and reduce the ratio of debt to GDP. This happens with a sustained reduction in the risk premium and
domestic interest rates. If Argentina could have sustained an annual GDP growth of 3 percent, with real
interest rates at 9 percent, it would have needed a primary surplus of 3 percent of GDP in perpetuity to
stabilise the debt ratio. Thus, just like Italy, Argentina would have needed to achieve a primary fiscal
surplus of at least 4 percent of GDP (Wolf, 2000).
17
The sustainability of a current account deficit is closely linked with the way this deficit
is financed. Perhaps reflecting the continuation of the catching-up process, Estonia
finances the most substantial part of its current account deficit with foreign direct
investments rather than with portfolio flows; that is Estonia’s current account deficit is
mostly financed with non-debt-creating capital flows.39 Thus, Estonia’s deficit should
be, in principle, more sustainable than that of Argentina.40 A sudden reversal of capital
flows following a crisis in emerging markets or a monetary tightening in the G-3 would
have a much less severe impact on Estonia’s balance of payments than on Argentina’s.
This is explained by the nature of the components of Argentina’s capital flows, which
were more volatile and sensitive to market sentiment. In sum, the different structure and
composition of the two countries’ capital account surpluses leave them unequally
protected from a potential liquidity crisis.
TABLE 6
Estonia’s Balance of Payments (EEK, million)
Current account
Trade balance
Capital and financial
account
Direct investments in
Estonia
Overall balance
Reserve assets
1996
-4 806,9
-12288,2
1997
-7810,2
-15652,8
1998
-6760,2
-15725,5
1999
-4334,9
-12938,6
6396,4
10953,3
6869,8
6266,6
2000
-5709,1
13496,7
7620,4
1814,4
3694,1
8071,4
4448,0
6807,3
1228,4
-1228,4
2771,3
-2771,3
126,4
-126,4
1797,6
-1797,6
2270,5
-2270,5
Source: Bank of Estonia
In addition, Estonia does not have heavy debt repayments to make, so its large current
account deficit is much less an urgent call for devaluation. This was not the case for
Argentina, which needed exports in excess of imports in order to accumulate the foreign
exchange necessary to honour its debt payments.41 In this respect, the significant
widening of spreads on Argentina’s sovereign debt was largely the reflection of the
39
In the year 2000, the net inflows of FDI covered 73 percent of the foreign trade deficit (Bank of
Estonia).
40
Argentina alone accounted for 25 percent of emerging markets traded bonds.
41
In 2001, Argentina had a debt payment of $27bn in obligations, including $14.3bn on medium and
long-term bonds and $5bn on short-term debt.
18
scepticism concerning its ability to generate enough foreign exchange to service its
debt. Even though Estonia’s external debt in current US dollars was multiplied by four
between 1994 and 1998 (from $0.19bn to $0.78bn), it remains relatively low in relation
with the size of the domestic economy.42 With a low ratio of debt service-to-GDP,
Estonia seems immune from the investors’ fears that lead recently Argentina into an
external liquidity crisis.43
A greater degree of openness to trade is also generally perceived as another important
indicator of sustainability. In 1998, Estonia’s exports and imports of goods and services
as a percent of GDP stood at 79.8 and 89.4, respectively. In comparison, Argentina had
similar ratios of 10.4 and 12.9, only. A very open country will generate more easily the
foreign currency receipts needed to service its external debt. Openness, as measured by
the addition of exports and imports as a share of domestic production, was thus 169.2 in
Estonia in 1998, and further increased to 186 the subsequent year. With an openness
ratio that is nearly twice the size of production, the Estonian economy is undoubtedly
wide-open. Argentina’s ratio of openness (23.3 and 21.3 in 1998 and 1999) showed that
its economy is more closed, which is consistent with the difference in size of the two
countries. In addition, Argentina’s exports remained tiny in relation to the country’s
debt: in 1998, the total debt service in percent of exports of goods and services was 58.2
for Argentina and only 2.1 for Estonia.
A higher growth rate of production also improves significantly the prospects of
intertemporal solvency (as the recent noticeable improvement in Brazil’s public
finances shows). Accelerating growth of production will mechanically generate higher
government revenues, which will facilitate the attainment of fiscal balance, at a given
level of spending. Estonia compares favourably with Argentina since its growth has
been systematically higher over the last three years. In 1999, both countries were in
recession but Estonia’s GDP shrank much less than that of Argentina (1.1 and 3.2
percent). In the year 2000, Argentina’s economy remained stuck in a deep and longlasting recession whereas production growth resumed in Estonia and the outlook for the
years ahead remain favourable. With the course of economic policy being led by
42
A large debt-servicing burden can easily exhaust export revenues and preclude imports of investment
goods that are needed for growth. In such a case, the debt burden can create a trap that inhibits any
growth policies (Roubini and Wachtel, 1997).
43
In 1998, Estonia’s ratio of total debt service to GNP was 1.7 percent, against 7.4 percent for Argentina
(WDI-2000).
19
Estonia’s desire to join the European Union, sustained growth is likely to be supported
by increasing investment from European firms.
In summary, Estonia’s external position benefits from a relatively low external debt
burden and important inflows of foreign direct investments. In addition, the acceleration
of GDP growth, wide-openness to trade, and strengthening of the reserve position
constitute additional favourable indicators of international solvency.44 In short, with its
stronger external position, Estonia seems better placed to weather the impact of reduced
capital inflows and is apparently safe from the type of crisis that hit Argentina at the end
of the year 2000.
5. Concluding Remarks
This paper has highlighted the dangers associated with super-fixed monetary regimes, in
reference of the recent crisis in Argentina. It started with a brief historical review to help
us understand why Argentina and Estonia adopted a Currency Board Arrangement
despite the lack of flexibility and adaptability that characterises such exchange-rate
regimes. Certainly, Argentina’s Convertibility regime had broken the inflationary
dynamics and had moved the economy from a poor equilibrium to a better equilibrium.
Nonetheless, in today’s world in which deflation rather than inflation is the most
prominent danger, it seems that Argentina would have been better off allowing some
degrees of freedom to its monetary policy. The constraints associated with CBAs
outweigh their benefits by a wider margin than a decade or so ago. In the past, hard pegs
were often selected by default, because other monetary regimes generally produced
worse outcomes. But the argument that emerging economies cannot afford to have an
inflation-targeting regime, i.e. an independent monetary policy, seems outdated, as the
Brazilian example shows.
The main objective of this paper, however, was not to make a comparison between
alternative monetary regimes and assess their respective benefits. Rather, the essential
44
Foreign exchange reserves are in excess of the requirements for full currency board cover by a
comfortable margin. Between August 2000 and February 2001, the net foreign reserves of the Eesti Pank
have been rising continuously, from 2,034 to 2,387 million kroons (Bank of Estonia).
20
purpose was to assess the relevance of Argentina’s recent crisis for Estonia, a country
which opted for a CBA in 1992, one-year after Argentina. As with Argentina, it seems
that Estonia has reaped the benefits of the CBA in the early years of its implementation.
Gradually, the RER has been appreciating vis-à-vis the main trading partners and
competitiveness problems have arisen. As with Argentina, Estonia was in recession in
1999 after several years of euphoric growth. However, the two countries do not exactly
face similar issues: Argentina’s problem is essentially fiscal. While tax revenues were
failing to keep up with spending and privatisation revenues were drying up, Argentina’s
government has been looking to outside sources of financing. The substantial rise in
government spending at state and federal levels has pushed the public sector external
debt up.
Beyond fiscal issues, Estonia seems also immune from Argentina’s problem of sparking
consumer confidence to revive growth. After the monetary shift in the United-States in
the course of the year 2001, and the modest appreciation of the euro, the external
environment played increasingly in favour of Argentina. But the heavy borrowing
requirement of the government left it vulnerable to a tightening of international
liquidity. Negative events in other emerging markets had also a serious impact on the
level of international liquidity, as the effects on global business sentiment from the
Turkish Lira devaluation have shown. At the domestic level, the lack of recovery in
economic growth made the future of Argentina’s monetary regime uncertain. A
Currency Board Arrangement (CBA) is not the most suitable kind of exchange rate
regime for a country that has a very regulated labour market and in which political
obstacles block the implementation of necessary reforms.
Estonia does not have a highly regulated labour market and is not in danger of
defaulting on its debt. The fiscal responsibility that goes hand in hand with the adoption
of a hard peg has been understood and accepted ever since the CBA was implemented
in 1992. But the significant deterioration in the current account balance in the second
half of the 1990s has raised the issue of the sustainability of the Currency-Board
Arrangement in the medium-run. Fortunately, the pronounced monetary loosening in
the United-States in 2001 should have two distinct benefits for Estonia and other
emerging markets: (1) it will contribute to decrease the real interest rate paid on foreign
borrowings and, perhaps most importantly, (2) it should encourage liquidity to emerging
markets. However, if interest rates were to increase later in industrialised countries,
21
capital inflows would inevitably slow down and Estonia’s large current account deficit
would be more difficult to finance. Lower capital inflows would signify less foreign
exchange reserves, which, given the CBA, would push interest rates up and lower
economic activity.
Overall, Estonia’s currency board does not appear to be in as a great a danger as was
that of Argentina in November 2000. The very small size of the domestic economy, its
wide openness and the flexibility on the labour market make Estonia a ‘natural’
candidate for a CBA. And a fairly sound banking sector and a low ratio of debt (and
debt-service) to GDP are additional strong support to the viability of its exchange rate
regime. Estonia does not heavily rely on external financing, which means that it is much
less vulnerable than Argentina was to a tightening of international liquidity and/or to a
change in investors’ sentiment. Nonetheless, recent figures related to current account
data suggest that Estonia might have crossed the line of real exchange rate
overvaluation. Deprived of the option to correct the nominal value of its currency and
with a budget already in equilibrium, Estonia will have to undertake further supply-side
reforms to add extra degrees of flexibility to its economy. The question is whether those
reforms, if implemented, would be sufficient to maintain an adequate degree of
competitiveness until EMU membership.
In contrast to Estonia, which opted for a CBA based on the currency of its main trading
partner, Argentina did not have a natural anchor currency and tied the peso to the
currency of a country which represented only roughly one tenth of its external trade. In
doing so, Argentina was inevitably more vulnerable to an exchange rate appreciation of
the anchor currency than Estonia would be, should the euro appreciate sharply. When
Estonia adopted a currency board, it did so to allow its economy to sail in a as safe a
way as possible until EMU membership, whereas Argentina never had a clear exit
strategy from its currency board arrangement.
22
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