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CENTRE FOR ECONOMIC REFORM AND TRANSFORMATION School of Management, Heriot-Watt University, Riccarton, Edinburgh, EH14 4AS Tel: 0131 451 3623 Fax: 0131 451 3498 E-Mail: [email protected] World-Wide Web: http://www.som.hw.ac.uk/cert 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. 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