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Argentina's Convertibility Plan- The fight for Stability Kristina Spacone Matthew Peabody Heather Edelstein Lino Covarrubias 5/23/2017 1 Topics of Discussion Brief history of Argentine economy Overview of different plans Define convertibility plan Macro-economic effects Long-run consequences 5/23/2017 2 Inflation Big 3 (80-90s) 3000 Big 3- Inflation 2500 %Price Growth C.P. 2000 Argentina Mexico 1500 Brazil 1000 500 0 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 Year 5/23/2017 Austral/Cruzado Convertibility Real 3 Big 3- Growth (1940-1989) Big Three % Gwth 1940-1989 7 6 5 %Gwth of GDP/capita 4 3 Argentina 2 Mexico Brazil 1 0 1941-49 1050-59 1060-69 1970-79 1980-89 -1 -2 -3 Years 5/23/2017 4 CA Deficit Big 3- (1940-1989) CA Deficit % GDP FOR BIG THREE 0 YEAR 1982 1983 1984 1985 1986 1987 1988 1989 -2 -4 CA Deficit % GDP -6 -8 Argentina -10 Mexico Brazil -12 -14 -16 -18 -20 Year Mex Pacto- 1987 5/23/2017 5 Argentina Pre-Convertibility Argentine Inflation 1970-1997 Avg %growth C.P./annum Convertibility 3000 2500 2000 1500 1000 500 0 1970 % Price Growth 1980 Year 5/23/2017 1990 1985- Austral 6 Argentine Growth (1940-1989) ARGENTINE GRWTH 1940-1989 4 3 2.8 2.3 %GWTH GDP/CAPITA 2 1.3 1 0.8 %GWTH GDP/CAPITA Series2 0 1941-49 1050-59 1060-69 1970-79 1980-89 -1 AUSTRAL PLAN (1985) -2 -2.3 -3 YEARS 5/23/2017 7 Austral Plan- (1985) 1.{The Heterodox attempt to Stabilize} Mechanism to adjust for inflation by the utilization of three elements: i. By freezing wages, Exchange rate. prices, and pegging the • 1. 40 Inspectors roamed to ensure price compliance • 2. Public confidence was the real watch dog. ii. Introduction of New currency and policy to Stabilize money Supply (i.e. kill the old “maquinita”). iii. Fiscal adjustment- taxation, government spending. Financing of debt with resources rather than with printing of money. 5/23/2017 8 Austral Plan (1985) Con’t year proved successful with Austral Plan i.Inflation reduced 30%/month to 3%/month. However, caused decline in output. The plan was not a long-term fix. i.Exchange rate Overvalued When price freeze was lifted, prices again took off in 1987. 1st 5/23/2017 9 Why didn’t Austral WORK? Wages, government revenues decreased and the corresponding CA deficit increased. By 1989, per capita output was the lowest in 15 yrs. Per capita GDP was 10 percent lower than in 19801 Gov’t weak and unable to collect taxes- Tax Revenue Interest rates back up to 150%/month CA deficit was 7.6 percent of GDP1 Political unrest: President Raul Alfonsin to transfered power to newly elected president Carlos Menem five months before the normal time. After election of 1989, Austral was devalued but the damage had been done- People had no confidence in the Austral. 5/23/2017 10 Convertibility Plan- 1991 • • • Crafted by Covallo One for one peg between the Peso and the dollar Gov’t agreed to issue no new pesos unless the money was backed 100% by dollar reserves in the cental bank 5/23/2017 11 Impact of Convertibility Plan • • • Maintained pesos value End of Hyperinflation 1991-1994- GDP was growing 8% annually 5/23/2017 12 What made it a success? Structural Changes Entrepreneurship Privatization Fiscal discipline 5/23/2017 13 Implications • • Periods of Instability (Brazilian, Mexican and Asian crises) Exchange rate risk 5/23/2017 14 Balance of Payments Current Account + Financial Account + Reserves = ZERO 5/23/2017 15 Argentine Monetary Policy Reliance on international support No control over money supply Government financing Interest rates 5/23/2017 16 History What is Dollarization ? A foreign currency that displaces the domestic currency. (In the case of Argentina the U.S. dollar replacing the Peso) OFFICIAL vs. UNOFFICIAL Dollarization UNOFFICIAL: Asset holdings converted to US $ to protect from domestic currency volatility. OFFICIAL: U.S. Dollar becomes the countries currency. • Panama: (1904) Only Latin American Country in category 5/23/2017 17 Advantages to Dollarization PROS-for Argentina Fit for Dollarization-history of Hyperinflation Lower inflation since U.S. monetary policy is imported Increase in growth because of absence of devaluation risk. Should spur in local savings, lower interest rates, and increase FDI Less perceived volatility especially capital outflows- Mex. Peso Crisis Budget constraint- Gov’t Wouldn’t be able to run “la maquinita” thus would have to adjust via internal programs. Shared seigniorage 5/23/2017 PROS-for the United States Increased seigniorage Elimination of currency conversion fees for tourists and businesses Demand for U.S. goods Maintain position as the premier international currency 18 A Quick Lesson In Seigniorage Dollarized country’s share of net seigniorage =total average monetary base over the period (circulation + reserves) X average interest rate on 90-day T-bill during the period - net cost of operation the Federal Reserve X dollarized countries share of total monetary base X proportion of seigniorage revenue that the United States pays ARGENTINA’S SHARE OF THE SEIGNORAGE-estimations but close to actual values. =$16 billion / $566 billion ($550 base+ars 16mm) = 2.8% Suppose average rate on T-bills is 5% and net cost of operating the Reserve is $1 billion Average monetary base is $580 =($580 billion X 5%)-$1 billion) x 2.8% X1 =($29 billion-$1 billion) X 2.8% X 1 $784 million Clearly under a shared seigniorage system Argentina would be better served than collecting interest payments. $784mm vs. $750mm In addition it is hard to put a dollar amount on the investor confidence gained by extinguishing the risks of devaluation. 5/23/2017 19 Disadvantages to Dollariztion Cons-for Argentina Country gives up fiscal and monetary control-surrender to the FED Loss of revenue (seigniorage) Lose Lender of last resort Popular Opinion Representation at FOMC Optimum Currency area? MERCOSUR trading bloc Cons-for the U.S. Ease of conducting monetary policy? Interest rate pressure Dumping of Dollars Lack of prior knowledgefaces challenges of being a pioneer. Panama offer the only situation from which to learn. • Brazil 5/23/2017 20 Bilateral Exchange Rate Bilateral Real Excange Rates 160 U.S 140 Bra zil Ge rma ny 120 Ita ly Ne the rla nds 100 Spa in 80 60 40 20 0 1996 5/23/2017 1997 1998 1999 Source: IIF estimates 2000 21 Unit Labor Costs (ULC) Unit Labor Costs 120 100 80 60 40 20 Brazil U.S. Germany Italy 19 95 19 96 19 97 19 98 19 99 20 00 0 Argentina Unit labor costs (ULC) are defined as ULC=(W/E)/(Q/L) where W is the total nominal wages for the manufacturing sector, E is the level of manufacturing employment, Q is an index of industrial output, and L is employment in the manufacturing sector. Values converted to dollars. Source:Ministry of Economy, Banco Central do Brazil, International Financial Statistics, Datastream. 5/23/2017 22 What do the Pro’s think? FOR “Given the economic program Argentina designed for itself in the Convertibility Plan, dollarization makes senses.” -Sheila Campbell “In Argentina, dollarization is feasible; and I would even say appropriate.” -Nicolas Eyzaguirre, Executive Director IMF “I would say that the idea merits American blessings even if it can’t be official blessings.” -Jeffrey A. Frankel “In the long term, finding ways of bribing people to dollarize, or at least give back the extra currency that is earned when dollarization takes place, ought to be an international priority. For the world as a whole the advantage of dollarization seems clear to me.” -Larry Summers 1992 AGAINST “Argentina will go on the dollar when the United States agrees to put Eva Peron on the dollar bill.” –Argentine Cab Driver On the subject of dollarization: “A disastrous option.” -Francisco Chico Lopez, President of the Central Bank of Brazil 5/23/2017 23