Minicase: The Argentine Experience of Currency Board, pp

Emerging Markets and Regime Choices: Currency board A currency board exists when a country’s central bank commits to back its monetary base – its money supply – entirely with foreign reserves at all times. Generic name for a commitment by a country to link its money supply to its international reserves. – The country cannot issue currency without having an equivalent amount of foreign exchange in its reserves. – The country agrees to exchange foreign currency for its currency at an agreed rate. This means that a unit of domestic currency cannot be introduced into the economy without an additional unit of foreign exchange reserves being obtained first.

What’s Happening in Argentina Before 1991? An official currency was Argentine peso. Hyperinflation ravaged the country. International indebtedness was very high. A chronic budget deficit was severe with no sign of improvement.

The Argentine Currency Board Argentina moved from a managed exchange rate to a currency board in In 1991 the Argentine peso had been fixed to the US dollar at a one-to-one rate of exchange. In other words, ARS1 = USD 1. Every peso issued in Argentina had to be backed by gold or US dollars held on account in Argentine banks. (100% reserve system) Only after Argentina had earned these dollars through trade could its money supply be expanded. A currency board structure was implemented in an effort eliminate the source inflation that had devastated the nation’s standard of living in the past. Argentine residents and non-residents could place US dollar deposits at Argentine banks – equivalent to Eurodollars.

The Early Success with Currency Board Remarkable success in restoring confidence in the peso and subdued inflation The idea was simple: limit the money supply to the rate at which the country receives net inflows of U.S. dollars. However, there was a cost: restrictive money supply limited economic growth and unemployment rate was rising. And the Central Bank could not do much due to its lack of flexibility of currency board system.

The Argentine Crisis of 2001 By 2001, after three years of recession, three important problems with the Argentine economy became apparent: – The Argentine Peso was overvalued. – The currency board regime had eliminated monetary policy alternatives for macroeconomic policy. – The Argentine government budget deficit – and deficit spending – was out of control.

Overvalued Peso Overvalued peso could not be adjusted because of its rigid nature of currency board. This is the main problem of fixed rate system: It can’t allow the market forces to adjust foreign exchange rate. As a result, Argentina’s product was the most expensive in all of South America, which reduced exports.

Sluggish Economy A sluggish economy warranted a monetary expansion. But, the currency board limited due to its rigid nature of currency board. – Remember the each peso is tied with each dollar. – So, Central Bank could not inject more money into economy to boost consumer confidence and economic growth, unless the country earned dollars from trade activity, which was decling.

Budget Deficit Government spending continued increasing, but tax receipts did not. Foreign debts was rising faster. Government’s credibility to keep the fixed rate system was severely undermined.

The Argentine Crisis of 2002 Experiment ended in January The country ended the currency board as a result of substantial economic and political turmoil. In January 2002, the peso was devalued as a result of enormous social pressures resulting from deteriorating economic conditions and substantial runs on banks as well as speculative attacks against the currency. However, the economic pain continued and the banking system remained insolvent. Social unrest continued as the economic and political systems within the country collapsed; certain government actions set the stage for a constitutional crisis.

Exhibit 10.6 Daily Exchange Rates: Argentine Pesos per U.S. Dollar

Lessons from Argentine Currency Board Currency board is indeed a fixed rate system that does not allow much flexibility. Market confidence did play a significant role. Government credibility is a key in keeping currency board. – For a currency board to be successful, it must have credibility in its promise to maintain the exchange rate. Indeed, speculative attacks in foreign exchange market are detrimental to already difficult economy in Central bank’s ability to control over money supply is a valuable tool to lose. Government should have an ability to intervene in order to defend its position against the pressures exerted by economic conditions, as well as by speculators who are betting that the currency board will not be able to support the specified exchange rate.