REUTERS
By Marjorie Olster
Argentina's expected abandonment of its currency peg to the dollar has revived questions over whether fixed exchange rate regimes help or hurt emerging market countries plagued by financial instability.
Argentina's interim government gave the first sign this week it was preparing to abandon a decade-old policy of keeping the peso valued at one-to-one to the dollar. The country was introducing a third currency to pay state salaries that would be allowed to depreciate and may eventually replace the peso.
Fixed exchange rates have played a part in virtually every major emerging market financial crisis in the last decade. They limit flexibility at a time of increasingly volatile global capital flows and require an iron-clad political commitment to fiscal discipline and market reforms.
Argentina would join a long list of emerging market countries that have had to abandon fixed rates in the midst of crisis, including Mexico in 1994, Thailand, Indonesia and Korea in 1997, Russia in 1998 and Brazil in 1999, and Turkey in the past year.
Argentina introduced a particularly rigid form of pegged exchange rates, a currency board, in 1991 to try to crush hyperinflation that sent consumer prices skyrocketing 5,000 percent annually in 1989.
Under the currency board, the central bank ensured the money supply was backed fully by foreign currency reserves and the government in effect pledged to convert all local currency into dollars if needed.
It was successful for a number of years in bringing inflation under control and stabilizing the economy.
But the peg removed flexibility in adjusting exchange rates and interest rates. Because the government could not print money to cover spending beyond its means, U.S. academic experts said, the peg required an extraordinary commitment to fiscal discipline that Argentina's former government simply lacked.
DEFICITS WERE MAIN PROBLEM
Carol Wise, an associate professor at the School of Advanced International Studies at Johns Hopkins, said the peg was wrong for Argentina.
Argentina's inflexible labor market, with trade unions that resisted reforms, hampered increases in productivity and efficiency needed to stay competitive, especially without the option of adjusting exchange rates.
``Under a currency board, you have got to run a very tight fiscal policy rule No. 1,'' said Wise. ``They couldn't run a tight fiscal policy because the labor market wasn't reformed. The cost of doing business in Argentina is 40 percent higher than in industrial bloc countries.''
David Beim, a Columbia University finance professor, said deficits, not the currency board, were at the heart of the problem.
``If you are going to have a currency board, you must control your deficits,'' Beim said. ``The lesson from Argentina is, unless you are very sure you can control your deficits for the future and your credit ratings are unimpeachable, you have to leave room to get out of the regime.''
FORMER GOVERNMENT POLICY FAULTED
Steve Hanke, a Johns Hopkins University professor of Applied Economics and an outspoken advocate of currency boards who has advised several emerging market governments, said it was not the peg but a ``series of near-catastrophic economic policies'' at the root of Argentina's problems.
``Any country that has an incompetent government gets into trouble,'' Hanke said, faulting the former government for a series of tax increases in the last two years while the economy was in a slump.
Argentina's experience has not altered Hanke's view that a currency board that locks in a fixed exchange rate regime is desirable for any developing country that suffers from financial instability.
A hard peg, as opposed to a soft peg, which allows a currency to fluctuate within a band, was thought to give greater immunity against speculative attacks like those that caused the Asian financial crisis in 1997-1998.
Hanke cited Hong Kong, Estonia, Lithuania, and Bulgaria as examples of countries where currency boards successfully stabilized their economies. China and Malaysia also have fixed exchange rates.
LOSS OF SHOCK ABSORBER
Critics of fixed exchange rate regimes say the inability to devalue a currency removes a key shock absorber to deal with economic downturn.
Under a floating exchange rate, a currency can lose value in hard times, making exports cheaper and stimulating the economy. But if the currency is fixed, exchange rates can get out of alignment with those of major trading partners.
That was the case in Argentina. A strong dollar put it at a competitive disadvantage to its major trading partners in the region, like Brazil, which devalued its currency in 1999.
Another problem with Argentina's system was that it did not prevent heavy foreign borrowing, a debt the country eventually became unable to service.
In the 1990s, capital flows grew more volatile, with money moving rapidly around increasingly globalized financial markets. That made it more difficult for economies with fixed exchange rates to cope.
Argentina saw net private capital flows shift to an estimated deficit of $13.3 billion in 2001 from an average annual surplus of $14.7 billion in 1997-99, according to U.S. investment bank JPMorgan.
SMALLER MAY BE BETTER FOR PEG
Analysts said a currency board has not yet succeeded in a large country like Argentina. But it seems to work better when a small economy that depends heavily on a particular large economy for its trade and capital account transactions links its currency to its main trading partner.
The best candidates are states with small deficits and strong political commitment to fiscal controls, said Wise.
``Argentina is not a natural candidate for a currency board,'' she said. ``The natural candidate is a small, open economy with a very flexible labor market, like the former Soviet states.''
In Argentina, the challenge went from hyperinflation to deflation. But Wise said the Argentines did not have the flexibility or the political will to deal with the fundamental shift.
``A currency board does not exist in a vacuum -- it's part of the political economy,'' she said.
``The lesson here is, the currency board required more cohesive and a tighter political coalition than they realized,'' she said. ``There was no political coalition to support the currency board. They have nobody to blame but themselves. The politics are pathetic.''
Send to Kindle
