From hard-peg to hard landing?: recent experiences of Argentina and Ecuador
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Abstract Based on the analysis of the Argentinean currency board and the full dollarization scheme in Ecuador this paper argues that an intermediate exchange rate regime (compared to free floating or hard peg) will be a better option for countries subject to external financial shocks and a worldwide export and import structure. It shows that the Argentine convertibility system was successful as an anti-inflationary program. However, the reduction in the inflation rate has been accompanied by a dramatic change in relative prices of tradable and non tradable goods and services, which have caused serious problems in the international competitiveness of the economy. The dollarization regime in Ecuador did not lead, as in Argentina, to a rapid reduction in the inflation rate (in 2001, CPI may still increase 30%); if inflationary inertia persists for too long, Ecuador may witness the same deterioration of relative prices between tradable and non tradable products, negatively affecting its external sector. Price stability is not a synonym of economic stability. The convertibility system generated a paradoxical situation, in which the economy is very stable when judged by the stability of the general price level and the exchange rate, but very unstable, if one looks at the growth rates of the economy. This instability relates to external credit cycles and changes in export income which directly affect the monetary base and hence the level domestic credit. Also, the absence of the adjustment in relative prices between tradables and non-tradables, requires that in the event of an external deficit, the entire burden of adjustment falls on the contraction of the economic activity, since this is the only way to reduce imports. Hard-peg regimes heighten the external sector's influence over the pace of economic activity, even in a country like Argentina, with low coefficients of trade openness (in 2001, importsand exports each represented less than 10% of GDP in current values). In Ecuador, trade openness coefficients are around 30%. Argentina took advantage of the availability of foreign capital that emerging markets enjoyed beginning in 1991-1992. In the first half of the nineties, the capital inflows permitted the financing of the current account deficit and significant pace of economic growth. Nevertheless, it has resulted in high external indebtedness and rising payments of interest and capital income, which, in the absence of a sustained rate of export growth, jeopardized the future viability of the convertibility scheme. A lesson that arises from the Argentine experience is that it is not possible to sustain in the long run a hard peg regime together with long lasting fiscal or current account deficits; either fiscal or current account equilibrium have to be achieved, which as it was seen is not an obvious outcome of hard peg regimes. In Argentina, this simultaneous equilibrium was not attained: when the economy grew, it produced an increase of imports and a trade deficit; when it did not grow, there was a fall in tax revenues, which led to a fiscal deficit. Increasingly since the Mexican crisis, the way to elude this contradiction was the increasing in public external debt. In this sense contrary to what was suggested, the convertibility system stimulated public external indebtedness instead of forcing a move towards fiscal discipline. As a final result, at present Argentina had to face severe deficits both in the fiscal and external sectors. This implies that in the case of Argentina the convertibity law was able to eliminate for several years the devaluation risk, but dramatically increased the default risk, which has proven to be as costly as the former and led to a strong attack to convertibility. It is also shown that for the Argentinean case the automatic adjustment mechanisms implied by hard pegs has not operated in a smooth way. This is due to the fact that international financial markets tend to adjust via quantity rather than via prices: a rise in interest rates does not lead to an increase in capital inflows to a country whose over-indebtedness is already manifest, as is the case of Argentina and Ecuador and they can not rely on a permanent access to the international financial markets at reasonable interest rates. Also, external crisis go hand by hand with domestic banking crisis introducing difficulties in the dynamics of the automatic adjustment. The natural raise in the domestic interest rates to attract external financing has a strong effect in deepening domestic recession and increasing financial cost. These two factors create solvency and liquidity problems in the corporate level, worsening the risk of the banking sector liabilities and driving it towards a banking crisis. As long as the exchange rate regime places limits on the Central Bank to act as a lender of last resort problems of insolvency can spread more easily to the banking system.