Currency Boards - Essay Example

Currency boards. Second life The World war II saw off not only thousands of brave soldiers but also saw off many currency boards riding back on the winds-of-change euphoria that was just beginning to catch on. Perhaps unfairly, many associated the then existing boards with imperialism. From the highs of 30 in 1960, the number of countries that saw the need for currency boards plummeted to 20 in 1970. In the late 80's, only 9 countries had currency boards. But now, according to the IMF, the currency boards have been enjoying some favorable attention since the late 90's, with several countries choosing to experiment with them. The recent fascination appears to have been inspired by their success in dealing with hyperinflation in several countries such as Argentina and Bulgaria. Argentina did in fact abandon its currency board sometimes back in 2002 after it experienced one of it's worst recession. Lithuania and Estonia also turned to currency boards to obtain credibility for their newly established countries. The renewed appetite for fixed exchange rate regime justifies a closer look at ideal conditions for their establishment, with particular interest to the Argentina's experience. A currency board combines three aspects; one, the exchange rate is fixed to an anchor currency. Secondly, there must be automatic convertibility- it should be always possible to exchange local currency at the fixed rate and thirdly, there should be a long term dedication to this system. The fixed exchange regime that that currency board imports is usually appropriate for small economies with fragile central banks. The fixed exchange rate regime will only be effective if there are sufficient foreign exchange reserves to cover the local current issued. A fixed exchange rate system will be of no use if a country is unable to maintain a sustainable exchange rate to the anchor currency. This might cause serious balance of payment problems if the local currency is overvalued. Argentina paid scant respect for these economic principles that precipitated its financial crisis of 2002. The peso was locked at one US dollar since 1991, when then the currency board was established. Because of this overvaluation, Argentina exported too little and imported too much. The manufactured balance of payment problems rendered it difficult for the country to earn the foreign exchange it needed to repay its foreign debts. Usually, currency boards have the capacity to instill confidence in the public and financial markets because of the certainty of payment adjustment mechanism. However, experiences with Argentina and Hong Kong shows that currency board are not immune to speculative tendencies induced by fear of devaluation. Devaluation did actually take place in Argentina in 2002. Though this was meant to help resolve the countries balance of payment problems, it rendered many businessmen who had borrowed in foreign currency bankrupt. It is also essential for the fiscal policy of a country to be disciplined by the establishment of a currency board and this requires political will from the establishment. At least initially, Argentina bureaucrats played by the rules of the game. But they were perhaps emboldened and the discipline was lost in the late 90's when Argentina picked where it had left from and proceeded to ruin its economy by running persistent deficits. Argentina Convertibility Plan: Mission Impossible. The convertibility plan got its name from the currency board arrangement that was at the centre of economic program in Argentina. At first, it experienced a measure of success and was credited with the growth and stability experienced there in the first half on the 1990's. The initial success, which saw the growth rates going up to 9 percent in 1994, momentarily made Carlos Menem, the then President, and Domingo Cavallo, the then minister of finance heroes in Argentina. The latter years were far from rosy. It's hard to put a finger at what really went wrong and some things even surprised seasoned economists, like the fact that unemployment increased at the times of rapid economic growth. Much literature on Argentina's problem point out that the near-tragic events are attributable to a combination of factors including external shocks, both economic and political, spineless domestic institutions and questionable economic policies. When the convertibility law was passed in 1991 which, among other things, pegged the exchange rate of one peso to one dollar, few had any hope that the chronic hyper inflation seen in the 1989 (at 3000 percent) would ever be reigned in. by 1997 the inflation rate was at 0.5 percent which seemed a miracle to many Argentine's eyes. Some of the causes of the later crisis did not emanate from Argentina. Falling agricultural prices for its products and pure speculation did fuel the downfall of the peso. The Asian crisis of the 1997 didn't help either. But the self-made problems were big too. The government threw fiscal discipline out of the window and became a spendthrift, creating perennial deficits. The reluctance to change labor laws that would have made it easy for firms to lay off workers to maintain competitiveness also had something to do with it. Things started really going haywire from June 2001, when the peso was devalued by about 8 percent. The free spending attitude of the government accelerated the problems. The currency board's credibility took a battering, and the country defaulted on its $132 billion debt. What caused al this Empirical evidence suggests that currency boards have a good record of maintaining price stability. But lack of fiscal discipline, legal and structural defects found in Argentina's whole plan could render impotent even the most astute of currency boards. It is a problem that could have been resolved through the political process onside Argentina. The balance of payment problems that the country experienced also meant that it could not accumulate enough hard currency reserves to protect it from the external shocks talked about earlier. In a country with no fiscal discipline as we have seen, it is improbable that the currency board could instill fiscal discipline. The first resort that the government took to borrow money from abroad in a desperate attempt to balance the books. But at a heavy price as the interest rates were ruinously high. This was the precursor to the default that occurred later. The currency board flouted the rules generally accepted for such institutions; it acted as a lender of last resort, engaged in monetary policy activities, and was susceptible to political manipulation. The convertibility plan failed in the end. But there were several things that could have been done differently; tariff changes to offset BOP problems, increased export subsidies, improving productivity and the also the way MERCOSUR was implemented and devaluation. Lamentably, we now have to study Argentina's failed model in business classes to avoid one more mistake. Carlos Menem. Economic Czar Other countries may still better Argentina's record on hyperinflation (think Zimbabwe) but it's still one of the economic stories to tell. In 1977, someone living in Buenos Aires, Argentina's capital, could buy a container of milk with one peso. If that person went back to buy the same commodity about 14 years later, he would be asked to part with 1 billion pesos (or austral, which the country adopted for a while in 1980's). That was the state of Argentina's economy when Carlos Menem took office from Raul Alfonsin in 1989. the initial efforts by Menem were far from satisfactory, and he could have been just another president that Argentine's could have thrown out and forgotten. But Domingo Cavallo, the then economic minister had other ideas. He is credited with dragging Argentina from the fire of inflation. So how did he do it Apart from introducing a new currency (the new peso), he drummed up a comprehensive reform package. With the full backing of President Menem, Cavallo helped stem the omnipotent budget deficits and proposed measures aimed at making Argentina competitive globally. Measured geared at cutting back on budget deficits included slashing government spending, reforms on the internal revenue system and catching up with tax evaders. The government also adopted a more laissez faire attitude to foreign imports and reduced tariffs as well. But the boldest of measures introduced under Menem's watch was the passing of the Convertibility law in the country's congress. This law facilitated the establishment of a currency board in that country. This is a monetary arrangement under which domestic money supply is restricted to the amount of foreign reserves held by the central bank. The desired effect of a currency board is to instill confidence in the public that money supply will not be recklessly increased. This in turn ensured there was a stable money supply in the economy and thus the inflation would be kept low. One peso was pegged to one dollar (though actually some loopholes in the law allowed there to be some more pesos than dollars) and thus one peso was as good as one dollar. The currency board achieved some of its goals. Price stability was restored. And inflation went down below 1 percent by the mid 90's. Impressive growth rates were also to be seen in the mid 90's, buoyed by high prices for primary commodities, Argentina's main exports until the Tequila Effect in 1995. Perhaps the best explanation to the Argentina's initial success would be that there was enough political will that enabled policymakers swallow bitter pills like massive privatization and labor reforms. Domingo Cavallo must have realized from the beginning that hyper inflation had caused the freefall of confidence in the Argentina's government so much that less drastic measures would have been inadequate. It is very likely that the idea of a currency board did not appeal to the establishment, but the politicians and policy makers alike realized that it might serve to reassure the public that the government did not have a free hand on fiscal policy, a condition antecedent to maintaining convertibility. Read More