The convertibility system is near the end of its existence. As my colleague Kurt Schuler and I have said for more than ten years, convertibility is an unorthodox mixture of a currency board system and a central banking system. Argentina has two choices: officially dollarize, which is consistent with the spirit of an orthodox currency board system, or float the peso, which means expanding the powers of the BCRA and hoping it will use them wisely.
Argentina’s experience with floating exchange rates and other forms of independent monetary policy has been disastrous. From the time the central bank was established in 1935 until 1991 the peso depreciated against the dollar by a factor of 3,000,000,000,000. That leaves dollarization as the only choice that experience suggests will provide stability.
Does the exchange rate have to be devalued because Argentina is not competitive? The classic sign of not being competitive is a decline in exports. Argentina’s exports have risen every year of the last ten years except 1999. If the rest of the economy were growing at the same pace as the export sector-about 3 percent a year-Argentina would not be in a recession.
If devaluation alone could make a country competitive, Argentina should have been one of the world’s most competitive countries in the 1980s, when the currency was depreciating rapidly. Devaluation can give exporters a temporary cost advantage, but making a country competitive over the long term requires an efficient and honest legal system, a tax code that encourages enterprise and compliance, flexible labor laws, and other institutions that are outside of monetary policy. Argentina made great progress in these areas in the early 1990s, but has done little since then. In some areas, notably tax policy, it has even retrogressed.
Does Argentina have enough reserves to dollarize at 1 peso = 1 dollar? There are two misconceptions about the reserves necessary for dollarization. The first misconception is that dollarization requires reserves beyond those necessary to cover the monetary base (the monetary liabilities of the central bank). That is not correct. Moreover, dollarization in the form I have proposed (see below) is likely to reduce the reserves Argentina’s financial system needs.
The second misconception is that Argentina now lacks sufficient reserves to cover the monetary base. Although it is true that the “pure” foreign reserves of the central bank were only about 14.8 billion pesos on Dec. 5th, versus a monetary base of 15.8 billion pesos, the central bank also has domestic assets exceeding 11 billion pesos. Provided that the central bank is reporting its accounts accurately and does not have large hidden liabilities, it could eliminate the gap in foreign reserves by selling some domestic assets for dollars. Even if the gap in foreign reserves were much larger, there would be ways to minimize its effects.
Any exchange rate other than 1 peso = 1 dollar would create widespread disruptions. Devaluing the peso would hurt borrowers by bankrupting many people who have borrowed in dollars. Making a forced conversion of dollar loans into pesos would hurt bank depositors and other lenders by devaluing their loans. A forced conversion would be the third such event in 20 years. The lesson people would learn from it is that they should never again keep their savings within the reach of the Argentine government.
Would dollarization intensify the current loss of confidence in the banking system? Loss of confidence in the peso has affected the banking system. Bank depositors do not want to see their savings evaporate as part of an ineffective attempt to defend the currency, such as the first Cavallo plan or the Bonex plan. By eliminating the peso, dollarization would eliminate that fear. Ecuador froze its bank deposits in March 1999 (under a floating exchange rate) and the government seized bankrupt banks that held about two-thirds of all bank deposits. The currency remained unstable and the economy plunged further into a recession. After Ecuador dollarized in January 2000, although the banks remained troubled, deposits rushed back in, increasing from 2.5 billion dollars in December 1999 to 3.3 billion dollars in November 2001. Dollarization has helped Ecuador’s banks become stronger. It would have the same effect in Argentina.
I have proposed that banks in Argentina be allowed to issue their own notes, denominated in dollars, to replace both peso notes issued by the BCRA and dollar notes issued by the U.S. Federal Reserve System. (The text of the proposal is available at http://www.cato.org/pubs/fpbriefs/fpb-067es.html.) This step has the potential to increase bank reserves by billions of pesos, because the public currently holds 8.3 billion pesos in notes issued by the BCRA and an estimated 25 billion dollars of notes issued by the Federal Reserve. If the public can be persuaded to use bank-issued notes even to a small extent, bank reserves (Dec. 5th= 10.7 billion pesos) would increase by a corresponding amount. The replacement of government-issued notes with bank-issued notes would be on a purely voluntary basis, with no forced exchange involved. Historically, systems of bank-issued notes have operated in many countries, and where they have been free of intrusive government regulations they have worked quite well.
Dollarization was a good idea when it was debated in 1999 and it remains a good idea today. With dollarization Argentines know that they will receive a stable currency and eliminate devaluation risk. The same cannot be said about allowing the peso to float.