Currencies issued by central banks in emerging-market countries are often the targets of speculative attacks that almost always end with a sharp devalution. This is not the case with currency boards, which provide a local currency with the backing of a relatively firm measure of value, such as the dollar, euro or gold. Yes, currency-board systems do occasionally come under speculative attack. Unlike central bank currencies, however, those issued by currency boards have always survived speculative onslaughts without devaluing.
Argentina, which has had a currency board—like system since April 1991, is a case in point. In 1995 speculators engaged in a fruitless attack on the Argentine peso. Today the peso is again under attack, trading at a deep discount to its U.S. dollar anchor on the forward market. The annualized implied yield on the one-month forward market is 90%; it recently exceeded 150%.
How did Argentina become embroiled in another bout of currency turmoil? Even though Argentina emerged intact from Mexico’s tequila crisis of 1995 and its GDP grew by 5.5% in 1996 and 8.1% in 1997, its economy ran into trouble in 1999 after Brazil’s devaluation and before its own presidential elections.
The inauguration of Fernando de la Rua as president in December 1999 engendered some economic optimism, but the de la Rua government was a weak left-wing coalition. It quickly proved incapable of reforming the supply side of the economy and bringing order to Argentina’s fiscal affairs. A crisis ensued.
Earlier this year, de la Rua was forced to appoint Domingo Cavallo as his economic czar. Cavallo (who served as Forbes Global’s publisher until 1999) designed Argentina’s unorthodox currency board, which killed the country’s hyperinflation. But this time around Cavallo has made missteps that have worsened Argentina’s predicament.
In June, Cavallo introduced a dual-currency regime. Under this setup, all exports (excluding oil) take place with a devalued peso; all imports with a revalued peso. All other transactions take place at a peso-dollar rate of 1-to-1. Then a law was passed in which the peso’s anchor will switch from the dollar to a basket of 50% euros and 50% dollars once the euro reaches parity with the dollar.
Not surprisingly, these changes were viewed by the markets as moves by Argentina to eventually abandon its currency board. They were not reassured when, on July 9, the Agence France Presse quoted Cavallo as saying that Argentina “will leave the peg one day.” Interest rates shot up in anticipation of an exit and a devaluation.
This raises the issue of whether, and how, to drop an exchange-rate regime. Countries that exited from flawed soft regimes and adopted currency boards or “dollarized” in the 1990s have all seen dramatic improvements in their macroeconomic indicators. Examples include Argentina, Estonia, Lithuania, Bulgaria, Bosnia and Ecuador. Indeed, a shift from a soft regime to a hard one has always ended a currency crisis.
But not so with shifts from hard regimes to soft. Recall Hong Kong’s exit from its currency board in November 1974. The floating Hong Kong dollar became wildly volatile and steadily lost value against the U.S. dollar. The volatility reached epic proportions in late September 1983. Hong Kongers panicked, hoarding toilet paper, rice and cooking oil. The chaos ended on Oct. 15, 1983, when Hong Kong reinstated its currency board.
Domingo Cavallo should understand that merely talking about the idea of abandoning a hard regime in the middle of a crisis is playing with dynamite. In July the dynamite exploded. (Military history teaches the same lessons about the dangers of discussing exit strategies. In his new book, Waging Modern War, General Wesley Clark shows that every time the U.S. Department of Defense spoke about exit strategies for U.S. troops in Bosnia, the Bosnian Serbs would intensify their efforts, causing no end of problems for the allies.)
To stop its financial panic, Argentina should exit its semi-hard regime and adopt a totally hard one, the dollar. Pesos should be removed from circulation and replaced by dollars. Under this dollarization, any other currency could be legally used in transactions, too. However, if no currency was specified, the dollar would serve as the default currency.
Dollarization would immediately eliminate Argentina’s currency risks, lower interest rates and stop the panic.