Global Policy Forum

Five months after the collapse of Argentina's ten-year-old currency board, and the subsequent plunge in the value of the peso, the country has at last taken some long-awaited steps towards restoring economic stability. But Argentina's painful experience remains a warning for emerging-market economies struggling to choose the right exchange-rate regime

For the ordinary citizens of Argentina, it is bad enough living in an economy now in its fourth year of recession, and to have seen the value of their savings plunge by around two-thirds this year. But they also have to put up with a system of government which enables political leaders to spend their time arguing with each other, eyes firmly on their prospects in the presidential election due next year.

An important step towards reform was at last passed by the country's Senate on May 30th, when the controversial economic-subversion law, which the courts had used against bankers, was repealed. This meets one of the preconditions for any international rescue package for Argentina. There was further progress on June 1st when Roberto Lavagna, the economy minister, unveiled a plan to lift the hated freeze on withdrawals of bank deposits, imposed last December. Under the new plan, deposits will be convertible into bonds maturing in three or ten years.

Even so, the road back to economic and financial health is going to be long and painful. Economists are still arguing about what might have been done to prevent the catastrophic breakdown of the country's ten-year-old currency board. The debate is being watched closely by the governments of other emerging-market economies and their advisers. They want to know where Argentina went wrong, and whether they could avoid a similar disaster.

In the aftermath of such a crisis there is, of course, plenty of mud-slinging. In Argentina's case—and in many similar episodes in the past—the International Monetary Fund (IMF) comes close to the top of the list of targets. Even now, many Argentines cannot understand why the IMF did not do more to help, and there is genuine puzzlement as to the IMF's continuing refusal to reach a deal with the government. Every now and again, a member of the government talks about an imminent deal. Repeal of the economic subversion law shows that, at last, a start is being made on the more difficult economic reforms demanded by the IMF and its paymasters, the G7 industrial countries.

Despite abundant evidence of political irresponsibility, it is hard not to feel some sympathy for Argentina. The latest conventional wisdom is to argue that the country was badly mistaken to cling for so long to the currency board, which pegged the peso at parity with the American dollar. It is also widely accepted now that the $8 billion rescue package which the IMF put together for Argentina in August last year was a mistake—encouraging the then government to prolong the pain imposed on the economy by its exchange-rate regime.

Yet there were few voices advising Argentina to move to a different exchange-rate regime when a switch might have been less painful. Nor was there much dissent when Argentina introduced the currency board in 1991, or when it pointed to the dramatic falls in inflation for which the hard-currency peg got the credit.

No wonder, then, that emerging-market economies are confused about the right exchange-rate regime to pursue. Economists are confused too. If there is any truth in the old joke that says for every two economists you get three opinions it surely applies to discussions of exchange-rate policy.

The challenge is not a shortage of evidence, but interpreting it. One of the biggest obstacles is also one of the most basic—working out which exchange-rate regime is actually being applied. There is often a considerable gap between what countries say their policy is—known as the de jure classification—and what policy the government actually follows in practice—the de facto approach.

Correct classification is important because it enables economists to measure the supposed benefits in terms of reduced inflation, for example. And the costs of a regime going wrong can be high. A long list of emerging-market exchange-rate crises in the 1990s is a reminder both of how painful such crises are for the country concerned and how great the impact can be on the international financial system as a whole.

The crises of the 1990s did, however, tend to have one thing in common: they all had some kind of fixed exchange rate, often a fixed peg or link to another currency, usually the dollar, or an exchange-rate band, again usually linked to the dollar. The "tequila" crisis in Mexico in 1994; Thailand, Indonesia, Malaysia and South Korea in 1997; Russia and Brazil in 1998; Turkey in 2000 and 2001, and, of course, Argentina, all had some kind of peg. None was floating. Indeed, studies have shown that even when emerging-market economies say they are floating (as Malaysia, for example, used to), they tend to rely more heavily than the industrial countries do on interest-rate policy and foreign-exchange market intervention to limit actual movements in the exchange rate.

Yet Argentina's experience provides clear evidence that even currency boards, where the rate is fixed by law, and where the domestic currency has to be backed by hard-currency reserves, are not immune from crises. And such hard exchange-rate regimes do not offer suitable policy instruments for domestic economic management: Argentina's monetary policy was, in effect, made in Washington and was often inappropriate for Argentina's needs. Nor was the government able to use fiscal policy to stimulate the economy when the recession started, because of the fragile nature of the country's external-debt position.

One of the biggest problems in emerging-market economies is currency "mismatching", where most of the debts in an economy are denominated in one currency, whereas many of the borrowers' assets are in another. When a crisis erupts the consequences are far more serious because of the mismatch. Thus, in Argentina, many loans were taken out in dollars: this had catastrophic consequences for borrowers once the peg collapsed, since dollar loans suddenly surged in peso terms.

Argentina's experience has prompted a large number of economists to come forward with their prescriptions. Most recently, Morris Goldstein, of the Institute for International Economics, has made a persuasive case for a framework he calls "managed floating plus". By this he means a managed floating exchange-rate, giving the country the advantages of flexibility by allowing it to pursue its own monetary policy while still being able to adjust in response to external shocks. This is combined with the "plus": policies such as inflation-targeting and measures to reduce currency mismatching.

There are many other distinguished economists, however, who argue that the attempt to come up with a formula which all countries can use is in itself flawed: circumstances vary and so must policies. And none of the present debate will bring much comfort to Argentina in the short term, of course. But those arguing for returning to the currency-board regime at a different rate, or for full dollarisation, which would eliminate any policy flexibility for the Argentine government, should at least be given pause for thought.

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