Abstract
This paper discusses the implications of the collapse of Argentina's currency board arrangement on the debate about appropriate exchange rate regimes for emerging market countries (EMCs). It highlights the link between the inherent vulnerability of the EMCs (the so-called original sin hypothesis) and the operation of different exchange rate regimes. The structural weaknesses that typically make EMCs vulnerable to negative external shocks affect different currency regimes, as is illustrated using examples such as Argentina with its currency board arrangement, Brazil with its floating currency, and Panama with dollarisation. We contrast the experience of these countries with that of the accession countries in Central and Eastern Europe, which are much less sensitive to external shocks no matter what their exchange rate regime. It is argued that the main reasons for this difference are the smaller role of debt-creating flows in the financing of current account deficits, higher domestic savings, and – most important of all – the prospect of accession to the European Union and Economic and Monetary Union.
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Notes
As Larraín and Velasco (2001) observe, ‘a good deal of enthusiasm over currency boards owes to the experience of one country, Argentina, over a fairly brief period of time. All other experiences, except for Hong Kong's, have been too short-lived to be informative.’
For examples of the agnostic approach to currency regimes, see Cooper (1999) and Frankel (1999). Steve Hanke is one of the strongest proponents of CBA or dollarisation, but many economists seem to prefer the float. For arguments against CBAs, see Roubini (2001). For a comprehensive discussion of various views on optimal exchange rate arrangements, see Goldstein (2002).
For example, Masson (2001) argues that there were frequent crossings between the different exchange rate regimes in the 1990s, rather than a shift from middle to corner regimes. See also Calvo and Reinhart (2000).
Being an emerging market is like being a teenager. The innocence of childhood is gradually being lost, but the mature judgement of adulthood is not yet well enough established to guide the teenager through this sensitive period when he/she becomes exposed to the temptations and pitfalls of life.
Moreover, faced with an adverse external shock, EMCs with a large share of debt denominated in foreign currency and/or of short-term debt will not be able to pursue the same shock-mitigating policies used by advanced economies with well-established policy credibility and better developed financial markets. Often, EMCs must pursue procyclical policies to avoid a loss of confidence and financial instability, in spite of the cost to output and employment. See Mishkin (1996).
Eichengreen et al. (2002) recently proposed another solution to the original sin problem: the World Bank and other developments banks would sponsor a mechanism that would allow the EMCs to issue more debt in their own currencies. However, the main problem with this mechanism is that it does not provide strong incentives to address the fundamental weaknesses and problems of EMCs leading to the original sin problem.
This conclusion holds for very open economies, where changes in the exchange rate have a strong effect on domestic prices. The obvious question is whether a fixed (and therefore stable) exchange rate is more helpful in overcoming the original sin problem. Again the prospects are not promising, as shown by the experience of Argentina. The CBA helped speed the establishment of price stability and growth, and allowed Argentina to borrow abroad, but even a decade of exchange rate stability could not improve Argentina's credibility enough to redeem it from its original sin. The former central bank governor Pedro Pou (1999) complained in 1999, before the crisis escalated, that despite having played by the currency board's rules for 9 years, Argentina could not borrow in domestic currency from international investors except at short-term maturities.
To illustrate, if domestic savings are being used to finance investments equal to 30 percent of GDP, and the country is also using external savings (running a current account deficit) equal to 5 percent of GDP, then external savings are financing one-seventh of total domestic investments (which equal 35 percent of GDP). If domestic savings can finance investments worth only 15 percent of GDP, then the same amount of external savings would be financing one-fourth of total domestic investment.
However, Baer (2001) correctly observes that it is not only the return, but also the variance (risk) that determines investors’ willingness to invest in EMCs. High risk can partly or fully cancel the attractiveness of a high return.
It can be assumed that the low level of domestic savings was an important factor pushing Argentina towards the liberalisation of capital flows.
Moreover, some authors argue that net debt may underestimate the extent of vulnerability of Brazil's public sector because its assets may not be as liquid as its liabilities. A more realistic appraisal of liquidity of government assets could imply a higher level of net debt. For a discussion of this issue, see Goldstein (2003).
The Brazilian currency, the real, has lost 35 percent of its value in 2002, while the benchmark C-bond fell from about $83 in early 2002 to the low of $49 in mid-October 2002, with spread on Brazilian debt rising to about 2500 points.
At present, the Czech Republic has no outstanding foreign currency-denominated sovereign bond, even though there are indications that demand for such an instrument would be high. In late 2001, Hungary changed its borrowing strategy from borrowing in foreign currency to borrowing in local currency, and in November 2001, it issued a heavily oversubscribed 15-year Hungarian forint bond.
Of course, it is another question whether the independent conduct of monetary policy brings the desired results. Buiter and Grafe (2002) warn that in most accession countries, underdeveloped debt markets will prevent monetary policy from being very effective for stabilising output. However, local debt markets are developing rapidly, at least in the more advanced transition countries.
However, at the end of 2002 and in early 2003, Hungary faced a different problem, increased tension between its commitment to keep exchange rate within the ±15 percent fluctuation band and meeting its inflation target. For a more detailed discussion, see Jonas and Mishkin (2003).
Baer (2001) discusses some of the potential problems connected with FDI inflows.
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1The views expressed here are author's own and do not reflect the official position of the IMF.
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Jonáš, J. Original Sin and the Exchange Rate Regime Debate: Lessons from Latin American and Transition Countries. Comp Econ Stud 45, 232–255 (2003). https://doi.org/10.1057/palgrave.ces.8100017
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DOI: https://doi.org/10.1057/palgrave.ces.8100017