argentina dollar ization

8/10/2019 Argentina Dollar Ization

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Should Argentina Dollarize or Float?

The Pros and Cons of Alternative Exchange Rate Regimes

and their Imlications for Domestic and Foreign De!t

Restructuring"Reduction

by

Nouriel RoubiniStern School of Business,

New York University

First Draft:December 2, 2!

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"he o#inions #resente$ in this #a#er are solely those of the author% the usual $isclaimera##lies&'s 'r(entina is in the mi$$le of a ma)or financial turmoil an$ the currency boar$ re(ime

is on the ver(e of colla#se, the country is consi$erin( whether it shoul$ formally $ollari*e, i&e&(ive u# the #eso alto(ether an$ formally a$o#t the $ollar as its currency for all contracts an$

transactions&+n this #a#er + com#are an$ $iscuss the forei(n echan(e currency re(ime o#tionsavailable to 'r(entina -section !. an$ then $iscuss the formal criteria to assess a country/srea$iness for $ollari*ation -section 2.& 'lternative echan(e rate re(imes have $ifferentim#lications for the amount of $omestic an$ forei(n $ebt restructurin( an$0or $ebt re$uction thatthe country will have to un$ertake in the near future to restore me$ium term $ebt sustainability&"hus, while $iscussin( these alternative currency re(imes, + will also consi$er the im#lications ofthese alternatives for the amount of $ebt re$uction that will be re1uire$ to restore the me$iumterm sustainability of the $ebt of the country -section !.&

"he main conclusions of the #a#er are as follows:!& "he currency boar$ re(ime an$ convertibility3 are effectively $ea$ as severe ca#ital

controls an$ restrictions on bank $e#osits -a #artial free*e. have been im#ose$& "hecountry will have to move soon to a new forei(n currency re(ime&2& "he only feasible currency re(imes are either a move to a float -fleible echan(e

rate. or $ollari*ation&4& Dollari*ation coul$ occur at the current #arity or after a final $evaluation&5& +n the short run the balance sheet effects of a $e#reciation0$evaluation un$er a move

to a float or a $ollari*ation cum $evaluation3 woul$ be si(nificant& "hus, a (reater$ebt write$own of (overnment an$ #rivate sector forei(n currency liabilities woul$become necessary if the chan(e in currency re(ime is associate$ with a nominal an$real $e#reciation& Such $ebt write$own will be #articularly messy an$ com#le toachieve for the #rivate sector a(ents/ $ollar liabilities with the risk of severe real costs$erivin( from $isor$erly bankru#tcies& "hus, some creative e6ante solutions tore$uce such real costs are $iscusse$ an$ e#lore$ in the #a#er&

7& 8n the other han$, a real $e#reciation is necessary to restore com#etitiveness as theoverall evi$ence su((ests that currency is overvalue$ an$ the fun$amental realechan(e rate is si(nificantly $e#reciate$ relative to its current value& "hus,$ollari*in( at the current #arity woul$ be un$esirable&

9& Balance sheet effects $erivin( from the real $e#reciation necessary to chan(e relative#rices -real $e#reciation. woul$ occur, in amounts similar to the re(imes of float or$ollari*ation after final $evaluation, even if 'r(entina $ollari*es without first$evaluin(% such effects woul$ occur via the #rice $eflation necessary to chan(erelative #rices& "hus, $ollari*in( without $evaluin( will not #revent such balancesheet effects from occurrin( an$ causin( financial $istress for a(ents whose relativeterms of tra$e have worsene$ for (oo$& "hus, the ar(ument that $ollari*in( at thecurrent #arity avoi$s balance sheet effects is flawe$&

& ;tensive ca#ital an$ echan(e controls an$ a free*e of bank liabilities will benecessary for 1uite a #rotracte$ #erio$ of time re(ar$less of which new currencyre(ime is chosen& "he loss of cre$ibility in the financial system an$ the severe realan$ financial $istress of a wi$e ran(e of financial an$ non6financial institutions will

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re1uire etensive controls to #revent a $isor$erly run on assets& But the restructurin(of various claims will be messy an$ #rolon(e$ in any case an$ scenario&


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5& '$o#t a $ollar6#eso stan$ar$ at the current echan(e rate #arity an$ create asecon$ary non6convertible currency unit -the @eco#s or Aatacones. that will#rovi$e sei(nora(e but whose value0echan(e rate will $e#reciate over time&

7& ?aintain the current currency boar$ but try to avoi$ the colla#se of this re(imethrou(h the ty#e of ca#ital controls an$ the bank free*e intro$uce$ on

December !, 2!&

'mon( these o#tions, it is clear that the last one, maintainin( the currency boar$ withconvertibility, is the least feasible as the currency boar$ re(ime is now effectively $ea$ with therun on the currency an$ the bank in the last weeks of November 2!& "he only way theauthorities coul$ try to tem#orarily salva(e the currency boar$/s #e( #arity woul$ be to maintainan$ eten$ the $raconian ca#ital an$ echan(e controls an$ bank $e#osit free*e im#ose$ onDecember !& But this solution means the effective $eath of the most crucial com#onents of thecurrency boar$ system -the convertibility3 of #eso into $ollars without any ca#ital accountrestrictions.& So, as of December !, 2!, convertibility is $efunct an$ so is, for all #ractical#ur#ose$, the currency boar$ re(ime& >hile the controls may (ive some short term breathin(

time in terms of allowin( a smoother move to a $ifferent echan(e rate re(ime, a $ifferentre(ime will emer(e 1uite soon&8ne is therefore effectively left with the o#tions of floatin( or $ollari*in(% the other

o#tion, the one of the creation of a secon$ary local currency the @eco#s0Aatacones o#tion isalso hi(hly unlikely to be feasible for reasons to be $iscusse$ above&

"herefore, float an$ $ollari*ation as the only realistic an$ feasible o#tions& +f $ollari*ationis chosen, the issue will be whether to $ollari*e at the current #arity of one #eso #er $ollar orwhether to $ollari*e after havin( $evalue$ the currency one last time& "he ar(uments for$ollari*in( only after $evaluin( are twofol$:

!& if there is currently a com#etitiveness #roblem in 'r(entina, one final$evaluation will be necessary to chan(e the real echan(e rate, re(aincom#etitiveness an$ hel# restorin( economic (rowth%

2& $evaluin( before $ollari*in( will allow the country to save some fore reservesafter havin( $ollari*e$& Since the current stock of reserves barely covers thecurrency in circulation, all those reserves woul$ be use$ in the echan(e ofreserves for US C notes necessary to $ollari*e an$ none woul$ be left for len$erof last resort su##ort of banks an$ for li1ui$ity buffer nee$s for #ublic $ebtmana(ement #ur#oses& Devaluin( before $ollari*in( woul$ instea$ allow tomaintain some li1ui$ fore reserves to be use$ to re$uce futureli1ui$ity0rollover risks of banks an$ the (overnment&

&alance sheet effects under a move to floating exchange rates as comared to devaluation

follo'ed !% dollarization

"he main ar(ument a(ainst $ollari*in( after $evaluin( -as o##ose$ to $ollari*in( at thecurrent #arity. is that $evaluation will cause severe balance sheet effects for the (overnment, thebanks, the non6financial firms an$ all other economic a(ents that have o#en forei(n currencyliability #ositions& "hus, com#are$ to $ollari*ation at the current #arity, $evaluation #lus$ollari*ation may cause a (reater amount of bankru#tcies amon( financial an$ non6financialfirms -es#ecially firms0househol$s with $ollar liabilities in the non tra$e$ sector. an$ will re1uirea (reater write$own of their forei(n currency liabilities& "he si*e of these balance sheet effects

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an$ the ensuin( financial $istress will $e#en$ on the si*e of the real $e#reciation that a nominal$e#reciation0$evaluation causes& Such balance sheet effect will also im#ly that, in the short run,the amount of haircut on soverei(n forei(n currency $ebt will be (reater than those that woul$occur if the (overnment $ebt is restructure$ but the country $ollari*es at the current #arity&

>hile the two o#tions of float or $ollari*ation after $evaluation will have $ifferent

im#lications an$ conse1uences, the two alternatives are similar in one $imension: if 6 an$ this isa bi( if 6 the rate of real $e#reciation after a move to a float is e1ual to that that woul$ beobtaine$ with the $evalue $ollari*e o#tion, the balance sheet effects of the two o#tions woul$be i$entical& +&e& the amount of financial $istress for banks, firms an$ (overnment $erivin( fromthe real increase in the real value of the forei(n $ebt after a $evaluation will be similar un$er thetwo re(imes& +n$ee$, one #otential $ifference between the $ollari*in( at the current #arity o#tionan$ the two other o#tions -float or $evalue an$ $ollari*e. is that, in the short run, the a$$itionalbalance sheet effects of a $evaluation on all a(ents with net $ollar liabilities, woul$ be avoi$e$ if'r(entina $ollari*es at the current #arity% but as we will see below, over the me$ium term,$ollari*in( at the current #arity will not #revent such balance sheet effects from occurrin( as they$e#en$ on a necessary an$ unavoi$able chan(e in relative #rices&

?ovin( to a float or $evaluin( $ollari*in( $iffer, however, in a number of ways:!& "he same amount of real $e#reciation in the two re(imes may be consistentwith very $ifferent amounts of nominal $e#reciation an$ inflation in the twoalternatives& +f a move to a float were to lea$ to a shar# fall of the currency an$a nominal $e#reciation in si(nificant ecess of what is re1uire$ to restorecom#etitiveness -a risk that shoul$ not be un$erestimate$., the #ass6throu(h ofsuch a $e#reciation to $omestic inflation may become very lar(e& Un$er oneetreme scenario, a com#lete loss of monetary cre$ibility may lea$ to hi(hinflation, or even hy#erinflation, un$er a move to a float&

2& +f un$er a float the currency initially falls more than the amount of $evaluationin the $evalue $ollari*e o#tion, the short run -an$ most likely lon( run. real$e#reciation of the echan(e rate may be lar(er than un$er the alternativere(ime o#tion& "hus, balance sheet effects, an$ the ensuin( $istress of firms,banks an$ (overnment, woul$ be much lar(er un$er a float in the short run, an$in the me$ium lon( run too if the me$ium run $e#reciation is (reater un$er afloat than un$er the $evalue $ollari*e alternative&

"hus, assumin( that 'r(entina nee$s to $evalue -either via a float or in the #rocess of$ollari*in(. in or$er to re(ain com#etitiveness -rather than $ollari*in( at the current #arity., therisks of a float relative to $evalue $ollari*e are a free fall of currency an$ hi(h inflation an$more severe balance sheet effects if such a free fall occurs&

A comarison of the main ros and cons of alternative forex regime otions

?ore in (eneral, the benefit of a float, com#are$ to either one of the two $ollari*ationo#tions is the #otential, in the me$ium6lon( run, of usin( the nominal echan(e rate to absorb$omestic an$ eternal shocks that re1uire a real $e#reciation& "he main risk of a float is that'r(entina will (o back to severe monetary instability an$ hi(h inflation& "hus, if a float ischosen, the issue is whether 'r(entina coul$ avoi$ both the short run overshootin( of nominalechan(e rates an$ a #erverse shar# fall of its currency value that woul$ s#ike inflation& +&e&, theissue is what woul$ be the nominal anchor for inflation e#ectations un$er a floatE +nflation

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tar(etin( an$ the choice of a cre$ible conservative central banker -as in Bra*il un$er Fra(a. is theo#tion most likely to succee$ if a return to hi(h inflation has to be #revente$& iven the historical#oor #olicy cre$ibility of monetary #olicy authorities in 'r(entina, other monetary re(imes un$era float -a "aylor rule, monetary a((re(ate tar(etin(, et cetera. are less likely to be effective than acre$ible inflation6tar(etin( re(ime to ensure #ersistent low inflation&

+f instea$ $ollari*ation is chosen, the choice between $ollari*in( at the current #arity an$$ollari*in( at a $evalue$ currency level $e#en$s on the two factors $iscusse$ above& +f it isbelieve$ that 'r(entina has a com#etitiveness #roblem, $ollari*ation after a final $evaluation isbetter& Similarly, the latter o#tion $ominates also when one consi$ers that it woul$ allow thecountry to maintain a buffer of fore reserves after $ollari*ation to be use$ for len$er of lastresort su##ort of banks an$ avoi$ future rollover crises on the #ublic $ebt& "he main$isa$vanta(e of $evaluin( an$ $ollari*in( -as well as of a float. com#are$ to $ollari*in( atcurrent #arity is that the short balance sheet effect on all $ollar6liability a(ents will be lar(er an$re1uire si(nificant further $ebt write$own of $ebts of firms an$ banks, in a$$ition to those of the(overnment&

"hus, in com#arin( $ollari*ation at the current #arity with the two other alternatives, the

issue becomes of how to $eal with such short run balance sheet effects& Gere are some issues tobe consi$ere$&

De!t restructuring"reduction imlications of alternative exchange rate regimes

First of all, it is now clear that, un$er any new echan(e rate re(ime, a semi6coerciverestructurin( of #ublic $ebt will occur with certainty% how coercive such restructurin( will be isuncertain but the two main o#tions are:

!& "he one currently favore$ by the (overnment, &e& maintain the face value of theclaims an$ re$uce the cou#on0interest rate at below market rates% this o#tionbein( similar to the $ebt restructurin( in Aakistan an$ Ukraine&

2& a re$uction in the face value of the claims -a formal haircut of #rinci#al. on to#of a ca##in( of the cou#on rate as in the cases of Russia an$ ;cua$or&

>hile both o#tions im#ly the reco(nition that the NAH of the ori(inal claims is re$uce$,i&e& there is effective $ebt re$uction in both cases, the latter o#tion woul$ im#ly a (reater NAHhaircut for investors& "hus, the choice between the two o#tions $e#en$s on an assessment of howinsolvent3 'r(entina is, i&e& how much $ebt relief is necessary to achieve me$ium term $ebtsustainability&

Secon$, re(ar$less of how lar(e the haircut of the $ebt is, if a $e#reciation occurs -eitherun$er a float or a $evalue $ollari*e o#tion. the initial balance sheet effects of such real$e#reciation woul$ be lar(er for all a(ents with net $ollar liabilities&

Sovereign de!t restructuring imlications

'fter a $e#reciation0$evaluation, the (overnment real $ebt woul$ increase for tworeasons:

!& "he $irect effect on the real value of the $ollar $ebt $erivin( from the$evaluation%

2& "he increase$ fiscal cost of bailin( banks an$ other institutions that maybecome bankru#t after a $evaluation&

Dealin( with the (reater $istress of the (overnment $ebt #osition $erivin( from the$e#reciation0$evaluation woul$ be, however #ainful, much more sim#le than $ealin( with the

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$istress of #rivate sector a(ents -banks, firms, househol$s.& +n fact, as the (overnment is anyhowrestructurin( its $ebt re(ar$less of the currency re(ime, any etra real $ebt bur$en costs $erivin(from a real $e#reciation coul$ be in #rinci#le $ealt with a (reater haircut on the value of the(overnment $ebt&

Note that this (reater haircut3 strate(y woul$ necessarily re1uire a (reater haircut of the

$ebt hel$ by forei(ners -nonresi$ents. to re$uce the real bur$en of the $ebt for the (overnmentan$ the country& +n fact, if $evaluation lea$s to a (reater $irect $ebt bur$en for the (overnmentan$ (reater in$irect bur$en -via bankru#tcies of banks an$ these institutions liabilities are(uarantee$ by the (overnment., a ca#ital levy on the $omestic banks -via a (reater haircut of$omestically hel$ $ebt. woul$ only increase the im#licit liabilities of the (overnment -if$e#ositors of banks are truly (uarantee$ an$ are not to take a real hit. an$ the nee$ to raisefurther revenues to #ay for these a$$itional etra costs& +n other terms, any ca#ital levy that hits$e#osit6(uarantee$ $omestic banks is )ust an inter6(overnment accountin( reshufflin( ofliabilities: an haircut on $ebt hel$ by banks increase their hole on their asset si$e an$ thusincreases the im#licit liabilities of the (overnment -who will nee$ to reca# these banks. with nonet chan(e in the $ebt bur$en for the (overnment& "hus, to (et a true haircut an$ re$uction in the

(overnment an$ country/s $ebt bur$en, a (reater hit will have to be taken by the non6resi$enthol$ers of the country $ebt& >hether this can be le(ally an$ #ractically $one is a com#le issuethat we will not a$$ress here&

8f course, the $ebt bur$en for the (overnment from financial $istress of banks -un$er ahaircut of $omestic $ebt. coul$ be re$uce$ if $omestic $e#ositors take a hit as well, i&e& $e#ositsare not, e6#ost, fully (uarantee$ an$ #art of the haircut of the assets of the bank -therestructurin( of the (overnment $ebt they hol$. is taken by the hol$ers of such bank liabilitiesrather than the (overnment& "he hit on $omestic $e#ositors -that is startin( with the currentfree*e on $e#osits. is like a ca#ital levy on $omestic hol$ers of assets& "he ca#ital levy on$omestic a(ents -househol$s, firms an$ banks. may then be re$uce$ if forei(n hol$ers of$omestic (overnment an$ #rivate $ebt take a bi((er hit& "hus, the (overnment coul$ re$uce itsbur$en by increasin( the bur$en on forei(n hol$ers of (overnment e#licit an$ im#licit $ebt& "hee#licit (overnment $ebt will be re$uce$ via a (reater haircut% the im#licit $ebt -the one $erivin(from cross bor$er interbank claims on the $omestic bankin( system an$ other forei(ners $e#ositsin the bankin( system. coul$ be re$uce$ if such $e#osits are not (uarantee$ e6ante an$ e6#ostan$ take some of the hit once bank assets are re$uce$ via a ca#ital levy on their hol$in(s of(overnment $ebt&

>hile all these o#tions are messy an$ risk to further un$ermine the financial system an$the #rivate a(ents/ confi$ence in it, in #ractice the messa(e is that, if the (overnment an$ thecountry has, on net, to re$uce its $ebt bur$en, any ca#ital levy on $ebt hel$ by $omesticresi$ents, will only im#ly a reshuffle of wealth an$ liability between (overnment, banks, firmsan$ househol$s& ' true $ebt re$uction for the country means a (reater levy on forei(n -i&e& nonresi$ents. hel$ $ebt& 'n$ since any currency re(ime o#tion that re1uires a real $evaluation of thecurrency will increase the $irect an$ in$irect $ebt bur$en of the (overnment, for any $e(ree of#re6$evaluation insolvency of the (overnment, a (reater haircut of forei(n hel$ $ebt becomesnecessary if a $e#reciation0$evaluation takes #lace&


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Private sector"agents de!t restructuring"reduction imlications (and the )ausmann

roosal*

Dealin( with the financial $istress an$ balance sheet effects of a $evaluation on banks,#rivate firms an$ househol$s becomes much more messy an$ $ifficult than $ealin( with the etra$istress of such a $evaluation for the (overnment& Aotentially a lar(e amount of #rivate a(ents

may become financially $istress an$ bankru#t after a $evaluation& Such $istress will $e#en$ ontwo factors: the amount of net forei(n currency liabilities of each a(ent% the si*e of the real$e#reciation of the currency for each s#ecific a(ent0firm& >hile $ealin( with the etra $istressfor the (overnment is easy3 in the sense that the liabilities of this a(ent have to be restructure$anyhow, with or without a chan(e in the currency re(ime, restructurin( the liabilities of thousan$of #rivate a(ents becomes a #rolon(e$ an$ com#le issue as the eam#les of +n$onesia, Ioreaan$ other financial crises e#iso$es show&

8ne a##roach to $eal with such balance sheet effects of a real $evaluation an$ theensuin( financial $istress of #rivate a(ents is to eliminate it e6ante via a systematic re$uction ofreal $ollar $ebts -as in the Gausmann #ro#osal. as o##ose$ to $ealin( with it e6#ost via costlybankru#tcy0restructurin( #roce$ures&

"he ar(ument for an e6ante solution is com#ellin(: if a real $evaluation will lea$ to thewi$es#rea$ bankru#tcy of #rivate a(ents -househol$s with $ollar mort(a(es, non6tra$e$ sectorfirms with $ollar liabilities, banks with net forei(n currency e#osure an$ banks with no $irectforei(n currency e#osure but that will be $istresse$ anyhow once the $ollar loans to $istresse$firms an$ househol$s become non #erformin( after a $evaluation., then the real resource costs ofrestructurin(, re$uction of $ebts an$ li1ui$ation of assets may be massive lea$in( to a severecre$it crunch an$ a shar#er fall in out#ut than socially necessary or $esirable& Since these arereal resource an$ out#ut costs that can be an$ shoul$ be avoi$e$, it is better to $eal with them e6ante by re$ucin( the real value of $ollar $ebts than e6#ost throu(h messy, costly an$ #rotracte$bankru#tcy0restructurin( #roce$ures&

8ne way to solve this balance sheet #roblem e6ante is via the Gausmann #ro#osal ofturnin( all $ollar $ebts into $omestic currency $ebt an$ in$ein( the returns of these claims tothe inflation rate& "his way, the cost of any real $e#reciation, that woul$ have increase$ the realbur$en for the hol$ers of this $ollar $ebt, is shifte$ instea$ to the cre$itors0hol$ers of theseclaims& +&e&, if a real $e#reciation woul$ make such $ebtors insolvent an$ lea$ them to $efault onthese $ebts anyhow, it may be less costly an$ more efficient to achieve such a real $ebt re$uctionvia an e6ante transformation of such forei(n currency liabilities into #eso, inflation6in$ee$liabilities& "his way any real $ebt bur$en increase $erivin( from real, but not nominal, real$e#reciation is automatically shifte$ to the cre$itors rather than to the $ebtors&

"his Gausmann solution to the #roblem of the balance sheet effects of a $evaluation hasmany #ractical shortcomin(s that have been alrea$y wi$ely $iscusse$ -for eam#le, manyforei(n investors are institutionally #rohibite$ to hol$ forei(n currency, i&e& non6$ollar, assets.but it is conce#tually a lo(ical an$ sensible way to avoi$ the inefficient costs of bankru#tcy an$restructurin( that woul$ $erive from $e#reciation6in$uce$ financial $istress& +ts main conce#tual,as o##ose$ to #ractical, shortcomin(s are $ifferent ones&

First, this solution re$uces the real bur$en of $ollar liabilities across the boar$ for all$ebtors re(ar$less of their ability to #ay it& For eam#le, take two firms with the same amount of$ollar $ebt, one bein( in the tra$e$ sector an$ the other bein( in the non6tra$e$ sector& 'fter areal $evaluation the latter is bankru#t while the former is not an$ woul$ be able to continueservicin( its $ebts& "here is no reason to #rovi$e the same $ebt bur$en re$uction to both firms%


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the $ebt re$uction shoul$ be a(ent0firm s#ecific an$ tailore$ to the real $istress that the real$evaluation im#lies for the s#ecific a(ent& 'n$ #ara$oically, unnecessary $ebt re$uction forfirms that are able to service their forei(n currency $ebt woul$ #ossibly restrict their ability toborrow in the future an$0or woul$ increase the cost of future borrowin(&

Secon$, across the boar$ $ebt relief (ives unfair3 $ebt re$uction to firms0a(ents that

ha##en to have borrowe$ in forei(n currency rather than in local currency& "ake two a(ents0firmswith same borrowin( #atterns, one that borrowe$ at lower $ollar interest rates in forei(ncurrency an$ the other who borrowe$ at the hi(her local currency interest rates in local currency&>hen all $ollar liabilities are turne$ into real #eso liabilities, the first a(ent0firm benefits twice: itwas servicin( its $ebt at lower nominal an$ real interest rates to be(in with havin( borrowe$ in$ollars an$ now it obtains another $ebt re$uction via the transformation of such $ebt into real#eso $ebt& +nstea$, the latter firm that #ai$ hi(her interest rates in #esos to be(in with $oes not(et any $ebt relief& "hus, the across the boar$ transformation of $ollar $ebt into real #eso $ebthas severe $istributional effects& Such re$istribution of wealth is not )ust from $omestic a(ents toforei(n hol$ers of these claims but also re$istribution from local a(ents who ha$ $ollar liabilitiesto those who were hol$in( $ollar claims a(ainst such a(ents&

>hile across6the6boar$ e6ante solutions to the balance sheet effects of real $e#reciationsare, as $iscusse$ above, unfair3 in a number of $imensions, the alternative #rocess, i&e& afirm0a(ent6s#ecific restructurin( re1uires much more costly out6of6court or in6courtbankru#tcy0restructurin( #roce$ures that are likely to be lon(, messy an$ hi(hly costly an$eventually of little benefit to $ebtors an$ cre$itors&

Ideas for artiall% selective as oosed to across the !oard rivate de!t restructurings

"hen, one sensible com#romise woul$ be to make the $ebt relief more in$ivi$ual s#ecificbut with some across6the6boar$ features& For eam#le, since all mort(a(es are in $ollar in'r(entina an$, as in the case of ?eico in !==7, millions of househol$s hol$in( such mort(a(eswoul$ sto# #ayin( them (iven their inability to service a lar(er real $ebt after a severe$e#reciation, one coul$ (ive across the boar$ relief to househol$s with mort(a(es -maybe onlyeclu$in( hi(h income househol$s.& "hen, the (reater amount of $istress for the banks an$financial institutions who hol$ these $ollar claims woul$ be sociali*e$, as in the case of ?eico,via a (overnment reca#itali*ation of these banks& 't the en$, the hi(her costs of bailin( out orreca##in( the banks woul$ be still borne by the avera(e househol$ -as taes will have to beraise$ over time to service these (reater (overnment liabilities. unless the (overnment im#oses a(reater ca#ital levy -haircut. on the forei(n hol$ers of its $ebt&

Similarly, the relief for non6financial firms coul$ be tailore$ to their financial $istressafter a real $e#reciation& For eam#le, firms in the tra$e$ sector woul$ not nee$ $ebt relief astheir $ollar liabilities are automatically insure$ via the hi(her #rice of their (oo$s -e#ort #ricesor local currency #rices of im#ort com#etin( (oo$s. an$ (reater amount of com#etitiveness aftera real $e#reciation& Firms in the non6tra$e$ sector instea$ woul$ e#erience much more financial$istress if they have lar(e amounts of $ollar liabilities& "hus, a stron(er case can be ma$e for(ivin( across the boar$, e6ante $ebt relief for these firms/ $ollar $ebts&

Finally, there is the issue of how to $eal with the financial $istress of the bankin( systemafter a real $evaluation& Gere, the first #oint to notice is that while 'r(entine banks are formallyforei(n currency he$(e$, as the amount of their forei(n currency liabilities is on a((re(ate, e1ualto the amount of their forei(n currency assets -as they borrowe$ in $ollars an$ lent to $omestic

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a(ents in $ollars in e1ual #ro#ortions., their effective forei(n currency e#osure is massive an$their a##arent currency he$(in( faulty for two reasons:

!& By borrowin( in $ollars an$ len$in( in $ollars, they )ust transferre$ thecurrency risk from themselves to the firms an$ househol$s who borrowe$ fromthem& But once the $evaluation occurs, many amon( such firms an$ househol$s

will (o bankru#t an$ their loans will become non6#erformin(% thus, the banksthemselves woul$ be in turn $istresse$&2& "he bank liabilities, 9J in $ollar an$ 5J in #esos, coul$ be instantaneously

transforme$ into $ollars by $e#ositors, thus su$$enly lea$in( to a currencymismatch between assets an$ liabilities& "hen, banks can only he$(e this riskby sellin( assets an$ buyin( the forei(n reserves of the central bank, thusun$erminin( the currency boar$& 'lso, the fore reserves of the central bank aremuch less than the #eso $e#osits that can be instantaneously transforme$ into$ollar $e#osits& "hus, banks have no way to truly he$(e such a su$$en currencyshift of their liabilities&

"he above ar(uments su((est that a real $e#reciation will severely affect the financialcon$itions of the bankin( system an$ coul$ be a cause of severe financial $istress for them& "he$istribution of such losses between the bank sharehol$ers, the (overnment, the banks $e#ositorsan$ the forei(n hol$ers of claims on such banks will be a most messy #rocess& Rather thanhavin( wi$es#rea$ bank insolvencies an$ bankru#tcies an$0or a hu(e increase in (overnmentliabilities, it may be better to $eal with this #roblem e6ante& +f firms in the non6tra$e$ sector an$househol$s hol$in( mort(a(es will (et $ebt relief -either e6ante or e6#ost via an initialsus#ension of their servicin( of these $ebt. an$ if the bank hol$in(s of (overnment $ebt will takea hit -either via a loss in their market value or a formal haircut., bank liabilities will have to bere$uce$ or otherwise the (overnment will have to #ick u# the bill& "his means a combination oflevies on sharehol$ers of the banks, on forei(n hol$ers of interbank claims an$ on $e#ositors -asin the case of a free*e that lea$s to some real haircut of claims% note that, so far, the December !free*e $oes not have yet such features.& Since the ob)ective shoul$ be to maintain the viability ofa soun$ #rivate bankin( system while minimi*in( the im#licit liabilities of the (overnment, ane1uitable $istribution of costs woul$ im#ly that all claimants will take a hit: sharehol$ers,$e#ositors an$ forei(n cre$itors on the liability si$e of the banks/ balance sheet& 't the sametime, the amount of $ebt relief to be #rovi$e$ to the banks borrowers in $istress -non6tra$e$sector firms an$ mort(a(e bur$ene$ househol$s. will have to be restricte$ -but not so much as tocause wi$es#rea$ #rivate sector bankru#tcies. if severe $istress of such bank claims an$ bankinsolvencies have to be avoi$e$&

Current need for a !an+ deosit freeze and extensive caital and exchange controls under

an% alternative scenario for Argentina$

Note also that the secon$ #roblem $iscusse$ above -currency mismatch of the banks. an$the risk of an im#licit or e#licit ca#ital levy on $e#osits is also behin$ the bank run that hasbeen observe$ in 'r(entina in the last weeks& "he December !, 2! $ecision to #artially free*e$e#osits is only a tem#orary solution to this severe #roblem& +f the free*e woul$ have inclu$e$ a#rohibition to switch #eso $e#osits into $ollars, such ca#ital controls woul$ im#ly that once the$e#reciation occurs, the ca#ital levy hits the #eso $e#ositors rather than the (overnment an$0orthe owners of the bank& "hus, this channel of financial $istress coul$ be #lu((e$ even the effect

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of a real $e#reciation on non6#erformin( loans of $istresse$ non6tra$e$ sector firms an$mort(a(e bur$ene$ househol$s woul$ not be #lu((e$& But since the measures announce$ onDecember ! im#ly that effectively all $e#osits are turne$ into $ollar $e#osits -the $ecree saysthat they can be but the ca##in( of $e#osit rates im#lies that all $e#ositors will switch their$e#osits to $ollar $e#osits, an effective $ollari*ation of all bank liabilities., the currency

mismatch of banks is now severely worsene$ unless the country formally $ollari*es& +n fact, nowbanks effectively have all their liabilities in $ollars while 5J of their assets are still in localcurrency, these mostly bein( their hol$in(s of #eso (overnment bon$s an$ some local currencyloans& Formal $ollari*ation woul$ turn all banks assets an$ liabilities into $ollar ones but if a$ollari*ation is #rece$e$ by a one time $e#reciation, the balance effects of this $e#reciation forfirms an$ househol$s woul$ lea$ to a s#ike in non6#erformin( loans an$ financial $istress forbanks&

Note also that a broa$ bank free*e, one even more etensive than the one $eci$e$ onDecember !, will have to be maintaine$ for a while even if the country $ollari*es at either thecurrent #arity or a lower #arity& +n the latter case, the free*e is necessary to $eal with the balancesheet effect mess of a $evaluation in a situation where a bank #anic an$ run is alrea$y un$er way&

;ven if the country were to $ollari*e at the current #arity, an etensive free*e as well as ca#italcontrols to avoi$ a run on the forei(n reserves of the central bank by #anicky banks, firms an$$e#ositors worrie$ about $efault risk 0ca#ital levy, as o##ose$ to currency risk, will be necessaryfor a while, as in the case of ;cua$or& "his means that, for the time bein(, convertibility an$ca#ital mobility are $ea$, an$ neither banks, househol$s nor firms will be allowe$ to access theforei(n reserves of the central banks or freely move assets abroa$ -strict ca#ital an$ echan(econtrols.&

iven the #otential for $isor$erly runs, ca#ital fli(ht an$ roll6off runs on #ublic $ebtwhile the messy transition to a $ifferent currency re(ime an$ a restructurin( of (overnment an$#rivate a(ents liabilities occurs, etensive ca#ital0echan(e controls an$ an etensive free*e ofbank $e#osits cannot be avoi$e$ at this #oint& "his also means that the $iscussion on anyalternative echan(e re(ime, maintainin( the current #e(, movin( to a float or $ollari*in( with orwithout #revious $evaluation will have to be ma$e while strict ca#ital an$ echan(e controls, aswell as etensive bank free*es, will be in #lace&

' formal run on reserves, a colla#se of the #e( an$ move to a float tri((ere$ by as#eculative attack may be tem#orarily avoi$e$ via etensive ca#ital controls on all #rivateresi$ent an$ non6resi$ent economic a(ents& "hese controls will have to be etensive as in thecurrent con$itions, the incentive to run, he$(e an$ cover currency risk are massive& But a moveto a float may not be avoi$able if there are leaka(es in the ca#ital control re(ime that allowresi$ents an$ non resi$ents to access the central bank reserves at the current #arity& >hile thecosts of shortin( the #eso are now very hi(h, (iven the etremely hi(h, short term interest rates,this may not #revent a run on the reserves -if ca#ital controls are not im#ose$. as the e#ecte$benefits of coverin( currency #ositions are hi(her than any sustainable short6term interest rate&

Note that even in "urkey, overni(ht interest rates of 7J on February 2!, 2! $i$ not#revent a further run on reserves an$ the move to a float that $ay as such rates im#lie$ only a 2Je#ecte$ $aily return on local currency assets& Un$er those con$itions, more than a !J#robability of a 2J overni(ht $evaluation is enou(h to make #rofitable shortin( the currencyan$ buyin( reserves even with such etreme overni(ht rates& "hus, 'r(entina can in the veryshort run avoi$ the fate of "urkey, a su$$en market tri((ere$ colla#se of the #e(, only viaetensive an$ #ersistent ca#ital controls&

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Arguments against dollarization at the current arit%

"he $iscussion above makes evi$ent the #otentially $isor$erly effects on balance sheetsof a $e#reciation un$er either one of the $e#reciation scenarios -float or $evalue $ollari*e.&;verythin( else e1ual, this woul$ su((ests that the alternative of $ollari*in( at the current #arity

may make sense as such balance sheet effects may be avoi$e$& But the $ollari*ation at thecurrent #arity may not make sense for many im#ortant reasons:!& Balance sheet effects $erivin( from eternal shocks re1uirin( a chan(e in

relative #rices -real echan(e rate. cannot be avoi$e$, in the me$ium run, evenin a $ollari*ation without $evaluation re(ime&

2& +f, as likely, the country has a com#etitiveness #roblem, a real $e#reciation isnecessary to restore (rowth% otherwise, (rowth will sta(nate, $efault risk willincrease an$ a more severe $ebt crisis may recur $own the line& 'lso, if thecountry will face in the future real shocks that re1uire a real $e#reciation,$ollari*ation will not be o#timal an$ nominal echan(e rate fleibility -i&e& afloatin( echan(e rate re(ime an$ monetary #olicy in$e#en$ence via the

eistence of a local currency. may be re1uire$ to absorb such shocks&4& Severe ca#ital an$ echan(e controls, as well as a bank free*e, will have to bemaintaine$ to have an or$erly restructurin( of $omestic an$ forei(n claims of(overnment, firms, banks an$ househol$s& +&e& the transition to a $ollari*e$system -even without a final $evaluation. will be messy&

5& "he country $oes not satisfy the tra$itional criteria for rea$iness for, an$o#timality of, $ollari*ation&

&alance sheet effects 'ill occur even 'ith dollarization at the current arit%

"he first #oint is the most im#ortant& >e have so far con$ucte$ the $iscussion un$er themaintaine$ assum#tion that there woul$ be severe balance sheet effects un$er the twoalternatives where the currency is $e#reciate$0$evalue$ but no balance sheet effects if thecountry $ollari*es at the current #arity& But, over time, the balance sheet effects are the same,re(ar$less of which currency re(ime is chosen an$ cannot be avoi$e$ even in the $ollari*ationwithout $evaluation re(ime&

"he reasons why $ollari*in( at the current #arity $oes not #revent balance sheet effect arealrea$y well known in the theoretical literature on the sub)ect -see Kalvo -2!., Kes#e$es,Khan( an$ Helasco -2!.. but are worth remin$in( as there is a wi$es#rea$, an$ wron(#erce#tion, that they can be avoi$e$ if 'r(entina $ollari*es at the current #arity& "he ar(ument isas follows: su##ose that a country e#eriences a shock that re1uires a real $e#reciation such as ane(ative term of tra$e shock or a shar# fall in the $eman$ for its e#orts or any other real$eman$ or su##ly shock that re1uires a real $e#reciation& Un$er fleible echan(e rates, such$e#reciation will occur via a nominal $e#reciation& Un$er a fie$ echan(e rate or in a $ollari*e$re(ime, such a real $e#reciation will occur throu(h a fall in the relative #rice of $omestic (oo$s,for eam#le a fall in the relative #rice of non6tra$e$ (oo$s& "hus, re(ar$less of the currencyre(ime, the balance sheet effect $erivin( from the increase in the real value of $ollar $ebt -oncethe relative #rice chan(e occurs. cannot be avoi$e$&

+n a $ollari*e$ re(ime, the fall in the relative #rice of non6tra$e$ (oo$s will im#ly thatthe real value of $ollar $ebts of non6tra$e$ firms whose out#ut #rice is fallin( will be as lar(e as

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the one that woul$ have occurre$ un$er fleible echan(e rates with a real $e#reciation $rivenby the echan(e rate a$)ustment rather than the (oo$ #rice a$)ustment& 'n$, in$ee$, in'r(entina, these balance sheet effect un$er fie$ rates, are alrea$y un$erway for a cou#le ofyears as sustaine$ #rice $eflation has been the channel throu(h which the real $e#reciation isoccurrin( an$ the way the #rice of non6tra$able is re$uce$&

"hus, since 'r(entina nee$s a chan(e in relative #rices to re(ain com#etitiveness, thebalance sheet effects of this re1uire$ chan(e in relative #rices are alrea$y at work, even while nonominal $evaluation has occurre$ yet& +n other terms, if one is concerne$ about balance sheeteffects of a real $e#reciation, one cannot avoi$ them by $ollari*in( at the current #arity% theywill, an$ they are alrea$y, emer(in( re(ar$less of&

+t is correct that, while balance sheet effects $erivin( from a chan(e in the fun$amentalreal echan(e rate $o not $e#en$ on the currency re(ime, their short6run severity may be re$uce$if the country $oes not $evalue or $ollari*es without $evaluin( first& +t has been ar(ue$ that,when a country moves to a float or $e#reciates an$ $ollari*es, the balance sheet effects occur allat once an$ lea$ to instantaneous $istress for banks an$ firms while if the currency #e( ismaintaine$ or $ollari*ation without $evaluation occurs, the real $evaluation occurs only slowly

over time via #rice $eflation so that firms an$ banks have time -the years that it takes for the real$e#reciation via $eflation to occur. to a$)ust to the shock&But this time to a$)ust may be only of limite$ benefit as firms knowin( that the real #rice

of their (oo$ will fall over time will re$uce investment an$ out#ut in e#ectation of lower #ricesfor their (oo$s& "hus, slowin( the a$)ustment of balance sheet an$ the re1uire$ real resourceallocation via a (ra$ual emer(ence of the balance sheet effects may not be either feasible noro#timal% if the real #rice is e#ecte$ to fall the real $ebt bur$en is e#ecte$ to be hi(herre(ar$less of whether the #rice a$)ustment has occurre$ instantaneously or not& "hus, $elayin(the a$)ustment may not solve the #roblem cause$ by the re1uire$ chan(e in relative #rices&

"he only case that can be ma$e for $elayin( the a$)ustment an$ smoothin( it over timevia $eflation rather than nominal echan(e rate a$)ustment is that, if a float occurs, there may bean unnecessary overshootin( of the real echan(e rate -relative to its new fun$amental value.that is $riven by the attem#t of all a(ents to he$(e their currency liability e#osure% thisovershootin( may then cause in the short run much more massive an$ socially inefficient balancesheet effects of the $evaluation that will in turn cause more ne(ative effects on investment an$out#ut than those that woul$ occur if the real $e#reciation was closer to what is re1uire$ by thesmaller chan(e in the fun$amental3 real echan(e rate& +n other terms, if the move to a floatwere to be $isor$erly an$ lea$ to an overshootin( of the real echan(e rate -as observe$ in alle#iso$es of currency crises in the !==s., avoi$in( such overshootin( via a $ollari*ation withoutinitial $evaluation may be #referable -in$ee$, Roubini, Aerri, Schnei$er6Iisselev an$ Kavallo-2!. #rovi$e a theoretical mo$el an$ em#irical evi$ence of this overshootin( an$ its realcosts.&

But if this is true, there is another way to #revent an overshootin( of the real echan(erate if the $ollari*ation o#tion is #referre$: first to $evalue by the amount necessary to chan(e thereal echan(e rate to its new e1uilibrium0fun$amental value an$ then $ollari*e& "hus, the abovelo(ic su((ests that $ollari*ation without a $evaluation is $ominate$ by $evaluation $ollari*ation -or a float if the overshootin( can be somehow avoi$e$. as lon( as a chan(e inrelative #rices is re1uire$&

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Is the Argentina eso overvalued? Is a real dereciation necessar% and feasi!le under flex

rate in Argentina?

"his lea$s us to the secon$ #roblem with the o#tion of $ollari*in( at the current #arity& +fthe real echan(e rate is overvalue$ an$ a real $e#reciation is necessary, it makes sense toachieve this real $e#reciation ri(ht away since #ost#onin( the balance sheet effects via #ersistent

$eflation is as costly as $ealin( with them ri(ht away throu(h a nominal an$ real $e#reciation&"hen, the 1uestion becomes of whether the #eso is overvalue$ to$ay an$ whether a real$e#reciation is necessary to restore com#etitiveness an$ (rowth&

Some ar(ue that com#etitiveness is not a bi( issue in 'r(entina to$ay& "he ar(uments area combination of the followin( #oints: there was not much overvaluation in the first #laceaccor$in( to some measures% #rice $eflation is alrea$y lea$in( to real $e#reciation% wa(es arefallin( in nominal an$ real terms faster than can be seen in actual numbers% e#ort were (rowin(fast until recently an$ the tra$e balance is alrea$y im#rovin(% a small o#en economy with (iventerms of tra$e cannot affect them with a nominal $e#reciation% an$ the e#ort to DA ratio issmall -about !J. so that a real $e#reciation will not stimulate net e#orts or (rowth very much&

+ am not convince$ by the above ar(uments an$ + believe that a si(nificant real

$e#reciation is necessary&First of all, while $ifferent measures of the real echan(e rate show $ifferent $e(rees ofovervaluation, several of them estimate it to be currently aroun$ 2J&

Secon$, as the country has (one throu(h three years of severe recession an$ lowinvestment, the fun$amental real echan(e rate may be more $e#reciate$ to$ay than a measurebase$ on #ast historical avera(e of the real echan(e rate woul$ su((est& 8nly a shar#$e#reciation will re$uce the real #rice of #hysical assets an$ ca#ital in 'r(entina to the #oint thatit will be convenient for forei(n investors to buy such assets an$ start investin( into more#ro$uctive ca#acity in the country& 'lso, only a lar(e real $e#reciation, even beyon$ the lon( rune1uilibrium value, will stimulate com#etitiveness an$ (rowth& 'r(entina, as many otheremer(in( market economies that e#erience$ a crisis, may nee$ an un$ervalue$3 currency for awhile to restore (rowth& "hus, a lar(e real $e#reciation is necessary&

"hir$, #rices an$ wa(es are fallin( but they are fallin( a very slow rate% it woul$ take a$eca$e for a 2J overvaluation to be un$one by $eflation if #rices an$ wa(es are fallin( at a 2Jrate #er year&

Fourth, the tra$e balance an$ current account of 'r(entina are im#rovin( but onlybecause the country is in a severe recession an$ thus im#orts an$ investment are shar#ly $own&>hile both "urkey an$ 'r(entina were runnin( a 5J of DA current account $eficit in 2!,"urkey was (rowin( at 9J that year while 'r(entina/s DA was fallin(& "hus, the full6em#loyment tra$e $eficit an$ current account $eficit of 'r(entina are much lar(er than theirrecession6$e#resse$ levels&

Fifth, while a small o#en economy e#ortin( raw materials cannot affect its terms oftra$e, it can affect the $omestic relative #rice of tra$e$ versus non6tra$e$ (oo$s, i&e& the realechan(e rate, via a nominal $e#reciation% in$ee$ commo$ity e#orters such as 'ustralia, NewLealan$ an$ Kana$a successfully a$)uste$ to these terms of tra$e shocks in the last few yearsthrou(h a nominal an$ real 6 $e#reciation of their currencies&

Finally, while current tra$e shares are small, this $oes not im#ly that real $e#reciationwoul$ not hel#& For one thin( it $i$ in the case of Russia, a country with as small a tra$e share as'r(entina& >hile e#orts may not (row very fast at first, they may over time as relative #riceschan(e in their favor& 'lso, im#ort com#etin( sectors of the economy that are now sub)ect to

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shar# im#ort (oo$ com#etition will benefit from the real $e#reciation an$ will (row, in the sameway in which un#rofitable im#ort com#etin( firms in Russia became hi(hly #rofitable after theruble $e#reciation& 'n$, as $iscusse$ above, a nominal $e#reciation will re$uce the relative #riceof non6tra$e$ to tra$e$ (oo$s an$ will incentivate over time the allocation of resources an$investment in the tra$e$ sector&

'lso, if the country will face in the future real shocks that re1uire a real $e#reciation,$ollari*ation -un$er either one of its two variants. will not be o#timal an$ nominal echan(e ratefleibility may be necessary: 'r(entina will nee$ monetary #olicy in$e#en$ence via theeistence of a local currency an$ the fleibility of a floatin( echan(e rate& "his is the mainar(ument for movin( to a fleible echan(e rate re(ime& +n any case, the $iscussion abovesu((ests that, even if the country were to $eci$e to $ollari*e, the com#etitiveness ar(umentwoul$ su((est that $ollari*ation shoul$ occur after $evaluation rather than at the current #arity&

,h% the -ecos"Patacones solution 'ill not 'or+

"he nee$ for a real $e#reciation in 'r(entina is also the reason why the solution currentlyfavore$ by some in 'r(entina, the creation of a $ual monetary re(ime with a Dollar6Aeso fie$

rate stan$ar$ an$ a #arallel currency -the @eco#s0Aatacones stan$ar$. 6 whose value woul$$e#reciate over time 6 woul$ not work& "he current creation of the @eco#s to #ay for central(overnment an$ #rovincial (overnment wa(es an$ #ensions woul$ work, as a $is(uise$ way tocreate sei(niora(e, if the country $i$ not have a com#etitiveness #roblem& "he issuance of the@eco#s woul$ im#ly that hol$ers of this asset will see its value re$uce$ over time -an$ in$ee$@eco#s are alrea$y tra$in( at a = cents on the $ollar $iscount relative to their face value., aneffective $e#reciation of this new currency whose creation restores real sei(niora(e revenues tothe (overnment& "hen, in an i$eal scenario, the #rivate sector woul$ remain on a $ollar6#esostan$ar$ at the current #arity an$ there woul$ be not balance sheet effects an$ no real wa(echan(es& 8nly (overnment workers an$ #ensioners woul$ take a hit -a re$uction in real(overnment s#en$in( necessary to restore the fiscal balance of the (overnment. both throu(h thecut in their nominal incomes -the !4J cut in wa(es an$ #ensions. an$ the re$uction in the realvalue of the @eco#s they are #ai$ with& ;ventually, as the su##ly of @eco#s increases, the ri(ht currently in #lace 6 to #ay taes at the full face value of these assets woul$ have to be #hase$ out%otherwise as the nominal an$ real echan(e rate of these assets falls, the (overnment ability toetract sei(niora(e from these assets woul$ be re$uce$&

But if the country suffers of a com#etitiveness #roblem, this clever attem#t to createsei(niora(e without a $e#reciation will fail& +f a chan(e in relative #rices an$ real wa(es isnecessary to restore (rowth, such real $e#reciation has to occur either throu(h a nominal$e#reciation or throu(h #ersistent an$ costly $eflation& Since the latter, as ar(ue$ above, is not$esirable, 'r(entina cannot (et itself out of its com#etitiveness, (rowth, $ebt an$ solvency#roblems )ust by issuin( @eco#s& "his easy solution to 'r(entina/s #roblems is too clever to beri(ht&

.onetar% olic% indeendence in Argentina 'ith a float

' number of authors challen(e this ar(ument in favor of floatin( echan(e rates byar(uin( that, in the case of 'r(entina, there is no in$e#en$ent monetary #olicy nor there can beany un$er floatin( echan(e rates since the country is so heavily $ollari*e$& "he ar(ument isthat, while other emer(in( markets, such as Bra*il, Khile, ?eico -as well as others in 'sia an$

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in other re(ions. may have benefite$ from fleible echan(e rates an$ are able to live reasonablewell un$er them, 'r(entina coul$ not benefit from fleible echan(e rates an$ woul$ have nomonetary #olicy autonomy because of its etensive liability $ollari*ation& For eam#le, it hasbeen ar(ue$ Bra*il may have financial in$eation but liability $ollari*ation there is limite$ -foream#le via le(al restrictions to writin( local financial contracts in forei(n currency.% thus, there

is room for in$e#en$ent monetary #olicy in Bra*il but not in 'r(entina& ' somewhat $ifferentvariant of the same ar(ument is that 'r(entina, (iven its history of monetary mismana(ementan$ hi(h inflation, has never ha$ an in$e#en$ent monetary #olicy an$ it will never will&

"hese ar(uments a##ear to be flawe$ after some closer ins#ection& First of all, a nominal$e#reciation un$er fleible echan(e rates will lea$ to a real $e#reciation an$ a chan(e in therelative #rice of tra$e$ an$ non6tra$e$ (oo$s re(ar$less of the amount of liability $ollari*ation%this #oint is clear from economic theory an$ #ractice& "his real $e#reciation $e#en$s on the factthat, if nominal wa(es are $ownwar$ infleible but real wa(es are not $ownwar$ infleible, anominal $e#reciation will re$uce real wa(es an$ will increase real com#etitiveness re(ar$less ofliability $ollari*ation& So unless, one wants to ar(ue that real wa(es are $ownwar$ infleible in'r(entina, there is room for a nominal $e#reciation to lea$ to a real $e#reciation& +n$ee$, as

recent evi$ence show, both real an$ nominal wa(e are $ownwar$ fleible in 'r(entina& So, thisar(ument a(ainst fleible echan(e rates is not vali$&Secon$, one coul$ ar(ue that, (iven the history of hi(h inflation in 'r(entina until !==,

any nominal $e#reciation will lea$ to hi(her inflation with no real $e#reciation, another way ofsayin( that a nominal $e#reciation woul$ not re$uce real wa(es& But even this ar(ument isflawe$& +n all e#iso$es of a currency colla#se in the !==s -?eico, Iorea, +n$onesia, "hailan$,Russia, Bra*il, "urkey. a nominal $e#reciation has been associate$ with a real $e#reciation&'ctually, the sur#rise is why the #ass6throu(h to $omestic inflation has been so small in all thesee#iso$es an$ why inflation rates have not sur(e$ -or they have sur(e$ for a year an$ thenreturne$ to sin(le $i(its.& ;ven in countries with a #ast history of hi(h inflation an$0or in$eation-?eico, Bra*il, Russia. the #ass6throu(h has been small an$ inflation either $i$ not sur(e orshar#ly fell to sin(le $i(its after the initial sur(e& +f countries such as ?eico, Bra*il, Russia an$others were able to $esi(n un$er float monetary re(imes -such as inflation tar(etin(. that#rovi$e$ an anchor for inflation e#ectations in s#ite of their history of hi(h inflation, whyshoul$n/t 'r(entina be able to $o soE 'fter all, if the #ass6throu(h an$ the sur(e of inflation aftera $evaluation $e#en$ on a country history of inflation, 'r(entina has ha$ a fie$ rate an$ lowinflation for much lon(er -over a $eca$e now. than ?eico, Russia an$ Bra*il $i$ -about 7 yearseach on avera(e.&

"hus, the view that 'r(entina woul$ move to hi(h inflation after a move to a float is notwarrante$ an$ this ar(ument is in$e#en$ent of whether the country/s financial assets are$ollari*e$& "he crucial factor is rather whether real wa(es are $ownwar$ fleible or not& 'n$ allthe evi$ence for 'r(entina is that they are $ownwar$ fleible& +n this re(ar$, the fact that many#rivate sector wa(es are to$ay set in $ollars is irrelevant% the issue is more whether, after a$e#reciation that re1uires a re$uction in $ollar wa(es, such real wa(es woul$ fall& Since they arefallin( to$ay both in nominal an$ real terms (iven the recession an$ the nee$ to re$uce unit laborcosts, there is not reason why they woul$ not fall in real $ollar terms after a $evaluation& Formal#artial $e6in$eation of wa(es to the currency may occur over time an$ anyhow wa(es arealrea$y informally $e6in$ee$&

+n conclusion, while the ability of 'r(entina to con$uct an in$e#en$ent monetary #olicyun$er a float may be limite$ -but it is also limite$ in many other emer(in( market economies

!9


17/31

with fle rates., it ability to en(ineer a chan(e in relative #rices an$ the real echan(e rate un$era float woul$ not be limite$ even with liability $ollari*ation& Domestic an$ eternal shocks thatlea$ to a nominal $e#reciation in an emer(in( market with fleible echan(e rates lea$ to a real$e#reciation even if monetary #olicy in$e#en$ence is limite$ -see Bra*il in 2! whosemonetary #olicy has been strai(ht6)ackete$ by the inflation tar(et but whose currency value has

fallen in nominal an$ real term over the year as $riven by market forces.& So, fle rates can#rovi$e shock absor#tion benefits to an emer(in( market economy re(ar$less of whether itsmonetary #olicy fleibility is somewhat limite$ by the nee$ to maintain #olicy cre$ibility an$avoi$ ecessive inflationary fall of its currency&

The relation !et'een default and currenc% ris+ in Argentina

' relate$ issue in the $ebate between floatin( an$ $ollari*in( is whether the country$efault risk is hi(h to$ay because of the currency risk an$ woul$ shar#ly fall once the country$ollari*es& First of all, one thin( is clear an$ self6evi$ent& >hile $ollari*ation eliminates thecurrency risk, it $oes not automatically re$uce the country risk% the latter reflects mostly theability -an$ willin(ness. to #ay of the (overnment an$ its #rivate a(ents& "hus, to a first

a##roimation, it is not affecte$ by the currency risk& +f 'r(entina is insolvent, it will remaininsolvent with or without $ollari*ation an$ will have to restructure0re$uces its forei(n $ebtre(ar$less of its choice of the currency re(ime& 'n$ in$ee$ the (overnment is currentlyattem#tin( this restructurin( even while tryin( to maintain the current #e(&

'lso, it is clear that, while $ollari*ation by $efinition eliminates the currency risk an$ therisk of a currency crisis, it neither #revents an$ avoi$s $ebt crises $erivin( from li1ui$ity runs onbanks or rollover runs on the short term (overnment $ebt& Dollari*ation also $oes not eliminate$ebt crises $erivin( from ecessive $ebt -insolvency an$ semi6insolvency $ebt crises. as thee#erience of Aanama with $efault an$ Bra$y restructurin(s su((ests& So, $ollari*ation $oes noteliminate li1ui$ity0rollover risk nor insolvency risk&

"he more so#histicate$ ar(ument in favor of $ollari*ation su((ests that, whilecountry0$efault risk an$ rollover risk woul$ not be eliminate$ with $ollari*ation, it woul$ besi(nificantly re$uce$ if the currency risk is eliminate$& "he ar(ument (oes as follows: the current$efault risk #remium is hi(h -a s#rea$ of over 4J on the $ollar $ebt of 'r(entina in earlyDecember 2!. in #art because of the currency risk& +n fact, if a currency colla#se lea$s to lar(ebalance sheet effects an$ banks0firm0(overnment e#erience $istress because of these balancesheet effects, the country risk will be hi(her because firms, banks an$ (overnment with a hi(herbur$en of their $ollar $ebts after $evaluation are more likely to $efault& "hus, eliminatin( thecurrency risk woul$ also re$uce the country risk but re$ucin( the risk of $isru#tive balance sheeteffects&

Gowever, this ar(ument is not convincin( for a number of reasons:!& ;ven if the $efault risk was #artially relate$ to the currency risk, the em#irical issue is

how much& 8ne can ar(ue that many a(ents in 'r(entina, inclu$in( the (overnment,are bor$erline insolvent re(ar$less of the currency risk& So, the re$uction of countryrisk is not (oin( to be si(nificant once $ollari*ation occurs an$ currency risk iseliminate$& 'fter all, ;cua$or/s country s#rea$ is still one of the hi(hest amon(emer(in( markets -at !7J the thir$ hi(hest after 'r(entina an$ Ni(eria. even after$ollari*ation an$ any re$uction in this s#rea$ relative to its level in the $efault #erio$has more to $o with the economic reforms an$ better macro #olicies recentlyim#lemente$ rather than $ollari*ation #er se&

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18/31

2& +f, as ar(ue$ above, balance sheet effect will be lar(e even if 'r(entina $ollari*es atthe current #arity, the (overnment/s real $ebt bur$en as well as the one of many other#rivate a(ents will be lar(e an$ increasin( over time as $eflation increase$ this $ebtbur$en an$ makes the balance sheet effects emer(e& "hus, eliminatin( the currencyrisk woul$ not eliminate the balance sheet effects $erivin( from the nee$e$ chan(e in

relative #rices for some a(ents in the economy& "hus, elimination of the currency riskwoul$ not $ecrease such $efault risk #remia&4& +f the country has structural ri(i$ities, such as labor market ri(i$ities that lea$ only to

a slow re$uction in nominal wa(es after real shocks that re1uire them to fall innominal an$ real terms, $ollari*in( as o##ose$ to movin( to a float, woul$ eacerbatethe effects of these ri(i$ities an$ cause an increase in country risk& +n other terms, if areal shock re1uires a fall in real wa(es an$ a real $e#reciation but these occur onlyslowly, via $eflation in a $ollari*e$ economy, the ne(ative effect of such ri(i$ities onem#loyment, out#ut an$ (rowth may increase the country risk un$er $ollari*ation& 'neconomy with ne(ative (rowth or low (rowth will e#erience a faster increase in its$ebt to DA ratio an$ an increase in its $efault risk& So, bein( stuck in a re(ime that

ensures low lon( run (rowth an$ inability to absorb shocks with a nominal$e#reciation may lea$ to a more unsustainable $ebt #ath an$ (reater $efaults overtime&

"he above $iscussion su((ests that the fre1uently ar(uments that country risk woul$ fallafter $ollari*ation because of the elimination of the currency risk are not very convincin(& Muiteto the contrary, the country risk may actually increase after $ollari*ation&

Caital controls and !an+ing freeze in the move to dollarization

@et us consi$er net the thir$ issue above, whether $ollari*ation at the current #arity canrestore confi$ence an$ #revent the on(oin( bank run an$ attack on the reserves of the centralbank& + will ar(ue that strict ca#ital an$ echan(e controls, as well as a broa$er bank free*e, willhave to be maintaine$ to have an or$erly restructurin( of $omestic an$ forei(n claims of the(overnment, firms, banks an$ househol$s even if the country $eci$e$ to $ollari*e at the current#arity&

"he reason is that, at this #oint, the transition to a $ollari*e$ system -even without a final$evaluation. will be messy an$ $isor$erly as the confi$ence in the safety of the bankin( system,convertibility an$ the #e( has been un$ermine$ an$ as economic a(ents reali*e that a costlyrestructurin( of the liabilities of the (overnment an$ of many #rivate a(ents is unavoi$able&

First, note the run on the banks is not the result of irrational #anic& "he asset si$e of thebalance sheet of the $omestic banks has lost value in a number of ways while the real cost ofbank liabilities has been (oin( u# because of:

!& "he semi6coercive #lacin( of (overnment bon$s on banks balance sheets whosemark6to6market value is fallin( with the rise of (overnment bon$s rates whilethe $omestic $ebt restructurin( im#oses interest rate ca#s on these bank assets&

2& "he increase in non6#erformin( loans after three years of a severe recession&4& "he reali*ation that many firms an$ househol$s that hol$ $ollar liabilities to

banks will be severely $istresse$ if a real $e#reciation occur an$ will also be

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19/31

$istresse$ if the nominal $e#reciation will not occur -as the balance sheeteffects of the real $evaluation via $eflation unfol$.&

5& "he mismatch between the currency $enomination of assets -where a fraction isstill in #esos. an$ that of liabilities in a situation where a(ents can -an$ willsoon. instantaneously switch #eso $e#osits into $ollar $e#osits&

7& "he increase in the cost of banks liabilities, as overni(ht rates were sur(in( an$#eso $e#osit rates were also sur(in( ma$e inevitable the nee$ to ca# the interestrate on #eso $e#osit even if those #olicy actions un$ermine$ the confi$ence inthe bankin( system&

't the same time that banks/ solvency was bein( un$ermine$, all a(ents in the non6tra$e$sectors -househol$s hol$in( $ollar liabilities such a mort(a(es an$ firms in the non tra$e$ sector.were also facin( increase$ financial $istress as the on(oin( chan(e in relative #rices -#rice$eflation. was increasin( their effective real interest rates an$ the real bur$en of their $ollar$ebts& "hus, the (rowin( concern that wi$es#rea$ bankru#tcies woul$ become unavoi$able&

Finally, at the (overnment level an alrea$y hi(h $ebt bur$en an$ the failure to re$uce

fiscal $eficit to levels com#atible with a sustainable $ebt $ynamics was lea$in( to the nee$ torestructure $ebt obli(ations on coercive terms& 'lso, the currency boar$ was becomin(increasin(ly unsustainable an$ not cre$ible (iven all the eternal shocks hittin( the economy an$the #olicy mistakes that increasin(ly un$ermine$ its cre$ibility& "hus, the increasin( loss of forereserves as $omestic an$ forei(n a(ents starte$ to he$(e to cover their currency e#osure&

't the en$ only $rastic ca#ital controls an$ a free*e on bank liabilities may #revent afinancial melt$own an$ a twin currency an$ bankin( crisis& But, even if the current turmoil willlea$ the authorities to move to $ollari*ation without a $evaluation, the $ama(e to the balancesheets of most economic a(ents is alrea$y severe an$ the confi$ence in the $omestic financialsystem seriously un$ermine$& 'lso, $ollari*in( without $evaluin( will not solve thecom#etitiveness #roblem while not #reventin( the balance sheet effects of the on(oin( real$e#reciation via #rice $eflation from takin( #lace&

'll these vulnerabilities that un$ermine$ investors confi$ence im#ly that etensiveca#ital controls an$ restrictions on bank liabilities will be necessary even if the $ollari*ationo#tion will be chosen&

Does Argentina satisf% the criteria for dollarization? /o

"he final issues in $iscussin( the ar(uments for $ollari*ation is whether 'r(entinasatisfies the tra$itional an$ non6tra$itional criteria to assess whether $ollari*ation makes sensefrom a lon( run #ers#ective -see the secon$ #art of this #a#er for a more $etaile$ $iscussion ofsuch criteria.& "hese criteria are useful to assess whether $ollari*ation woul$ be o#timal in thelon( run -com#are$ to the alternative of a float. re(ar$less of whether a final $evaluation before$ollari*ation occurs&

+n summary, it $oes not seem that 'r(entina makes an overall (oo$ case for $ollari*ationfrom a lon(6run #ers#ective& Konsi$er the followin( shortcomin(s of $ollari*ation&

First, the 'r(entinean business cycle is not hi(hly correlate$ with the U&S& one as thecountry is mostly a #ro$ucer an$ e#orter of commo$ities an$ raw materials& +n$ee$, the Fe$shar# monetary ti(htenin( in the !===62 #erio$, at the time when the US was (rowin( veryfast while 'r(entina was in a recession, shows how ina##ro#riate it may be for 'r(entina toa$o#t the monetary #olicies of the U&S&&

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20/31

Secon$, 'r(entina is a close$ economy that tra$es very little with the US& +ts e#ort toDA ratios is barely above !J an$ only about a 1uarter of its e#orts (o to the U&S&& >hiletra$e liberali*ation, F"'' an$0or bilateral tra$e e#an$in( a(reements with the U&S& mayincrease over time its tra$e inte(ration with the U&S& this will occur only slowly over the lon(run&

"hir$, $ollari*in( will im#ly that the echan(e rate of the 'r(entina -its nominal an$ realechan(e rate. will be tie$ to the U&S& $ollar% if the $ollar kee#s on stren(thenin( relative to the;uro an$ the Yen, further losses of com#etitiveness of 'r(entina relative to these tra$in( areaswill ensue& 'lso, if as likely, most @atin 'merican economies maintain fleible echan(e ratesan$ their currencies $e#reciate over time relative to the US $ollar, further losses ofcom#etitiveness of 'r(entina/s tra$e$ (oo$s sectors com#are$ to its re(ional #artners will result&'lrea$y the shar# fall of the Bra*ilian #eso this year, on to# of the !=== $e#reciation, an$ ofother @atin 'merican currencies has lea$ to further nominal an$ real a##reciation of the'r(entine #eso relative to these currencies an$ to severe stress on the ?ercosur free tra$earran(ements& Such $iver(ence of relative #rices may occur in the lon( run if these currenciesremain on a float while 'r(entina $ollari*es&

Fourth, 'r(entina will kee# on bein( buffete$ over time by real eternal an$ $omesticshocks that re1uire a real $e#reciation% for eam#le, terms of tra$e shocks& +f such $e#reciationcannot be achieve$ via a nominal $e#reciation because of $ollari*ation, it will have to beachieve$ via #ainful $omestic #rice an$ wa(e $eflation&

Fifth, 'r(entina/s labor markets are ri(i$ an$ nominal wa(es are $ownwar$ infleible inthe short run& "hus, any real shock re1uirin( a fall in real wa(es may cause instea$unem#loyment an$ low (rowth if real wa(es cannot be re$uce$ via a nominal $e#reciation&Gon( Ion( was able to absorb the !==< overvaluation shock by re$ucin( ra#i$ly nominal wa(esin a very fleible labor market an$ thus restore (rowth by !===& 'r(entina, instea$, has beenstuck in a recession for three years now&

Sith, while room for in$e#en$ent monetary #olicy is limite$ in emer(in( markets in(eneral an$ heavily $ollari*e$ economies in #articular, this $oes not mean that 'r(entina woul$have no fleibility to use monetary #olicy to #artially absorb shocks that re1uire a real$e#reciation& Usin( monetary #olicy to allow a nominal an$ real $e#reciation un$er a float maybe necessary an$ useful to $am#en the real out#ut effects of such shocks, >hile liability$ollari*ation further constraints the autonomy of monetary #olicy, as lon( as real wa(es are not$ownwar$ infleible, monetary #olicy can be use$ to allow a nominal an$ real $e#reciation an$stimulate $eman$ an$ out#ut& 't the same time, as in many other emer(in( market economies,inflation cre$ibility can be maintaine$ throu(h alternative monetary re(imes such as a formalinflation6tar(etin( re(ime&

Seventh, the fiscal #osition of the country is still severely imbalance$ an$ the $ebtsituation unsustainable& "hus, $ollari*ation may not #revent further $ebt an$ rollover crises&

;i(ht, the soun$ness of the bankin( system is by now un$ermine$ -see the $iscussionabove. while, at the same time, $ollari*ation will further limit the ability of the central bank to#rovi$e len$er of last su##ort to the bankin( system& >hile such su##ort is limite$ even un$erfleible echan(e rates in emer(in( markets as li1ui$ity in)ections may lea$ to shar# ca#italfli(ht an$ currency $e#reciation, the loss of all fore reserves in the #assa(e to $ollari*ation is afurther loss of len$er of last su##ort resources that is s#ecific to $ollari*e$ economies& Gow willlen$er of last resort -@8@R. su##ort will be #rovi$e$ in a $ollari*e$ economyE "his is not clear&

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21/31

Aanama #ri$es itself for not havin( any @8@R facility but the country is an internationalfinancial center, most of its banks are forei(n owne$ an$ the +?F has been effectively #rovi$in(su##ort to the country as Aanama has been the most assi$uous client of the +?F for the last 27years -over !2 +?F #ro(rams.& +n ;cua$or, that recently $ollari*e$, most of the bankin( systemis still insolvent an$ in the han$s of the (overnment while the reca#itali*ation of the banks has

not fully occurre$ yet& 'lso, the issue of how to #ay for the im#licit liabilities to the (overnmentfrom the losses incurre$ by the ;cua$orian bankin( system has not been solve$ yet& 'n$ thereare no meanin(ful len$er of last resort resource to$ay& Finally, limitin( future (overnmentliabilities via #artial an$ market #rice$ $e#osit insurance may not #revent future bank runs&

Ninth, the amount of labor mobility between 'r(entina an$ the US is very limite$ asthere is no free an$ unrestricte$ mi(ration& 'n$ the amount of im#licit fiscal fe$eralism $erivin(from workers/ remittances -im#ortant for many central 'merican economies. is absent in thecase of 'r(entina&

Finally, the loss of sei(nora(e $erivin( from $ollari*ation, while not bein( hu(e is noteconomically insi(nificant as it amounts to about &7J of DA #er year&

8n the #ositive si$e, 'r(entina satisfies some of the non6tra$itional criteria for o#timal

$ollari*ation&First, the economy is alrea$y #artially $ollari*e$% so movin( to full $ollari*ation will berelatively easy&

Secon$, 'r(entina has alrea$y a currency boar$ with all the costs of the lack of monetaryin$e#en$ence while #ayin( the costs of the #artial cre$ibility of the currency boar$ #e(& "hus,(ivin( u# alto(ether monetary autonomy with $ollari*ation will im#ly small mar(inal costsrelative to the current re(ime of a currency boar$&

"hir$, (iven its history of #oor monetary cre$ibility an$ hi(h inflation as well as liability$ollari*ation, 'r(entina has very limite$ monetary #olicy autonomy& So, at the mar(in the fullloss of monetary autonomy woul$ be relatively small while the benefits of low inflation woul$be #ermanently locke$ in&

Fourth, $ollari*ation may force the #olitical system to un$ertake the macro an$ structuralreforms re1uire$ for $ollari*ation to succee$& But the $ollari*ation strait)acket -as Ulysses tie$ tothe mast to resist the lure of the Sirens/ son(. may or may not incentives the necessary economicreforms& For eam#le, Aanama has been fiscally irres#onsible for $eca$es, in s#ite of the$ollari*ation strait)acket, eventually $efaulte$ on its forei(n $ebt an$ has #ermanently relie$ onthe financial +?F life su##ort&

Fifth, 'r(entina $oes have enou(h (ross fore reserves so far to $ollari*e if it wishes to$o so& But (iven the amount of forei(n liabilities owe$ to the +?F, net international reserves arelower an$ net reserves may not be sufficient to allow $ollari*ation unless a final $evaluation isen(ineere$ before the $ollari*ation&

Finally, lar(e sections of 'r(entina/s #o#ulation may su##ort $ollari*ation% thus, there issi(nificant #olitical su##ort for $ollari*ation&

Konsi$erin( both #ros an$ cons, a careful assessment su((ests that the cons $ominate the#ros an$ that 'r(entina $oes not make a (oo$ can$i$ate for successful $ollari*ation from a lon(run #ers#ective& "his su((ests that 'r(entina may be better off by floatin( its currency% it woul$then have to avoi$ currency overshootin( an$ ensure monetary stability an$ low inflation viainflation tar(etin( an$ the choice of a cre$ible, in$e#en$ent an$ conservative central banker& "herisks of a float are hi(h, es#ecially in the short run% they are the #ossible return to hi(h inflationan$ $isor$erly balance sheet effects if the nominal an$ real echan(e rates overshoot& But

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22/31

$ollari*ation may be a more risky lon(6run strate(y, even with a final $evaluation before$ollari*ation&

Some may ar(ue that even ;cua$or $i$ not make an obvious case for $ollari*ation as itsfiscal balances were in shambles, its $ebt unsustainable, it banks bankru#t an$ other $ollari*ationcriteria not satisfie$& 'n$ some ar(ue that, in s#ite of not satisfyin( these formal criteria for

$ollari*ation, $ollari*ation has be so far a success in ;cua$or& But the )ury on whether$ollari*ation will be successful in the lon( run in ;cua$or is still out& Fiscal con$itions haveim#rove$ but not enou(h% #ositive terms of tra$e shocks, such as the increase in the #rice of oiluntil recently as well as new #ro$uction an$ $istribution of oil via a new #i#eline have im#rove$the country #ros#ects% the country $efaulte$ on its forei(n $ebt an$ re$uce$ the #rinci#al valueof its forei(n $ebt but, in s#ite of that, the forei(n $ebt to DA ratio is still close to !J%financial con$itions in the bankin( system have im#rove$, the bank $e#osits free*e has been#hase$ out but the financial system still remains very fra(ile, many banks are still un$er(overnment control, the bank reca#itali*ation still to be finishe$ -an$ the resources to finance itnot yet foun$. an$ the issue of how to #rovi$e len$er of last su##ort un$er $ollari*ation is stillunresolve$% finally, si(nificant +?F an$ other multilateral su##ort to ;cua$or has si(nificantly

hel#e$ to finance the transition to $ollari*ation& "hus, the relative im#rovement in ;cua$or/scon$itions in the last year $oes not yet #rove that this is a successful case of $ollari*ation& 'n$any inferences from ;cua$or to 'r(entina woul$ be a matter of s#eculative (uesswork&

/eed for sound monetar% and fiscal olicies and structural reforms regardless of the

currenc% regimes and the amount of de!t restructuring

Re(ar$less of the new currency re(ime an$ the amount of $ebt restructurin(0re$uction,ra$ical economic reforms will have to be un$ertaken to ensure lon( run fiscal $isci#line,o#enness to tra$e an$ structural chan(es that ensure chan(es in the functionin( of the state an$ a(reater structural fleibility of the economy& ' better currency re(ime may hel# an$ $ebtrestructurin( may hel# to re$uce the bur$en of forei(n $ebt but, unless the #olitical system isable to ensure soun$ money, soun$ fiscal balances an$ structural reforms that o#en the economyan$ #rovi$e the necessary efficiency an$ fleibility of the economy, any monetary re(ime will beboun$ to fail an$ recurrent financial an$ $ebt crises may occur&

It is !etter to float in Argentina

Sub)ect to the above caveat that soun$ macro an$ structural #olicies are necessary in anyre(ime, overall a move to a float makes more sense than $ollari*ation for 'r(entina& "he risk ofovershootin( an$ hi(h inflation may be limite$ with an alternative monetary re(ime -inflationtar(etin(. while the balance sheet effects of the real $e#reciation can be a$$resse$ throu(h alar(er write$own of soverei(n $ebt an$ a selective write$own of some #rivate $ebt& Somemonetary autonomy, however restricte$, will be maintaine$ un$er a float an$ the nominalechan(e rate a$)ustment will allow a chan(e in real echan(e rates when internal an$ eternalshocks re1uire it&

Part 0$ Criteria to assess 'hether a countr% is read% for dollarization

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Net, in this section we analy*e an$ $iscuss the criteria to assess whether a country isrea$y for $ollari*ation& "he a##lication of this analysis to 'r(entina has been alrea$y #rovi$e$ inthe section above&

.onetar%1 financial and fiscal factors

Polic% credi!ilit%

Kountries where #olicy makers have historically suffere$ from a lack of #olicy cre$ibility,es#ecially in the monetary area, may benefit from the $isci#line im#ose$ by a rule6base$monetary re(ime such as a currency boar$ or $ollari*ation& "he inability of $iscretionary #olicymakers to cre$ibly commit to monetary stability an$ $isci#line has been su((este$ as one of thestron(est ar(uments in favor of the ri(i$ monetary $isci#line im#ose$ by $ollari*ation& "here aresometimes #artial ece#tions: monetary unions such as ;?U resulte$ more from the $esire tocreate stron(er economic an$ #olitical ties than )ust the nee$ to #rovi$e monetary an$ inflationstability& But emer(in( market economies that $esire to im#ort the cre$ibility of a low inflationanchor country may consi$er $ollari*ation as a stron( $isci#line $evice&

"he lack of #olicy cre$ibility can be measure$ by lookin( at a number of variables such as:the country/s e#erience with inflation% a #ast history of echan(e rate instability an$ crises% theeistence of #revious financial an$ bankin( crises% the $e(ree of unofficial $ollari*ation% thecountry/s inability to borrow lon(6term in $omestic currency% the country/s fiscal recor$% thes#rea$ between local $ollar6$enominate$ an$ local currency $enominate$ interest rates&

Inflation exerience

"he role of recent inflation history is ambi(uous& 8n one si$e, countries that nee$ the mostrules -such a currency boar$ or $ollari*ation. are those that have ha$ a history of monetaryinstability% an$ in$ee$, countries such as 'r(entina an$ others switche$ to a currency boar$ as away to break out of a cycle of hi(h inflation& 8n the other si$e, a recent low inflation

#erformance si(nals that the country is cre$ibly able to commit to the monetary $isci#linere1uire$ to #ursue #rice stability& ?ost likely, $ollari*ation is most a##ro#riate for countries thathave sinne$ in the #ast -have ha$ hi(h monetary instability. but now have com#etent an$ stable(overnments with $ee# #o#ular su##ort that are $etermine$ to commit to ri(i$ monetary rules tomaintain lon(6run #olicy stability& +n this $imension 'r(entina a##ears to fare better than Bra*ilan$ other Kentral 'merican countries&

Current exchange rate regime

>hile a country coul$ $ollari*e startin( from any echan(e rate re(ime, a successfule#erience with currency boar$s or cre$ibly fie$ echan(e rates si(nals that the country hasalrea$y shown its commitment to a stable currency, has #roven its willin(ness to #ay any costs

associate$ with fie$ echan(e rates an$ is thus unlikely to e#erience further lar(e costs from(ivin( u# alto(ether a national currency& 'lso, the a$$itional transitional cost of movin( to$ollari*ation from fie$ rates or currency boar$s are lower than when startin( from more fleibleechan(e rate re(imes& ' transitional currency boar$ sta(e shoul$ not, however, be a necessarycriterion for $ollari*ation& 's currency boar$s may im#ly some costs -the risk of eventual$evaluation. without the full cre$ibility benefits of $ollari*ation, it may make sense for a countryconsi$erin( $ollari*ation to avoi$ a transitional sta(e of currency boar$ an$ move $irectly to theelimination of the national currency& ;#eriences such as ;?U su((est that the #ath to monetary

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union an$ $ollari*ation $oes not necessarily (o throu(h a linear transition involvin( (reaterechan(e fiity: ;?U was im#lemente$ even as the !==26=4 ;R? crisis le$ to a si(nificantformal wi$enin( of the ;R? echan(e rate ban$s&

Reserve coverage of monetar% !ase

' minimum criterion for $ollari*ation is that the forei(n echan(e reserves of the $ollari*in(country shoul$ at least cover the monetary base -or the currency in circulation.& Gowever, somecountries that may otherwise be (oo$ can$i$ates for $ollari*ation may not satisfy thisre1uirement in which case they may consi$er borrowin( the necessary reserves from official or#rivate cre$itors& >hile this solution to the nee$ to convert the money base into $ollars istechnically #ossible, the increase$ forei(n currency liabilities of the central bank may un$erminethe cre$ibility of the $ollari*ation& +n estimatin( whether forei(n currency reserves are sufficientto cover base money, one shoul$ look at usable reserves& For eam#le, Kosta Rica inclu$esamon( its fore reserves over C4m cre$its to Nicara(ua an$ Gon$uras that have not beenservice$ in a lon( time an$ are unlikely to be service$ ever& +n a$$ition to monetary base, onemay want to inclu$e other -$omestic an$ forei(n currency. liabilities of the central bank in the

a((re(ate that nee$s to be covere$ by forei(n reserves& By these criteria, a number of Kentral'merican countries $o not a##ear to have sufficient fore reserves to be able to $ollari*e withoutfurther forei(n currency borrowin(s& For eam#le, the Dominican Re#ublic $oes not even haveenou(h forei(n reserves to cover the currency outsi$e the $e#osit money banks% Beli*e an$ KostaRica have reserves below the monetary base% uatemala has reserves below the sum of themonetary base an$ central bank bon$s -issue$ for the #ur#ose of o#en market o#erations.& Suchreserve covera(e looks even worse if we inclu$e the forei(n liabilities of the central bank&Konversely, 'r(entina, ;l Salva$or, Gon$uras an$ Nicara(ua have enou(h reserves to covermonetary base an$ the bon$s of the central bank& 8bviously, if the reserve covera(e (oes beyon$the monetary base an$ the other liabilities of the central bank, the country will have resources to#rovi$e #artial covera(e of the liabilities of the bankin( system, i&e& to #rovi$e some len$er of

last resort services& "his issue is $iscusse$ in more $etail below&

Soundness of the !an+ing s%stem

"he eistence of a soun$, com#etitive, well6su#ervise$ an$ well6re(ulate$ bankin( system isan im#ortant con$ition for a successful $ollari*ation& >eak bankin( system may e#eriencesystemic crises that are fiscally costly an$ may, in the absence of a stron( len$er of last resortfacility, lea$ to financial #anic an$ serious economic $istress& Such fiscal costs of systemicbankin( crises are lar(er the lar(er is the financial sector relative to the si*e of the economy& 'lar(e #resence of forei(n banks in a $ollari*in( economy may hel# as it will: -a. re$uce the riskof bankin( crises% -b. #rovi$e im#licit len$er of last resort su##ort throu(h home country hea$offices& Some have ar(ue$ that a weak bankin( system shoul$ not be an ecuse for $elayin(

$ollari*ation as #oor financial systems #ose serious #roblems re(ar$less of the echan(e ratere(ime an$ bankin( fra(ility may be use$ as an ecuse to $elay reforms an$ monetary stability&Gowever, the cre$ibility of $ollari*ation may be un$ermine$ if a systemically fra(ile bankin(system im#lies lar(e fiscal costs of a bailout of the bankin( sector, es#ecially (iven the morelimite$ len$er of last resort resources available in a $ollari*e$ economy&

Extent of informal dollarization

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"he (reater is the $e(ree of current unofficial $ollari*ation, the smaller the benefits ofechan(e rate $evaluation an$ the (reater are the #otential benefits of formal $ollari*ation& +f the$ollar is alrea$y use$ as a unit of account, means of #ayment an$ store of value, the costs of atransition to formal $ollari*ation will be minimi*e$& ?oreover, in an economy where a lar(e#art of the liabilities of the financial, cor#orate an$ househol$ sector are alrea$y in forei(n

currency, a currency $evaluation will have contractionary effects an$ may lea$ to severefinancial $istress for forei(n currency borrowers& "hus, liability $ollari*ation increases thebenefits of full $ollari*ation& +n #articular, countries that are not able to borrow lon(6term intheir own currency -ori(inal sin3 countries in the Gausmann terminolo(y. may also (ain fromthe financial $ee#enin( -such as $evelo#ment of ca#ital market for lon( term finance. associate$with formal $ollari*ation& Such financial $ee#enin( has been ar(ue$ to #otentially be anim#ortant benefit of $ollari*ation&

A!ilit% to rovide lender of last resort functions after dollarization

>hile a $ollari*e$ country is (enerally more restricte$ in its ability to #rovi$e len$er of lastresort services to its bankin( system, such a function can be #erforme$ even in a $ollari*e$

economy throu(h a variety of channels& First, if the forei(n reserves are in ecess of what isre1uire$ to cover the monetary base, such ecess reserves can be use$ to cover #art of wi$ermonetary a((re(ates such as $eman$ $e#osits an$ other lon(er term li1ui$ liabilities of thebankin( system& Secon$, the $ollari*e$ country coul$ buil$6u# li1ui$ reserves via borrowin(from the #rivate sector -#rivate contin(ent cre$it lines. or international financial institutions&"hir$, chan(es in reserve re1uirement ratios may #rovi$e further li1ui$ity to a bankin( systemun$er #ressure& Fourth, un$er a sei(niora(e revenue6sharin( arran(ement, the $iscounte$ valueof the stream of future sei(niora(e #ayments coul$ be use$ as a collateral for lines of cre$it with#rivate an$0or official cre$itors& Konce#tually, other revenue streams or assets coul$ also be use$as a collateral for such cre$it lines even if one woul$ nee$ to consi$er the im#lications of suchcollaterali*ation for the overall sustainability of the #ublic $ebt of the country&

Some have ar(ue$ that the actual ability to #rovi$e len$er of last resort functions un$er afleible echan(e rate re(ime may also be effectively limite$ by the availability of forei(nechan(e reserves when the bankin( system has lar(e forei(n currency liabilities& 'ttem#ts tosystematically rescue a bankin( system un$er $istress via massive li1ui$ity in)ections -aso##ose$ to limite$ li1ui$ity su##ort to selecte$ banks un$er #ressure. may cause inflation,currency $evaluations an$0or a run on the reserves of the country as banks face a si(nificantrollover risk for their forei(n liabilities& "hus some have ar(ue$ that e#eriences such as those of+n$onesia su((est that, un$er con$itions of limite$ fiscal resources for a bankin( system bailout,len$er of last resort su##ort throu(h ecessive li1ui$ity creation un$er a $e#reciatin( currencymay actually be $estabili*in(, es#ecially in

argentina dollar ization

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