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Central Europe: What Lessons Can Be Learned From Argentina's Economic Crisis?

  • Kathleen Moore

Argentina's economic crisis took a nasty turn when thousands took to the streets this week to protest the government's handling of the country's financial problems. At least 21 people have been killed in looting incidents and in clashes with police, and the protests forced Economy Minister Domingo Cavallo and President Fernando de la Rua out of office. So how did things get so bad for a country that adopted a currency regime designed to ensure stability? And are there lessons for the countries in Central Europe that have similar systems?

Prague, 21 December 2001 (RFE/RL) -- For much of the 1990s, Argentina was seen as a relative success story in its region. Economic growth outpaced that of its neighbors, and it tamed hyper-inflation, brought down interest rates, and lured foreign investment.

But it began running into serious problems when Brazil -- its main trading partner -- devalued its currency in 1999.

Domingo Cavallo, the man pivotal to Argentina's earlier economic successes, was brought into the government again earlier in 2001 to rescue the economy, which was by then mired in recession.

This time, Cavallo's policies lacked that magic touch.

Last summer, Cavallo started tinkering with Argentina's currency regime. The new dual-currency setup devalued the peso for exports -- making exported goods cheaper -- while revaluing the peso for imports. And then the authorities added the euro to the currency board mix.

Rightly or wrongly, investors saw this as a sign that Argentina was about to abandon the currency regime that tied the peso to the dollar and devalue. Interest rates shot up. And when Cavallo cut spending to narrow the budget deficit, tax revenues dropped and unemployment spiked higher.

In November, Cavallo said Argentina would have to cut interest payments on its huge foreign debt. This prompted a run on the banks. Faced with the prospect of a massive capital flight, he restricted bank withdrawals.

Then this week, the country's deepening austerity and poverty prompted the worst civil unrest in more than a decade, prompting the president to declare martial law on 19 December.

Argentina now faces the possibility of a devaluation or a default on its debt.

As experts and politicians pore over the causes of the crisis, attention is focusing on the country's currency regime.

Some influential economists -- such as Steve Hanke of Baltimore's Johns Hopkins University -- argue that much of Argentina's earlier economic success was due to the currency board-like system it adopted in 1991 to manage its exchange rate. Others argue that it overvalued the local currency, making Argentina uncompetitive by effectively pricing its goods out of the market.

Under this system, the exchange rate is, in effect, fixed to an "anchor currency" -- in Argentina's case, the U.S. dollar. The board exchanges local currency for the anchor currency at a permanent fixed rate. This takes the power of printing money away from the central bank -- a practice that, if too enthusiastically pursued, can fuel inflation.

A similar system is in use in three European Union candidate countries -- Estonia and Bulgaria, which initially chose the German mark but have since pegged it to the euro, and Lithuania, which picked the dollar but which will repeg it to the euro early in 2002.

Giancarlo Perasso is a Central Europe economist at JPMorgan Chase in London. He says the regime has served the three candidate countries well in their periods of transition: "Especially in the case of the Baltic countries, as it immediately established a credible anchor for monetary policy and it allowed the two countries -- in the case of Estonia more quickly and a bit more slowly in the case of Lithuania -- [to lower] inflation fairly rapidly during the transition period. And at the same time, it allowed the new authorities to gain credibility. So it worked very well. In Bulgaria, they adopted the currency board later but, again, it immediately helped to stabilize inflation at very low levels. It is fully credible, so I would say that, yes, it has served the countries well."

Perasso says having a currency board is not enough to guarantee a stable economy. Governments still have their part to play and must be prudent with the public purse. He says a currency board seems to work best when the country has a very open economy -- in other words, when it trades a lot with the outside world.

Robert Stone is director of global financial services at Emerging Market Economies in London. He says it's hard to draw lessons for Estonia, Lithuania, and Bulgaria from the Argentinean crisis, since Argentina's regime and its economy are very different.

He also notes that economists are divided on the merits of currency boards: "The very decision to have a currency board is an expression of a determination to crack these economic problems. It's like if you decide to give up smoking, then you'll probably give up smoking if you've really decided, whichever method you use. The method's less important than the decision."

Perasso says one of Argentina's problems was that it did not restructure its economy after the initial successes of the currency board in taming inflation.

And it does not fit the ideal model of a small, open economy, as Perasso explains: "Argentina is not a very open economy. Exports are just above 15 percent of GDP [gross domestic product], so it is difficult for Argentina to earn the foreign currency necessary to sustain the expansion of the monetary base because that is the basis of a currency board. So at this point, after the initial success, the country kept borrowing abroad in order to keep the money supply growing and therefore sustaining growth."

Perasso says the big advantage that the three EU candidate countries have over Argentina is that they have what he calls an "exit strategy" out of the regime: "One of the problems with the currency board is that once you are in, it's very difficult to abandon it [while] maintaining the credibility of the authorities, because it is the cornerstone of the whole economic-policy apparatus. That was the problem in Argentina. If you abandon the currency board, what is going to happen? Devaluation? What happens to the assets and liabilities of the banks and companies in the country because of currency mismatches and so on? The Central European countries, on the contrary, have a well-defined exit strategy, which is joining the EU and then EMU [European Monetary Union]."

He says that unless politicians in these countries do "something strange," they will eventually join the EU and monetary union.

To be sure, Estonia is in the midst of its own political turmoil after Prime Minister Mart Laar announced he will resign in the new year. But all major parties share similar foreign-policy priorities; and if Estonia can assemble a new government in fairly short order, its negotiations to join NATO and the EU should not be imperiled.

Perasso says the Argentinean crisis does not necessarily mean the currency board system is wrong, as such. But he says there are implications for its future use.

"I think that it may make people focus more on the conditions for successful currency boards. As I said, a very open economy -- if it's closed and not integrated into the trading systems, the currency board is not really the right policy prescription," Perasso says.

"The other thing is fiscal policy. [Clearly,] a currency board is much more of a straightjacket than a floating exchange rate, and therefore the tensions may accumulate if fiscal policy is not prudent. So I think that it's not the system per se [that's wrong], but it highlighted that just establishing a currency board [is] not enough. Other domestic policies are necessary."