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Argentina Devaluation Makes Dollarization Look Far Better


By: Charles Roth
Dow Jones Newswires, July 10, 2002



NEW YORK -- Some six months into Argentina's devaluation of the peso, the economic turmoil now gripping the country appears to have settled last year's debate about whether it should dollarize or let the peso float.

"It was a huge mistake not to dollarize," said Gersan Zurita, senior direct of international public finance at Fitch.

Adopting the U.S. currency would have spared Argentina from the profound plunge in output that it's now suffering, he said. Other analysts agreed, and most reckon the country's economy will contract between 10% and 15% this year, despite having already shrunk every year since 1998.

What's more, many still see dollarization as a distinct possibility, a way to stabilize what has become an economically - and socially - volatile situation.

Since abandoning its 11-year currency board, which pegged the peso to the dollar at 1:1, shortly after the start of the year, the peso ($1=ARS3.62) has lost more than 70% of its value.

Strict capital controls, imposed last December to staunch a run on bank deposits, still haven't been lifted. If Argentines had real access to their money, authorities fear, they would scramble to exchange their forcibly converted pesos back into dollars and ship them overseas. The teetering banking system would quickly collapse.

To be sure, analysts say dollarization wouldn't have stopped Argentina from defaulting on $141 billion in public debt, the largest default in history.

But had the country dollarized, neither depositors nor banks would be taking the continual hit to which they are both subject, said Larry Krohn, Latin America economist at ING Financial Markets. Nor would the payments system remain virtually paralyzed, he added.

On the other hand, the predictions of those who touted the usual advantages of devaluation haven't panned out. For example, exports, which would typically increase with a weaker local currency, have actually declined, and high interest rates, which were needed to defend the peg, remain high.

Ironically, given the dollar's steady weakening this year - not to mention low dollar-linked interest rates and inflation - Argentina's trade competitiveness would presumably have risen anyway. Krohn noted that more than half of Argentine exports go to the euro block, whose currency unit has gained markedly against the dollar.

The 2001 currency plan presented by Domingo Cavallo, Argentina's former economy minister, now looks remarkably prescient. He introduced a system of trade subsidies and tariffs that was to be in place until the euro reached parity with the dollar, at which point the peso would be pegged to a basket of foreign currencies.

Inflation, meanwhile, has replaced deflation, and many expect prices to leap anywhere from 80% to 100% or so this year. The tremendous loss in purchasing power has badly affected consumer confidence, and angered Argentines.

  Full Faith And Credit Of Govt Meant Little To Citizens

Although the extent of the fallout from devaluation was never easy to predict, that it was a clear mistake isn't just a matter of hindsight being 20/20, Fitch's Zurita suggested. He pointed to Argentines' long-standing views on the dollar, the peso and the country's feckless politicians.

Just before former President Fernando de la Rua imposed capital controls early last December, 72% of banking sector deposits were in dollars, up from 64% at the end of 2000.

In addition to fears of the government turning to devaluation to help it balance its books and try to end the recession, many people had also anticipated its move to slap controls on bank withdrawals: deposits fell 20% last year.

They were also rightly skeptical of the government's ability to reach a consensus on how to turn the economy around, Zurita said, pointing to the recent resignation of central bank head Mario Blejer over differences with Economy Minister Roberto Lavanga.

Nor has the government had much luck in getting all spendthrift governors to mend their ways and rein in the issuance of quasi-money public bearer bonds, or in securing Congress's full support for repeal of an "economic subversion" law that dims investment prospects, all measures that have kept Argentina from obtaining a new International Monetary Fund lifeline.

Argentines' lack of faith in the government's ability to pay its debts continues. An auction of three-year dollar-denominated government bonds priced at ARS2.75 a dollar closed Friday. Out of some ARS30 billion in savings and checking accounts, only ARS103.1 million in offers were extended. Of those, the government accepted ARS23 million.

The vast majority of accepted offers came from the Argentine subsidiary of Canada's Bank of Nova Scotia, which has been suspended since late April. The market reading: only those who think their bank is going to fail were interested in the government bonds.

With precious few believers in the politicians' capacity to manage monetary and fiscal policy, and the moribund financial system encased in capital controls, the only direction for the economy is down, analysts say.

To restore confidence, lift the controls and stabilize the economy, Argentina may ultimately be forced to come full circle, and once again give up its "monetary sovereignty." Only this time, instead of a currency board, the "positive shock" would be outright dollarization, some analysts say.

   Dollar-Induced Stabilization Not Painless

Few expect Argentina to move toward dollarization anytime soon, particularly under the administration of President Eduardo Duhalde, who decided on the devaluation strategy.

But Duhalde doesn't appear able to resolve the country's current plight, analysts say, noting that the president advanced elections by six months to March next year. "My suspicion is that he's doing it to avoid making the tough decisions," Fitch's Zurita said.

More pain awaits Argentina, and whoever wins office in the new elections "will have to deal with that," he added.

The pain will also have to be widespread, noted Vincent Truglia, sovereign ratings head at Moody's Investors Services. "Argentine residents have to face the reality that dollar-denominated savings will be worth far less than one peso per dollar."

Politicians, so far unable, will at some point have to muster the gumption to tell the truth, however politically unsavory: Argentina doesn't have the dollars to fully back up dollar deposits and couldn't dollarize at 1:1, he added.

That leaves an Ecuador-style dollarization, in which the sucre was 40% devalued before the dollar was adopted and authorities were able to clean up the banking system. After dollarization, it became Latin America's fastest growing economy in 2001, and continues to outperform in the region.

Although they would be deeply unhappy about such a hit, Argentines would at least have access to their diminished dollar savings. In all probability, confidence would take off as the long-held fear of peso-linked hyperinflation would vanish. The banking system, free of capital controls, could once again function as the anchor of the economy.

Once stabilized, though, Argentina would have to push through politically sensitive fiscal, labor, social security other reforms to make it work. Even then, given its few links to the U.S. economy and its small foreign trade sector, it will someday have to consider ways to move out of dollarization, perhaps something along the lines of a Cavallo-style peg to a foreign currency basket, analysts said.

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