June 2001
Cavallo, Mundell, Hanke, and Pou: What Next for Argentina?
by Owen Lippert
Currency rumbles are again reverberating out of South America. The Brazilian currency, the real, drops daily. Even in steady Argentina, instability is in the air. When business leaders and trade ministers met in Buenos Aires on April 4 to 6 to discuss a Free Trade Area of the Americas, another, quieter conference was taking place at the Central Bank of Argentina to commemorate the tenth anniversary of Argentina's decision to make its peso fully convertible to the US dollar. That policy has pegged the value of the peso to that of the dollar. Though the tenth anniversary conference did not feature protestors, it still had its share of fireworks as a result of a major policy speech made the very night before. Dr. Domingo Cavallo, Argentina's once again economic minister and the man who had initiated convertibility 10 years before, proposed changing the convertibility policy to link the value of the peso to the euro as well as the dollar. Moving rapidly, Cavallo has now sent draft legislation to Argentina's Congress. That action has set economists to work dissecting the plan. Companies— particularly foreign banks—operating in Argentina are now wondering what euro convertibility might mean to them.
First, some background. By 1991, after decades of inflation, Argentina's monetary policies had run out of credibility. Domingo Cavallo, then economic minister, convinced then President Carlos Memem to create a currency board and to guarantee Central Bank independence.
The plan's key feature was the convertibility of the Argentine peso to the US dollar. Convertibility requires that the money supply not exceed the stock, in this case, of US dollars held by the Central Bank, which, in turn, sets its interest rates to ensure that that does not happen. The effect is to "peg" the peso to the US dollar, minus, in Argentina's case, a small risk premium imposed in case Argentina abandoned convertibility.
Cavallo, a charismatic, Harvard-trained economist, has given various accounts of what inspired him. At the America's Business Forum, a meeting of business leaders running concurrently to the trade ministers' meeting in Buenos Aires, he told delegates that the idea came to him while reading Frederich Hayek's Denationalization of Money. Earlier, I had heard him say something to the effect that people think that it took great courage to bring in convertibility, but actually, it was quite simple. At the time, there was in circulation $3 billion worth of Argentinean pesos and $15 billion of US dollars. Argentineans had already decided on convertibility.
Whatever its origin, convertibility worked. Inflation shrank to US levels. Though interest rates remained high, Argentina's financial markets weathered the 1990s monetary shocks in Mexico, South-East Asia, and Russia, quite well. In the early and mid-1990s, Argentina posted an average five percent real income growth.
By the late 1990s, however, Argentina's growth had stalled. Over the last two years, the economy has shrunk by roughly three percent. At a recent conference of economists in Punta Del Este, Uruguayan economist Ernesto Talvi put it this way: "When Brazil devalued the real in 1998, it contributed to an overall drop in Argentina's economy because roughly one-third of its exports went to Brazil." To be sure, Argentina has other economic problems. As Dr. Carlos Pou, now former head of Argentina's central bank and a Chicago-trained economist, has said often, convertibility is a "necessary, but not sufficient" condition for economic growth.
Argentina's ongoing economic slump forced the new president, Ferdinand Del Rua, to reach out to the one person with the economic reputation and political savvy to quell international doubts— Cavallo. To no one's surprise, Cavallo was soon in full swing.
In his speech to the Free Trade Area of the Americas crowd the night before the Central Bank's conference, Cavallo told hemispheric business leaders: "During the last three years, the Central Bank has had the tools necessary to increase liquidity and it has chosen not to do so... it holds to a more expensive monetary policy... it should abandon the idea that convertibility is equal to dollarization." To correct the problem of liquidity, Cavallo suggested, "we should move to promote the utilization of the euro." The next week, Cavallo suggested the peso should be pegged to a "50-50" basket of dollars and euros. This could have the effect of both expanding the supply of pesos and of lowering their value if either the dollar or the euro dipped below the value of the other.
I asked the 1999 Nobel Laureate in Economics, Dr. Robert Mundell, who was attending the Central Bank conference, about Cavallo's proposal. Mundell is credited with designing the euro. He explained that "Cavallo is correct that convertibility is not dollarization" (that is, the adoption of the US dollar, so far only done by Ecuador). "With convertibility to the euro, the peso would be set at a [weighted] average of the dollar and the euro."
I then asked Mundell what he thought of Cavallo's proposal. He replied that it was "premature" because "it would increase uncertainty... the time to have introduced it was at the inception of convertibility." He then went on to praise Cavallo with whom he had met the day before.
Stephen H. Hanke, Professor of Applied Economics at Johns Hopkins University and former advisor to Cavallo, strongly opposes Cavallo's proposition. He wrote in an April 12 National Post article, "to avert disaster, Mr. Cavallo must stop the loose talk about altering the peso's value and instead eliminate the uncertainties about currency property rights by taking the high ground. Full dollarization—the forced conversion of pesos into dollars at parity—would do the trick."
Cavallo's proposal was also immediately opposed by Argentina's Central Bank President Pou. He said it does not deal with "an external debt that has created an unstable deficit and a political class that will only respond when they are at the edge of the abyss." Pou clearly considered his own independence at stake if Cavallo started meddling. He was right. Within three weeks, Pou would find himself removed at Cavallo's insistence. The reason given was Pou's alleged negligence in dealing with money laundering.
Whatever the merits of Cavallo's proposal, questions arise about how it will work in practice. Kenny McEwan, head of Lloyds Bank's Argentine operations, told me, "it's a guess whether euro convertibility will work." Similarly, David Roberts, Senior Economist with the Bank of America, told me, "in operational terms, euro convertibility would produce no major headaches. It would in time lead to a more complicated asset liability structure. The banking industry would have to hedge its assets in both euros and dollars. That's a tactical issue."
The underlying problem, of course, is the chronic morass of Argentina's public finances. The government owes $US 140 billion and has trouble just keeping up with its interest payments. This trouble is so severe that the government recently asked for, and received, a $US 40 billion line of credit from the International Monetary Fund. A stream of articles suggests that Argentina may default on its debt payments later this year. But, as bankers will remind you, defaulting on payments does not make the debt go away. It only makes matters worse.
It is worth asking why Argentina remains in a recession. By all accounts, it should not be. A recent World Bank study shows that the difference between Argentina's potential economic growth and its actual growth now stands at 11 percent of its Gross Domestic Product. In the last quarter of 1998, the last quarter of 1999, and the first quarter of 2000, it looked as if the economy would recover. Each time, a financial shock ended the rally; consumers retrenched in the face of renewed uncertainty.
Why is consumer and investor confidence key to Argentina's recovery? The reason lies in the closed nature of the economy. Argentina's exports and imports equal just 19 percent of its GDP. Increasing the former and decreasing the latter will, in the short run, not make much of a difference. That said, Argentina should increase its exports, but to do so will require that it further open its borders, and that this openness be reciprocal. Openness and reciprocity are something the country has done only reluctantly in the past.
Cavallo premises his plan on the assumption that Argentina does not have enough money in the system for people to spend and to invest in business enterprises. The flaw in his argument is that there is actually a lot of money available, but Argentineans are loath to spend or invest it inside their own country. Last December, Argentina's banks took in record levels of deposits. Argentina's non-government banks are holding $72 billion in deposits, more than enough to supply the necessary capital if investors had the urge to turn it to that purpose. That's not counting the billions of dollars that Argentineans hold outside the country, a figure no one—certainly not the government—really knows for sure.
Why, then, are Argentineans just leaving their money in banks at home and abroad? Why aren't Argentineans borrowing from banks to create and expand business? Argentina has strong economic potential in its resource, agricultural, and service industries. Why they don't is simple. To do so means exposing yourself to the risk of government confiscation through unrealistically high taxes, officially-sponsored extortion through a Mussolini-inspired labour code, and unofficially sponsored extortion through corruption. These are the fundamental problems that deserve Dr. Domingo Cavallo's full attention.
All a currency sideshow does is to raise more questions about the political—not the economic—risks of investing in Argentina.
The best advice one can give Dr. Cavallo is to stop worrying about how much money the banks have to lend, and focus instead on how much money the government is taxing and spending. Do that, and investors will be investors and bankers will be bankers.
Owen Lippert (owenl@fraserinstitute.ca) is a Senior Fellow in Law and Markets at The Fraser Institute. He received his Ph.D. in History from the University of Notre Dame, Indiana.
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