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Argentina's Convertibility Plan- The fight for Stability

Argentina's Convertibility Plan- The fight for Stability. Kristina    Spacone      Matthew    Peabody Heather    Edelstein      Lino    Covarrubias. Topics of Discussion. Brief history of Argentine economy Overview of different plans Define convertibility plan Macro-economic effects

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Argentina's Convertibility Plan- The fight for Stability

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  1. Argentina's Convertibility Plan- The fight for Stability Kristina    Spacone     Matthew    PeabodyHeather    Edelstein     Lino    Covarrubias

  2. Topics of Discussion • Brief history of Argentine economy • Overview of different plans • Define convertibility plan • Macro-economic effects • Long-run consequences

  3. Big 3- Inflation Real Convertibility Austral/Cruzado

  4. Big 3- Growth (1940-1989)

  5. CA Deficit Big 3- (1940-1989) Mex Pacto- 1987

  6. Argentina Pre-Convertibility Convertibility 1985- Austral

  7. Argentine Growth (1940-1989)

  8. Austral Plan- (1985) • 1.{The Heterodox attempt to Stabilize} Mechanism to adjust for inflation by the utilization of three elements: • i. By freezing wages, prices, and pegging the Exchange rate. • 1. 40 Inspectors roamed to ensure price compliance • 2. Public confidence was the real watch dog. • ii. Introduction of New currency and policy to Stabilize money Supply (i.e. kill the old “maquinita”). • iii. Fiscal adjustment- taxation, government spending. Financing of debt with resources rather than with printing of money.

  9. Austral Plan (1985) Con’t • 1st year proved successful with Austral Plan • i. Inflation reduced 30%/month to 3%/month.  • However, caused decline in output.  • The plan was not a long-term fix. • i. Exchange rate Overvalued • When price freeze was lifted, prices again took off in 1987.

  10. Why didn’t Austral WORK? • Wages, government revenues decreased and the corresponding CA deficit increased. • By 1989, per capita output was the lowest in 15 yrs. Per capita GDP was 10 percent lower than in 19801 • Gov’t weak and unable to collect taxes- Tax Revenue • Interest rates back up to 150%/month • CA deficit was 7.6 percent of GDP1 • Political unrest: President Raul Alfonsin to transfered power to newly elected president Carlos Menem five months before the normal time. • After election of 1989, Austral was devalued but the damage had been done- People had no confidence in the Austral.

  11. Convertibility Plan- 1991 • Crafted by Covallo • One for one peg between the Peso and the dollar • Gov’t agreed to issue no new pesos unless the money was backed 100% by dollar reserves in the cental bank

  12. Impact of Convertibility Plan • Maintained pesos value • End of Hyperinflation • 1991-1994- GDP was growing 8% annually

  13. What made it a success? • Structural Changes • Entrepreneurship • Privatization • Fiscal discipline

  14. Implications • Periods of Instability (Brazilian, Mexican and Asian crises) • Exchange rate risk

  15. Balance of Payments Current Account + Financial Account + Reserves = ZERO

  16. Argentine Monetary Policy • Reliance on international support • No control over money supply • Government financing • Interest rates

  17. History • What is Dollarization? • A foreign currency that displaces the domestic currency. (In the case of Argentina the U.S. dollar replacing the Peso) • OFFICIAL vs. UNOFFICIAL Dollarization • UNOFFICIAL: Asset holdings converted to US $ to protect from domestic currency volatility. • OFFICIAL: U.S. Dollar becomes the countries currency. • Panama: (1904) Only Latin American Country in category

  18. PROS-for Argentina Fit for Dollarization-history of Hyperinflation Lower inflation since U.S. monetary policy is imported Increase in growth because of absence of devaluation risk. Should spur in local savings, lower interest rates, and increase FDI Less perceived volatility especially capital outflows- Mex. Peso Crisis Budget constraint- Gov’t Wouldn’t be able to run “la maquinita” thus would have to adjust via internal programs. Shared seigniorage PROS-for the United States Increased seigniorage Elimination of currency conversion fees for tourists and businesses Demand for U.S. goods Maintain position as the premier international currency Advantages to Dollarization

  19. A Quick Lesson In Seigniorage • Dollarized country’s share of net seigniorage • =total average monetary base over the period (circulation + reserves) • X average interest rate on 90-day T-bill during the period • - net cost of operation the Federal Reserve • X dollarized countries share of total monetary base • X proportion of seigniorage revenue that the United States pays • ARGENTINA’S SHARE OF THE SEIGNORAGE-estimations but close to actual values. • =$16 billion / $566 billion ($550 base+ars 16mm) = 2.8% • Suppose average rate on T-bills is 5% and net cost of operating the Reserve is $1 billion • Average monetary base is $580 • =($580 billion X 5%)-$1 billion) x 2.8% X1 • =($29 billion-$1 billion) X 2.8% X 1 • $784 million • Clearly under a shared seigniorage system Argentina would be better served than collecting interest payments. • $784mm vs. $750mm • In addition it is hard to put a dollar amount on the investor confidence gained by extinguishing the risks of devaluation.

  20. Cons-for Argentina Country gives up fiscal and monetary control-surrender to the FED Loss of revenue (seigniorage) Lose Lender of last resort Popular Opinion Representation at FOMC Optimum Currency area? MERCOSUR trading bloc Brazil Cons-for the U.S. Ease of conducting monetary policy? Interest rate pressure Dumping of Dollars Lack of prior knowledge-faces challenges of being a pioneer. Panama offer the only situation from which to learn. Disadvantages to Dollariztion

  21. Bilateral Exchange Rate Source: IIF estimates

  22. Unit Labor Costs (ULC) • Unit labor costs (ULC) are defined as ULC=(W/E)/(Q/L) where W is the total nominal wages for the manufacturing sector, E is the level of manufacturing employment, Q is an index of industrial output, and L is employment in the manufacturing sector. Values converted to dollars. Source:Ministry of Economy, Banco Central do Brazil, International Financial Statistics, Datastream.

  23. What do the Pro’s think? FOR • “Given the economic program Argentina designed for itself in the Convertibility Plan, dollarization makes senses.” -Sheila Campbell • “In Argentina, dollarization is feasible; and I would even say appropriate.” -Nicolas Eyzaguirre, Executive Director IMF • “I would say that the idea merits American blessings even if it can’t be official blessings.” -Jeffrey A. Frankel • “In the long term, finding ways of bribing people to dollarize, or at least give back the extra currency that is earned when dollarization takes place, ought to be an international priority. For the world as a whole the advantage of dollarization seems clear to me.” -Larry Summers 1992 AGAINST • “Argentina will go on the dollar when the United States agrees to put Eva Peron on the dollar bill.” –Argentine Cab Driver • On the subject of dollarization: “A disastrous option.” -Francisco Chico Lopez, President of the Central Bank of Brazil

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