Devaluation Risk and Default Risk: On the costs and benefits of Dollarization/Euroization

1. Devaluation Risk and Default Risk:On the costs and benefits of Dollarization/Euroization Andrew Powell Universidad Torcuato Di Tella, Buenos Aires Presentation: London School of Economics May 2002

2. The Costs and Benefits Depend on Country Circumstances • Dollarization to consolidate a reform agenda • El Salvador 2001; Argentina 1999? • Dollarization as an element of crisis resolution • Ecuador 2000; Argentina 2002?

3. Argentina 1999:a short history (1) • Argentina hit by the attack on Hong Kong (Oct 1997) and the Russian crisis (Mid-1998) • Under the Currency Board, a strong correlation between devaluation risk and default risk • Through 1988, a small group in Central Bank and Ministry considered full dollarization • Informal talks with US authorities in late 1988

4. Devaluation and Default Risk:Argentina

5. Argentina 1999:a short history (2) • January 1999: Brazil devalued • ex President Menem stated Argentina may fully dollarize and asked for opinion

6. Argentina 1999:a short history (3) • Ex Central Bank President, Pedro Pou, stated there are 3 ways to dollarize and stated: • A) He was against unilateral dollarization • B) That full monetary union was impractical • C) But, Dollarization subject to a “Monetary Treaty” with the US could be beneficial to Argentina and warranted more serious consideration.

7. What would be in a Monetary Treaty? • Argentina suggested the Treaty include: • a rule to share seigniorage • a way of using seigniorage flows to collateralize a liquidity facility • Cf: Central Bank’s Contingent Repo. Facility (subsequently used successfully in 2001) • The US ruled out: • changing US monetary policy • being a “lender of last resort” • supervising Argentine banks

8. Potential Costs • Seigniorage • with the Treaty, less of an issue • Perhaps not much of an (economic) issue anyway, more politics than economics • Lender of last resort • with the Treaty less of an issue • Main Costs • Notions of sovereignty • Giving up the option of future monetary policy • But Argentina 2002 shows, never say never!

9. Potential Benefits • Eliminating devaluation risk • Eliminate peso interest rates • Lower default risk: Powell and Sturzenegger (2002) • Locking in reforms • Argentina: doubling the ‘bet’ of the c. board • Deeper trade/financial integration into US$ zone • Argentina: already highly dollarized - financially • but tension with Mercosur (cf: UK and EU?)

10. Powell and Sturzenegger • Eliminating devaluation risk could go either way • balance sheets vs. • inflexibility, inflation tax, seniority arguments • Standard time series analyses fatally flawed • joint tests of ‘efficiency’ and ‘causality’ • peso bond markets less liquid & less efficient • To avoid this problem, we conducted an ‘event’ study of exchange rate “events” on “default risk”

11. Powell and Sturzenegger • Latin American Countries • Lat. Am.: events related to ‘currency risk’ • Events Selected by colleagues in the region • Default risk: dollar spreads • European Countries pre-EMU • Events that altered perception of EMU success • Events from Zettlemeyer (1996)/Ungerer(1997) • Default risk: spreads on DM bonds

12. Default and “Devaluation” RiskMexico

13. Event Study: Methodology

14. ArgentinaBad News on Currency Risk

15. MexicoBad News on Currency Risk

16. ChileBad News on Currency Risk

17. Summary of the Resultsfor Latin AmericaPowell and Sturzenegger • Highly dollarized countries: strong positive effect from devaluation risk to default risk • Others: not significant or ‘other way’

18. Summary of the ResultsEMU CountriesPowell and Sturzenegger • Countries that entered EMU: strong negative effect from EMU ‘success’ to default risk • Countries that did not enter EMU initially: not significant or ‘other way’ • Exception: Portugal but not so clear ex ante

19. Argentina 1999:Dollarization, A missed opportunity? • Would Argentina have avoided crisis? • Depends on preferred crisis explanation - see Powell 2002. • Dollarization would have helped • reducing devaluation risk/default risk • increasing confidence/investment/growth • Dollarization would not have helped • problems of ‘competitiveness’ • fiscal problems not related to growth

20. Would dollarization havebeen permanent? • If dollarization had been perceived as permanent, had reduced default risk and enhanced fiscal sustainability sufficiently, then it would have been permanent! • If dollarization had not been perceived as permanent or competitiveness problems had been paramount then it might not. • A monetary treaty would have provided some incentives towards permanence

21. Motives for DollarizationEl Salvador (2001) • Locking in successful reforms • Deeper trade and financial integration into US dollar area (70% of trade with US or ‘dollarized’, remittances are 15% of GDP) • Lower interest rates: but El Salvador was not highly dollarized previously, reduction in interest rates due to replacement of colon with dollar rates and wider credit availability

22. Dollarization as Crisis Resolution: Ecuador 2000 • Main surprise: dollarization helped to stabilise the banking system despite bank resolution process being far from complete • Seems consistent with empirical results relating exchange rate regimes and financial system size. • But against some theoretical views; that dollarization implies no lender of last resort so less depositor confidence.

23. Argentina 2002 • Authorities caught between • political and economic costs of the financial system restrictions (“el corralito”). • potential exchange rate instability and inflationary consequences if lifted • Argentina cannot grow until this solved • if solved without generating an inflationary spiral, it may be possible to create some monetary instruments and hence an independent monetary policy (a First Best). • if not, Argentina will most likely have to reinvent Convertibility or Dollarize

24. Argentina and the IMF:a game with no solution? • The IMF has called for a ‘sustainable plan’ • If the IMF Assists, it may fear this reduces the incentives for prudence (Moral Hazard). • President Duhalde has said it is difficult to see a ‘sustainable plan’ without the IMF. • But if Argentina had a ‘sustainable plan’, why would not need the IMF? • Unfortunately Argentina has now wasted 4 months post-default/devaluation

25. Conclusions • Dollarization has been thought of in two ways: • to consolidate reforms & deepen integration • as crisis resolution. • In the case of an El Salvador or Argentina (1999): • the main costs are related to notions of sovereignty and (possibly) giving up future monetary policy • the main immediate gain is lower interest rates especially in dollarized economies (Powell & Sturzenegger). • In the case of Ecuador dollarization helped to stabilise the financial system. • Argentina 2002: dollarization should not be ruled out, otherwise it may very well still happen!