Question

Argentina’s peso was linked to the U.S. dollar through a currency board for ten years before it was cut loose. Why did Argentina peg its currency to the dollar in the first place? Then Briefly discuss Argentina’s Peso Crisis

Answer 1

Argentina introduced a fixed peso-to-dollar peg in April 1991, and promised convertibility under this system. That is to say, the central bank stood by translating pesos at the hard peg into dollars. From the outset, the option was nonsensical and completely unsuitable for the structure of trade and production in the country. Just like most EMU countries do not share anything like the features that would suggest an optimal currency region, Argentina never looked like a member of an optimal US-dollar zone.

The type of external shocks faced by his economy were different from those the US had to deal with for a start. The United States dealt primarily with countries whose own currencies fluctuated in line with the US dollar. The US economy could thus benefit from nominal exchange rate fluctuations and use them to offset the relative price of tradables and non-tradables, given its relative closeness and a broad non-traded goods market. Argentina was a very open economy, with a limited domestic market of non-tradables. So it took the brunt of trade swings terms which made domestic policy management very hard.

At some point in its history, Argentina's currency board violated all of those laws. The charter regulating the currency board of Argentina has allowed it to be partially backed by domestic assets, rather than hard foreign currency. Initially, the currency board was allowed to keep as little as 66.6 per cent of its assets in actual foreign reserves. Argentine government bonds could back up the remainder. The currency board may be following discretionary monetary policy as well. For 2001 alone, Argentina's foreign reserve support ranged from a peak of 193% to a low of 82%. Moreover, the central bank of Argentina set the reserve ratios and thus maintained some financial regulatory control

Additionally, Argentina had a few years of running large fiscal deficits. The government increased income taxes in 2000 in an attempt to balance its budget and imposed a levy on financial transactions in 2001. But those efforts failed as the economic crisis in Argentina worsened. The climbing deficit caused an rise in fears about devaluation. In 2001 the country fled roughly $20 billion in cash. Interest rates of the Peso grew to between 40 percent and 60 percent, further weakening the budget role of the government.

Argentina switched to a dual exchange-rate regime at the end of 2001, introducing a preferential peg for exports. This move removed the characteristic of complete convertibility — and every sense of a currency board with that. This failed to convince the public, however. The government then suspended bank deposits, effectively triggering a financial crisis, and abandoned the exchange-rate system for a floating mechanism in January 2002.