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Powell

VIEWS: 12 PAGES: 25

									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
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?
             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
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                                                                                                                                                                                                       Argentina




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                                                                NDF(12 months)
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Figure 1: Country Risk and the Forward Discount for Argentina


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                                                                                                                                                                                                                   Devaluation and Default Risk:




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                                                                                                                                             $/US$
          Argentina 1999:
          a short history (2)

• January 1999: Brazil devalued
• ex President Menem stated Argentina may
  fully dollarize and asked for opinion
              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.
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
            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!
             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?)
     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”
    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
                           Default and “Devaluation” Risk
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                                                                                                   EMBI+(Mexico)                   NDF (12 months)

                                                                  Figure 2: Country Risk and the Forward Discount for Mexico
                  Event Study: Methodology
      The     Constant     Mean     Model




                    Estimation window:                             Event window:           Post-event window:

                         10 days                                      4 days                   5 days




-14                                                  -4   -3                       0   1                        5




                                                               Day of event



            Figure 3: The Setup for the Constant Mean Model
      Argentina
Bad News on Currency Risk
       Mexico
Bad News on Currency Risk
         Chile
Bad News on Currency Risk
     Summary of the Results
       for Latin America
           Powell and Sturzenegger

• Highly dollarized countries: strong positive
  effect from devaluation risk to default risk
• Others: not significant or „other way‟
     Summary of the Results
        EMU Countries
           Powell 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
             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
    Would dollarization have
      been 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
       Motives for Dollarization
         El 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
     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.
             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
      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
                     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!

								
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