MIGUEL A. KIGUEL

1. Monetary Policy in Dollarized Economies: The Argentine Experience MIGUEL A. KIGUEL Universidad Di Tella & econviews December 2006

2. Monetary Policy in dollarized economies: Outline • General reflections about dollarization • How does dollarization affect the banking system • The experience of Argentina as a dollarized economy during the hard peg and after the 2001/02 Crisis • Final remarks and issues for discussion

3. Monetary Policy in dollarized economies under different exchange rate regimes • Fixed exchange rates (currency board): Little room for monetary policy but the central bank can affect the amount of bank credit. • Floating exchange rates: room for monetary policy, the main question is how effective can it be when dollarization is significant. • Is it better to target the money supply or interest rates in highly dollarized economies? • Is there a difference between dollarization and currency substitution?

4. International Comparison econviews Argentina is one of the few countries that managed to de-dollarized

5. How can dollarization help banking stability? • Dollarization allows portfolio changes to take place within the banking system, and hence it helps financial deepening • Reduces capital flight • Interest rates on dollar deposits and loans are largely insulated from changes in peso interest rates • It helps to develop a market for long term financial instruments (e.g. mortgages)

6. How can dollarization weaken banking stability? • Lack of confidence on the currency could lead to a systemic run of deposits • Lack of lender of last resort could lead to bank panics • Regulations do not usually include prudential regulations to limit convertibility in a panic (circuit breakers) • Banks could be hedged in dollars for the asset-liability management but borrowers might not be (e.g. personal loans, residential mortgages)

7. Dollarization and de-dollarization in Argentina • Dollarization has a long history in Argentina as a result of high inflation since the 1970s • The dollar became “the currency” during the hyperinflation in the 80s • In the 1990s, with the convertibility regime, dollarization increased in the banking system and it survived a critical test: the 1994 Mexican Crisis • There was an explicit policy to move towards dollarization in the 1990s • De jure de-dollarization after the 2001 crisis

8. Some stylized facts of dollarization in Argentina • Dollarization has been a one way street, very difficult to reverse • The payments system has worked mainly in pesos, even during the crises • The interest rate differential never disappeared for deposits in pesos and dollars during the period of convertibility • Lending interest rates in pesos remained extremely high during that period, why?

9. Argentina econviews Dollarization in the banking system increased over time, especially once deposits stabilized in the late nineties

10. Argentina econviews Prior to the crisis they reached 60% of the total

11. Argentina econviews Checking accounts and most transactional balances have remained in pesos

12. Argentina econviews The interest rate differential between pesos and dollars never disappeared. Both rates increased at times of crises, but peso rates increased more

13. Argentina econviews Ex-post real interest rates in pesos remained very high

14. The First test on Convertibility: The 1994 Mexican Crisis and its impact on Argentina • The Mexican devaluation generated fears of devaluation in Argentina • Deposits fell by almost 20% in just three months • Initially the run was stronger on peso deposits (flight to quality) but then it spreaded to dollar deposits as well • The central bank provided liquidity to the banking system and partially insulated the impact on credit to the private sector • The bank panic was stopped without restraining convertibility

15. econviews Deposita fell by 20%, initially pesos, then dollars, then free fall for all

16. econviews The Central Bank financed 70% of the fall in deposits and minimized the impact of credit

17. The First test on Convertibility: Implications of “surviving” the Mexican crisis • It increased the confidence in the hard peg regime as a policy alternative • It promoted more dollarization of the economy, and in the banking system • It increased the awareness about the importance of improving the ability of the central bank to act as lender of last resort • It created the case for full dollarization in a response to a possible crisis

18. Fixed exchange rates and monetary policy in dollarized economies: Lessons from Argentina • The quantity of money was demand determined • The central bank was able to affect the amount of credit in the banking system through reserve requirements and the provision of liquidity. • Convertibility did not eliminate the foreign exchange rate risk, as it remained a differential between similar deposits in pesos and dollars • The ability to act as lender of last resort was limited by the amount of international reserves

19. The collapse of the banking in 2001/02 • There was a run on the currency and on deposits could not be contained with international reserves. No “real” lender of last resort • The default on public debt weakened the banks’ balance sheet • Flight to quality meant capital flight • The devaluation was all but unavoidable, but had huge impacts on the banks and non-financial sectors balance sheets. • Foreign banks were not ready to bring financing from abroad due to “changes in rules of the game”

20. econviews There were no enough financial resources to withstand the attack on the currency and the bank panic of 2001 and banks reduced credit

21. Some stylized facts of dollarization during the period of the hard peg in Argentina • Run on the currency became run on banks • Was dollarization a key reason for the crisis? • Was the fixed exchange rate in a dollarized economy the main problem? • What was missing: A lender of last resort? A credible deposit insurance? • Could a floating exchange rate regime have helped to avert the crisis?

22. De-Dollarization and Monetary policy in the aftermath of the crisis

23. What did Argentina do to de-dollarize the economy? • It de jure converted dollar deposits and loans to pesos (at different exchange rates) • Contracts in dollars were transformed into pesos at old the exchange rate (utility rates, rents, etc) • A large part of the public long-term debt was converted to pesos and then indexed to the CPI • New regulations has restricted banks from in offering new loans in dollars (only to exporters and importers) • There is still dollarization for many long term contracts and for financial investments

24. Argentina econviews The “Original Sin” Redemption?

25. Argentina econviews The de-dollarization increased the demand for pesos. Currency substitution in reverse

26. Argentina econviews The banking system now works in pesos for Deposits…..

27. Argentina econviews …. And for loans

28. Argentina econviews But private sector deposits have not recovered their previous levels. Less financial deepening

29. Monetary Policy Where does Argentina stand today? • Is Argentina is trying to target • Inflation? • The real exchange rate? • The level of International reserves? • Interest rates? • The central bank sets a target for M2.

30. econviews Prices Inflation is under control but remains in the two digits

31. Monetary Program econviews The Central Bank targets the growth of M2

32. Monetary Program econviews Money supply is controlled by issuing Central Bank bills

33. econviews The stock of central bank debt is rising

34. Interest Rates econviews Policy interest rates have been rising, but they are still relatviley low.

35. Argentina econviews Real interest rates are now very low

36. econviews Monetary Policy The appears to be undervalued

37. Implications for Monetary Policy: Where does Argentina stand? • Flexibility in the exchange rate (dirty float), with a band for the nominal exchange rate • The central bank sets a target for M2. • Central bank controls the money supply (M2) through sterilization combined with capital controls • Policy interest rates have been gradually rising though they remain below inflation • Monetary policy basically accommodates inflation

38. Lessons from Argentina’s dollarization and de-dollarization processes • Dollarization is largely related to inflation and macroeconomic policies, but governments can affect it through policies, • Restrictions on dollar deposits and lending • Use of indexation as “quasi-currency” • The Argentine de-dollarization process has not yet extended to saving instruments • …and it has not been tested since the crisis, so far it is still smooth sailing • Currency substitution could be reversed if macroeconomic conditions change.

39. Implications for and questions about Monetary Policy in Dollarized Economies • Argentina so far has managed to use monetary policy by targeting the money supply • Low interest rates have helped the recovery from the crisis • The exchange rate remains competitive • Inflation is under limited control • But less dollarization in the banking sector does not necessarily imply that there is less currency substitution in the economy. • And the long term capital market still works largely in dollars

40. Thank you!