Thursday, June 7, 2007

McKinnon on Argentina’s Monetary Regime

By Ronald I. McKinnon

“Because Argentina’s monetary system is still in transition from the great crisis and deep devaluation of 2002, the principles behind its current monetary regime cannot be compared to other emerging markets or industrial economies which are more or less in steady states. Instead, it is necessary to look at the monetary options available to the Central Bank of Argentina (BCRA) after the 2002 currency depreciation and the restructuring of external debts.

Argentina’s initial massive depreciation, as measured from the third quarter of 2001 to the second quarter of 2002, was 275 percent—as shown in figure 1. Then by mid 2003, the nominal exchange rate had bounced back somewhat to a depreciation of just 200 percent (from 3Q 2001) and has subsequently remained remarkably stable. Since 2002, the nominal exchange rate has remained at 3 pesos per U.S. dollar, ± 3 percent.

Because the crisis induced a collapse in domestic spending including for imports, Argentina’s foreign trade balance turned sharply positive in 2002—and has remained positive as exports have picked up. From the surplus in the balance of payments, exchange rate stabilization has required heavy official intervention and a large buildup of dollar reserves. The monetary base in 2006-07 is increasing more than 30 percent per year—and, after partial sterilization, growth in M2 is now about 20 percent. But the velocity of M2 has pretty well stabilized: nominal GDP is growing at 19 percent while real growth is 8 to 9 percent. However, the banking system remains shrunken in real terms: M2 is less than 20 percent of GDP, and bank credit outstanding to the private sector is only about 10 percent of GDP.

What monetary rule is Argentina now following? BCRA is targeting the exchange rate as a nominal anchor for its monetary policy; and, as Governor Retrado emphasizes (quite correctly), it is not targeting any particular real exchange rate—and certainly no real interest rate. Although the nominal exchange rate is the target, it is not by itself a sufficient instrument to stabilize the rate of inflation—at least not for many years after the large devaluation. In addition, heavy intervention to sell central bank bonds and raise reserve requirements have been necessary to prevent an explosion in money growth that would have led to even higher inflation than the present 9 to 10 percent increase in the CPI.

If one presumed that the pre-crisis exchange rate in early 2001 was roughly at purchasing power parity, then a sustained 200 percent devaluation (the value of the dollar rises from 1 to 3 pesos) will eventually show up as a 200 percent increase in the domestic price level. Producer prices, which are more directly affected by the exchange rate, will react faster than consumer prices. And by early 2007, producer prices have already risen more than 180 percent while consumer prices rose by just 90 percent. Thus, at 3 pesos to the dollar, Argentina faces several more years of substantial inflation in its CPI before the fixed nominal exchange rate eventually ends it.

How fast Argentina’s economy should inflate before this new equilibrium is achieved is something of an arbitrary choice. But the government has apparently settled on allowing nominal GNP to grow 19 percent per year, which is partitioned between approximately 9 percent real growth and 10 percent inflation. So, under the current monetary regime, six or more years will elapse before the CPI stabilizes at the “international”, i.e., U.S., level. Nevertheless, the fixed nominal exchange-rate, with supporting interventions to control the excess money growth, is a consistent monetary strategy. Whether it is sustainable remains to be seen.”

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