Convertibility law

In March 1991, at the initiative of Domingo F. Cavallo (who was the Economy Minister of Argentina in the periods 1991-96 and 2001), the Argentine Congress passed a "Convertibility law" that established a Currency Board Arrangement (CBA). Contrary to the British colonial CBAs that existed from the nineteenth century to the end of the decolonization period, the most recent Argentine case was not aimed at encouraging a strong quasi-exclusive integration, but was conceived as an ultimate solution to hyperin- flation and exchange-rate instability (Ponsot, 2003). According to the Argentine govern- ment, the parliamentary decision reinforced its "credibility" in a framework of economic chaos.

The so-called Convertibility, supported by the Convertibility law and the reform of the central bank charter in September 1992, had the following three main features: (i) full convertibility between the domestic currency and the US dollar at a fixed exchange rate; (ii) lack of an unlimited lender of last resort (LLR); and (iii) a bi-monetary system (partial dollarization).

At the beginning of Convertibility, the exchange rate was fixed at 10,000 australes per US dollar, but eight months later the austral was replaced by a new currency, the peso. The new parity was fixed at 1 peso per US dollar in order to create the monetary illusion that both currencies were virtually the same.

After uncontrolled devaluations and three episodes of hyperinflation between 1989 and 1990, Convertibility stabilized the exchange rate of the peso and, consequently, the price level. However, prior to the "Convertibility law" a monetary policy shock occurred: in January 1991, the Argentine government increased both the exchange rate and interest rates. After correcting the expected returns (in US dollars) on local assets, Convertibility was successful in attracting short-term capital flows to cover the current account deficit of Argentina.

The conventional wisdom that supported Convertibility pointed out that as the foreign trade disequilibrium was the result of fiscal imbalances, the solution was the implementa- tion of a monetary rule. According to Cavallo (1996, p. 169), "a persistent fiscal deficit, increasingly financed by monetary emission, caused more and more frequent devalua- tions of the local currency". However, the fiscal deficit was in fact a consequence and not a cause of the current account deficit, as also occurred ironically under the auster- ity of Convertibility (Vernengo and Bradbury, 2011). On the one hand, Argentina was one of those Latin American countries involved in the so-called "debt crisis" explained largely by the "Volcker shock". Indeed, the impact of the sharp increase in the US federal funds rate of interest on developing countries was amplified by the large capital inflows recorded by them in the 1970s. Therefore, the rising interest payments on foreign debt increased public expenditures. On the other hand, in a framework of stagnant economic activity (revenues fall), persistent devaluations (increased interest payments measured in local currency) and high inflation ("Olivera-Tanzi effect"), the fiscal deficit increased explosively (Damill and Frenkel, 1990).

During Convertibility, initially, there was a rapid deceleration of inflation (1991-94), then the price level stabilized (1995-98), which was followed by a period of deflation (1999-2001). While exchange-rate stabilization resolved one of the most important cost factors that pushed inflation rates up, it is also true that distributive conflicts were not solved this time through repression by a military dictatorship but through a post-modern "market friendly" process. In a framework of fiscal austerity, trade liberalization and massive privatizations (as well as "foreignization") of public utilities increased unemploy- ment rates, thus reducing the bargaining power of workers and, consequently, real wages declined.

To some extent, Convertibility could be interpreted as a "heterodox" CBA, because the monetary authority never completely lost its ability to act as an LLR (Hanke and Schuler, 2002). While in a pure CBA the monetary base is fully backed by foreign reserves, Convertibility allowed that up to one-third of the backing could be composed of public bonds denominated in foreign currency and valued at market prices. Also, Conver tibility set a contingent repo facility with a consortium of foreign banks that, later, was reinforced with the support of the World Bank.

However, as Convertibility flexibilities were not enough to match domestic liquidity demand with foreign reserves, the Argentine government faced an unsustainable foreign indebtedness to support the CBA. For that reason, even under this extreme case money creation was credit driven and demand determined (De Lucchi, 2013).

Finally, the increase in the degree of financial fragility was also caused by the dollari- zation of private portfolios, which was stimulated by Convertibility. Based on a "metal- list" approach, Convertibility indeed allowed an indiscriminate use of US dollars for both commercial and financial transactions between residents. As part of a bi-monetary system, banks were allowed to function under a fractional reserve system even for US dollar deposits.

In December 2001, after a foreign credit rationing, Convertibility collapsed. The financial system that had been the most highly liberalized in the world in its time (O'Connell, 2005) was disrupted by a balance-of-payment, fiscal, and banking crisis with dramatic social and political consequences. As a matter of fact, Convertibility took place in a framework of radical neoliberal reforms that reinforced its contractive and regressive trends. In spite of the "carnal relations" with the United States, the US Federal Reserve never agreed, either in theory or in practice, to act as an international LLR. For that reason, contrary to the efficient-market hypothesis, the lesson of Convertibility is that in a monetary economy an unlimited LLR and financial regulation (that is, the State) are systemic needs.

See also:

Currency board; Currency crisis; Dollarization; Efficient markets theory; Fractional reserve banking; Hyperinflation; Lender of last resort; Money and credit; Money illusion; Volcker experiment.