Commentary: Argentina: The Peso Isn't The Real Problem

It has been Argentina's miracle cure for inflation, the source of its financial stability for the last eight years. But the country's currency board may have outlived its usefulness. Investors are now wondering whether it's time to get rid of the board, which uses ample reserves to keep the peso at parity with the U.S. dollar--but which deprives authorities of other monetary tools, such as printing money or devaluing. Even President Carlos Menem has looked into replacing the peso with the greenback as Argentina's national currency. The debate got hotter in late May, when uber-financier George Soros rattled the stock market by saying that the peso was overvalued.

Although most Argentines favor keeping the board, there's a strong argument for a more flexible approach. The danger is that whatever happens to the currency, Argentina will avoid the tougher task of liberalizing its economy. Without economic reform, any new currency reform will prove futile.

TWO OPTIONS. Argentines fear the peso's dollar peg is deepening their recession by making its products uncompetitive--at home and abroad. Indeed, if interest rates in the U.S. go up, Argentina's do, too--just what a recession-wracked economy doesn't need. The economy could shrink 2.5% this year. To ward off speculators eager to test the currency board's resolve, the government will probably have to cut the budget or increase taxes to cover its expected $6 billion fiscal deficit.

Should Argentina drop the board, its options are two. It can simply remove the peso from circulation and dollarize. The attraction of this approach is that speculators will have nothing to attack. The other alternative is to float the peso and let it drop. A cheaper peso would make Argentine products competitive again--and give the economy a shot in the arm.

If the government were to make a move, it would surely prefer to dollarize. The Menem government is already using the idea to discourage investors from fleeing now. If Argentines and foreigners believe dollarization is more likely than a messy peso devaluation, they are less likely to pull out of the market or withdraw bank deposits. In late May, Deputy Economy Minister Pablo Guidotti asserted that Argentina could adopt the dollar unilaterally if it saw a speculative threat.

Yet neither option presents an ideal solution. The peso already equals a dollar, so switching to greenbacks wouldn't make Argentina more competitive. With a dollarized system, Argentina would still lose ground when a trading partner such as Brazil devalues. U.S. officials have already told Buenos Aires that it would have no say in Federal Reserve Board or Treasury Dept. decisions. Some analysts, including former Economy Minister Domingo Cavallo, even say the dollar isn't the most appropriate currency to adopt, since Argentina trades more with Europe than with the U.S. Cavallo favors a common currency with Brazil.

CREDIBILITY GAP. A floating peso would present its own problems. Argentines fear that without the dollar as anchor, years of hard-earned stability would be thrown away, and an all-too-familiar run of hyperinflation would loom. Argentina could also attempt a managed-currency approach, by which the peso would be devalued gradually. But that would lack credibility, since the central bank has not actively handled exchange-rate policy since 1991.

Argentina's political situation also makes some investors uneasy. Menem will leave office in December after 10 years. Leading presidential contenders have pledged to maintain the status quo. But signs of political instability could trigger enough capital flight to crater the peso--and the board.

It's a risky situation. But Argentines will ratchet up the risk unless they tie currency reform to other, admittedly painful measures. No matter what path they choose, no currency overhaul will succeed until Buenos Aires begins to ease the heavy tax and regulatory burden on business and control government spending. An overhaul of the country's rigid labor and tax laws would help Argentine companies compete--and lend a solid foundation to whatever currency system the country finally chooses.

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