Currency Devaluation and Its Effects on the Economy

| Currency devaluation and its effects on the economy | Focus on the Argentine economy | Agustina DalFabbro, Michele Mottola, Giuseppe Merlino, Saskia Diehl 26. 05. 2012 | Inhalt 1. Introduction2 2. Convertibility and its problems in the 1999/2001 period2 1. 1Previous Devaluation Process in Argentina2 2. First moments of devaluation3 2. 1 Fixed exchange rate vs. floating exchange rate regimes3 2. 2 Two types of exchange rates and free floating currency5 2. 2 Free floating currency6 3. Effects of Devaluation process on6 3. 1 Trade Balance6 3. 2 Productive capacity6 3. 3 Salaries6 . 4 National Accounts6 4. Conclusion6 5. Literature7 1. Introduction Stable currency exchange rate regimes are a key component to stable economic growth (http://www. policyarchive. org/handle/10207/bitstreams/1311. pdf) 2. Convertibility and its problems in the 1999/2001 period 1. 1 Previous Devaluation Process in Argentina Three main large devaluation episodes prior to the monetary reform of 1991 can be iden tified in the graph: 1975-1976 (the so called â€Å"Rodrigazo†), 1982-1984 (the â€Å"Post Malvinas War† monetary collapse) and 1989-1990 (the â€Å"Hyperinflation†). (http://www. cavallo. om. ar/wp-content/uploads/2012/05/Devaluation-and-Inflation-. pdf) 2. First moments of devaluation Basically you can distinguish three half-year periods centered on the political and financial collapse at the end of 2001 namely: Precollapse (to September, 2001); Collapse (October 2001 to March 2002); and Depression (from April 2002). This section will focus on the end of the Collapse and the beginning and ongoing Depression. As earlier mentioned Argentina applied a currency board at the beginning of the 90’s which pegged the peso to the dollar and formed a fixed exchange rate.After the Crisis of Argentina had begun they had to decide how they can diminish the effect of the emerging depression. In December 2001 Argentina officially defaulted and in February 2002, the val ue of the pesos was almost half of the dollar, Eduardo Duhalde became president. He had to manage a country which was in a really bad condition. Different economists favored different strategies to stabilize the economy. Some favored a â€Å"pesification followed by a free-floating regime† and others â€Å"devaluation and subsequent dollarization†.Both of those possibilities are heavily discussed between the leading economists worldwide. After the financial crises in the 1990’s they suggested for developing countries to choose a corner solution and all intermediate exchange rate regimes were dismissed in order to be too risky. But in 2003, after the crisis of Argentina had reached its peak, the bi-polar view might be a good solution as well. The next section will be examine what Argentina did try to escape the crisis, after they had already implemented a currency board (fixed exchange rate), which eventually, with a lot of accompanying factors, evoked the crisis .They actually started floating their currency and implemented several other measures to save their economy. If this mixture of policies was successful will be analyzed in the following. 2. 1 Fixed exchange rate vs. floating exchange rate regimes For a better understanding what the next section is talking about, a brief introduction about the different exchange rate possibilities and their advantages and disadvantages will be implemented. A fixed exchange rate regime can be created in three different ways. The first two are either a Soft Peg or a Hard Peg of the currency.Hard Pegs are for example currency boards or currency Unions (Eurozone) and mean a complete fix to the currency of a foreign country (e. g. the currency board of Argentina pegged the Peso to the Dollar). Soft Pegs are the less strict version and link to other currencies is less direct. The third possibility is a fixed exchange rate peg to several countries. The main focus of this paper lies on the currency board as it was the case in Argentina. The main economic advantage of a hard peg (currency board) is, that it comes to a better trade between the countries that are part of the arrangement.Since the volatility of floating rates causes costs for exports and imports. It also encourages international capital flows which can profit the welfare of a country. Especially in case of developing countries these capital flows can be very large. One big Problem of the exchange rate regimes is the loss of monetary and fiscal possibilities to stabilize the economy as well as Limitation of the ability to pursue domestic goals. There is a slight difference between a hard peg and a fixed exchange rate, since the fix exchange rate can be with several countries whereas the hard peg only pegs it currency to one foreign country.They have more or less the same ad- and disadvantages, but with a fixed exchange rate, which is pegged to more than one country, the pursuit of domestic goals is easier, since the country does not depend on one foreign economy. One major weakness of the fixed exchange rate is, that when devaluation becomes necessary through fundamental changes in economy. Even the announcement of devaluation creates the danger of a crisis and eventually ends in a crisis, like the case of Argentina shows. It is also likely that a currency crisis after devaluation can end up in a banking crisis, since fixed exchange rates give incentives to take on debt. see below for further information) Floating exchange rates can be found for example in the arrangement of the U. S. with their major trading partners. It means that the value of the exchange rate will be freely determined in the market, depending on demand and supply. The main economic advantages of floating exchange rates are that they leave the monetary and fiscal authorities free to pursue internal goals. They can concentrate to generate full employment, stable growth, and price stability. Exchange rate adjustment often works as an automatic stabilizer to promote those goals.One main disadvantage of floating exchange rates is, that the exchange rate volatility and uncertainty, concerning costs on trade and investments, may discourage international investment. If foreign investment is a main source, as it is the case for most developing countries, floating exchange rate may impose real costs, not only for the exporters but also for the whole society. Whether a country should choose a fixed or a floating exchange rate depends on the dependency of the country on their neighbors and therefore their sensibility to external shocks.If it is very dependent on their neighbors and especially their neighbors’ economy the country is better of with a fixed exchange rate. But if the country is economically independent, a floating exchange rate would be the better choice in order to favor macroeconomic stability. 2. 2 Two types of exchange rates and free floating currency As the era of the currency board of Argentina was described earlier, the following focuses on the measures taken after the default of Argentina. The government chose a mixture of the two strategies mentioned before.Duhalde implemented his measures in a â€Å"schizophrenic† way. They started to devaluate the Peso from the originally 1 Peso to 1 Dollar rate to a 1. 4 pesos to 1 dollar rate (January 6 2002). On January 9th the government â€Å"pesified† dollar assets and liabilities, by converting the dollar to pesos at a 1 to 1 rate. This led to a â€Å"massive destruction of property rights† and a lot of utilities and companies ended up in bankruptcy. On February 9th they floated the peso by using the asymmetric pesification. This meant that dollar deposits were converted to pesos at the rate of 1 to 1. and dollar loans converted to pesos one to one. This imposed a large loss on the banking system and favored debtors owing dollar debts. A wide range of dollar denominated debt would be converted into pesos a t the old parity of one peso to one dollar. The holders of dollar deposits in the bank could convert those at a much more favorable exchange rate 1. 4 pesos to one dollar. It followed a great loss on the balance sheet of the Banks, who could only remain one peso for one dollar in debt owed by borrowers but owed 1. 4 peso for each dollar to the debtors.The asymmetric pesification amounted a total loss of $ 10- 15 Million Dollar compared to their equity of $ 17 million they had at the end of 2001. The government finally realized that it could not risk a total collapse of the banking system and offered to help the banks. They granted $ 9 million in the form of government bonds in order of compensation. This compensation covered most of the losses in nominal accounting but since the market value of the bonds was far below par not in real terms. 2. 2 Free floating currency http://www. nber. org/papers/w9808. pdf? new_window=1 in many emerging market economies, exports, imports, and ntern ational capital flows are a relatively large share of the economy, so large swings in the exchange rate can cause very substantial swings in the real economy. (p6) Under these circumstances, the monetary authority is likely to display â€Å"fear of floating† (Calvo and Reinhart, 2002), defined as a reluctance to allow totally free fluctuations in the nominal or real exchange rate, which Mussa (1986) showed are very closely linked. To â€Å"pesofy† all savings and debts Currency apparently has destroyed more the trust into the financial sector than the hyperinflation in 1989 did, although it was created to generate more trust.Argentina suffered from diverse devaluations of other currencies and then they devaluated their own currencies. Which effects did that have on other economies and their own? This question will be answered in the following section. 3. Effects of Devaluation process on 3. 1 Trade Balance 3. 2 Productive capacity 3. 3 Salaries 3. 4 National Accounts 4 . Conclusion 5. Literature Cline, William R. , 2003. â€Å"Restoring Economic Growth in Argentina†, Band 3158 von Policy research working papers , World Bank Publications 2003, 111 pages Labonte Marc, 2004. â€Å"Fixed Exchange Rates, Floating Exchange Rates, and Currency Boards: What Have We Learned? , Analyst in Macroeconomics Government and Finance Division, CRS Report for Congress, 24 pages Schuler, Kurt, 2002. â€Å" Ignorance and Influence: U. S. Economists on Argentina’s Depression of 1998-2002â€Å", Econ Journal Watch, Volume 2, Number 2, August 2005, pp. 234-278 ——————————————– [ 1 ]. http://www. nber. org/feldstein/argentina. pdf, p 10 [ 2 ]. Clarin. www. clarin. com. December 2001, available at http://www. servicios. clarin. com/notas/jsp/clarin/v8/edicant/edicantArchivo. jsp? dia=&mes=12&anio=2001&edAntTipo=edanter_diario&x=13&y=10, [ 3 ]. W. R. Clin e p. 47 [ 4 ].Labonte et al, 2004, p. 7 [ 5 ]. Labonte et al, 2004, p. 5- 18 [ 6 ]. Labonte et al, 2004, p. 3-5 [ 7 ]. Corrales, 2002, p. 38 [ 8 ]. Or â€Å"pesofication†, means conversion to pesos [ 9 ]. Corrales 2002, p. 39 [ 10 ]. http://www. tradingeconomics. com/argentina/currency [ 11 ]. Schuler 2003 (http://www. hacer. org/pdf/Tirania. pdf) p. 30 [ 12 ]. http://books. google. com. ar/books? id=HbEJy8KwYxcC&pg=PA53&lpg=PA53&dq=asymmetric+pesification&source=bl&ots=WWVnkeKfcW&sig=MEpQ9lphc-QTV68m-ctUWT2bAPk&hl=de&sa=X&ei=W6jCT5ekDZKk8QTnr-DACw&redir_esc=y#v=onepage&q=asymmetric%20pesification&f=false p. 45