The very foundations of the European monetary union have been severely shaken by the ongoing financial crisis and doubts surrounding its future have intensified. In this two part series, we explore the following issues: What are the key vulnerabilities underlying a shared currency union? What can we learn from past experiences and what would the impact be if the crisis escalates? And what policy measures should be taken?
Fragility of “hard” exchange rate pegs
A monetary union can bring large benefits in terms of trade, low inflation, and lower borrowing costs, but it comes with tight strings attached. As an extreme form of a hard exchange rate peg, it is vulnerable to “sudden stops” (De Grauwe, 2009 ). History is full of illustrations of the demands placed on an economy by hard exchange rate pegs, such as dollarization and currency boards. To be sustainable, a hard peg must be accompanied by fiscal discipline and labor and product market flexibility, since monetary and exchange rate policies can no longer be used to respond to shocks and safeguard competitiveness. The lack of these preconditions not only undermines the sustainability of the regime, but also impedes the recovery from an ensuing crisis in the wake of its collapse.
Past experience suggests that there is no silver bullet to resolve such a crisis. Effective resolutions depend on developing a comprehensive strategy, combining the full range of policy instruments including (Collyns and Kincaid, 2003):
• Fiscal measures to deal with immediate financing needs, and to provide a realistic path to medium-term sustainability;
• Monetary and exchange rate policies to reestablish a credible nominal anchor;
• A banking system strategy to stabilize the domestic financial system; and
• Debt restructuring to restore viable public and corporate balance sheets and normal creditor relations.
Financial crises rarely an isolated event
Contagion could spread through various channels, including economic and trade linkages, financial contagion through exposure to common creditors and debtors, a collapse of market confidence and increased risk aversion toward countries with similar economic and financial fundamentals, freezing of global funding markets, and impact of policy responses taken at national, regional, or global levels to stabilize the situation.
A case in point is the collapse of Argentina’s long-standing currency board arrangement in 2001, an arrangement that exhibited key similarities with the European situation today. The Argentine authorities adopted the currency board in March 1991 to put an end to a long history of large macroeconomic imbalances and high inflation that culminated in the hyperinflation of 1989-91. The currency board established a one-to-one fixed parity between the peso and the U.S. dollar and guaranteed full convertibility of pesos into U.S. dollars, with the objective to stabilize the currency, encourage foreign and local investment, and foster sustained economic growth.
After several years of growth and stability, the arrangement collapsed in 2001 because the rules of the currency board have been violated at one time or another. Full convertibility was put at risk upon implementation of exchange rate controls that provided a preferential exchange rate for exports. The board was allowed to hold up to one-third of its dollar-denominated reserves in the form of bonds issued by the Argentine government, act as lender of last resort, regulate reserve requirements for commercial banks, and engage in monetary policy activities. These exceptions reduced the credibility of the commitment to the currency board, putting speculative pressure on the peso.
The government eventually defaulted on a significant portion of its debt in late December 2001—known to be the largest sovereign default in history. The sovereign stress accumulated during 2001, with two debt restructurings before the default at year-end. Following the default, Argentina was forced to exit the currency board in January 2002 and floated the peso, which immediately depreciated sharply as the government lost access to international financial markets.
The crisis also illustrates the extreme measures that had to be adopted to stabilize the situation. The authorities responded by:
• prohibiting loan extensions and “pesification” of dollar-denominated assets and liabilities with different conversion rates for private sector loans and public sector loans and deposits;
• imposing a temporary dual exchange rate system—an official rate for public sector and most trade-related transactions and a market rate for all others;
• freezing term deposits and limiting monthly withdrawals on demand deposits to stem the bank run (corralito), as the deposit insurance backed by a government at the brink of a default failed to contain the run;
• restructuring foreign-currency denominated debt; and
• introducing capital/exchange controls to prevent capital flight and facilitate restructuring.
The crisis had enormous social, economic and political costs for Argentina and had cascading effects throughout Latin America, most acutely felt in Uruguay and Paraguay. By early 2003, the situation in the region as a whole had stabilized somewhat as most governments took effective measures to contain the crisis, but economic activity remained depressed and uncertain for some time. (Collyns and Kincaid, 2003):
Moreover, the impact on Argentina’s banking system was significant. The exchange, capital and deposit controls disrupted the payment system and led to liquidity crunch. The multiple conversion rates harmed bank balance sheets and deposit holders. The corralito led to significant distributional effects and cost the government the office. At the same time, leakages in capital and exchange controls provided limited relief and deposit runs continued in the first seven months of 2002, contained eventually by a combination of monetary tightening, government support for banks, and legal protection against deposit devaluation.
While this crisis may have happened in the distant past, its fallout offers many lessons—and implications—for the Euro Zone, which we will discuss in the second part of this series.