Policy Credibility Case Summary

Argentina's Convertibility Program

In December 1989 Argentina fell into hyperinflation. Inflation reached a monthly rate of 95% in March 1990, and the economy collapsed as residents scrambled to find alternative means for setting prices, maintaining savings, and doing economic transactions. A sharp contraction in monetary and fiscal policy brought inflation down to a monthly rate of 11% in April 1990. Further reductions in inflation were not achieved in 1990, and GDP, which fell by 6% in 1989, did not grow in 1990.

In March 1991 Argentina announced its Convertibility Program, a new initiative to improve policy credibility and to establish macroeconomic stability. The Convertibility Program established a currency board with an explicitly legislated, fixed exchange rate of 10,000 Australes per U.S. dollar. Any change in the exchange rate could be enacted only with new legislation. The currency board was required to provide full backing in U.S. dollars for any issue of Australes, and subsequently for the new peso. Moreover, the U.S. dollar was established as legal tender within Argentina.

The intent of the Convertibility Program is to establish strict discipline on Argentinean monetary and fiscal policy. The currency board rules constrain the government's ability to run fiscal deficits and finance them by creating additional money. The currency board rules also constrain the Central Bank's ability to pursue an active monetary policy. With a commitment to convertibility at a fixed exchange rate, money supply can only respond passively to changes in money demand. If citizens want to hold more domestic currency, they can exchange their foreign currency assets for domestic currency at a fixed rate. Similarly, if citizens desire to hold more foreign currency, they have the right to exchange their domestic currency for foreign currency at the fixed exchange rate. The effect of these rules is to sharply limit the government's economic policy options and to assure residents that they face no additional risk in holding domestic currency rather than foreign currency.

Under the Convertibility Program Argentina's macroeconomic position has improved considerably. Inflation fell from a monthly rate of about 11% in March 1991 to 1.5% from 1991 onwards, and by 1993 the yearly inflation rate was 8%. Output has grown sharply, while there has been a real exchange rate appreciation since inflation did not stop when the exchange rate was fixed. A potentially troublesome result, commonly observed in exchange-rate based stabilizations, has been a deterioration in the trade balance and the current account.

The Convertibility Program has played an important role in establishing the credibility of macroeconomic stability in Argentina. The spill-over effect from the Mexican economic crisis of December 1994 presented a major challenge to Argentinean macroeconomic policy. Rather than abandoning the Convertibility Program, Argentina adopted contractionary policies and an emergency debt package that allowed Argentina to cope with the crisis.

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