A Classic and a must read

Sudden stops, the real exchange rate and fiscal sustainability: Argentina’s lessons;

The fall of the Convertibility Program - the currency board regime in Argentina - has been subject of much discussion. This paper aims to provide a new interpretation of the collapse of Convertibility with a special emphasis on three key structural characteristics of Argentina’s productive and financial structure and on political economy considerations.

The paper starts by explaining the role of the Russian crisis of August 1998 in changing the behavior of capital markets and in producing an unexpected and prolonged stop in capital flows (which is referred to as Sudden Stop) to emerging market economies, including Latin America. It argues that Argentina is extremely vulnerable to a Sudden Stop in capital inflows such as the one that followed the Russian crisis. Factors contributing to this vulnerability include a relatively closed economy indebtedness; a high level of indebtedness; and financial currency mismatches due to a high degree of dollarization both in the public and private sectors.

The paper then identifies key vulnerability indicators by contrasting Argentina’s performance relative to other Latin American countries that were also subject to the Sudden Stop. It also provides an explanation for the political issues that ensued after the Sudden Stop and the fiscal collapse.

Three major findings emerge from this analysis:

* economies like Argentina are vulnerable to changes in international conditions and may require large increases in equilibrium real exchange rate (RER)
* large changes in the RER could generate deep financial distress in the corporate sector and/or lead to financial problems for the public sector
* a banking crisis may be the inevitable because banks are exposed to RER changes either directly or through the public sector and its large public debt

The paper concludes with some policy lessons for Latin America that emerge from Argentina’s experience. The recommendations mentioned in the paper include:

* switching to exchange rate flexibility as a way of reducing the real effects of Sudden Stops
* dealing with unsustainable fiscal positions in order to allow the public sector to adequately respond in times of crisis
* creating markets for the issuance of debt in domestic currency not indexed to the exchange rate
* increasing trade openness