Argentina's peso predicament

Argentina's economic standards have broken down

By BBC News Online's James Arnold

Argentina's new leaders face a list of problems as long as your arm.

But right at the top is devising a solution for the country's benighted currency, the peso.

Argentina's current crisis may now have spiralled onto the streets, but it has its roots firmly in the foreign exchange markets - and in particular the recent collapse in investor and popular confidence surrounding government financial policy.

Any attempt to lever Argentina back to economic health will have to begin with a strategy to win that confidence back.

At present, however, options look severely limited - and picking the best one is going to be a dangerous gamble.

Board games

At the heart of Argentina's peso problem is the foreign exchange structure currently in place - the so-called currency board.

Argentina's currency board - in place for 10 years - pegs the peso immovably at the level of one US dollar.

What began on the currency markets ended up on the streets

But more than that, it restricts the Argentine authorities' freedom of movement.

Every peso in circulation has to be backed by a dollar in the central bank reserves, and Argentina loses the power to set its own interest rates.

Under the currency board, therefore, Argentina has effectively imported its monetary policy wholesale from the United States.

This sort of move can work wonders in bolstering investor confidence in shaky economies, and was followed by a host of countries in the 1990s, including Hong Kong, Bulgaria and Estonia.

Faith no more

But a currency board is rather like the emperor's new clothes - only good as long as everyone has faith.

Earlier this year, the effects of a prolonged recession, and clumsy government attempts to tinker with the system, fatally undermined faith in the peso.

Convinced that the currency board would sooner or later be abandoned, the markets launched an out-and-out assault, creating the sort of instability and uncertainty that raised bigger questions about the country - notably, whether it would prove able to service its debt.

Ironically, the currency board - set up originally to eliminate uncertainty in the Argentine economy - has become the main source of panic, a symbol of all that was wrong with the country.

What's the alternative?

Trouble is, alternatives to the currency board are few, and fraught with danger.

Investors have lost confidence in government policy

The most tempting alternative - if only because it would represent the most complete change from the status quo - would be to abandon the currency board entirely, allowing the peso to float freely.

This is the traditional remedy of governments in trouble, adopted in recent years by a number of countries, including Russia, Brazil and Turkey.

Invariably, the currency plunges against the dollar once controls are lifted (the rouble lost 75% of its value in August 1998), which can help give a jaded economy a temporary boost.

More risk than reward

But this could be the most dangerous course.

Although Argentine exporters would benefit from a weaker peso, the price of imported goods would soar, provoking disastrous inflation - a reminder for Argentines of the traumatic 1980s, when restaurant bills had to be paid before midnight in order to ensure the price had not gone up.

Under such circumstances, peso-based assets, notably savings and pensions, would wither away in value, hitting hardest at some of the weakest members of society.

Wages of public-sector workers, unless they were in some way linked to the dollar, would dwindle in real terms, and Argentines would rush to get their money out of the country.

The banking system, with its heavy investments in local financial markets, would be thrown into chaos.

And in the longer term, a surprise devaluation would raise nervousness among investors, who invariably prefer continuity to nasty surprises.

Goodbye to the peso

The other big alternative is to swing in entirely the other direction, and adopt the US dollar as the country's official currency.

This is not as bizarre as it sounds: a number of countries, including Panama and Ecuador, have done precisely that, and dollarisation was a policy much discussed under the presidency of Carlos Menem, Fernando de la Rua's predecessor.

Since the peso is currently pegged to the dollar, and Argentine interest rates are effectively set by the US Federal Reserve, the total shift to the dollar would be merely a matter of changing the banknotes in circulation.

And, its proponents argue, it would have far more credibility than the currency board, opening up the possibility that the Fed could be persuaded to underwrite the Argentine financial system.

Dollar difficulties

But this alternative, too, is deeply flawed.

For a start, there is no guarantee that the US authorities would provide Argentina with any kind of assistance.

Although any country in the world is free to adopt the dollar as its currency, none qualify automatically for US help as a result.

Withdrawing pesos and distributing dollars would be a huge and expensive process, akin to the current introduction of the euro in Europe.

If this brings no special privileges from the mighty US, it might be a vast effort for absolutely no result.

And unlike the currency board, it is not easily reversed, and can prove politically unpopular, since it represents a highly visible abdication of economic control.

Muddle in the middle

In the end, Argentina - like most of its emerging-market peers - will probably opt for some sort of third way.

This could be a so-called "managed float", under which exchange-rate limits are set for the currency, with the promise of intervention and international support if those limits are breached.

A vast range of emerging-market currencies, from the Hungarian forint to the Singaporean dollar, use this sort of hybrid mechanism.

Pundits prefer them as a general rule, because they combine a dose of free-market flexibility, with a relatively solid backing from policy-makers.

Far from perfect

Like all compromises, this won't really convince anyone.

A slightly floating currency represents a tempting target for the speculators, and financial authorities have to spend much time, effort and money in keeping the whole tottering structure in place.

And crafting such mechanisms, which can come a wide variety of permutations, is an art in itself.

Looking for guidance in the labyrinth of foreign exchange policy won't help the Argentine government.

A mass of academic research into currency markets has only revealed the frustrating truth that there is no recipe for success - countries have to find their way through trial and error.

Argentina has certainly made plenty of errors so far.

As far as the peso is concerned, it can't afford many more.