Currency pegs: Is the game over or just beginning?

Global Finance, Feb 2002 by Platt, Gordon

EXCHANGE RATE POLICY

Hong Kong authorities strengthen resolve to maintain dollar peg, while Canada debates adopting the US dollar as its currency. * By Gordon Platt

Common wisdom holds that by pegging its peso to the US dollar for nearly 11 years, Argentina obstinately held to an ill-conceived exchange rate system that made its exports non-competitive and ended in a world record default. Not so, according to some economists, who point to, along with other evidence, countries where currency pegs are working well.

Exports were the only bright spot in Argentina's troubled economy in recent years, says Steve Hanke, professor of applied economics at Johns Hopkins University in Baltimore and a senior fellow at the Cato Institute in Washington, DC. "Argentina's exports rose 4% last year while the economy slumped, so the uncompetitive story is out the window," he says.

Hanke believes there are more than 60 countries that should replace their central banks with currency boards. "For developing countries, currency boards are superior to central banks and result in lower interest rates!

Preventing Currency Meltdown

Call it a self-imposed hair shirt. Currency boards are rule-bound monetary institutions whose purpose is to buy or sell any amount of domestic currency at the pegged rate for the reserve currency, usually the US dollar. Under such a system, the government promises to hold reserve currency at least equal to the amount of local currency in circulation.

Dollarization is the best way to prevent a currency meltdown and hyperinflation, Hanke argues. According to Therese Feng, associate director-sovereign at New York-based rating agency Fitch IBCA, Duff & Phelps, since 1983 Hong Kong's US-dollarlinked exchange rate system has maintained stability of and confidence in the Hong Kong dollar through emerging market financial crises, transfer of the territory's sovereignty, and profound economic transformation.

If Hong Kong were to come off the dollar peg, Feng says, the damage to its financial and currency stability and to its policy credibility would be substantial. "Breaking the peg would undermine Hong Kong's vital role in raising foreign capital for mainland Chinese enterprises," Feng says.To cope with any possible attacks on the dollar peg, Hong Kong authorities have accumulated a high level of reserves and have openly stated that they will defend the peg at any cost.

Dollarization Brings Immediate Benefits

Meanwhile, the foreign affairs committee of Canada's House of Commons plans nationwide hearings on the question of whether Canada should consider adopting the US dollar.The Canadian dollar, which was worth $0.90 a decade ago, has fallen below $0.63. Canada and the United States are the two biggest trading partners in the world. While Prime Minister Jean Chretien has so far rejected calls for adopting the US dollar, the mere fact that Canada is having such a debate is significant.

Hanke of Johns Hopkins says the euro zone countries, which locked their exchange rates against the euro in 1999, are operating just like a currency board. "And take a look at Ecuador, the fastest-growing economy in Latin America this year,"Hanke adds."Ecuador announced dollarization two years ago, and within weeks the economy turned around."

Lack of confidence in the Argentine peso is that country's biggest immediate obstacle to economic growth, Hanke says. "Who will trust a floating peso?" he asks."By the end of this year, we will have a rate of around 3.0 pesos to the dollar, Argentina's gross domestic product will fall by 50% in dollar terms, and its demand for US exports will dry up." That hair shirt might not seem so itchy after all.