POLICY   RESEARCH WORKING         PAPER        29 8 0
Living and Dying with Hard Pegs
The Rise and Fall of Argentina's Currency Board
Augusto de la Torre
Eduardo Levy Yeyati
Sergio L. Schmukler
The World Bank
Development Research Group
Macroeconomics and Growth
March 2003



PoiLIcY RESEARCH WORKING PAIPER 2980
Abstract
The rise and fall of Argentina's currency board shows the     abandonmenlt of the currency board and a sovereign debt
extent to which the advantages of hard pegs have bcen         default. The crisis can be best interpreted as a bad
overstated. The currency board did provide nomilinal          outcome of a high-stakes strategy to overcome a weak
stability and boosted financial intermediation, at the cost   currency problem. To increase the credibility of the hard
of endogenous finaicial dollarization, but did not foster     peg, the government raised its exit costs, which deepened
monetary or fiscal discipline. The failure to adequately     the crisis once exit could no longer be avoided. But some
address the currency-growth-debt trap into whichi             alternative exit strategies would have been less
Argentina fell at the end of the 1990s precipitated a run     destructive than the one adopted.
on the currency and the banks, followed by the
This paper-a product of Macroeconomics and Growth, Development Research Group-is part of a larger effort in the
group to understand 1ow currency regimes work. Copies of the paper are available free from the World Bank, 1818 H Street
NW, Washinigton, DC 20433. Please contact Emily Khine, room MC3-347, telephone 202-473-7471, fax 202-522-3518,
emilail address kkhiie@tworldbank.org. Policy Research Working lPapers are also posted on the Web at http://
econ.worldbank.org. The autIlors may be contacted              at adelatorre@Rworldbank.org, elyv@utdt.edu, or
sschmuklcr@worldbank.org. March 2003. (54 pages)
hlbe P'olic Research Working Paper Series disseminates the findings of ivork in progress to encourage the exchange of ideas about
developmient issuies Anl objective of the series is to get the findings ouit qtickly, eveni if the presentations are less than fully polisbed. The
papers carry the iarnes of the atbhors and shouild be cited accordingly. The fiuidcigs, interpretations, and coniclisionis expressed in this
paper are enitirely those of the autlbors. They do n(ot niecessartiy represent the vienv of the WIorld Bank, its Executtive Directors, or thse
counitries tls)e represent.
Produced by the Research Advisory Staff



Living and Dying with Hard Pegs:
The Rise and Fall of Argentina's Currency Board 0
Augusto de la Torre
World Bank
Eduardo Levy Yeyati
Universidad Torcuato Di Tella
and
Sergio L. Schmukler
World Bank
Keywords: exchange rate regime; currency board; dlollarization; floating; currency crisis;
banking crisis; convertibility
JEL classification: E44, F30, 31, F33, F36, F41, G21, G28
s Authors are Senior Financial Sector Advisor, Latin American and the Caribbean Region, Professor, and
Senior Economist, Development Research Group, respectively. An earlier version of this paper was
circulated as "Argentina's Financial Crisis: Floating Money, Sinking Banking." We are gratef il to Alberto
Ades, Javier Bolzico, Jerry Caprio, Jos6 De Gregorio, Graciela Kaminsky, Paul Levy, Sole Martinez Peria,
Guillermo Perry, Andrew Powell, Roberto Rigob6n, Luis Serven, Federico Sturzenegger, Ted Tnuman,
Andr6s Velasco (the editor), Charles Wyplosz, as well as participants at seminars held at Columbia
University, the LACEA Annual Meeting (Madrid), and Universidad Torcuato Di Tella for helpful
comments. We thank Tatiana Didier, Mariano Lanfranconi, Ana Maria Menendez, Josefna Rouillet, and
particularly Marina Halac for excellent research assistance. We thank Laura D'Amato, Femanda
Martijena, and Maria Augusta Salgado for help with the data. The views expressed in this paper are
entirely those of the authors and do not necessarily represent the views of the World Bank. E-mail
addresses: adelatorrealworldbank.org. elv(.utdt.edu. and sschmukleri)worldbank.or .






1.    Introduction
The rise and fall of Argentina's currency board (a textbook model of a rigid
exchange rate regime for more than 10 years) and the subsequent financial system
collapse yield important lessons for the debate on exchange rate regimes for developing
countries.' As expected, the Argentine case has already generated an extensive debate on
the causes and policy implications of the crisis.2 Current explanations, however,
concentrate too much on the latest years and do not pay enough attention to the
underpinnings of the currency board and to its implications for the financial system and
the economy at large.
In this paper, we study the Argentine experience from a perspective that links
money (in its function as store of value) and financial intermediation. This approach has
important advantages. By organizing the discussion of the different intervening factors
around a main motive, it allows us to balance the broadness of a comprehensive survey
with the focus needed to extract fairly general lessons. More importantly, it enables us to
highlight the role played by the currency board in the development of the financial sector
during the 1990s and in the genesis of its collapse. It also allows us to better understand
the nature of the currency-growth-debt (CGD) trap into which Argentina fell during the
late 1990s, and how it eventually led to a currency and bank run that precipitated a
devastating economic crisis.
In light of the Argentine experience, we argue that the benefits of hard pegs have
been much overstated. To be sure, by providing savers with the dollar as the store of
value (directly under dollarization, or via the peg under currency boards), a credible hard
peg ensures nominal stability and boosts financial intermediation. But even if credible, a
hard peg does not automatically lead to the emergence of alternative nominal flexibility
(particularly in wages, fiscal spending, and financial contracting) to compensate for the
loss of the nominal exchange rate as a policy instrument. This is particularly problematic
in the case of hard peg countries that, like Argentina, do not meet the classical conditions
for an optimal currency (dollar) area. Partly as a result, hard pegs do not per se induce
fiscal or even monetary discipline. The monetary framework of a harcd peg, although
typically protected by a heavy legal and institutional armor, can be dismantled more
easily than expected through the emergence of quasi-monies in response to extreme
budgetary cash flow pressures coupled with insufficient nominal flexibility in fiscal
spending and public sector wages. Moreover, with its credibility being a positive
function of its exit costs, a hard peg creates powerful incentives for the government to
raise exit costs further (re-double the bet) when the hard peg is under pressure. A
paiticular way in which hard pegs endogenously raise exit costs is by fostering
dollarization, including of the liabilities of debtors in the non-tradable sector-as the
government would rather not adopt measures to explicitly discourage dollarization for
fear of undermining the credibility of its commitment to the hard peg.
' See Frankel et al. (2001) for a brief history of this debate.
2 See among others, Feldstein (2002), Calvo, lzquierdo, and Talvi (2002), Perry and Serven (2002), Mussa
(2002), Hausmann and Velasco (2002), and Powell (2002).
1



Exiting a hard peg is inherently a very painful affair, given the contradiction
between hardening the peg and allowing for a smooth exit. But some ways of exiting can
be more disastrous than others. We analyze the Argentine experience to draw lessons on
alternative exit strategies.  With the benefit of hindsight and the caveats of any
counterfactual analysis, we argue that the forcible pesification of existing financial
contracts ("stock pesification") was the most costly choice, for it was bound to cause an
excessive destruction of property rights with long-lasting consequences for financial
intermediation and, by creating a massive peso overhang in the midst of a currency run,
was likely to rekindle the deposit flight and exacerbate the exchange rate overshooting.
By contrast, an early (before 2001) exit into full dollarization (of financial contracts and
money in circulation) might have averted the bank run, thus protecting financial
intermediation and the payment system, but would have done nothing to mitigate the
deflationary and recessionary costs of a protracted adjustment of the real exchange to a
more depreciated equilibrium level. In this light, we find support for an intermediate exit
option: dollarization of existing financial contracts ("stock dollarization") to respect the
widespread use of the dollar as store of value, combined with "pesification at the margin"
(for instance, via the consolidation of the existing pesos and quasi-monies into a new
national currency) to exploit the use of the peso as means of payment and unit of account,
which remained extensive and resilient throughout the convertibility period and even
during the run.3 While this alternative would not have spared Argentina from significant
banking system stress and even some individual bank failures, as debtors in the non-
tradable sector would have seen their balance sheets and payment capacity adversely
affected by the real exchange rate correction, it might have provided a margin of nominal
flexibility while avoiding a systemic financial collapse and the unnecessary destruction of
property rights.
Within the terms of the exchange rate debate, the failure of the Argentine currency
board is sure to elicit two reactions. On the one hand, bipolar proponents may conclude
that currency boards are not hard enough and that sustainable pegs have to go all the way
to formal dollarization. On the other, hard peg critics may interpret the case as evidence
that the regime debate has been settled in favor of fully floating regimes. We argue that a
one-dimensional emphasis on pure fix versus float dilemma is insufficient and can even
be misleading. It would be more productive to focus on the weak currency problem that
plagues most emerging economies and on the need to build healthy links between money
(in its function as store of value) and financial intermediation, while establishing
adequate flexibility, including in financial contracting, to facilitate adjustment to shocks.4
3It is useful to state at this point that we do not favor re-dollarization of contracts once the costs of
pesification have been largely incurred, as a previous version of the paper might have mistakenly led to
believe (see, among others, The Economist 2002).
4 Underscoring this view is the need for institutional building irrespective of the exchange rate regime of
choice. The case of Argentina clearly illustrates the difficulties of importing monetary institutions through
the adoption of a peg. We conjecture that these difficulties would not have been bypassed by unilateral
dollarization.
2



The rest of the paper is organized as follows. Section 2 analyzes the rise and fall
of convertibility, distinguishing between the good times of financial deepening that were,
nonetheless, accompanied by persistent and rising financial dollarization, and the bad
times that witnessed the fall of the Argentine economy into a CGD trap from which it
could not break free, and the resulting meltdown, triggered by a massive run on the
currency that evolved into a deposit run. Section 3 draws lessons from the Argentine
experience on hard pegs: their limitations as commitment mechanisms, their specific
prudential concerns, and the alternative exit strategies. Section 4 offers some final
remarks.
2.    The rise and fall of Argentina's currency board
It was never a mystery that the rigid peg of the peso to the dollar under
convertibility was a highly inconvenient choice from the point of view of Argentina's
trade and productive structure. In effect, Argentina is far from meeting the conditions for
an optimal currency (dollar) area. It is subject to typically different shocks than the U.S.,
it has a substantial share of its foreign trade with countries whose currencies fluctuate vis-
a-vis the U.S. dollar and, as a relatively closed economy with a large non-tradable sector,
could benefit much more (compared to open economies with relatively small non-
tradable sectors) from nominal exchange rate adjustments to correct for misalignments in
the relative price of tradables to non-tradables.
Convertibility was chosen in Argentina despite the mentioned reasons and not
even in light of long-term growth considerations. It was a decision understandably driven
by overriding monetary and financial considerations. Convertibility in fact arose as an
extreme response to hyperinflation and the consequent implosion of financial
intermediation that had taken place in the 1980s, and against a much longer history of
repeated episodes of debasement of the domestic currency and fiscal mismanagement.
From its introduction in April 1991, however, convertibility was much more than
a simple peg or an expedient exchange rate arrangement to conquer inflation. For
starters, the peg was embedded in a broader monetary arrangement that featured, at its
heart, a money issuance rule that legally precluded the creation of pesos not backed by
hard dollars, except within a very limited range.5 Convertibility was intended to produce
a nonreversible break away from monetary and financial instability. It was expected to
mark for the Argentine psychology a point of no return and a one-way path forward,
much like Hernan Cortez's decision to burn the ships had marked for his crew.
Moreover, convertibility was from the outset envisioned to have implications well
beyond the pure monetary sphere, for it aspired to become an institutional axis that would
help put order in other institutions and align incentives among agents, particularly in the
economic sphere (fiscal process, bank regulation, labor markets, etc.) but also in the
social and political spheres. Convertibility indeed became a central ccimponent of the
5 The law allowed for up to one-third of disposable international reserves to be constituted with
internationally traded, dollar-denominated Argentine sovereign bonds, valued at market prices. This
proviso enabled a very limited role for the central bank as lender of last resort-it could create and provide
peso liquidity to the banking system in exchange for sovereign Argentine bonds, rather than hard dollars.
3



social contract, a key institution in the economic and political life of the country.
Convertibility was not a contract like any other; it was rather a core or master contract,
one upon which other (financial and non-financial) contracts depended.
Mr. Cavallo, Minister of Economy of Argentina at the beginning and at the end of
the convertibility decade (1991-2001), used to insist that there was, by design, only one
way to exit convertibility in accordance to the law-that is, once the Argentine peso had
established itself as an international currency, and a strong one at that. In effect, the
convertibility law stated that the central bank would stand ready to buy and sell dollars at
no more than one peso per dollar. By implication, the central bank could eventually buy
dollars at less than one peso per dollar. Obviously, the catastrophic manner in which
convertibility collapsed in January 2002 was a far cry from the glorious exit that had been
envisioned by its framers in April 1991.
What explains this massive departure of reality from vision? In the remainder of
this section we attempt an explanation. Convertibility did deliver broadly according to
promise with respect to the deepening of the financial system, although at the cost of a
persistent and rising level of financial dollarization.' In contrast, convertibility failed to
deliver with respect to the expectation that, being a permanent monetary "straightjacket,"
it would, by itself, discipline the fiscal process and induce reforms that would endow
Argentina with adequate nominal flexibility (particularly in fiscal spending and wages) to
compensate for the absence of nominal exchange rate flexibility. Such a failure became
particularly taxing after 1998, as the country was increasingly caught in what we label a
currency-growth-debt (CGD) trap that ultimately precipitated the collapse.
2.1.   Good times:financial deepening and increased dollarization
Out of the ashes left by hyperinflation and financial disarray in Argentina in the
1980s, the one-peso-one-dollar rule of convertibility quickly restored the function of
money as a store of value, thereby enabling a rapid regeneration of financial
intermediation as reflected a steep growth of bank deposits and loans throughout 1999
(Figure 1).' Moreover, the rapid taming of inflation brought about by convertibility
greatly enhanced the political viability of a number of first generation reforms that the
nominal instability of the past had rendered infeasible. Rapid changes thus swept the
Argentine economy in the first phase of convertibility, particularly with the restructuring
of the external debt (under the Brady Plan), a tax reform centered on the VAT, a series of
privatizations, social security reform, and the deregulation of financial markets. This,
combined with a wave of capital flows to emerging economies in which Argentina shared
6 By financial dollarization we refer to the holding by residents of foreign currency-denominated assets and
liabilities. As argued in Ize and Levy Yeyati (2002), financial dollarization reflects mostly an asset
substitution phenomenon (that is, the use of a foreign currency as store of value), as opposed to currency
substitution (that is, the use of the foreign currency as unit of account and means of payment).
' After a major step increase between 1991 and 1994, banks deposits continued rising steadily from 17
percent of GDP by the end of 1994 to 26 by the end of 1998. Calomiris and Powell (2001) compellingly
show that convertibility is indeed key to understanding the rapid growth and strengthening of the financial
system in the 1990s.
4



prominently, fueled aggregate demand and boosted GDP growth to a brisk average of 6.4
percent per annum during 1991-1998 (9.1 pe:rcent during 1991-1994), well above the
Latin American average of 3.7 percent in 1991-1998 (4.3 percent in 1991-1994).
The sustainability of convertibility's early successes was transitorily but severely
questioned during the Mexican (Tequila) crisis of 1995. The Tequila contagion led to a
major run on the Argentine peso and bank deposits. Deposits fell by almost 20 percent in
a span of few weeks, nearly bringing down the financial system and convertibility with it.
This crisis marked a turning point in financial sector policy. The authorities responded
by affirming convertibility, while recognizing that its viability required a particularly
resilient financial system given the limits imposed by the currency board on the central
bank to act as lender of last resort. They launched a series of ambitious financial sector
reforms to give effect to this conviction, as illustrated in Appendix Table 1.
The results were impressive according to any standard.! The banking system
consolidated and became internationalized, while many public banks were privatized (see
Table 1). By the end of the 1990s, a resilient banking system was the crown jewel of
convertibility-induced reform. Convertibility did not lead to strong fiscal institutions,9
but few doubted that it had led to a shock-resistant banking sector.
The banking system was arguably in a. very solid position before the Brazilian
devaluation of January 1999, and was still reasonably healthy through the end of 2000,
despite the post-1998 continued economic contraction. In effect, comrnon indicators of
financial health, shown in Table 2, depict a well capitalized, strongly provisioned, and
highly liquid banking system through the year 2000, although a system experiencing
losses and increasingly burdened by bad loans after 1998. '
The Tequila aftermath affirmed convertibility as a central piece in the social
contract, with post-1994 reforms creating a banking system that, though costly, appeared
convertibility-compatible in most respects. Towards the end of the decade, the financial
system's prudential buffers were sufficient to withstand sizeable liquidity and solvency
shocks-including a flight of about one-third of'the deposits as well as further significant
8 So much that by 1998 Argentina ranked second (after Singapore, tied with Hong Kong, and ahead of
Chile) in terms of the quality of its regulatory environrnent, according to the CAMEILOT rating system
developed by the World Bank. This system combined separate rankings for capital requirements (C); loan
loss provisioning requirements and definition of past-due loans (A); management (M), defined by the
extent of high-quality foreign bank presence; liquidity requirements (L); operating environment (0) as
measured by rankings with respect to property rights, creditor rights, and enforcement; and transparency
(T), as measured by whether banks are rated by international risk rating agencies and by an index on
corruption. Argentina ranked first for C (tied with Singapore), fourth for A, third for M, fourth for L,
seventh for 0, and second for T. For details see World Bank (1998), pp. 39-61 and Appendix A.
9 See Gavin and Perotti (1997) and Tornell and Velasco (2000).
'0 Profits turned negative already in 1998 and became deeply negative during 1999-2000 partly because of
the need to constitute provisions in the face of rising bad loans. NPLs rose to 11.6 percent of total loans in
2000, from 10.5 percent the year earlier (Table 2).
5



decay in the loan portfolio-without endangering convertibility."        The important
presence of reputable foreign banks (they accounted for over 70 percent of total banking
assets in 2000, as shown in Table 1) was broadly perceived to implicitly augment these
liquidity and solvency cushions. These banks were expected to stand behind the capital
and liquidity of their affiliates in Argentina, at least in the context of bad states of the
world associated with bad luck. (Few were thinking then of bad states of the world
caused directly by confiscatory government policy.)
The remarkable strengthening of the banking system was accompanied by a
persistent and rising level of financial dollarization. This phenomenon was not part of
the intention of the framers of convertibility. But it was an almost inevitable corollary of
policy incentives created by convertibility itself coupled with a stubborn market
perception of exchange rate risk that convertibility could not remove, despite its heavy
institutional and legal armor.
The founders of convertibility envisioned a strong peso as the way for an elegant
and almost natural exit from the one-peso-one-dollar rule. Such an aspiration, however,
could not be easily translated into measures to discourage financial dollarization. This
was because of the risk that such measures be interpreted by the market as an indication
that the authorities themselves did not think that the one-peso-one-dollar rule was to
endure under most states of the world. Hence, the authorities faced incentives not to
adopt prudential norms (e.g., loan classification and provisioning rules, liquidity
requirements) that would explicitly discourage the use of the dollar in financial
contracts.'2 Similarly, the government did not issue peso debt in domestic markets not
just because dollar debt was less costly, but also because incurring the additional cost
could only have been interpreted as a hedge against a future devaluation, undermining the
confidence in the one-to-one rule that convertibility was meant to inspire.
At the same time, markets did not fully take to heart the mantra of "no more than
one peso for one dollar, forever."     Instead, they continued to attach a nontrivial
probability to the risk of a nominal devaluation of the peso. This perceived currency risk
was a key factor behind a peso problem that persisted throughout the 1990s, spiking
during turbulent times, as shown in Figure 2. 3
The lasting perception of a residual risk of nominal devaluation, together with the
mentioned incentives faced by the authorities (which resulted in an essentially currency-
blind prudential framework), constitute an important part of the explanation of the rise in
" Table 2 puts systemic core liquidity (disposable international reserves of the central bank plus foreign
exchange in cash or near-cash held abroad by banks) at about 39 percent of banking system deposits at end-
2000. However, there was a significant variance in the distribution of such liquidity across banks. This
may explain why the "corralito" was imposed at the end of 2001 before deposits had fallen by 30 percent.
12 We come back to this point in the next section.
'3 The interest rate differential reflected not only exchange rate risk, but also default risk as discussed in
Broda and Levy Yeyati (2001) and Schmukler and Serven (2002).
6



financial dollarization throughout the convertibility decade.'4 Dollarization permeated
both private and public sector financial assets and liabilities, and was very significant in
loans to the non-tradable sector. Figure 2 shows the steady rise in the share of dollar
credit in total credit to the private and public sectors. The first panel of Figure 3 shows
that dollarization of mortgage loans (that is, loans to an important non-tradable sector)
increased significantly since 1994, while the second panel of the same figure shows that
dollar debt, as indicated by firms' balance sheets, was even higher for non-tradable firms
than for tradable ones.
Dollarization of public sector debt also rose significantly, and not just in terms of
bank credit to the public sector. In particular, the public debt made explicit as a result of
the reform in the social security system was denominated in dollars. At the same time,
certain other policies taken by the public sector encouraged real dollarization-for
instance, the decision to allow public utility tariffs to be denominated in dollars (done to
reassure a dollar income to the privatized utility companies, thus recognizing that
convertibility was not fully credible in the view of such companies).
Financial dollarization in Argentina reflected an asset substitution phenomenon (a
shift to the dollar as a store of value), and was accompanied by currency substitution (a
shift to the dollar as a unit of account and means of payment) only to a minor degree.
Dollar pricing was limited mostly to internationally traded goods and big-ticket items
such as real estate, and use of the dollar for everyday transactions was rather marginal, as
reflected in marked differences in dollarization ratios for different types of bank deposits
(Figure 4).  Time deposits became increasingly dollarized during convertibility.    In
contrast, the degree of dollarization of passbook saving accounts, albeit high (about 40
percent), remained relatively stable throughout the 8 years ending in 2000. Moreover, the
degree of dollarization of demand deposits was strikingly low (well under 10 percent)
and stable during most of the decade. "5
To be sure, the authorities tried an indirect avenue to deal with the currency risk
associated with financial dollarization through prudential norms-namely the interest rate
factor.'6 As explained in Appendix Table 1 and shown in Table 3, regulatory capital
requirements for credit risk were not only determined in line with the typical Basle-type
procedure of applying higher weights to riskier loan classes. They also tried to take into
account the risk of individual loans within each loan class. This was operationalized by
increasing the weight applied to individual loans that charged higher interest rates-i.e.,
by adding a so-called interest rate factor. The underlying assumption was that if banks
price risks correctly, these should be fully reflected in the lending interest rate. The norm
14 The peso problem was not independent of the degree of financial dollarization, as explained at the end of
this section.
15 The evidence of a resilient transactional demand for pesos was ultimately confirmed by the stability of
real peso balances following the abandonment of convertibility, as we show below. Even after the
corralito was lifted in December 2002, M1/GDP remained slightly above its historical levels. The
distinction between currency and asset substitution will play a crucial role when we come back to the exit
strategy problem in the next section.
16 We thank Andrew Powell for raising this point.
7



was initially designed to take into account different interest rate scales and thresholds
depending of the currency of loan denomination (Table 3). This innovative system was
probably effective in capturing some risk differences across loans, but failed at capturing
the specific risk of dollar loans to the non-tradable sector (a point further discussed in
Section 3). Rather, the interest rate factor may have encouraged dollarization because it
was in fact higher for peso loans than for dollar loans, given that the peso problem
entailed systematically higher peso interest rates (Figure 5). Moreover, in 1999, when
currency risk became a source of policy concern, the differentiation in the interest rate
factor according to the currency of loan denomination was eliminated-yet another
example of the contradictions inherent in the convertibility game of continuously raising
the stakes.
At any rate, the increasing level of financial dollarization further affirmed the one-
peso-one-dollar but at the expense of the peso-i.e., by departing from the admittedly
unrealistic vision of a strengthening peso that, as noted earlier, was held by the
convertibility framers. As financial dollarization persisted and increased, it also became
clearer that a disorderly breakdown of the one-peso-one-dollar rule would be an
unmitigated catastrophe-it would wreck the solvency of debtors in the non-tradable
sector and, hence, of the banking system. As such, dollarization was not an undesirable
side effect but rather a crucial ingredient in the convertibility scheme: by increasing the
exit costs, it reinforced the "burning-of-the-ships" effect.
The high level of financial dollarization appears to have been a key factor behind
the ambivalence of investor confidence in the currency board and the easy shifts in
market sentiment. On the one hand, by raising the stakes and creating incentives in favor
of policies that would not undermine convertibility, in tranquil times dollarization seems
to have reinforced the perception that convertibility would endure, which was reflected in
a peso premium that, at its minimum, was remarkably low (Figure 2). On the other,
during times of financial turbulence when the sustainability of the currency board was put
to test, high dollarization exacerbated investor anxiety and the currency premium spiked
sharply. By raising the costs of exit from the currency board to catastrophic levels,
dollarization seems to have increased the scope for multiple equilibria and self-fulfilling
runs, as manifested in a highly volatile currency premium.
2.2.  Bad times: a currency-growth-debt trap
Right from the beginning of the De la Ruia administration (which assumed power
in December 1999), the Argentine economy was caught in a CGD trap. The currency
was overvalued, growth was faltering, and the debt was hard to service. This trap was in
no small part due to major external shocks. This section analyzes the elements of the trap
and the policy failures in addressing them.
The Argentine peso appreciated sharply relative to most trading partners, in
tandem with the revaluation of the U.S. dollar vis-a-vis European and emerging market
8



currencies (particularly the Brazilian real)." The real exchange rate (RER) overvaluation,
in turn, masked the precariousness of Argentina's sovereign debt position. To be sure,
the reported debt-to-GDP ratio, while on the rise (from less than 40 percent in 1997 to
over 50 percent by the end of 2000), was not high in comparison to other Latin American
countries. However, when measured at the equilibrium RER, the debt-to-GDP ratio was
very high and assailed by a potentially explosive dynamic. Perry and Serven (2002)
estimate that, relative to a benchmark analysis of fiscal sustainability, the use of the
equilibrium RER in the sustainability calculation adds 24 percentage points to the public
sector debt-to-GDP ratio in 2001, and leads to an average increase of about two
percentage points in the annual primary fiscal surplus required (in 2000-2003) to attain
inter-temporal fiscal solvency.
After 1998, Argentina slipped into an unyielding economic recession and rising
unemployment,'8 triggered by a sudden stop in capital flows that, while regional in its
origins, was particularly acute and persistent in Argentina after the 1999 Brazilian
devaluation.'9 This capital flow reversal, together with doubts about fiscal viability, was
reflected in sharp increases in the marginal cost of capital for Argentina (as measured by
the spread of Argentine bonds over U.S. Treasury bonds), reinforcing pessimistic
expectations regarding future growth and fiscal revenues, and exacerbating the perception
of a potentially explosive debt trajectory. All of this fed doubts about the sustainability
of the one-peso-one-dollar commitment.20
The government's strategy to break free from the CGD trap focused on reviving
growth, although the means to achieve this objective changed dramatically after April
2001, when Mr. Cavallo took the post of Minister of Economy.2' During 2000, growth
resumption was sought indirectly-trying to regain investor confidence through fiscal
adjustment, including the tax increase ("impuestazo") enacted in January 2000. It was
hoped that improved confidence would eventually lead to more capital inflows and
growth, making the debt and current account sustainable. To be sure, the authorities also
tried to address the problem of currency overvaluation indirectly, through a rather
" Perry and Serven (2002), for example, estimate that, by the year 2000, the Argentine RER was
overvalued by about 50 percent. While estimates may diverge, the perception of overvaluation was
widespread both at home and abroad.
18 GDP shrank by nearly 4 percent in 1999 (although it registered a rather strong, albeit fleeting, revival in
the last quarter of 1999). GDP continued to contract at about 2 percent per year in 2000-2001. Open
unemployment rose from about 13 percent in 1998 to over 15 percent in 2000.
'9 Perry and Serven (2002) provide evidence that: (i) during 1999 Argentina was not affected as severely as
other countries in Latin America by the slowdown in capital flows; and (ii) the sharp reversal of capital
flows to Argentina in 2000-2001 was mainly endogenous to domestic factors.
20 Some people still argue that the currency was not overvalued, as most observers claimed at the time.
Note, however, that, even if this was the case, a widespread belief that the currency is overvalued is enough
to generate a preventive retrenchment of capital flows that could give rise to a CGD trap, as described in
this section. See Razin and Sadka (2001) for an analytical discussion.
21 See Appendix Table 2 for a chronology of the political and economic events.
9



marginal flexibilization of labor markets.22 In addition, as confidence was not restored
and growth failed to pick up, the authorities shifted their attention towards calming fears
of a possible debt default. The December 2000 IMF bailout package (advertised as a
US$40 billion package) was negotiated with this latter objective prominently in mind.
However, none of these actions achieved the expected results and hopes of reviving
growth faded away.
Minister Cavallo banked on his prestige to pull off the rescue. Empowered by
Congress with special powers, he focused on rekindling growth, but this time directly,
through heterodox measures. These included imposing a tax on imports and subsidizing
exports (a fiscal devaluation for trade transactions), lowering reserve requirements, and
announcing the eventual peg of the peso to the dollar and the euro (with equal weights),
once these two currencies reached parity. From hindsight, it is clear that the growth-
focused strategy, particularly in Mr. Cavallo's heterodox version, was half-blind. It not
only did not yield growth, it also escalated the uncertainty about the debt and currency
components of CGD trap. 23
Doubts about the maintenance of the one-to-one correspondence of the peso to the
dollar soared after April 2001 (Figure 2).24 This correspondence had already been broken
through the back door for trade transactions and it was feared that it could be broken also
for financial transactions. In addition, Mr. Cavallo had pushed successfully for the
resignation of central bank president Pedro Pou, who was viewed by investors as a strict
guardian of monetary and banking system soundness.' Moreover, Mr. Cavallo used his
special powers to reform the central bank charter, removing limits on the ability of the
central bank to inject liquidity, thereby effectively dismantling the money-issuance rule
that underpinned convertibility.26
22 The approval of the labor market reform was linked to a bribery scandal, in which senators were accused
of receiving payments from the government to approve the law. The scandal was unresolved, leading to the
resignation of vice president Carlos Alvarez.
23 Whether this risky bet was justified ex-ante is difficult to ascertain given the foreseeable costs of
attempting an early exit. At any rate, the decision illustrates how a government facing a dilemma between
a sure loss and an improbable salvation is tempted to gamble by adopting desperate measures that make the
loss even larger in the event those measures fail.
24 For a detailed chronology of the impact of political and economic announcements on the currency
premium, see Schmukler and Serven (2002).
25 At the time of this writing (January 2003), the Argentine Supreme Court was discussing the
constitutionality of Mr. Pou's forced resignation.
26 As mentioned above, prior to the April 2001 amendments to the central bank charter, dollar-
denominated, internationally traded Argentine government bonds valued at market prices could be treated
as part of the country's disposable international reserves. After the amendments, the claims on the
government received by the central bank (in repo or as collateral) in the context of its liquidity operations
with the banking system no longer counted as part of the maximum of 33 percent of disposable
international reserves. Thus, the April 2001 amendments enabled unlimited injection of lender of last
liquidity with the backing of government paper, thereby effectively eliminating the money issuance rule of
convertibility. In practice, the claims on the government that the central bank received as part of its lender
of last resort activity during 2001 did not exceed the 33 percent limit. Nevertheless, the amendment
contributed to increasing the doubts that the currency board would be maintained.
10



At the same time, uncertainty about the debt component of the CGD trap grew as
the government procrastinated in taking a decision on the debt. Instead cf accepting that
an orderly approach to debt reduction was becoming a necessity following the failed
attempts to restore growth, the government averted debt service arrears temporarily by
absorbing the liquidity of the financial system--mainly of banks and pension funds. In
particular, in April 2001, the government used moral suasion to place US$2 billion of
bonds with banks in Argentina, allowing banks to use those bonds to meet up to 18
percent of the liquidity requirement. The banking system thus became less liquid and
more exposed to a government default. Total banking system claims on the government
rose gradually from less than 10 percent of total bank assets at the end of 1994 to 15
percent at the end of 2000, and jumped to over 20 percent by end-20()1, as shown in
Figure 6. This, in turn, heightened concerns about a potential abandonment of the
currency board. As choices to finance the deficit through debt rapidly shrank, the specter
of money printing loomed bigger. In the process, the fate ofpublic finances, the banking
system, and the currency became tightly linked
The elements of the CGD trap reinforced each other in a perverse way. Continued
economic contraction, increasing doubts about the sustainability of the public debt, and
soaring uncertainty about the permanence of the one-peso-one-dollar rule fell into a
vicious circle. This led to capitulation-including a massive run oil bank deposits
(Figure 7). The run, in turn, precipitated an economic meltdown by the end of 2001,
which featured the imposition of limits on cash withdrawals from bank accounts
("corralito") and the consequent disruption of the payment system. 27
The "corralito" was immediately followed by angry riots that prompted changes
in presidents, a default on the government debt, the abandonment of the currency board
into floating (an initial 40 percent devaluation immediately proved insufficient), the
forcible conversion of dollar-denominated financial contracts into peso-denominated ones
with different conversion rates applied to bank. loans and deposits ("asymmetric stock
pesification"), and the lengthening of their maturities.28 This unprecedented destruction
of property rights was compounded later on by new measures (e.g., the d.e-indexations of
27 The name corralito ("little fence") was initially adopted because deposits could be used freely inside the
fnancial system but could not leave the system. This measure should not be confused with the forcible
reprogramming of time deposits that followed in January 2002, referred to locally as the corral6n ("large
fence").
28 Dollar loans were forcibly converted to pesos at I dollar = I peso, while bank deposits were converted at
I dollar = 1.4 pesos. Pesified loans and deposits were indexed to the CPI, although part of the loans were
subsequently de-indexed. Also, pesified deposits (loans) were subject to a minimum (maximum),
administratively imposed, interest rate. The asymmetric pesification transferred part of the currency
mismatch that had previously resided in the balance sheets of debtors in the non-tradable sector to the
balance sheets of their creditor banks, resulting in less losses than otherwise to depositors. However, the
(already bankrupt) government undertook to compensate banks for the impact of the asymmetric
pesification on their net worth, through the so-called "compensation bond." On impact, the asymmetric
pesification left banks with a capital loss and a major open exposure to foreign exchange risk (because their
foreign liabilities cannot be pesified through a domestic decree). The compensating bond would thus have
to offset both problems. The amount of the compensating bond is estimated at 14.6 billion pesos. To close
the open foreign exchange position, the equivalent of 13.8 billion pesos (US$9.8 billion) of that total would
have to be denominated in dollars.



part of the pesified loans, changes in the corporate bankruptcy code, a series of court
rulings on "amparos" regarding deposit freeze, etc.).
In the next section we abstract from the stream of ill-advised measures that
followed the collapse of convertibility to examine in some detail the salient features of
the depositor run that precipitated the collapse.
2.3.  Meltdown: currency and deposit run
Understanding the nature of the bank run in Argentina is essential to answering
key questions regarding alternative paths to exit convertibility. Could a different exit
strategy have enabled the authorities to preserve, and capitalize on, the high quality of the
banking system and its regulatory framework, including the large presence of foreign
banks? Was the "corralito" a coarse measure mainly aimed at saving the few (mostly
public) banks with significant fiscal exposures that were suffering large deposit
withdrawals? If so, was the "corralito" a vehicle through which the government exported
the crisis to otherwise liquid institutions, leading in the process to a currency run that
made the abandonment of convertibility inevitable? Or was the "corralito" rather the
consequence of a run on the banking system? What triggered the run, perceived currency
risk, perceived country risk, or both? What was behind the run is ultimately an empirical
question, to which we now turn.
To better identify the factors that fueled the run, we compiled a rich bank-level
dataset on deposits that distinguishes both across currencies (peso and dollar), as well as
deposit type (demand, savings, and time). We also use banks' balance sheet data to
control for bank-specific fundamentals. We analyze the top 50 banks, which accounted
for 98 percent of total private deposits as of December 2000. Our empirical analysis
supports the view that it was the rising perception of currency risk that generated a run on
the currency, illustrated by a shift from peso to dollar deposits between February 2001
and July-August 2001, which evolved into a run on bank deposits regardless of currency
of denomination or bank characteristics, probably out of increasing fears that a major
devaluation could lead to bank failures and some form of deposit confiscation.29
Figures 7 and 8 show the evolution of deposits and of the currency premium over
time. Regarding demand and savings deposits, while dollar deposits remained stable,
even increasing up to the end of 2001, peso deposits started to decline after February
2001. The pattern is more salient in the case of time deposits, with dollar deposits
steadily increasing until the second semester of 2001.
The December 2000-November 2001 deposit withdrawal was not just focused on
few banks or on certain types of banks (Figure 9). It spread to almost all banks as the
crisis progressed.30 By November 2001, 47 of the top 50 banks had suffered withdrawals
29 In this regard, the 2001 run presents a striking similarity with the post-Tequila crisis, both in terms of the
displayed symptoms as well as the underlying drivers.
30 Banks differed, however, in their level of liquidity. Towards the end of 2001, as the deposit run
intensified, the government put pressure on the most liquid private banks to re-circulate their liquidity
12



relative to December 2000. Local private, foreign private, and public banks were all
affected by the run, with no particular ranking by type of bank.  A breakdown by
currency and deposit type confirms that there was no particular pattern regarding
withdrawals by bank type (Figure 10). Withdrawals of peso deposits were generalized
and substantial. The average withdrawal for the top 50 banks was 34 percent for peso
demand and passbook savings deposits and about 40 percent for peso time deposits. But
the figures are different for dollar deposits. There were more banks that gained rather
than lost dollar demand and savings deposits-on average, the top 50 banlks gained close
to 25 percent of dollar demand and savings deposits relative to the December 2000 level.
By contrast, more banks lost than gained dollar time deposits-on average, the top 50
banks lost 5 percent of their dollar time deposits, although 18 out of the 50 banks
registered an increase in their dollar time deposits. This suggests that whatever flight to
quality there may have been, it mainly involved dollar time deposits and did not favor, as
expected, foreign-owned over locally owned banks.
A more formal examination of the deposit run yields the same insights. We
follow the methodology used in Martinez Peria and Schmukler (2001), which regresses
the change in monthly deposits on different banlk-specific characteristics to gauge the
importance of bank fundamentals. If depositors distinguished between banks with
different risks, bank fundamentals would appear as statistically significant in the
regression. We run the same regressions for different types of deposits and for different
periods, namely, a "pre-crisis" period (1997-1999) and a "crisis" period (2000-2001).
Bank fundamentals are chosen based on standard measures of bank risk characteristics.
Since this information is published with a delay of three months, variables are lagged
accordingly. We also add bank-type dummies to test whether the crisis affected different
types of banks differently.
Table 4 reports the results for the monthly change in dollar and peso deposits, and
for the pre-crisis and crisis periods. The ratio of capital to total assets and that of non-
performing to total loans are bank-specific risk features that had an statistically
significant effect (with the expected sign) during the pre-crisis period. The other
explanatory variables, including the bank-type dummies, are not significant. However,
during the crisis period, almost all bank-specific risk variables become insignificant.
Only cash over total assets is significant in the regression for peso deposits, while no
variable is significant in the regression for dollar deposits. Table 5 ;shows that the
proportion of the R-squared explained by bank fundamentals decreases from 19 percent
during the pre-crisis period to less than 4 percent during the crisis periocd in the case of
peso deposits. A similar phenomenon affects dollar deposits, with the proportion falling
from 10 to 1 percent. In other words, the importance of systemic effects (relative to bank
fundamentals) rose sharply during the crisis period, suggesting that whatever the
influence bank-specific fundamentals had on depositors' behavior in the preceding
towards the relatively less liquid (mainly public) banks. This is consistent with the view of the corralito as
an extreme (and highly inefficient) way of distributing the burden of the run between liquid and illiquid
banks. It does not detract, however, from the fact that the run was systemic in nature and was not directed
only to those banks with relatively weak fundamentals.
13



period, it was dwarfed by systemic factors during the 2001 run, and confirming the
pattern displayed in figures 7-10 examined above.3'
To further probe on the factors behind the systemic effects, we run regressions by
type of deposits in which the time dummies are replaced by time-varying variables. The
results are reported in Table 6 (bank fundamentals are included in the regressions but
omitted from the table). The top panel of Table 6 displays the results for peso deposits,
divided by demand and passbook savings deposits, on the one hand, and time deposits, on
the other. The bottom panel shows similar estimations for dollar deposits. Regarding
peso deposits, the currency risk (measured by the interest rate differential) is statistically
significant for demand and savings as well as time deposits. This result is robust-it
holds even when including country risk and the interaction between country risk and
exposure to the public sector.32 By contrast, systemic variables are not statistically
significant in the regression for dollar demand and passbook savings deposits-not too
surprising given that these deposits remained flat throughout the crisis. Regarding dollar
time deposits, the currency risk is statistically significant when introduced as the only
systemic factor, but it becomes non-significant when country risk (measured by bond
spreads) is introduced. Thus, while currency risk was the dominant factor behind the
generalized withdrawal of peso deposits, country risk appears to be a more precise
thermometer of the evolution of dollar time deposits. Overall, the result seems to support
the view that the crisis was originated in a currency run that affected banks across the
board, regardless of their fiscal exposure or other bank-specific characteristics.
3.     Living or dying with hard pegs: lessons from Argentina
This section reviews the salient lessons that can be drawn from the Argentine
experience for hard pegs and formally dollarized systems. Three sets of lessons are
worth emphasizing. The first relates to the practical limitations of a hard peg (including
its extreme version of formal dollarization), particularly in the case of countries that do
not meet the conditions for an optimal dollar area. The second set relates to issues in
designing appropriate prudential norms given the hard peg (that is, accepting its premise
that the exchange rate will not be modified). The third one concerns an issue on which
the literature on hard pegs has always been speculative: strategies to exit hard peg
arrangements. While the Argentine case certainly does not provide a blueprint for a
smooth exit, it does illustrate the costs of sub-optimal strategies.
3.1. Limitations of hard pegs as commitment mechanisms
As discussed in Section 2. 1, one obvious benefit of a hard peg system is that, by
providing savers with an unquestionable store of value, it boosts financial intermediation,
albeit at the expense of rising financial dollarization. The drawbacks of hard pegs have
been extensively discussed in the economic literature, particularly for the case of
31 This pattern is similar to those obtained for the Tequila crisis in Argentina and Mexico, and the debt
crisis in Chile, as studied by Martinez Peria and Schimukler (2001).
32 The fact that the latter is never significant contradicts the view that depositors run from those banks most
exposed to the public sector.
14



countries, such as Argentina, that do not meet the conditions for an optimal currency area
(see the beginning of Section 2). Nonetheless, advocates of hard pegs frequently
downplay the practical difficulties of establishing greater nominal flexibility in fiscal
spending and wages in light of the limitations imposed by the loss of the nominal
exchange rate as an adjustment mechanismi, and of establishing a fiscal discipline
consistent with the loss of the inflation tax.33 Moreover, these advocates tend to overstate
the potential disciplining spillovers of hard pegs. They often advertise hard pegs as an
irrevocable decision that, inasmuch as it restricts monetary financing of the budget, can
help foster fiscal prudence, inducing governments eventually to learn to adjust nominal
fiscal spending.34
This view is naive and ultimately wrong, particularly in the case of hard peg
countries that are open to capital flows but far from meeting optimal currency area-type
conditions, therefore exposed to significant shifts in the equilibrium RER. The fact is
that no matter how credible, a currency board (or dollarization) per se does not create
nominal flexibility and fiscal discipline." The Argentine experience illustrates this well.
To start with, nominal flexibility in fiscal spending is seldom verified in practice (in
either emerging or industrial economies). Political realities of democratic processes
severely constrain the margin to reduce nominal fiscal expenditure, especially in the
context of a recession. As noted, this was a decisive factor in the! evolution of the
Argentine CGD trap. Nominal adjustment of the Argentine budget was achieved only to
a limited extent and in the context of a protracted recession. Indeed, the reduction in
public expenditure that should have accompanied the curtailment of access to external
financing did not go beyond an insufficient and politically costly wage cut never meant to
be permanent.36
The restriction on monetary financing of the deficit was not relevant in practice
during the good times of convertibility because Argentina had access to voluntary debt
placements in international and local markets. In effect, the pro-cyclicality of access to
international capital markets helped create incentives against appropriate fiscal discipline
in good times.3" When foreign markets closed, the restriction imposed by convertibility
was violated through a somewhat compulsory placing of domestic debt.. And when even
33 To be sure, hard peg advocates recognize these needs, but tend to simply state them as obvious
conditions for the success of hard pegs, without highlighting the practical obstacles to their feasibility. For
instance, Calvo (2002) writes that hard pegs have "to be supplemented by adequate institutions and
regulatory conditions. For example, it is essential that government wages and regulated prices show a high
degree of flexibility."
34 See, for example, Baliflo and Enoch (1997) for a discussion of the pros and cons of currency boards.
35 See, for example, Levy Yeyati (2001) or, for the case of PanamA, Goldfajn and Olivares (2001).
36 Public sector wages and contracts in the federal government were cut by 13 percent in the second
semester of 2001, but the reduction could not be extended to provincial workers. Moreover, although the
cuts were meant to adjust endogenously in order to meet the zero-deficit rule, further reductions were
judged to be politically unfeasible and were never implernented.
37 Perry and Serven (2002) analyze cyclically adjustecl measures of (federal government) fiscal stance.
They show that fiscal policy thus assessed was unduly expansionary in the "good" years of 1996-1998, and
that fiscal adjustment was actually insufficient during 1999-2001, except in few months leading to the 1999
election.
15



compulsory access to local banks and other local sources of financing (like pension
funds) was exhausted, the public sector resorted to the issuance of central government
and provincial paper that differed from currency only cosmetically.
Figure 11 depicts this process. Growing financing needs were met in the first half
of the 1990s by recourse to the sale of state-owned assets and, when this source dried up,
by borrowing in international capital markets. After the Tequila crisis, the government
started to rely on domestic savings, notably pension funds and local banks, which steadily
increased their share up to 2001. Once the funding capacity of the domestic markets was
exhausted, the government resorted to the issuance of small-denomination federal bonds
(lecop) redeemable for federal tax payments.38 Similarly, in the case of the province of
Buenos Aires, financing needs exceeding local revenues and federal transfers were
eventually met by the placement of provincial bonds in domestic markets and the launch
of the province's own small denomination paper, the patac6n (Table 7).39 Thus, the
persistent fiscal imbalance, far from adjusting to the budget constraint presumably
imposed by the monetary regime, defacto circumvented it, rendering the regime all but a
formal arrangement in this regard.
Two lessons can be drawn from this evidence. Firstly, there are perils in trying to
impose a hard budget constraint when the government is incapable of squaring its fiscal
accounts in the short run. One key peril is the spillover of fiscal problems into the
financial system. On its way towards outright monetary financing of its budget, the
Argentine government dramatically increased the exposure of the banking sector to fiscal
default. We discuss the prudential implications of this process in Section 3.2 below.
Secondly, the monetary discipline of hard pegs appears easier to abandon than
often believed.  This is illustrated by the relative ease with which the Argentine
government in need of funds resorted to money printing with another name (lecops,
patacones, and the like). It is also clear that the same could have happened under formal
dollarization. Dollarization per se would not have overcome the CGD trap as long as the
fiscal imbalance was a given (at least in the short term); it was not easily reversible by a
reduction in nominal public expenditure. Dollarization too would have likely been
accompanied by a proliferation of local quasi-monies that would have reflected the
simple fact that a fiscal deficit cannot be eliminated merely by a monetary arrangement.
Quasi-monies more than a problem in themselves are, therefore, a symptom of a deep
inconsistency between a strict monetary framework and the nominal rigidities that this
framework cannot magically eliminate.
3.2.   Prudential lessons
38 The figure underestimates the monetary expansion, by excluding indirect deficit financing through
central bank lending to Banco Naci6n, which accelerated substantially during 2001.
39 Figure 11 understates the surge of quasi-money printing. As Table 7 indicates, a number of other
provinces adopted similar mechanisms to finance their deficits and, as a result, the total stock of quasi-
monies reached more than 2.6 billion pesos or about 26 percent of total pesos in circulation by the end of
December 2001, and had doubled by the end of March 2002.
16



The financial system was not a cause of the Argentine crisis but rather its victim.
The evidence clearly indicates that, under convertibility, Argentina wvas able to build a
strong and well-supervised banking system-a model to be emulated by other emerging
markets. Moreover, Argentine authorities displayed considerable innovative capacity in
developing prudential norms, particularly in terms of liquidity buffers, suitable to a hard
peg system (see Appendix Table 1).
Nonetheless, from hindsight, the Argentine experience reveals some prudential
shortcomings and, hence, suggests directions in which prudential policy needs to be
tailored further to better deal with risks that are specific not just to hard peg regimes but
also, and more broadly, to financial systems that are de-facto highly dollarized. Three
weaknesses in the otherwise sound Argentine regulatory framework can be identified by
taking as given the rules of the convertibility game-i.e., by assuming the permanency of
the one-peso-one-dollar rule. They have to do with: (i) the insufficient realization that
general liquidity buffers do not fully protect the payments system from a run; (ii) the
exposure of the banking system to government default; and (iii) the link between debtor
capacity to pay and the deflationary adjustment to a more depreciated equilibrium RER.
High liquidity requirements, as those in effect in Argentina during the second half
of the 1990s, enhance the resiliency of the banking system-they cushion the system vis-
a-vis liquidity shocks and deter runs, thereby, reducing the scope for multiple equilibria.
Thanks to its liquidity requirements, the Argentine banking system withstood a prolonged
and severe process of deposit withdrawal in the Tequila and also during 2001. At the
same time, however, the Argentine experience suggests that once a run is underway,
relaxing liquid reserve requirements can have adverse signaling effects that exacerbate
the attack on the peso (instead of spurring credit growth as Minister Cavallo hoped for),
further weakening confidence.40 Moreover, Argentina illustrates that, as confidence
collapses, a general liquidity requirement (available to all deposits oni a first come first
served basis) fails to protect the payment system, as liquidity is rapidly consumed by the
flight of time deposits.
The lesson is sobering. In the absence of an effective and credible lender of last
resort, the payment system is vulnerable and can collapse under a run, even when
liquidity is high but still a fraction of deposits equally available to pay any deposit
withdrawal.4" It thus would appear that, under a currency board or dollarization, the
protection of the payment system from bank runs might actually require prudential norms
that give some form of priority of claim over available liquidity to transactional deposits,
that is, to deposits that are germane to the functioning of the payment system. This does
40 During the Tequila crisis in the mid-1990s, the Argentine authorities reduced liquidity requirements to
help the banking system confront the deposit withdrawals, and this regulatory action did not seem to have
exacerbated such withdrawals. The deleterious effect of the relaxation of liquidity requirements during the
2001 run was probably because it contributed to the already high uncertainty about the authorities'
commitment to the currency board. Many analysts cautioned about the potential negative effects of using
prudential policy as a counter-cyclical instrument in 20(01. In effect, this issue was a major cause of dispute
between the central bank and the ministry of economy.
41 See Chang and Velasco (2000) for an argument along these lines.
17



not necessarily require a narrow-bank type structure. It could also be achieved, for
instance, by an ex-ante rule that, under specified conditions, earmarks available liquidity
to demand deposits. While the operationalization of this concept does not appear easy,
the prudential principle on which it is based warrants serious consideration. The
objective of such prudential innovation would be to preserve the functioning of the
payment system even in the extreme scenario where banks are unable to honor
withdrawals of time deposits.42
The second prudential weakness has to do with credit risk. It arises from the
Argentine failure to sufficiently isolate the solvency of the banking system from the
solvency of the government. As discussed earlier, no matter how credible, a currency
board (or dollarization) per se does not create fiscal discipline. To the extent that banks
hold significant claims on the domestic government, a fiscal and public debt crisis would
immediately affect banking system solvency. However, one silver lining of convertibility
(or dollarization) is that, in principle, it makes it possible to protect banking
intermediation from the vagaries of the fiscal process, including an event of government
debt default, as long as banks are not significantly exposed to domestic government risk.
The reason is that the store of value that underpins financial intermediation in a currency
board (or dollarized) country is ultimately the dollar, whose quality does not depend
directly on the solvency of the domestic government.43 This feature should have been
harnessed through prudential norms in Argentina, all the more considering the country's
recurrent fiscal problems. As described in Appendix Table 1, the authorities moved in
this direction belatedly, in 2000, when they introduced mark-to-market requirements for
government bond holdings and established a positive weight for loans to the government
for the purposes of determining regulatory capital requiremenis. It would have been
advisable to take this approach more aggressively and much earlier in the decade, and to
complement it by limiting the exposure to the public sector of individual banks, and the
amount of government debt that could count as part of the assets eligible to meet bank
liquidity requirements.
The third weakness has to do, again, with credit risk-the latent non-performing
loans (NPLs) in the context of a misalignment of the RER relative to a more depreciated
equilibrium  level.  Convertibility (or formal dollarization), as Roubini (2001) has
correctly stressed, does not immunize a country from the balance sheet effects of a RER
adjustment.   In particular, RER   overvaluation is corrected under convertibility (or
dollarization) slowly, through painful deflation and unemployment (particularly if
rigidities in the labor market are significant), which certainly erodes the capacity to pay
42 Developments during the recent crisis in financially dollarized Uruguay are an ex-post rendition of this
concept. In effect, as the run intensified, the Uruguayan authorities decided to concentrate central bank
reserves (which were bolstered by an IMF-led emergency package) on fully backing demand deposits in
troubled banks. Time deposits of troubled banks were, by contrast, restructured by decree. The same could
be achieved in a more orderly manner by imposing ex-ante a stop-loss clause on the use of bank liquid
reserves, forcing automatic restructuring of time deposits once the decline reaches certain threshold.
43 In contrast, this condition cannot be obtained where the store of value is the domestic currency.
18



of debtors whose earnings come from the non-tradable sector.' Under a hard peg or a de
facto highly dollarized financial system that breeds a systematic and severe "fear of
floating," the erosion of capacity to pay of debtors in the non-tradable sector occurs
regardless of whether the loans in question are denominated in dollars or in pesos.
The lesson here has much less to do with the Argentine failure to single out the
currency of loan denomination in the design of its prudential norms, than with the failure
to explicitly recognize the special credit risk of loans to debtors in the non-tradable
sector-a credit risk that would materialize in the event of significant adverse shocks that
led to a deflationary adjustment of the RER. This risk arises from the simple fact that
debtors in the non-tradable sector cannot denominate their debts in terns of non-tradables
or hedge when contracting debts in terms of tradables. The implication is that the
authorities in fixed exchange rate economies vwould be well advised to establish relatively
tougher loan classification criteria, higher loan-loss provisioning rules, and possibly also
a higher weight for the purposes of measuring capital requirements for loans to the non-
tradable sector in either currency.45 In addition, the authorities could promote the
development of a market for financial contracts indexed to the price of non-tradables.
A final point is useful to clarify how the previous analysis can be extended once
the assumption of a permanent peg is relaxed. While the first two lessons are fairly
general to any monetary arrangement, a distinction must be made in the third lesson for
the case of financially dollarized economies in which changes in the nominal exchange
rate have non-zero probability. While the curTency of denomination is irrelevant where
the peg is preserved, it is crucial in the event of a nominal depreciation of the local
currency. In financially dollarized economies under flexible regimes, the considerations
discussed in the previous paragraph apply only to dollar loans to non-tradable income
producers.    The presence of a not-fully-credible peg      in a financially dollarized
environment adds an obvious complication. Conditional on the survival of the peg, non-
tradable debtors are exposed to real exchange rate risk regardless of whether they borrow
in pesos or in dollars. However, if the peg is abandoned, their exposure is more dramatic
but only if they borrow in dollars. Thus, some degree of currency discrimination in
prudential norms may be warranted in countries committed to a hard peg, although these
44 Deflationary adjustment in a currency-board (or dollarized) country lowers the value of non-tradable
income in terms of tradables, which implies that the burden of the debt rises (capacity to pay falls) for the
non-tradable sector. By contrast, in a country with a flexible exchange rate (i.e., where a fixed parity is not
part of the social contract) and without a substantial problem of dollar debts in the non-tradable sector, the
adjustment to a more depreciated equilibrium RER would come through nominal depreciation, which
would be associated with an improvement (via debt dilution) in the capacity to pay of debtors in the non-
tradable sector.
45 Given that information asymmetry problems in buoyant times lead to rising bank exposure to the non-
tradable sector without adequate internalization of risks, a system of counter-cyclical loan-loss provisioning
requirements, like the one established at end- 1999 by the Bank of Spain (Circular No. 9/1999 of December
17, 1999), could help address risks in loans to the non-tradable sector. This is because lending booms are
mainly to the non-tradable sector and, hence, the loan decay after the boom affects primarily loans to non-
tradable producers. The Spanish system requires a buildup of counter-cyclical provisions in good times
(thereby curbing excessive dividend distributions), which are shifted into specific provisions in bad times
(without passing through'the income statement) as the loan portfolio decays.
19



considerations should be weighted against a signaling effect that may weaken the
credibility of the peg.
3.3.  Exit strategies
With the benefit of hindsight, this section focuses on counterfactual analysis:
What would have happened if Argentina had adopted different policies in the months
before the crisis erupted? And, were there superior exit strategies open to Argentina from
the CGD trap? By nature, this type of analysis is very difficult to back with real data and
hard to substantiate. Nevertheless, a serious consideration of the different arguments
presented here may help to draw relevant policy lessons for the future, particularly for
countries with weak national currencies and highly dollarized financial systems.
Four alternative courses of action can be identified in relation to the Argentine
case, particularly for the period after the January 1999 devaluation of the Brazilian real.
Those that emphasized the RER overvaluation as the source of the sluggish growth
recommended floating the currency, despite its adverse balance sheet effects (for
instance, Roubini 2001, Krugman 2001). Those that disbelieved the existence of a
demand for a floating peso recommended de jure dollarization (for instance, Dornbusch
2001, Calvo 2002). Those concerned about the balance sheet implications of a float but
also worried about the RER overvaluation, recommended "stock pesification cum
float"-i.e., the forcible conversion of dollar-denominated domestic contracts into CPI-
indexed peso-denominated ones, followed by the abandonment of the peg (in particular,
Hausmann 2001). In Section 3.3.4 below, we submit a fourth alternative: early
dollarization of existing financial contracts ("stock dollarization") complemented by the
introduction of a new national currency ("pesification at the margin") to function as a
means of payments.
The main messages from the counterfactual analysis are as follows. The floating
alternative could have corrected the overvaluation problem, but would have destroyed the
convertibility contract and, by fueling the currency run of peso depositors, would have
had a massive and immediate adverse impact on debtor and banking system solvency.
Formal dollarization at a 1:1 rate would have respected the structure of property rights
and would have had a better chance of preventing the run on deposits, but would have
done nothing to attenuate the protracted and contractionary RER adjustment.' Stock
pesification cum float was probably the most disorderly exit alternative. While in
principle it limited the immediate impact on balance sheets of the unavoidable RER
adjustment by shifting the losses to depositors, its destructive effect on property rights
and institutions will probably have long-lasting costs in terms of financial
desintermediation. Moreover, by creating a huge peso overhang in the context of a
currency run, it fueled the deposit flight and the unprecedented exchange rate
overshooting that followed. For the same reasons, stock dollarization cum pesification at
the margin could have averted the run. It would not have spared debtors in the non-
tradable sector from the adverse balance sheet effects of the devaluation. But, by
46 If done at a much more depreciated rate, formal dollarization would have had similar (immediate)
adverse effects on debtor and banking system solvency as the previous alternative.
20



providing a margin for nominal flexibility, it could have facilitated the RER adjustment
without unduly disfiguring property rights.
3.3.1. Float
Floating the peso would have immediately addressed the C component of the
CGD trap, albeit at the cost of: (i) a run on the currency, as peso depositors moved to
protect the real value of their savings, adding to the exchange rate overshooting; (ii) a
sharp and immediate deterioration of the payment capacity of private and public sector
debtors in the non-tradable sector, compoundled by the overshooting to be expectedfrom
the currency run; and (iii) a run on bank deposits, as agents anticipated that banks would
become insolvent immediately after the float. Moreover, a disorderly float in the context
of widespread dollar debts among non-dollar earners would have likely led to a long
period of continued RER depreciation, as Ecuador's experience suggests.4"
While the second cost was inevitable in the context of a RE]R adjustment, and
may have prompted government action to compensate bank losses and minimize
depositors' misgivings about bank solvency, the currency run induced by the floating of
the peso was the main drawback of the "just float" exit strategy. The resulting exchange
rate overshooting would have not only accelerated the RER adjustment but also
exacerbated its balance sheet effects. Even if depositors were allowed to dollarize their
savings within the banking system (as Minister Cavallo encouraged by end-2001, once
the run was underway), existing limits on foreign exchange open positions would have
forced banks to drastically reduce dollar vis-a-vis peso deposit rates to balance their
positions, which could have resulted in a dollar deposit flight. At any rate, it is not
obvious whether an early move to a float would have triggered a run to the dollar bill.
But it seems realistic to assume that, once underway, such a run would have only ended
once deposits became dollarized, an outcome that could have been achieved in a more
orderly fashion through a preemptive de jure dollarization of all financial contracts, as
explained in Section 3.3.4.
From a political economy perspective, a substantive devaluation would have
coordinated the actions of debtors (even those in the tradable sector that preserved their to
capacity pay) and would have likely triggered an enormous pressure to the government to
provide exchange rate insurance or some kind of compensation to private debtors,
increasing either the fiscal cost of the bailout, the level of non-perforning loans (NPLs),
or both.48
Such likely consequences made the "just float" alternative highly unlikely
politically, particularly in 1999 when there was not still a clear perception of the
47 Ecuador's 1999 crisis illustrates the dire consequences of floating in the context of a weak fiscal position
and widespread currency mismatches (dollar debts of non-dollar earners). The crisis deepened dramatically
as nominal devaluation and debtor insolvency were caught in a feedback loop, leading to an excruciatingly
long period of a collapsing real exchange rate. See De la Torre, Garcla-Saltos, and Mascar6 (2002).
48 In turn, the perception of a bankrupt financial sector as NPLs mounted, could have re-ignited the run on
bank deposits.
21



imminence and size of the crisis. From a practical point of view, however, and as the
margin to avoid a full-blown crisis narrowed, many analysts came to believe that, in the
event of a float, something drastic had to be done to avoid its deleterious impact on
balance sheets.
3.3.2. Stock pesification cum float
Because of widespread balance sheet mismatches (dollar debts of non-dollar
earners), an increasing number of analysts believed that exiting convertibility by floating
required the prior pesification of existing domestic financial contracts by decree. As the
argument goes, without prior stock pesification, a significant and discrete devaluation
would have immediately wrecked debtors in the non-tradable sector and, hence, the
banking system. A way to deal with the adverse real and financial impact of a
devaluation would have been a massive public bailout (of banks and firms), but this
possibility was by mid-2001 out of the question for a government on the verge of default.
By contrast, stock pesification cum float promised a way to address the C component of
the CGD trap that presumably avoided the adverse balance sheet effect on debtors by
transferring the burden of the expected bailout directly to private creditors.49 It was the
alternative chosen by the Argentine government under pressure at the beginning of 2002.
The forcible pesification of domestic financial contracts only created a mass of
previously dollarized savings whose owners could not wait to re-dollarize them before
the expected RER     adjustment drastically reduced their dollar value.       Even after
abstracting from the social discontent that such a massive confiscation unsurprisingly
stirred,50 one could not ignore the fact that pesification could only exacerbate the ongoing
currency run, fueling the overshooting of the nominal exchange rate, and turning a
potential solvency problem into an immediate liquidity problem. Stock pesification was
a desperate attempt to escape what Eichengreen and Hausmann (1999) call the "original
sin," but it gave way to a graver sin-the murder of money as store of value.5' Pesified
Argentina now awaits a sort of miracle, that is, the resurrection of the peso as a store of
value and, with it, the regeneration of peso financial intermediation.
49 Not surprisingly, this option appeared late in the crisis process and was originally presented in the
context of the debt restructuring debate, with an emphasis on the compulsory conversion of sovereign debt.
At the time of this writing, the Supreme Court was considering a ruling stipulating the re-dollarization of
deposits. Since the re-dollarization of debts appeared politically unlikely, it was widely believed that such
an action by the Supreme Court would induce the government to assume the banks' balance sheet losses.
Under that scenario, the pesification adventure would go full circle to become a blanket exchange rate
guarantee to be financed by taxpayers in years to come-a massive bailout that stock pesification was
intended to avoid.
50 This discontent had non-negligible political economy consequences, as witnessed by the subsequent
reluctance of the judicial system to validate the pesification and the decision of the government to allow the
re-dollarization of reprogrammed deposits through their swap for dollar government bonds.
5' As defined by Eichengreen and Hausmann (1999) the "original sin" refers to the condition of a country
that is unable to issue peso debt in international markets. As a result, such country is tragically trapped
between currency mismatches (it can only issue long-term debt in dollars) and maturity mismatches (local
markets only accept short-duration peso debt).
22



Was stock pesification cum float a feasible alternative for earlier, more tranquil
times? Would it have been less destructive then? We have serious doubts that there is a
yes answer to these questions. Since forcible stock pesification curn float necessarily
implied a departure from the one-peso-one-dollar rule, no government had an incentive to
implement such a departure in tranquil times. Forcible pesification cum float was
therefore a feasible alternative only for turbulent times.52 In addition, the massive
violation of property rights implied in stock pesification (and the massive transfer of
wealth involved) meant that any anticipation of it would have triggered a run. Hence,
stock pesification cum float would have required the simultaneous establishment of a
deposit freeze or securitization as well as widespread capital controls in order to keep
depositors and investors from fleeing.
In sum, stock pesification cum float was arguably: (i) not an alternative that could
have been feasibly implemented in tranquil times or without a change of government; (ii)
an alternative that would have in any case provoked a run, requiring a deposit freeze of
some form; and (iii) a deleterious alternative for financial intermediation. All these
reasons lead us to believe that stock pesification was the least desirable alternative.
3.3.3. Formal dollarization
Was formal dollarization then a better option? Dollarization would have been
consistent with the Argentine social contract based on the long-term commitment to one-
peso-one-dollar, with salutary implications for depositor confidence, which would have
been boosted not just because the perceived risk of deposit confiscation would have been
dimmed significantly, but also because the option-value of foreign bank access to their
parent's capital and liquidity would have been better protected. That is, even if a run
would have occurred, foreign banks would have likely been more willing to stand behind
their Argentine affiliates, compared to the current situation marked by confiscatory (and
asymmetric) stock pesification.
Dollarization, though clearly not easy politically, would have not necessarily
entailed a change of government-it would have arguably been within the scope of the
government in power, inasmuch as it respected the one-peso-one-dollar rule. In this
sense, there is an asymmetry in the political economy of dollarization versus stock
pesification. It is generally less costly politically for developing-country governments to
maintain an exchange rate parity than to break it. This argument is a fortiori stronger in
the case of Argentina, given the crucial relevance of the currency board to the operation
of the financial system.
The dollarization alternative would have been more likely to avert a run if
adopted early in the game-i.e., before 2001. It was in fact considered by the Argentine
government in 1999-2000, but it lost ground afterwards partly due to political
polarization: it was construed as a symbol of support for Mr. Menem. By contrast,
against a background of continued recession and increasing RER overvaluation, the
52 Indeed, it was an alternative that almost by necessity had to be implemented in the context of a change in
government.
23



proposal of stock pesification cum float gained ground.53 The feasibility and potentially
salutary effects on depositor confidence of dollarization clearly narrowed during 2001,
but did not disappear. A run became more likely once the government raided the
liquidity of the financial system and was clearly headed towards default in the context of
no access to capital markets.5
Could formal dollarization have still averted the run if adopted belatedly in 2001?
Any answer to this question is, of course, highly speculative. Nonetheless, we are
inclined to answer with a cautious yes. This is in part because, while deposit withdrawals
in 2001 were probably motivated by heterogeneous expectations, much of the depositor
activity appears to have reflected fears of a nominal devaluation, as discussed in Section
2.3. The possibility of no run under dollarization, even in the face of a default in
government debt, appears reasonable in light of Ecuador's experience (Figure 12). In
Ecuador, the sole announcement of dollarization in January 2000 (formal dollarization
was put into law only in March 2000) had an immediate positive impact on deposits even
though the Ecuadorian government was in open default (the debt restructuring agreement
was signed several months after the dollarization announcement), most banks were highly
exposed to the government, and it was no secret that many of the large banks were
completely insolvent. There is no obvious reason to believe that developments would
have been different in Argentina, particularly considering that the Argentine banking
system was unquestionably in a substantially better shape than Ecuador's. Moreover, to
reinforce the stabilizing effects of dollarization on depositor behavior, Argentina could
have taken additional positive steps to relax the link between banking system solvency
and fiscal solvency.55
In all, it is difficult to escape the conclusion that, from the point of view of
increasing the chances for averting a run, preserving healthy links between money and
banking, and preventing a disorderly RER adjustment, the more obvious non-traumatic
strategy would have implied the dollarization offinancial contracts. Under this strategy,
though painfully, the banking system could have absorbed over time the losses associated
with rising NPLs as the RER adjusted towards equilibrium through deflation.'
A formal move to full dollarization (of financial contracts and money in
circulation), however, would have been clearly inadequate to mitigate the fundamental
inconsistency between the peg to the dollar and Argentina's trade and productive
53 It in fact became somewhat popular in academic and policy circles after Prof. Hausmann's public
recommendation to Argentina, presented in the October 2001 Latin American and the Caribbean Economic
Association Meetings in Montevideo (see Hausmann 2001). This proposal failed to anticipate that it would
inevitably lead to a deposit freeze. The proposal, moreover, seriously underestimated the difficulty of
establishing the peso as a store of value in order to re-generate financial intermediation going forward.
54 The failure to secure debt rollover in July 2001 was probably the threshold.
55 The decree passed in 2001 (Presidential Decree 1005) to enable the use of the amounts falling due in the
government debt to pay taxes would have helped in this regard.
56 Moreover, as the recent Uruguayan experience illustrates, a securitization of liabilities can be designed
selectively (distinguishing across banks and, within them, between deposit and non-deposit claims),
without changing the original currency of denomination of bank assets and liabilities.
24



structure. And it would have not addressed the problem posed by severe practical limits
to nominal flexibility in fiscal spending in a recessionary context. Initially, the main
function of dollarization would have been to stabilize the financial system and hopefully
stem the run. Over time, however, the premium of introducing some nominal flexibility
would have risen. As a result, dollarization would have appeared as only one step
towards building a viable paradigm that conibines the dollar as the store of value with
substantive nominal flexibility (particularly in wages and fiscal spending).57
3.3.4. Stock dollarization cum pesification at the margin
From'the previous discussion it follows that dollarization was a better exit strategy
only if it had been followed by greater nominal flexibility. Indeed, full dollarization
would have eliminated two sources of flexibility available at the time: the peso-
denomination of most prices and non-financial contracts, and the transactional demand
for the local currency. In this section, we argue that the stabilizing benefits of stock
dollarization could have been reaped while preserving these two source of flexibility
through "pesification at the margin"-i.e., the introduction of a new domestic currency,
initially circumscribed to transaction purposes, either by design or spontaneously, as was
already occurring in Argentina, albeit in a disorderly manner, through the issuance of
quasi-monies.
The simplest version of this alternative strategy would have implied dollarizing
by decree the stock of existing financial contracts (without redeeming the pesos in
circulation with dollars), in order to stem the run and stabilize financial conditions, and
then consolidating into a single (new) national currency the peso and quasi-monies (such
as the lecops and patacones) in circulation. That national currency would have floated
against the dollar and would have been voluntarily used for future flows (payments, wage
and prices, and new financial contracts). It w"ould have had legal tencler privileges under
the control of the central bank. This process would have provided a much less disruptive
way out of the rigid constraint imposed by the one-to-one rule, without unduly violating
existing contracts. By offering the government an escape valve out of nominal fiscal
rigidities in the face of a drying up in financing, the consolidation of the peso and quasi-
monies in circulation into a single currency vwould have turned the disorderly situation of
quasi-monies into an opportunity forxrecomposing a degree of sustainable flexibility (to
adjust the budget as well as real wages) in a financially dollarized economy.
In Argentina, not only did the recourse to printing quasi-monies relax the cash
flow constraints faced by the public sector. It also worked as an adjustment mechanism
for the private sector, which rapidly embraced.the new "bills" as an instrument to reduce
labor costs and, thus, circumvent labor market rigidities. However, most of these quasi-
monies were accepted for tax payments at face value.   This, coupled with the
convertibility of the peso in which they were denominated, limited the nominal flexibility
57 This paradigm corresponds to what we elsewhere call the "dollar trinity." A key element of such trinity
is sound institutions, which we believe are a key precondition irrespective of the exchange rate arrangement
in place. See De la Torre, Levy Yeyati, and Schmukler (2003).
2'i



that could be achieved through its use to a secondary market discount that never exceeded
10 percent.58
To be sure, the introduction of a new currency may find political support only
once a crisis is well underway. Even at that stage, it is more likely that the process of
pesification at the margin in a currency board or dollarized country would start with the
spontaneous printing of quasi-monies. However, it seems plausible that, as part of crisis
management and resolution, once a quasi-money has emerged spontaneously the
authorities could shepherd it and eventually formalize it into a new currency. At any rate,
while the precise manner in which pesification at the margin could have been
instrumented is a valid matter for debate, the basic process is somewhat of a moot point,
given that the emergence of local currencies has to be resolved eventually in some form.59
The logic of pesification at the margin, grounded theoretically and empirically in
the distinction between currency and asset substitution discussed above, is reinforced by
the post-devaluation experience in Argentina. The legal and political obstacles that
hampered the government's strategy to stock pesify exemplify the difficulty of
establishing the peso as a store of value. By contrast, the transactional demand for the
domestic currency (both for the old peso and the quasi-monies) remained relatively stable
even through the depths of the crisis, as the worst devaluation expectations materialized
(Figure 13).6 This evidence suggests that stock dollarization cum pesification at the
margin was a viable option for Argentina.
Arguably, reluctant acceptance of the new local currency could have fueled a
sharp depreciation that would have defeated the objective of achieving a gradual and less
traumatic RER adjustment, prompting central bank foreign exchange intervention and
undesired nominal uncertainty. Ultimately, whether dollarization should have been
extended, preemptively, to the purchase of pesos in circulation, or be limited to financial
contracts only is also a matter for debate, with the answer depending on the estimated
demand for the new local currency.
In any event, the new currency would have been, initially, part of a bi-monetary
system in which the peso would have been used, as before, for transactions and as unit of
denomination for most wages and prices, while the dollar would have retained its role as
store of value for financial savings. The new currency would have realistically been
externally non-convertible, fluctuating against the dollar. Moreover, in addition to its
legal tender status, it could have possibly been granted exclusivity for tax payments
purposes, so as to consolidate its transactional demand.
58 The discount was due more to a liquidity premium than to perceived credit risk.
59 We deliberately abstract from the problem of an unfair wealth transfer between different issuers once
currencies are monetized by a central bank. Conceivably, such transfers could be undone either within the
monetization scheme or directly through countervailing budgetary transfers.
60 As noted above, the degree of dollarization of deposits in Argentina has historically been inversely
related to their transactional nature (Figure 4). The flipside of this is the low level of dollarization of bank
overdrafts (Figure 3).
26



Pesification at the margin is certainly not a panacea, but it would have allowed a
marginal degree of nominal flexibility for a dollarized financial system-flexibility to
adjust fiscal spending to income and, to the extent that there was less than complete
indexation of wages and prices to the dollar, to help correct misalignments in the RER.
While the adverse balance sheet effects of RER adjustment on debtors in the non-tradable
sector were inevitable, pesification at the mnargin would have mitigated the need for a
long recessionary and deflationary adjustment of the RER, could have prevented the
collapse of the banking sector, and would have avoided the long-lasting effects of the
massive violation of the rule of law as a consequence of a forcible stock pesification.
Ultimately, the sustainability of pesification at the margin would have crucially depended
on the re-composition of strong and viable fiscal institutions, financial reforms designed
to address the risks of dollar loans to the non-tradable sector, and the strengthening of the
local currency through an independent monetary policy credibly focused on price
stability.
4.    Final remarks
Although now devastated by its crisis, the main challenge for Argentina currently
is no different in nature from that faced at the beginning of the convertibility decade: to
build a strong and sustainable link between money and financial intermediation, given the
initial condition of a weak currency.6'
Formulating the basic challenge in thi.s way shifts the debate on bi-polar (floating
versus hard peg) exchange rate systems to the terrain of financial intermediation and
financial globalization. Once in this terrain, it is easy to see that a one-dimensional focus
on the fix-float dilemma is insufficient. In effect, having a national currency that floats
(freely or dirtily, it does not matter) and thus helps the RER to adjust to shocks is not
enough if, at the same time, financial intermediation in that currency is non-existent or
shallow and dominated by extremely short-duration contracts. Similarly, having a hard
peg (including formal dollarization) and thus enjoying dollarized financial markets that
are deeper and with longer-duration contracts could be extremely hazardous in the
absence of adequate nominal flexibility.
In the heyday of the currency board, Argentina was able to develop a relatively
deep and, by most standard measures, sound banking system, but its inability to generate
a minimum degree of nominal flexibility to deal with shocks that resulted in a major
depreciation of the equilibrium RER proved to be ultimately devastating. After the
collapse of the currency board, Argentina regained a currency that floats and thus
facilitates rapid adjustment in the RER. Butt financial intermediation has been all but
wiped out. Argentina, which previously had financial intermediation without a flexible
currency, now has flexibility without financial intermediation.  Hence the central
challenge for Argentina is how to re-construct sustainable links between money and
61 De la Torre, Levy Yeyati, and Schmukler (2003) define "weak currency" as one not accepted as a
reliable store of value by either residents or non-residents, a concept that relates to Eichengreen and
Hausmann's (1999) "original sin" and to the widespread financial dollarization observed in numerous
developing countries.
27



financial intermediation. It is the same challenge that haunts many weak currency
countries regardless of their ostensible exchange rate arrangements.
What is specific to Argentina is the daunting difficulty in tackling that challenge.
During the 50 years that preceded convertibility, Argentine citizens were subject to a
history of intermittent debasement of the national currency. Convertibility soothed those
nightmares away with a heavy legal armor designed to make people believe that the
ultimate store of value for their savings was the dollar-a hard currency that national
mischief could not debase.  Then the currency board imploded via the forcible
pesification of financial contracts, which debased something even more fundamental than
a national currency, namely, the contractual environment itself.
If major price instability is avoided, pesified Argentina should be able to maintain
and enhance the function of the peso as a means of payment. That is the relatively easy
part. As long as inflation is not out of control, the transactions demand for pesos is likely
to be resiliently stable. The difficult part would of course be the establishment of the
peso as a reliable store of value that can underpin sound financial intermediation. In
effect, the re-establishment of the peso as a means of payment, even if sustained through
a viable fiscal process, is not of itself an automatic guarantee that the peso would become
a trusted receptacle for saving, particularly considering that the bad memory of the
forcible pesification of their savings is likely to torment the Argentines for a long time.
If the goal in Argentina is to promote the peso as the currency for financial
intermediation through limits or outright prohibition of dollar deposits and credit, then
one might expect many years of a relatively narrow banking system (focused mainly on
payments) while credible institutions are built and proven. Alternatively, a bi-monetary
scheme (peso transactions and dollar savings) may be considered to try to restore a
degree of financial intermediation earlier in the game, although the prospects for the
restoration of dollar-based financial intermediation appear also bleak, given the severe
damage to the contractual environment inflicted by stock pesification." In either case,
there is no substitute to the hard work of institution building to underpin sustainable
linkages between money and banking.
62 The prudential lessons drawn from the Argentine case should come in handy to better internalize and
manage the attendant risks if financial re-dollarization is the option of choice.
28



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Foreign Debt Restructuring/Reduction," mimeo, New York University,
December.
Schmukler, Sergio, and Luis Serven, 2002, "Pricing Currency Risk under Currency
Boards," Journal ofDevelopment Economics, 69:2, pp. 367-391, December.
The Economist, 2002, "Argentina's Bottomless Pit," Economic Focus, Aug 8th.
Tomell, Aaron, and Andres Velasco, 2000, "Fixed Versus Flexible Exchange Rates:
Which Provides More Fiscal Discipline?" Journal of Monetary Economics, 45:2, pp.
399-436.
World Bank, 1998, Argentina: Financial Sector Review, Report No. 17864-AR,
September.
World Bank, 1999, Argentina: Implementation Completion Report, Provincial Bank
Privatization Loan and Bank Reform Loan, Report No. 19467, June.
30



Figure 1
Financial Deepening
Credit/GDP
Deposits/GDP
40%
35%
30%   -
25%                      Credit/GDP
20%   -                 Deposits/GDP
15% /
10%
5%
0%  -,........ 
1991    1992     1993    1994     1995    1996     1997    1998     1999    2000    2001
Credit includes loans to private sector, loans to public sector, loans to residents abroad, and private and public
securities held by the financial system. Deposits include demand deposits, savings deposits, time deposits,-and
other deposits, by private sector, public sector, and residents abroad. Figures correspond to end-of-year values.
Sources: Central Bank of Argentina and The World Bank
31



Figure 2
Loan Dollarization and Currency Premium
Credit in U.S. Dollars
over Total Credit                                                            Basis Points
100%   - -    Credit to public sector (Left scale)                                  1,200
Credit to private sector (Left scale) 
80%-   C   urrencyyremium (Rgh scle                                           -1,000
80%                                                                                1,00
-800
60%
-600
40%
400
20%                                                                                 200
0%                                                                                0
Apr- Feb- Dec- Oct- Aug- Jun- Apr- Feb- Dec- Oct- Aug- Jun- Apr-
91    92    92    93    94    95    96    97   97    98    99    00    01
The currency premium is measured by the differential between peso and dollar interbank deposit rates, using
daily one-month interest rate premium. Credit to public and private sector correspond to end-of-period values
and currency premium is monthly average.
Source: Central Bank of Argentina
32



Figure 3
Private Sector Dollarization
By Type of Credit
Credit in U.S. Dollars
over Total Credit
100%     Pledge lending                                                   --,-_--
80% -
60%     Mortgage loans
40%
20%
Overdrafts
0%,                                                 .     ... 
Jan-   Sep-  May-   Jan-   Sep-  May-    Jan-  Sep-   May-   Jan-  Sep-   May-
94     94     95    96     96     97     98    98     99     00    00     01
Firm's Balance Sheet Dollarization
Average Share of U.S.
Dollar Debt across Firms
83%                                790/o
67%
60%
1998                                1999
0 Tradable sector  U Non-tradable sector
Sources: Central Bank of Argentina and Buenos Aires Stock Exchange
33



Figure 4
Dollarization by Type of Deposit
Dollar Deposits over
Total Deposits
100% -
80%-a
80% -                             ~~~~~~~Time deposits    _
60%-
hk                ~~~~~Savings deposits          i
40%-
20% -
Demand deposits
0%-                                                                  I 
Apr- Feb- Dec- Oct- Aug- Jun- Apr- Feb- Dec- Oct- Aug- Jun- Apr-
91    92    92    93   94    95    96    97    97    98    99    00    01
Source: Central Bank of Argentina
34



Figure 5
Interest Rate and Risk Slpreads by Type of Loan
Peso-Dollar Interest Rate Spread
Basis Points
2,000 -
1,600 -
1,200 -
800 -
400 -
0-              __                _       _._                                           _     _.
Overdrafts on    Bills up to a 89-  Pledge lending up  Pledge lending  Personal loans up
current account      day term       to a 1 -year term  over 1 -year term  to a 180-day term
Peso-Dollar Risk Spread
Risk Indicator Spread
1.00
0.80
0.60
0.40
0.20 -
0.00          i                  ._I_I
-0.20    Overdrafts on     Bills up to a 89-  Pledge lending up  Pledge lending  Personal loans up
current account      day termn       to a 1-year term  over 1-year tern  to a 180-day term
The top figure shows the average spread between peso and dollar financing interest rates. The bottom figure shows the
average spread between peso and dollar financing risk indicators. The period covered is July 1993-December 1999, when
the risk indicator was different for peso and dollar financing. Mortgage loans are excluded because only few banks in the
system granted mortgage loans in pesos during this period. Note that the peso-dollar risk spread for bills up to a 89-day
term is zero although the interest rate spread is positive. This is due to the fact that when the interest rate spread is small,
the same risk indicator is used for peso and dollar loans.
Source: Central Bank of Argentina
3'



Figure 6
Financial System: Exposure to Public Sector
Total Assets                                                             164,100
(Millions of Dollars)                                         153,252
130,929
125,069
105,776
91,534
82,528
_  _      -          -          .,~~~~~~~~~~~~~~ I - 
1994      1995       1996      1997      1998       1999      2000      2001
l Claims on the public sector       0 Liquid assets and claims on the private sector
Share of Claims on the Public
Sector to Total Assets
25%
20% -
15%-
10% -
5% -
0%             I     
1994      1995       1996      1997       1998      1999      2000       2001
Financial system is defined to include public banks, private domestic banks, foreign banks, and non-bank financial
institutions. Figures correspond to end-of-year values.
Source: Central Bank of Argentina
36



Figure 7
Evolution of Private Deposits
Index of Deposits
(=100 in December 2000)
110 -
i  S  s               ~~~~~~Dollar Deposits
100
\ _   Peso Depos~~its                  _
90 
80 -
70 -
60
Dec-00 Jan-01 Feb-01 Mar-01 Apr-01 May-01 Jun-01     Jul-01 Aug-01 Sep-01 Oct-01 Nov-01
Source: Central Bank of Argentina
37



Figure 8
Demand and Savings Deposits
Millions of Dollars
25,000
Peso Deposits
20,000-
15,000                                                        July 01
10 000 -                                                         October 01
10,000                      Dollar Deposits
5,000 
0                       I
Jun-98 Oct-98 Feb-99 Jun-99 Oct-99 Feb-00 Jun-00 Oct-00 Feb-01 Jun-01 Oct-01
Millions of Dollars                 Time Deposits
60,000 -
50,000 -
Dollar Deposits
40,000 -                             A                               1
30,000
20,000                Peso Deposits
10,000 
Jun-98 Oct-98 Feb-99 Jun-99 Oct-99 Feb-00 Jun-00 Oct-00 Feb-01 Jun-01 Oct-01
Differential of Interest Rates
Basis Points
1600 -
1200 -
800-
400 -
0 
Jun-98 Oct-98 Feb-99 Jun-99 Oct-99 Feb-00 Jun-00 Oct-00 Feb-01 Jun-01 Oct-01
Deposits include private and public deposits. Differential of interest rates is defned as the spread between
domestic interest rates for 30-day time deposits in pesos and U.S. dollars.
Source: Central Bank of Argentina
38



Figurie 9
Change in Private Deposits for 50 Largest Banks
Cumulative                             December 2000 - March 2001
Change
20% -
10%  Iilfffhllifff.nn,-.-
0% -        n   unun      nI=,        -IwMUEEEEuMI
-10% 1                                                                         Ul,  -      immll0
-20% -
-30% -
-40%
Cumulative                             December 2000 - July 2001
Change
20% -
-10% 
-20%
-30%
-40%
Cumulative                             December 2000 - November 2001
Change
20% -
'0ml   I     im IPJU 
-10%                     U   I  U   U     U
-20%-
-30%-
-40%
0 Local private 1 Foreign private * Public
Sample: Average Deposit Change (%)          Banking System: Total
Local private  Foreign private  Public   Total     Deposit Change (%)
December 2000 - March 2001            -0.5          -4.0         -1.4      -1.9            -2.8
December 2000 - July 2001            -6.7           -6.1         -6.0      -6.3            -8.9
December 2000 - November 2001        -20.1         -18.6        -16.5     -18.8           -19.1
The bars in the graphs represent the cumulative change in private deposits sorted from largest positive to largest negative
change. A positive (negative) bar means that the bank gains (loses) deposits during the period. The different colors indicate
whether the bank is local private, foreign private, or public. The 50 banks in the samnple represent 98% of private deposits
and 96% of total deposits in December 2000. In the bottom table, banking system total deposit change includes all banks in
the system.
Source: Central Bank of Argentina
39



Figure 10
Change in Private Deposits for 50 Largest Banks by Deposit Type
December 2000 - November 2001
Cumulative                       Peso Demand and Savings Deposits by Bank
40%
0%
-40%
-80%-
Cumulative                     Dollar Demand and Savings Deposits by Bank
80%
-40%
Cumulative                             Peso Time Deposits by Bank
Change
80%
40%
-80%
Cumulative
Change                                Dollar Time Deposits by Bank
400/o-I
0%
-so%                           O Local private  El Foreign private  * Public
Sample Avrage Deposit Change (%/)         Banking System: 'Iotal
Local privat         rivate  Public    Total   Deposit Change (%)
Peso Demand and Savings Deposits       -31.5         -35.7        -36.3    -34.1         -36.0
Dollar Demand and Savings Deposits      35.6          14.4         19.8    24.6           11.3
Peso Time Deposits                     -45.2         -37.3        -32.7   -39.5          -37.7
Dollar Time Deposits                    -6.5         -13.0          7.5     -5.4         -13.9
The bars in the graphs represent the cumulative change in private deposits sorted from largest positive to largest negative
change. A positive (negative) bar means that the bank gains (loses) deposits during the period. The different colors indicate
whether the bank is local private, foreign private, or public. The 50 banks in the sample represent 98% of private deposits
and 96% of total deposits in December 2000. In the bottom table, banking system total deposit change includes all banks in
the system.
Source: Central Bank of Argentina
40



Figure 11
Financing Sources
Federal Government
Millions of Dollars
25,000 -
20,000-
15,000 -
10,000 
5,000 -
1991   1992   1993  1994   1995   1996  1997   1998   1999  2000   2001
E1 Privatizations and other capital income EIJ International financial institutions
1 International market, voluntary debt  0 Domestic market, voluntary debt
* Lecop
Province of Buenos Aires
Millions of Dollars
3,500 -
3,000 -
2,500 -
2,000 -
1,500-
1,000                                         M
500 
0o                           - X_ X__ 1~ l         1                ________
1992    1993   1994    1995   1996    1997    1998   1999    2000   2001
CV Privatizations                     EI International financial institutions
iU International market, voluntary debt  0 Domestic market, voluntary debt*
* Patacones (I and II)
*Includes bank debt and national govermnent financing.
Source: Central Bank of Argentina
41



Figure 12
Ecuador: Bank Deposits and Dollarization
Index of Total Deposits
(=100 in January 2000)
200 -                                            Government announces
180-                                           i dollarization
160 -
140 -                             i   ~~~~~~~~~~Dollarization is  _c
140-
|implemented: 
120-
100 
80
60                            F0:00 
40~
20
Jan-   May-   Sep-   Jan-   May-   Sep-    Jan-  May-    Sep-   Jan-  May-    Sep-   Jan-   May-
98     98     98     99     99     99      00     00     00     01     01     01     02     02
Dollarization was announced by President Mahuad in January 2000 but legally entered into effect only in March 2000, with
the approval of the respective law, and after President Mahuad was replaced by President Gustavo Noboa. Sucre deposits
are scaled by the conversion rate at which dollarization took place (25,000 sucres per dollar).
Source: Central Bank of Ecuador
42



Figure 13
Real Cash and Quasi-Monies in Circulation
200 -    -Real cash in circulation (Left scale)                                    4.00
180     --Real cash and quasi-monies in circulation (Left scale)                   35
Nominal exchange rate (Right scale)                                       35
160-
3.00
140 -
2.50
120
100                                                                                2.00
80                                                                                1.50
60 - -
1.00
40
20 -                                                                            . - 0.50
O 0                                      -                                       0.00
Jan-01  Mar-01  May-01    Jul-01  Sep-01  Nov-01   Jan-02  Mar-02 May-02     Jul-02
Quasi-monies only include Patacones and Lecop. Cash and quasi-monies in circulation are scaled by CPI.
Figures are monthly averages.
Sources: Central Bank of Argentina and International Financial Statistics
43



Table 1
Consolidation and Internationalization of the Banking System
1994         1998        2000
Numberoftotal banks                        166          104           89
Foreign banks
Number of banks                           31           39          39
Number of branches                       391        1,535        1,863
Share oftotal assets(%)                   15           55          73
Number of public banks                      32           16           1 5
Figures correspond to end-of-year values.
Source: Central Bank of Argentina
44



Table 2
Selected Banking System Indicators
1997         1998         1999         2000
Net Worth/Assets                                   12.1         11.4         10.7         10.5
Capital / Risk Weighted Assets                     18.1         17.6         18.6         21.2
Non-Performing Loans/Total Loans (a)               10.1          9.1         10.5         11.6
Provisions/Total Loans                              6.2          5.5          6.1          7.3
Provisions/Non-Performing Loans (a)                60.9         60.4         58.4         63.3
Systemic Core Liquidity (b)                        43.0         39.6         40.9         38.7
Return on Equity before Provisions                :22.6         10.6          8.4          7.8
Return on Equity after Provisions                   7.4         -2.2         -6.7         -9.4
Return on Assets after Provisions                   1.0         -0.3         -0.8         -1.0
Leverage Ratio (not in precent)                     6.1          7.3          7.7          8.3
(a) Non-performing loans is defined as the sum of loans with problems, loans with high risk and non-recoverable
loans.
(b) Defined as the ratio of international reserves of the central bank in foreign currency and other liquidity
requirements held abroad by banks to total deposits.
Figures are in percent and correspond to end-of-year values.
Source: Central Bank of Argentina
45



Table 3
Risk Indicators
Date       Annual interest rate (%)                   Annual interest rate (%)    Risk
7/1/1993   Peso financing                             Foreign-currency financing
up to 24                                   upto 18                      1.00
more than 24 to 27                         more than 18 to 21           1.20
more than 27 to 30                         more than 21 to 24           1.40
more than 30 to 33                         more than 24 to 27           1.60
more than 33 to 36                         more than 27 to 30           1.80
more than 36 to 39                         more than 30 to 33          2.00
2/1/1996   Peso financing                             Foreign-currency financing
up to 18                                   up to 14                     1.00
more than 18 to 21                         more than 14 to 17           1.20
more than 21 to 24                         more than 17 to 20           1.40
more than 24 to 27                         more than 20 to 23           1.60
more than 27 to 30                         more than 23 to 26           1.80
more than 30 to 33                         more than 26 to 29           2.00
Peso and foreign-currency financing: personal
1/1/2000   loans, credit card financing, and overdrafts  Other financing
up to 26                                   up to 16                     1.00
more than 26 to 29                         more than 16 to 19           1.10
more than 29 to 32                         more than 19 to 22           1.20
more than 32 to 35                         more than 22 to 25           1.30
more than 35 to 38                         more than 25 to 28           1.40
more than 38 to 41                         more than 28 to 31           1.50
more than 41 to 44                         more than 31 to 34           1.60
more than 44 to 47                         more than 34 to 37           1.90
more than 47 to 50                         more than 37 to 40           2.20
Risk indicator is used in the calculation of the risk value of loans and other financing (excluding credit to financial
institutions), which is then used to determine the capital requirements for credit risk. For higher interst rates other risk
indicators apply.
Source: Central Bank of Argentina
46



Table 4
Response of Peso and Dollar Deposits to Bank Risk Characteristics
1997-1999                         2000-2001
Pre-Crisis Period                   Crisis Period
Growth of      Growth of          Growth of      Growth of
Peso Deposits Dollar Deposits     Peso Deposits Dollar Deposits
Capital/Total Assets (t-3)     0.112 *        0.091              0.039          0.051
[0.068]        [0.062]            [0.053]        [0.059]
Non-Performing                -0.104 **      -0.067 *            0.009         -0.023
Loans/Total Loans (t-3)       [0.041]       [0.038]            [0.028]        [0.031]
Mortgage Loans/Total          -0.009         -0.007             -0.024         -0.003
Loans (t-3)                  [0.032]        [0.029]            [0.027]        [0.029]
Personal Loans/Total Loans    -0.010         -0.(19             -0.021          0.001
(t-3)                         [0.027]       [0.025]            [0.021]        [0.023]
Cash/Total Assets (t-3)       -0.112         -0.136              0.167 **       0.081
[0.094]        [0.086]            [0.075]        [0.083]
Public Exposure (t-3)         -0.036          0.050              0.002         -0.053
[0.048]        [0.0414]           [0.036]        [0.040]
Dummy Public Bank              0.010         -0.009             -0.004          0.008
[0.014]        [0.013]            [0.011]        [0.012]
Dummy Private Local Bank      -0.007         -0.011             -0.007         -0.004
[0.010]        [0.0(9]            [0.009]        [0.010]
Overall R-squared               0.05           0.08               0.07           0.15
Number of observations          1469           1469               1144           1144
Number of banks                   50             50                 50             50
The table reports regressions of growth of deposits on bank fundamentals including time dummies. Public exposure is
calculated as public bonds and loans to the public sector over total assets. Robust standard errors are in brackets. *
significant at 10%; ** significant at 5%; *** significant at 1%.
47



Table 5
Percentage of Variance Explained by Bank Risk Characteristics
1997-1999                     2000-2001
Pre-Crisis Period                Crisis Period
Growth of Peso                      19.2%                          3.6%
Deposits                            [0.05]                         [0.07]
Growth of Dollar                    10.3%                          1.2%
Deposits                            [0.08]                         [0.15]
The figures indicate the percentage of the overall R-squared explained by bank fundamentals, as a
proportion of all the time varying variables. They are calculated as the R-squared of the
regressions of growth of deposits on bank fundamentals over the R-squared of the regressions of
growth of deposits on both bank fundamentals and time dummies. Overall R-squared is in
brackets.
48



Table 6
Private Deposit Withdrawal by Currency and Type
December 2000 - November 2001
Growth of Peso Demand                Growth of Peso
and Savings Deposits                Time Deposits
(1)         (2)                 (1)          (2)
Currency Risk               -0.006      -0.012               -0.011      -0.011
[0.001]     [0.003]              [0.001]     [0.004]
Country Risk                             0.003                            0.000
[0.002]                         [0.002]
Country Risk*Public                      0.003                            0.000
Exposure                                [0.006]                         [0.008]
Overall R-squared             0.03        0.03                0.05         0.05
Number of observations       1144         1144                1144         1144
Number of banks                50           50                  50           50
Growti of Dollar Demand              Growth of Dollar
and Savings Deposits                Time Deposits
(1)         (2)                  (1)         (2)
Currency Risk                0.002      -0.006               -0.005      -0.001
[0.003]     [0.007]              [0.001]     [0.002]
Country Risk                             0.004                           -0.003
[0.004]                          [0.001]
Country Risk*Public                      0.000                            0.002
Exposure                               [0.014]                          [0.003]
Overall R-squared             0.00        0.01                 0.05        0.05
Number of observations       1140         1140                1140         1140
Number of banks                50           50                   50          50
The table reports regressions of growth of deposits on bank fundamentals and country and currency risks.
Although included in the regressions, bank fundamentals are not reported in the table. Figures correspond to end-
of-period values. Standard errors are in brackets. * significant at 10%; ** significant at 5%; * significant at 1%.
49



Table 7
Quasi-Monies in Circulation
(Millions of Argentine Pesos)
Denomination           December 2001      March 2002
a. Federal government             Lecop                          1,039           2,543
b. Provincial "own" securities                                   1,627           2,591
1. Buenos Aires                Patac6n                          822           1,591
2. Buenos Aires, City          Porteno                          -               -
3. Catamarca                   Ley 4748                          26              31
4. Chaco                       Quebracho                         50             100
5. Cordoba                     Lecor                            200             300
6. Corrientes                  Cecaror                          193             185
7. Entre Rios                  Bonfe                             54             148
8. Formosa                     Bocanfor                          33              50
9. Jujuy                       Patac6n                          -                 6
10. Mendoza                    Petr6m
11. La Rioja                   Bono de Cancelaci6n                8               8
12. Tucuman                    Bocade                            98             173
Total quasi-monies (a+b)                                         2,666            5,134
Total quasi-monies                                                26.2             37.5
(As percentage of pesos in circulation)
Source: Ministry of Economy, Argentina
50



Appendix Table 1
Post-1994 Banking System Strengthening
Eff CLive and anbitious f inbcial sector reforms,vigorously adoptedl in th second'haf'f the 1990s. were translated i ;nmajor
consolidation and internationalization of the balng system (Tab!'  'T The nunber of banks shrunk from 166 in -1994to 89-'
in-2000. Banks exited not just through mergers and acquisitions:but also through bank closures. The number of public lxnks'
decreased from 32 in 14994 to 15 in ;2000, reflecting an aggressive privatization process of provinuiial bans- The n'umber 9of
,branches of foreign-owned banks increased from 391 in' 1994to 1 '1163 in 2000,-while the share of these banks in the -systems
assets rose from 15 to 73 percent. ;  
This process was accompanied and- underpinned by an acceleration, inithe pace of legall rigulator  and superisory
i'innovations. The main improvements in the regulatory and-contractual-cnvironmrentiforIthe lEanldng-system are-briefly
described belo                                                  '                           -r
1 4 quantum leap fonard in a m'arkpt-friendly:approach to         ig 
-Much of this process was organized"arournd the innovative BASIC progran (in,Spanish: B. jbonos, A auditoria S
supervision' conso'lidada I =informacion  and C  calificadoras denriesgo),, BASIC wias an,Argentine -bred apprbach;
superimnposed on interrnaionally recognized CAMIELSbased supervisory mnethodology, to. enhince the complementarity
between official and market monitoring The "B" in BASIC'ermphasizedthe requirement oi baisi' to issue subordinated debt
so as to generate better price signals of bank risk. Tihe "A"' stood for a. program to improve initernlLl and external audits. The:
"S"'relerred to the implementation,of consolidated supervision of fianciaal conglomerates. The "1'.,reflected a major progrrf
Lo enhance the0quality depth, coverage, and dissemination ofninfopria on--througirhigher reporting standards fot financial
statements, broader and'easily accessible information on debtors, mnd more stringent iriformatioi requi ifments on fipancial'
grou-p sd-ucure- and oi%nership. .And the IC" refetred to the requiwement on larger. banks :ti hav nnual ratings byg
international rating-firms. ,Patly as a result of the imnplemnentatiDn 01 the BASIC program,,itr kvas broadly believed;that
Argentina in the late 1990s was near-full,,o,rnpliance with the Basle Core Principles'for Effective Binking Superviision.
-  |;- -                        I1 *8> fit1IL
Particularly noteworthy in the Argentine regulatory -eform was the introdut ion of rigorous system of capital requirementis
defined -to absorb both credit and market risks, and.significantly more stringent that the Basle minimum standard  The system
featured various, components. One~ component was minimum capital requirementt for credit rissof -1:5 percentVof risk'.
- weighted Ioan exposures td the private sector, with variable weights,within each loan class depending dn the'risk of ipdividuafi
loans, as m'easured, b ,Lhe inierest, rale-charged on.the' Idan. T lus ratio; moreover,- was augnem1ited by a, faclor f6r1baik
receiving lower CAMEL, ralings. In addition, during 2Q00, positive risk weights-were intro,duced fEr loans,to the governmrent-
and-mrk'to mark'eete uirieents were iritroduced for holdings of 1o'-eminent bonds, Finally- cariital requiremnents"were set'
separately to absorb unexpecied fluctuationi in interest rates and in lhe6prices of private sector secwuiies. ',--~,~
.:Also notewonhy-were the suringent -liquidity, requirements,- high -by -international standards, and itended two'wrk counter,-
-cyclically-i.e., to be tightened during buoyant times and relaxed durinig times of systemic liquidity squeeze. By'1998, most
d4iosits (those with m'aurities 6f less-than 90,days) required a 20 percent (fernunerated) reserve- '- -
,, ,  , -  --  , - j-  -                          :  |                          -r
,            ;~ I  !                    -  - .           I ;-'                           r[~ ' ~ _| r  ) ; r) > |;
* ~ ~~~~ _  -  , -*,  - I'  --                                                       **  _  I -   1-  - - 
Sl~~~~~~-                                *--



Appendix Table 1 (Continued)
Post-1994 Banking System Strengthening
2.A  'si'*r                        i 4-                                                                      . -
2. l4best pr,actice ;schteme fr tro2ubled bank resolution w '         ->-- --t;..,- r'__ . 
1'  -     -                _  -
ifltr the Tequila,' Arg'eniina introdu'cd key institutional innovationfs io enhance the b'ank exit framreiork,- including An. 35bis
- the banking law''-vwhicbicreatedE an -efficient system fo'r bank closure and,resolution-and a pv'Iaely managed' imited
depoitiiinsurance scheme (SEDESA) This fraework greatlycontributed th econsolidation of the banking system through the 
exit of unviable banks. '-Argenttna.became a salienficase inthe region' where un-viable banks (and not jusL small ones)'were.
::actually tlosed-between l)99-and 2000 about 20 banks were closed using the powers of Article 35bis.(I)
*      Lfrt r.;E1 .;-  . =-  I
-3P     arlvatLzn of provlicial baks'i
Between 1994andLl998e16.provinciaI bankswerepnriatized wvithina process that though not perfect was among the most
aggressive and successful in the rgion (2)               -
ii~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~7
4'Contngent repofacirs
; 5;w.-.                q;,>. . }i1,-;:, ,;, 
,This -was-,an oter collacera1izedsfacility structured in order to partially compersate for the'vitualWlack of a domestic lender of'
Iar'resort and to swengtheith'e bariing system s capacity to weather.a liquidity crisis. .The t'acility gave the BCRA the optioni-
.to selldollar denominated Argentinegovernment bonds to a consortium  1oreputable iniernational:banks, subject to a buy-bac-
clause:(wiith'an emkbeddedimplicit interest rate)  n i999 the'World'Bank-reinforced-this facilit,yby committing conlingent
-idst'o-'help m;eet:margin calls in the<eventitwas'activated  By the!endof thet 1990s,the-contingenttrepo lineerisured the;
',liquidit ;of:abo'ut I'@percentb1I -sStem. deposits, in addition to the etquivalent of nedrly 20 percent ot deposis alr
- held inNt.'f6rm'lof iiquid -ands  'FX assets (dollar cash and near-cawh in the central bank and commercial banks)
!Cr %g -- j q; ,,  ';1< 2 F  ; _~~~~~A-                                 -
.;5: .Imnprovements in the framework for creditor rights and corpora'le insolpencyor'- .
in.-;995  Argentiria enacted ainew-' modernm-insolvency.law  that fostered a substantiaily improved1 syteM of corporte
.liquidation. anid-'rehabilititon.4'Similarlyimnportan.trefonns-were imnpiemienited- to improve the enforcement of secured and
-_unsecured creditor -rihts- The WorldBBank assessmento1 Argentinia's-degree ot cormpliatnce :with international sLandards on.
tisolvNency.-and 1cre7ditrarits f6ound tha,- if one ignores the c hangs introduced mnost r'ectnly (in March 2002), the
permanenlt" frakm-ework for ,corporate insolency'and creditors rights is largely consistent'with the Principles."-
:~ !                                  --d                                -                              .  - 
'  _ t' '  -; ,. r-                                           i     -|    I ~1 t 
(1) For further details see De la Tone (2000)
(2) A thorough assessment of the process and results of provincial bank privatization in Argentina can be found in World Bank (1999).
52



Appendix T'able 2
Argentina's Via Crucis
- President De la.R1atlakes power in'Deceriber 199 when the country is already in recession and the public debt has reached
high levels. -                                        ! *            -                       I       -'
- The government tries.to gain confidence, and ihus testore'gro6vtth, through fiai'idjistziierit.
- The "imp' estaz& is-implemented in January 2000. The new tax scheme inchjdes, among oth-r things, an increase in the
. taxation on consurner.goods, an' extension ot VAT to health ins'urnce and transportation and an extension of the income lax
base.     .                                          -.
- The fiscal adjustment does not bring growth. Rather, Lhe recession deepens and doubts aboutldebt sustainabilit) increase
dramatically;. 
- The-political weakness' of the De-la Rua's adrmiinistration becoines esvidnt When vice president Carlos-Alvarez resigns in
OcLober 2000.
-- In December 2000. MinisterMNlachinea negoliaces k' US$40 billion package with international financial institutions and
domesLic financial institutions to extend the public 'debt maturityand cry to ease fears of default' The deal implied a much
lower amount of fresh funds around US$12 billion    .                          '-
- The government's bet is that on&' these fears were eased;-growth .would resume, but growth does nit pick up and Mr.
NMachinea resigns in NMarch 2001.  -              -'
- The iewly appointed economy minister Lopez  urphy resigns after-tto weeks in office, upon stong opposition to the new
fiscal austerity packa4e he sent to Congress on March 16. '
- Mr. Cavallo becomes economy minister once more. 'He-is emporwered:b) Conjress"with special pow%ers and tries different,
more,direct, measures to revive grov;th.- On-April 16, 2001, he proposes to.congress an amendmenn tlo the convertibilio- law,,
according to which the-peso would be pegged to a basket consisting-of US dollars and euros with e6qualweights when-the
dollar-euro race reaches 1:1. Congress approves the amieniimeni in,mid-June 200 1. 'This charige aims, at better aligning the
peso imore with Argentina's trading partners.
- On April 25, 2001, the president of lthe central bank, MNr.,Pedrni Iou, resigns at;mid disagreements with Mr Casallo and other;
members of the government. Nlr. Roque Maccarone replaces NMr, Elou -    .
On July 10, '001. the govermnent, after being forced to pay 11:410 basis points over'US Treasuries to place a short-term
-bond, announces a "zero deficit" rule.
-- It thus becomes obvious that the govemment cannot tap capital markets without the-debt exploding.  .  -  ' '
-- TO implement the zero dGcit rule.- the government pushes' hard for- an [MlF-supported program. But to obtain it, the
government needed ai-agreement with-the proninces on tax revenu. sharing::  ' - ,     - - -   - - -  -
- Nr. John Taylor, US Treasury under secretary-; declares;thaU Lheie would not be& any external help for Argentina unLil it can
comply with its objective of a zero deficit.    ' -    .. -  .- -   . - : -  -      - ' -
- -On' October 26, 2001, the negotiations toward an agreement wicth the provinces on-the distribution of iax -revertues fail
(again).  ' .  .   - '    '       -'  - '         - * i-  I _         -  - '  '        -             '
- On October 28, 2001, minister.Cavallo starts negotiations to-obtain resources from the UIMF and ihe lJS Treasury tO purchase
collateral for new bonds to be issued in an exchange for the nearly US$100 billion 6f local and ext.:rrial debt'
On October 29, 2001, Nlr. Ca,allo-defines the debt exchange operation as' voluntary. The old debt would exchange for
bonds paying seven percent per year and guarantee by taxes reveril,es. However, the IN[F and US rreasury ask for compliance
with the zero-deficit and an agreement with the proiinces on-the ax revenue sharing before any kind of financial support is
given. The negotiations last for more than a month.-'     --   -   -   -       -
.  ;               -     I   , -  i.-  -       .      .         .       .  
….           .  ,.  -     -      '  .    i        -- '  -  -  '  :, .'  --
53



Appendix Table 2 (Continued)
Argentina's Via Crucis
November l9~~~~~~-200P tliflMF3ahnoun&ts ~ ~ ~ Llqf
-                            -t314.: b  chat.it'woduld not;ma dk  e d  s i  ge inuw
Me'dithm4hlo-4try -siscEfied4the;goa9s,pry1ousiysd6flnedt ,us. .--dar n.'.  
On Decembe2(2001,e                                                     wnounceslmeasures aestrcingdeie
-limifted to,250,pesds(d Oper,week;per'cbunL' *                       a        -;
to  Deeme O 19 2ob i  tttr:|WaIIb'nhd1l 4,ther m-n-s s'b o  h~np''ine'-   dn-'i
'WE  Jc-p.~ "~ c  -,Q . 
-Oin,Ddeember 20 1200! ;Presidpntl aR6reinadMRnonPuerta -becomes intenm-preii'dnt
'201M !E R * " u e a"gz rCr o'-f~htrocs, becomesin the. new :intenim-fpresident- W-s
=              i    uak;60tcays p,enffntil hle3ini ot2002Heldciaresthe suspension,of external debL:
t h 2   0     0     1    .      M~~~~~~~~~~~~4 -A,r~r - *+- - -e  -f-
-president. He,assumes-power.on Januar-~2 2002 -anid officialy ends 4Lecrc board and anouncesethe floting of the
54



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