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Dollars for everyone?

Top financial officials from the Americas and economists from multilateral institutions joined in an intense debate over dollarization at a recent seminar on how countries can deal with turbulence in world markets.

During the seminar "New Initiatives to Tackle International Financial Turmoil" finance ministers from Mexico, Chile and El Salvador, and senior economic officials from Argentina, Brazil and the United States, analyzed the advantages and drawbacks of keeping flexible or fixed exchange rates in the face of persistent market volatility. The event, which was held in Paris last March, in conjunction with the IDB annual meeting, was designed to provide technical support for countries formulating positions on these issues.

In his presentation, IDB Chief Economist Ricardo Hausmann argued that exchange rate flexibility had not been much of an asset for Latin America, resulting in higher real interest rates and smaller financial systems. An analysis of how interest rates behaved in 11 Latin American countries between May 1997 and October 1998-a period that included major shocks caused by the Asian financial crisis, the collapse of key commodities prices and the Russian debt crisis indicates that interest rates moved the least in countries with rigid exchange rate policies, such as Argentina and Panama. Such a result flies in the face of conventional theory.

Also, Hausmann said, the credibility of minor Latin American currencies, whether floating or fixed, is limited. This is proven by the fact that none of them has managed to create long-term debt markets denominated in their local currency. The result is that firms are forced to make a dangerous choice: borrow in dollars and be exposed to exchange rate mismatches, or borrow short term in local currencies and risk maturity mismatches and liquidity crises.

The presentation prompted both strong endorsements and criticism. Salvadorean Finance Minister Manuel Hinds clearly favored dollarization.

"You need to have a standard of value," said Hinds, who said he planned to recommend to the incoming administration of president-elect Francisco Flores to fully dollarize El Salvador's economy. "The population of Latin America already has a standard of value: it's the dollar."

In a paper he prepared for the seminar, Hinds called flexible exchange rates "a curse" for Latin America, and likened devaluations to leg amputations. "If you don't believe me, go ask common citizens in Mexico or Brazil who cannot pay their mortgages, who have lost their savings, who face sky-high interest rates and a drastic uncertainty," he stated in his paper.

Hind's Mexican counterpart, José Angel Gurría, vehemently opposed dollarizing, calling it inappropriate and ill-advised. "Would a dollar bill with the face of Columbus be the solution? The answer is no," he said. While he acknowledged that Argentina had benefitted from a rigid exchange rate system that ties its peso to the dollar, Gurría argued in favor of the floating rate regime Mexico has followed ever since the 1994 peso crisis.

Chilean Finance Minister Eduardo Aninat also voiced skepticism about dollarization. Until a recent slowdown triggered by a plunge in the price of copper, Chile's leading export, his country had managed to grow impressively during more than a decade while keeping a policy of exchange rate bands that affords its peso some flexibility.

"I am very skeptical about extremes in exchange rate regulations," he said.

Argentine Economy Secretary Pablo Guidotti, whose country has successfully maintained a currency board-like exchange policy since 1991 and has analyzed the possibility of switching to dollarization, said other countries should weigh the costs of sticking to national currencies. Arguing that in an increasingly globalized economy it made little sense to have to deal with 180 different national currencies, the Argentine official suggested that emerging countries will eventually have to come to terms with a dwindling demand for such a diversity of currencies. "Current financial trends tell us that the markets point toward an eventual decrease in the number of currencies," Guidotti said. "Something in the financial markets is asking us to find ways to reduce risk and uncertainty."

Brazil's Central Bank president, Armínio Fraga Neto, noted that a fixed exchange rate had worked for Argentina just as well as a more flexible regime had worked for Chile. The Brazilian government, which last January devalued its currency after keeping it on an exchange rate band system for several years, has since adopted a floating exchange rate. Fraga said the new regime is well-suited for a country of Brazil's geographic and economic size. "We've now had decades of experience with the gold standard, fixed exchange rates, floating rates, and to me the answer is really not so obvious. There is nothing telling me that Latin America is different from any other region," he said.

In his speech, U.S. Treasury Deputy Secretary Lawrence H. Summers said that dollarization may attract some governments with the promise of stability, but noted that countries embarking on such a course would have to be prepared to accept the outcomes.

"There is no substitute for national policy for shaping national outcomes," he told participants at the seminar.

While the U.S. official said that dollarization can help a country to integrate into the world economy, "it also means that a country must embrace greater discipline."

If a country did decide to dollarize, it should engage in technical consultations with U.S. officials first, he said.

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