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How to Forestall International Financial Rescue

The firemen at the International Monetary Fund are busy rescuing Argentina and Turkey. They have just confirmed a Dollars 10bn package for Turkey and an imminent package for Argentina will total at least Dollars 20bn. How can this be? For the last year, Argentina and Turkey have been touted as model IMF borrowers.

Argentina’s current problems began a year ago. To remedy an economic slump, the administration embraced an IMF-hatched economic plan based on a standard fiscal consolidation programme, including tax increases. We were told this would enhance confidence, lower interest rates and produce an economic expansion.

But as the government and the IMF peddled this tale, rates in the US, the euro-zone and even Japan were rising. How could a fiscal consolidation package lower interest rates in Argentina when those elsewhere were rising? The plan was hopeless and Argentina soon found itself in a crisis of confidence that sent rates higher. As a result, the slump intensified.

Since 1991, the Argentines have employed “convertibility”, an uncommon term for an unusual system. Although this monetary set-up looks like a currency board and is superior to the former regime, it deviates from orthodoxy in many ways. The Convertibility Law, which governs the central bank, requires only that the central bank’s peso monetary liabilities be covered by a minimum of 100 per cent in dollar-denominated assets. Accordingly, when the central bank’s assets exceed its monetary liabilities, the one-to-one link between foreign reserves and the monetary base is broken. Convertibility also allows the central bank to engage in limited lender-of-last-resort activities, to regulate reserve requirements of commercial banks and to hold up to a third of the dollar-denominated reserves it keeps to back its monetary liabilities in the form of bonds issued by the Argentine government.

It was inevitable that these deviations from orthodoxy would result in a less-than-perfect unification of the peso and dollar. Sure enough, even though the peso-dollar exchange rate has remained fixed at one to one, there has often been speculation of a peso devaluation. Interest rates in pesos have accordingly been persistently higher than interest rates in US dollars within Argentina.

To remedy this problem Argentina should eliminate the peso and fully dollarise its economy. Interest rates would plummet, as they have done in El Salvador, which has passed a monetary integration law allowing for full dollarisation.

Turkey is yet another IMF-generated fiasco, one that caused overnight interbank interest rates to soar to almost 2,000 per cent. Turkey, like Argentina before 1991, has a history of very high inflation – 80 per cent a year on average in the 1990s. The Turks bit the bullet in December 1999, when they agreed to a disinflation programme supported by an IMF Dollars 4bn stand-by arrangement. The linchpin of this programme is a crawling peg exchange rate in which the Turkish lira is allowed to depreciate slowly against a euro-dollar currency basket.

The unique feature of this set-up is an IMF-imposed requirement that the central bank must target the level of its net domestic assets (NDA). Accordingly, the only way the level of base money can change is if the foreign component changes as a result of inflows or outflows of foreign exchange at the central bank.

This looks like a currency board but it is not and does not even have the force of statute law behind it – the IMF agreement is the only place where the NDA target mechanism is spelled out. Since 1961, Turkey has signed 17 IMF agreements and has broken them all -a perfect record of failure. Consequently, the ersatz currency board arrangement is in effect worthless. In fact, the new set-up worked like a charm while the central bank was following the currency-board-like rules. Inflation and interest rates came down hard. Then, confronted with external drains of foreign reserves, the central bank decided to break the rules on November 17. To offset the decline in the foreign component of the monetary base it began to pump up the domestic component of the base by injecting liquidity into the system. As a result the NDA exceed-ed its end-of-December target by more than Dollars 3bn.

Turkey must abandon its ersatz currency board and install the genuine article. An orthodox board law that prohibits lender-of-last-resort must be passed. To give the law credibility, the government could write put options on the Turkish lira, essentially guaranteeing convertibility at a predetermined rate against their euro-dollar currency basket. These puts would create a strong incentive for the government to adhere to the currency board law: if it devalued it would be penalised.

Unless these proposals are followed, Argentina and Turkey will continue to struggle and the IMF’s programmes will probably fail once again.

Hanke also wrote the following letter to the Financial Times, which was published on Dec. 19.

From Prof Steve H. Hanke.

Sir, Mr Murat Ucer (Letters, December 15), asserts that I am “somewhat naive to think that a currency board would have avoided Turkey’s financial chaos during the past few weeks”. He then attempts to support his claim with standard dogma, namely that Turkey did not satisfy the preconditions necessary for such a rigid monetary framework.

Mr Ucer, and others that embrace this preconditions dogma, should examine the evidence before peddling their wares. In “The Disregard for Currency Board Realities”, contained in the current issue of The Cato Journal (, I present the evidence. It confirms that the dogma is literally nonsense.

Turkey’s wobbly banks, many which operate more like hedge funds than banks, became more emboldened after the IMF agreement of December 1999. Indeed, they borrowed dollars at low rates and invested in high-yielding Turkish T-bills with reckless abandon. In consequence, the banking system’s net foreign assets plunged deeper into negative territory. Many of these positions were in effect “open” because the off-balance sheet forward positions used to hedge this arbitrage were not worth the paper they were written on. Moral hazard was alive and well in Turkey. It is not surprising that foreign investors got spooked and started pulling funds out of Turkey on November 17.

With a currency board and no lender of last resort, none of this would have occurred. Indeed, the banks would have been forced to clean up their act as they have since 1991 in Argentina.


Author Steve H. Hanke

Wednesday March 23rd, 2016

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