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ByJoaquin Cottani

The myth is that Argentina’s strong post-crisis recovery was due, primarily, to the maintenance of a high and stable RER supported by government intervention and a prudent mix of fiscal and monetary policies. In reality, the high rates of growth observed since 2Q02 were due, primarily, to favorable international conditions and, secondarily, to an undervalued (hence, unstable) RER. Fiscal policy was expansionary and monetary policy was, at best, accommodating.

Let us begin by examining the facts. When the last financial crisis erupted in Argentina in 2H01, the RER was, clearly, overvalued. Due to a sudden stop in capital inflows, low terms of trade, a strong USD, and a depreciated BRL, the RER level needed to ensure full capacity utilization and external balance was about 25% lower than the actual one. But, since the Convertibility law prevented nominal depreciation, a quick adjustment was not possible and, as a result, the output gap and the current account deficit were unsustainably high. Argentina reacted to the crisis in 1H02 by defaulting on the public debt, then devaluing the peso. Relative to December 2001, the ARS is, even today, 50% cheaper in real effective terms. Yet, soon after these measures were introduced in 1H02, international conditions improved dramatically. Export prices increased, world interest rates declined, and the government was able to restructure the public debt in very favorable conditions. Moreover, the USD depreciated vis-à-vis the other main currencies of the world while the BRL appreciated in real effective terms. The combination of these effects was a major increase in disposable income, real GDP, the RER, the current account, and (since much of the external windfall was taxed by the government) also the federal and provincial budgets.

Thus, in retrospect, the 50% depreciation of the RER was, probably, not necessary. Of course, the government that lived through the crisis in 1H02 did not know that, a few months later, international conditions were going to improve as much as they did. The question is why, once that became clear, neither they nor the administration that followed let the RER appreciate but, to the contrary, made RER undervaluation an explicit (and key) policy objective. To some analysts, the reason is pretty obvious: by increasing export competitiveness, the low RER stimulates growth. The problem with this argument is that it does not differentiate between a low equilibrium RER and a low disequilibrium one: one thing is to reduce the RER by, for example, reducing government spending as as share of GDP and another is to do it by repressing inflation. The first policy generally leads to a sustainable increase in growth. The second does not (although it may exacerbate aggregate demand in the short run).

How did the government of Argentina manage to undervalue the RER? Very simple: it instructed the central bank to intervene in the FX market (to prevent nominal appreciation) and sterilize part of the excess supply of money resulting from this intervention (to limit real appreciation). Since this was not enough to do the job, the government also increased export taxes on food and fuel and imposed direct controls on basic consumption prices, formal wages, and the tariffs of most energy products and public services (incidentally, this is not very different from what China is doing). Thus, RER undervaluation caused a second round of expansion that drove the economy well beyond the point of adequate utilization of the installed capacity causing inflation to accelerate much more than the official records show.

Maintaining the RER at its current level without adjusting the fiscal/trade/incomes policy mix, will exacerbate distortions and, ultimately, become unsustainable. This, assuming the international environment remains favorable. If, on the other hand, the latter becomes unfavorable, Argentina’s twin surpluses (external and fiscal) will vanish and the RER will probably have to depreciate even more. The risk is that, in this context, the government will lose control of inflation. If this happens, the economy will, most likely, stagnate. Consider the following two alternative scenarios.

First, suppose, optimistically, that the world can avoid a global recession. To ensure adequate economic performance in the long run, Argentina’s growth model must undergo fundamental changes. For starters, domestic prices must be liberalized. This includes the realignment of tariffs in the energy and public services areas and the elimination of price controls on basic consumption items. These policies would inevitably produce inflation acceleration and a decline in the RER. The only way in which the government can ameliorate these effects is by implementing a tighter fiscal policy accompanied by trade (particularly, import) liberalization. But, this is opposite to what Argentina has been doing in the last three years.

Now, let us imagine there is a global recession. If this happens, Argentina will be ill-prepared to absorb the external shock . Unlike Brazil, which let the real exchange rate appreciate and the overall fiscal deficit to contract during the expansionary phase of the cycle, Argentina applied the opposite recipe: it let the real exchange rate depreciate until the latter became grossly undervalued, and allowed the fiscal surplus to fall in spite of record-high growth in tax collection (see graph). By implementing this highly pro-cyclical mix of policies, Argentina did exactly the opposite of what the doctor ordered. So, now, when rational policymaking would dictate that the currency be let depreciate in response to weaker external fundamentals and the fiscal surplus fall in response to an endogenous reduction in tax collection, there is little room for both.

Addendum: The case for a depreciated RER

Export-led growth—the idea that preserving the profitability of the export sector helps improves growth performance—has many adherents not only among professional economists, but also among politicians. Yet, not every advocate of export-led growth really knows what he/she is talking about. For some, it is merely a question of avoiding the “foreign exchange gap,” whatever that means. For others, it is the fact that productivity is higher in the exportables sector.

The problem with these linear interpretations is that they can be used to justify undervaluing the domestic currency as a way to jumpstart a growth process. Consider, for example, the argument that, because labor productivity grows faster in the tradables sector, the government should keep the RER as high as possible during takeoffs. This is like putting the “Balassa-Samuelson effect” on its head. What Samuelson and Balassa showed was that the difference in labor productivty growth observed in the tradables and nontradables sectors explains why the RER appreciates more in fast-growing countries than in slow-growing ones. If there is a causality, it goes from growth to the RER rather than the other way around. Moreover, the correlation is negative rather than positive!

While it is commonplace to invoke the role of a depreciated RER in the takeoffs of sucessful East-Asian exporters—Japan in the fifties, Korea in the sixties and seventies, and China in the eighties, nineties, and even today—the link between both was more sophisticated than RER activists typically assume. In those countries, income growth was reinforced by a phenomenal increase in saving and investment rates. Typically, saving rose more than investment, causing large trade surpluses and RER depreciation. Notice, however, that the likely cause of growth was not the high RER itself, but the fact that, to get to it, countries had to increase national income faster than consumption.