South-Western College Publishing - Economics  
Dollar Fixes and Peso-Problems
Subject Exchange Rate
Topic International Finance
Key Words Exchange Rates, Economic Growth
News Story

Argentina decided to peg the value of its currency, the peso, to the dollar, in an effort to control inflation and promote growth. This policy was very effective - moderate price increases provided the stability that produced average annual growth rate of 5.8 percent between 1991 and 1998. Argentina is now in a recession. The stability that resulted from the dollar-peso peg now prevents Argentina from stimulating its economy by weakening its currency.

Argentine exporters are burdened by high labor taxes, high interest rates - about 17 percent in inflation-adjusted terms, and high costs for business services. Without the ability to devalue its currency, business firms must seek alternative means to lower their costs. However, this being an election year, Argentina's government has not adopted cost-cutting policies for business. Tax cutting policies, like those adopted in the early 1990s, would increase competitiveness, but in this election year, proposed tax changes appear to hurt competitiveness. With an inflexible exchange rate and no policies to assist exporters, gross domestic product is predicted to fall 3 percent this year and exports to decline 12 percent.

Argentina's lack of competitiveness means that its exports either command lower prices, or that there are fewer buyers of its products. The consequent slowdown in economic activity is contributing to a rise in Argentina's debt at a time when servicing this debt is climbing. Argentina's reaction to its mounting debt is to refinance it. It recently swapped $3.91 billion of short-term notes for new two- and five-year notes.

Almost every major Latin American country has seen its currency weaken in the past few years. Some of these countries, like Brazil, responded by devaluing its currency. Argentina has stubbornly stuck to its dollar link. It therefore must seek other means to stimulate its economy.

(Updated June 1, 1999)

Questions
1. What happens to Argentina' exchange rate when it pegs the value of its currency to the U.S. dollar?
2. Why would pegging the value of its exchange rate help Argentina control inflation?
3. What would happen to Argentina's exports if Argentina were able to devalue its currency? What would happen to GDP?
Source Craig Torres, "Argentina's Peso-Dollar Peg Is a Drag On Efforts to Make Exports Competitive", The Wall Street Journal, May 19, 1999.

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