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Chapter 8

The International Financial System

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(Unsterilized) Foreign Exchange Intervention and Money Supply

To control the ExchRate, CBs might want to intervene in the forex mkt:

When Central Bank of TR purchases dollar (foreign currency) and sells TL (domestic currency), its dollar (international) reserves increase, the monetary base and the money supply (TL) increases.

When CBT sells dollars and purchases TL (dom. currency), its dollar (international) reserves decrease, the monetary base and money supply decreases.

Central Bank

Assets Liabilities

International Reserves ($)

+TL1B Reserves(or Currency in Circulation)

+TL1B

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Unsterilized Intervention When CB purchases or sells foreign currency from

and to the banking system, we call these operations “unsterilized interventions”. Why does the CB intervene?

An unsterilized purchase (sale) of foreign currency ($) leads to a gain (loss) in international ($) reserves, an increase (decrease) in the money supply,

and a depreciation (appreciation) of TL (domestic

currency) against dollar (foreign curr.)

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0.76

D’

0.62

S

D

0.83

Qty of TL assets

Effect of an Unsterilized Purchase of Foreign Currency

D’’

$/TL exch. Rate

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Sterilized Foreign Exchange Intervention

Since unsterilized interventions raise Mspply and might cause inflation, CBs usually sterilize forex interventions. Sterilization: By doing an offsetting open market operation, CB neutralizes the effect of the forex intervention on the money supply.

Example: If CB buys dollars and increases the TL reserves, immediately CB also sells govt. bonds at the same amount. This leaves the monetary base and the money supply unchanged.

Central Bank

Assets Liabilities

International Reserves +TL1m Monetary Base no change

(reserves+currency i.c.)

Government Bonds -TL1m

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Sterilized Foreign Exchange InterventionA sterilized purchase (sale) of foreign

currency leads to a gain (loss) in international reserves, No change in the money supply,

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Balance of Payments (BOP)Balance of Payments = Current Account +

Capital Account (Net Capital Inflows)

Balance of payments shows the net change in the foreign exchange (dollar) reserves of an economy during a certain time period.

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Balance of Payments1. Current Account :Inflows (+) Outflows (-)

1. Trade Balance = +Exports – İmports2. Services Balance

1. +Net Foreign Tourism Revenues2. +Banking & Insurance Net Revenue3. +Construction & Transportation Net Revenue4. +Workers’ Remittances + Paid Military Service

3. Net Income from Foreign Capital (interest+profit transfers)

4. Unilateral transfers (Aid to or from other countries)

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Balance of Payments“Current Account (CA) Deficit” means that

CA balance is a negative number. This is usually because the largest item “Trade Balance” is negative. For example, Turkey’s 2008 (2007) January-March exports are $33 ($24.4) bn, imports are $49 ($33) bn, trade balance is -$16 (-$8.6) bn.

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Balance of Payments2. Capital Account = Net Capital İnflows

=capital inflows – capital outflows1. +Purchases of Domestic (Turkish) assets by

Foreigners (ind., firms, govts) 2. – Purchases of Foreign Assets by Domestic

(Turkish) Residents3. Credits: + Net Borrowing of Turkish Residents

from Foreign residents (+borrowing, -lending)

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Balance of Payments Capital Inflows: Two types:

1.Foreign Direct Investments (FDI): Takes control of the firm, bank, etc. Ex: Migros sale to British, Finansbank sale to NBG, ToyotaSA, are FDI inflows. Ülker purchase of Godiva is FDI outflow.

2.Foreign Portfolio Investment (FPI) (stocks, bonds, credits). Foreign investors buying stocks at BIST, Turkish banks & firms borrowing from foreign banks are FPI inflows. Turkish banks lending to Azeri firms is FPI outflow.

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Balance of PaymentsDifference btw FDI and FPI: In FDI, the

investor has a share in the investment enough to control the decisions of the company (maybe10%). In FPI, investor is only creditor, takes less risk (only default and int rate risk). Has small shares in various companies.

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Balance of PaymentsExcept for year 2001, TR’s current account

has been negative. However, TR’s capital account surplus is positive and usually greater than its current account deficit. This means that there was a net dollar inflow into TR. This is why dollar has depreciated against TL during 2002-2007

2000 2001 2002 2003 2004 2005 2006 2007

Current Account/GNP(%) -4.90 2.37 -0.99 -2.86 -5.17 -6.39 -6.62 -5.7

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Exchange Rate RegimesFixed exchange rate regime

Value of a currency is fixed (pegged) to the value of one other currency (usually dollar or euro). CB intervenes daily by buying and selling dollars to keep ER fixed.

Turkey followed fixed ER regime before 2001. ER was kept within a band. Will explain below...

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Exchange Rate RegimesFloating exchange rate regime

Value of a currency is allowed to freely fluctuate against all other currencies: no interventions in the forex market.

Managed float regime (dirty float) Officially free floating, but from time to time, CB

intervenes by buying and selling currencies. Because sometimes the E.Rates becomes very volatile, during turbulances. Turkey has followed managed float after 2001. A turbulance in 2006, others. Turkey currently follows “inflation targeting”, but still want to control ERs: “impossible trinity”

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How a Fixed Exchange Rate

Regime Works Suppose that the official fixed parity is 1,31

TL/USD. Suppose that for some reason demand for TL assets increases. This increases value of TL in the free forex market above the official parity: 1,20 TL/USD.

In this case, CB buys dollars and sells TL and increases the money (TL) supply. This decreases the interest paid by TL assets, which reduces demand for TL assets. CB can buy dollars until the free market ER is equal to the fixed 1,31 TL/USD. CB’s international (forex) reserves increase.

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How a Fixed Exchange Rate Regime Works

1/1,31

D’

1/1,60

1/E S

D

1/1,20

Qty of TL assets

($/TL)

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How a Fixed Exchange Rate

Regime Works Now let us suppose that for some reason demand

for TL assets decrease (maybe because FED increases policy rates). TL loses value in the free forex market below the fixed parity.

In this case CB buys TL and sells dollars. This reduces money(TL) supply and increases the interest rate on TL assets, which increases demand for TL assets, which increases the value of TL back to 1,31 TL/$.

But notice that CB’s dollar reserves decline in this process. If CB does not have enough reserves to defend the peg, then it must either float or devalue TL to a lower level like 1,6 TL/$.

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How a Fixed Exchange Rate

Regime Works

1/1,31

D’

1/1,60

1/E S

D

1/1,20

($/TL)

Qty of TL assets

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Gold StandardGold standard: 19th century and until

World War I Fixed exchange rates system: all currencies are

pegged to (backed by) a certain amount of gold. No control over monetary policy Money supply influenced heavily by production of

gold, gold discoveries and imports. When gold production rate (or imports) is smaller than (higher than) GDP growth rate, money supply increases slowly (fast), deflation (inflation) happens. (qty theory, MV=PY)

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Bretton Woods System Bretton Woods System: 1944-1971

Fixed exchange rates system using U.S. dollar as the reserve currency: $ 35 convertible per 1 ounce of gold (only for governments and CBs, not public).

Institutions that support the system: International Monetary Fund (IMF) World Bank General Agreement on Tariffs and Trade (GATT)

Became World Trade Organization

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How Bretton Woods (1944-71) Worked Exchange rates adjusted (devaluation or revaluation)

only when countries experience a ‘fundamental disequilibrium’ (large and persistent deficits (or surpluses) in their balance of payments)

Loans from IMF to the deficit countries to cover loss in their international reserves

IMF encourages contractionary monetary and fiscal policies

Devaluation happens only if IMF loans are not sufficient

IMF cannot force surplus countries (Ger) to revalue.

U.S. could not devalue the dollar during 1960s (Vietnam war). The surplus countries did not want to revalue. System collapsed in 1971 (Nixon).

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Managed Float (1971-now) Bretton-Woods collapsed: US and many others

(developed) allowed exchange rates to float. Hybrid of fixed and flexible

Allow Small daily changes in response to market Interventions to prevent large fluctuations

Appreciation of domestic currency reduces exports, growth and employment. Increases current account deficit and risk of a BOP crisis.

Depreciation of domestic currency reduces imports and stimulates inflation. Inflation increases uncertainty and reduces long-run growth rate.

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European Monetary System European Monetary System: 1979-1990

Exchange rate mechanism (ERM) is a fixed ER regime within Europe. Before the euro in 1999, as a preparation for euro.

Euro’s challenge to the dollar as the reserve currency in international financial transactions: Not likely because Europe is not a united

political entity. Especially considering the “sovereign debt crisis” in Greece, Spain, Italy, Portugal and France (?) casts shadow on the future of euro. There is no “exit clause” for euro: http://euobserver.com/political/118925

http://www.reuters.com/article/2012/07/23/us-eurozone-exit-idUSBRE86M04J20120723

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European Monetary System

1979: 8 members of European Economic Community fixed exchange rates with one another and floated against the U.S. dollar

ECU value was tied to a basket of specific amounts of European currencies: “Exchange Rate Mechanism (ERM)”. ECU value fluctuated within limits. If it goes beyond limits, Central Banks intervene in the market by buying the weak currency and selling the strong currency.

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Currency or BOP Crises Fixed ER policies may lead to currency crises

involving speculative attacks: massive sales of the weak domestic currency and purchases of the strong currency (dollar or euro), “capital flight”.

Profitable for speculators if they can cause a sharp devaluation of the weak currency.

Turkey: 1994, 2001. Europe: 1992, Brazil 1998, East Asia 1997-98, Mexico 1994, Russia 98.

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What Happens Before a Currency Crisis? MICRO risks Before the crisis: Banks and financial institutions

take excessive risks of three types: Exchange Rate risk: Dollar (forex) liabilities (debt) are much

larger than dollar (forex) assets. Maturity Mismatch (Liquidity) Risk: Avg. Maturity of

Liabilities are much shorter than avg. maturity of assets. Banks always transform liquid liabilities into illiquid assets, but there is a healthy limit to this.

Excessive Leverage: banks finance assets by either equity (own funds) or debt. If Leverage=Assets/ Equity is very high, too much debt=too little equity causes risk of bankruptcy. “capital adequacy ratio”

Moral Hazard: if the Central Bank follows Fixed ER policy, transfers the ER risk to the govt. Encourages banks take more ER risk by borrowing in dollar, lending in TL.

What Happens Before a Currency (or BOP) Crisis? MACRO risks Fiscal Deficits: Government has high Budget

Deficits and relatively short-term Foreign Debt: Mexico 1994, Brazil 1999, Argentina 2002, Turkey 2001. Not in Asian 1997 crisis.

High current account deficits (CAD)/GDP. If CAD cannot be financed by capital inflows, then BOP is negative.

If Both deficits are present, called “twin deficits” very risky situation.

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What Happens During a Currency (or BOP) Crisis? During the Crisis: Speculators force the CB to

“float” or “devalue” by quickly selling TL assets and buying dollar assets: speculative attack. Their objective is to make profit from a potential devaluation.

CB sells dollars and buys domestic currency to defend the domestic currency (raise int rates). But when the CB runs out of dollars, then the CB cannot defend the value of TL anymore. So it is forced to float the TL(domestic currency) and allow it to depreciate: Devaluation.

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What Happens During a Currency (or BOP) Crisis? Self-fulfilling Prophecies: When creditors panic

and start to believe that the domestic country is unable to repay its debts and the domestic currency will be devalued, they stop lending to the country: “sudden stop”. Independent from initial fundamentals, this belief makes itself real.

Contagion: Currency or financial crisis in one country spreads to other countries that are similar: in 1997 from Thailand to Malaysia, Indonesia, South Korea,

Philippines. İn 1998 Russia to Brazil and 1999 and 2001 in Turkey,

then 2002 in Argentina

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European ER Crisis of September 1992

German unification (1990) and inflationary pressures led Bundesbank to increase interest rates.

This led Demand for British pound to fall and pound depreciated below the official ERM parity 2.778 DM/pound. To correct this, either British had to increase rates or Germans had to decrease rates. Neither wanted to do the necessary action b/c Britain was in recession.

Speculators knew pound devaluation is coming and sold massive amounts of pound assets and bought DM assets: speculative attack on pound. Demand for pound fell even further.

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European ER Crisis of September 1992 Sept. 16: British floated the pound: 10%

devaluation against the DM. They also quit the ERM and did not join the euro.

George Soros made $1 bn, Citibank made $200 mln.

Similar story in Turkey 1994, 2001, Argentina 2002, East Asia 1997, Mexico 1994, Brazil 1999.

Causes may be different. But all were following fixed ER policies.

Difference: Argentina’s 2002 and Turkey’s 2001 crises were both due to unsustainable government budget deficits and debt.

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Capital Controls Prevent Capital flight: Controls on Outflows

Outflows of capital promote financial instability by forcing a devaluation

Controls are seldom effective because it is easy to find ways around them.

Controls may block funds for productive uses such as roads, infrastructure

Chilean experience: capital cannot leave the country before one year (Tobin Tax on short-term capital) .

Controls on outflows reduces the inflows too.

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Capital Controls (cont’d) Controls on İnflows: Capital İnflows lead to a

lending boom and excessive risk taking by financial intermediaries (1997 Asian Crisis)

Strong case for improving bank regulation and supervision. Turkey has been successful in reforming the banking system after the 2001 crisis.

Financial integration or not?

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IMF Was established after World War II. Its purpose

was to maintain the fixed exchange rate system called “Bretton Woods” (1944-71) by lending to the countries that had balance of payments deficits.

However, the Bretton Woods system collapsed in 1971 and IMF became an institution that provides financial and technical assistance to member countries.

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IMF IMF has lent to less developed countries in repaying

their foreign debt during: 1980s’ Third World Debt Crisis, 1994-95 Mexican

Crisis, 1997-98 East Asian Crisis, and 2001 Turkish Crisis (~20billion).

Of course, during a credit arrangement, IMF asks the borrowing country to write a commitment letter in which the country’s government commits to the policies prescribed by IMF. Because if these policies are not followed, the same imbalances in the economy will cause another crisis in the future. If the borrowing country believes that IMF will bail them out even if they do not follow prescribed policies, then the country will never solve its problems and this is moral hazard problem.

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IMF Credits: (billion$, Radelet)Country Committed Realized

Turkey(99-02) 33,8 23,1

Brazil (2001-2) 35,1 30,1

Brazil (98-99) 18,4 17,5

Argentina (2000-1) 22,1 13,7

S. Korea (97) 20,9 19,4

Mexico (95) 18,9 27,6

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IMF Critics IMF critics say: To the governments that cannot

sell its debt and cannot preserve the value of their currency, IMF lends if the following conditions are promised by the borrower:1. Reduce government expenditures or

increase taxes (contractionary fiscal p.)so that you need to borrow less. Joseph Stiglitz and other critics: such measures during a crisis can only deepen the crisis and recession. They argue that government should increase expenditures and aggregate demand so that the economy is brought out of recession.

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IMF Critics2. Increase interest rates. This helps protect

the value of domestic currency from depreciation. However, according to Stiglitz, this causes otherwise sound firms to go bankrupt because they cannot repay their debt with higher interest rates and “Debt deflation”: Real value of nominal debt increases.

3. Trade and Financial Liberalization: Critics: The industrialized countries of today did not have liberal trade and financial systems when they were industrializing 200 years ago. Foreign banks take over the weak banking systems in less developed countries.

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IMF Critics4. Privatization: Critics argue foreign

companies take over sectors (monopolize) and increase dependency of domestic economy to foreign firms.

5. Fear of default. Critics argue that one of the objectives of the IMF is to ensure that high-risk, high-return loans from international banks to less-developed countries are repaid.

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IMF Critics6. Instead of financial reform, IMF

prescribes contractionary macroeconomic policies. This causes the IMF to be a profitable scapegoat for domestic politicians as anti-growth, anti-employment. IMF is seen as a foreign entity interfering with domestic policy. Do you agree?

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IMF as a Lender of Last Resort

IMF can prevent contagion of crises. “herding behavior” in financial markets causes contagion.

IMF bailouts may cause excessive risk-taking (moral hazard) for domestic banks and their international creditors. This will increase risk of crisis in the future.

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IMF Stand-By Arrangements with TR Figure 1. Stand-By Arrangements Cases in Turkey (1960-2004)2008 Karagöl, Erdal and Metin Özcan, Kıvılcım, “The Economic Determinants of IMF Standy Aggreements in Turkey”

Actual

0

0.5

1

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

Actual

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World Bank Mission: Established after WWII to provide funds

to reduce poverty and promote development in the world. Provides loans for infrastructural projects in health, education, agriculture, energy.

Critics: Stiglitz, Caufield: Too quick and unregulated free market reforms prevent economic development.

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Balance-of-Payments ConsiderationsCurrent account deficits in Turkey suggest

that Turkish producers are not competitive maybe because the TL is too strong (maybe b/c they are not productive).

CADs increases the risk of a BOP crisis. CB may reduce interest rates for this purpose: expansionary policy.

Expansionary (contractionary) policy reduces (increases) interest rates and decreases (increases) value of TL.

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Balance-of-Payments ConsiderationsBut expansionary policy increases risk of

inflation for two reasons: Prices of imported goods (tradables) increase

(energy)

Since money supply increases, real value of money (in terms of goods and services) decreases.

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Exchange-Rate Targeting in TR

ER targeting (Crawling Peg) Policy applied in Turkey 1999-2001 as a method to bring inflation under control. Tradable goods’ prices are quoted in dollars, so rate of inflation fell.

ER targeting keeps the ER in a pre-specified band. Ex: (1,50 TL/$ ± 0,20 TL/$) for a specific period. Allows lira to move within the band.

We floated after the 2001 crisis.

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Advantages of Exchange-Rate Targeting (Fixed ER)Automatic rule for conduct of monetary

policy. Prevents temptation of short-run benefits of expansionary policy. (Ex: election economics). Reduces political pressure on the CB to expand the money supply.

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Exchange-Rate Targeting for Emerging Market CountriesPolitical and monetary institutions

are weak. Not much to gain from independent mon. policy. But much to lose from irresponsible politicians (high inflation 1977-2003).

Helps tie the hands of the govt. from conducting expansionary policies.

BUT!!! Costs of a currency crisis much higher than these benefits.

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Disadvantages of Exchange-Rate Targeting Moral Hazard: Banks take on too much

exchange rate risk expecting the govt. to defend the peg. İncreases financial fragility.

Then economy becomes vulnerable to speculative attacks on currency. İnt. creditors suddenly sell lira assets, capital flight. Force the CB to devalue.

Loss of independent control of money supply. Cannot fix both ER and money supply. Cannot respond to domestic shocks.

Shocks to anchor country (US or Germany) are transmitted to domestic country

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Currency Boards Extreme case of fixed ER policy. Domestic currency is backed 100% by a foreign

currency CB establishes a fixed exchange rate and

stands ready to exchange currency at this rate. (Ex: 1 TL/$)

Money supply can expand only when CB’s dollar reserves increase. Decreases the possibility of a speculative attack-currency crisis.

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Currency Boards (cont’d) Stronger commitment by central bank Loss of independent monetary policy

and increased exposure to shock from anchor country

Loss of ability to create money and act as lender of last resort

Applied in Argentina (1991-2002), Bulgaria (1997), Bosnia (1998), Hong Kong (1983), Estonia (1992), Lithuania (1994)

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Dollarization Totally giving up domestic currency and adoption

of another currency (dollar) Ecuador dollarized in 2000. 15 EU countries “euroized” after 2002. 12 EU

member countries are not in “eurozone”. UK, Denmark and Sweden chose not to join.

Completely avoids possibility of speculative attacks on domestic currency

Loss of independent monetary policy and increased exposure to shocks from anchor country (US)

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Dollarization (cont’d) Inability to create money and act as lender

of last resort Loss of seignorage revenue earned from

purchasing bonds with printed currency. $30bn per year for US.

Ex: “President Carlos Menem of Argentina has advocated replacing the Argentine peso with the dollar. Dollarization would benefit Argentina because it would eliminate the peso-dollar exchange-rate risk, lower interest rates, and stimulate economic growth” March 12, 1999 by Steve H. Hanke and Kurt Schuler, ”A Dollarization Blueprint for Argentina”, CATO Foreign Policy Briefing No. 52