between two poles: a dual currency board for mercosur

North American Journal of Economics and Finance17 (2006) 349–362

Between two poles: A dual currencyboard for Mercosur

Matthias Busse a, Carsten Hefeker a,b,c,∗, Georg Koopmann a

a Hamburg Institute of International Economics (HWWA), Germanyb University of Siegen, Germany

c CESifo, Germany

Received 9 March 2005; received in revised form 23 April 2006; accepted 21 June 2006Available online 7 August 2006

Abstract

The paper explores exchange rate options for Mercosur countries. We start from the observation that mostof the countries in the region have a long-standing tendency for fixed exchange rates, and ask how such asystem could best be designed. The Argentine crisis has demonstrated that single currency pegs imply the riskof serious misalignments with other trading partners and could undermine regional integration initiatives.The standard basket peg is not a solution because of its limited transparency and credibility. We, therefore,discuss a proposal for dual currency boards that could be a workable solution for Mercosur countries.© 2006 Elsevier Inc. All rights reserved.

JEL classification: F 3; F 4

Keywords: Exchange rate regime; Currency board; Latin America; Mercosur

1. Introduction

How should countries in Latin America, and in particular Mercosur members, optimally struc-ture their exchange rate policies in view of a variety of partially overlapping trade agreements?How should these countries deal with the fact that their trade is not exclusively directed to onemajor currency area, such as the United States or Europe, and that capital flows are typicallydenominated in foreign currencies?1

∗ Correspondence to: Department of Economics, University of Siegen, Holderlinstrasse 3, 57068 Siegen, Germany.Tel.: +49 271 740 3184; fax: +49 271 740 4042.

E-mail address: [email protected] (C. Hefeker).1 Members of Mercosur are Argentina, Brazil, Paraguay and Uruguay. Bolivia, Chile, Colombia, Ecuador, Peru and

Venezuela are associated, Mexico has observer status. Bolivia was accepted as a member in late 2005, Venezuela isscheduled to become an effective member in late 2006.

1062-9408/$ – see front matter © 2006 Elsevier Inc. All rights reserved.doi:10.1016/j.najef.2006.06.004

mailto:[email protected]

dx.doi.org/10.1016/j.najef.2006.06.004

350 M. Busse et al. / North American Journal of Economics and Finance 17 (2006) 349–362

Trade and financial flows are, in general, reasons why emerging markets and developing coun-tries traditionally have had a tendency to choose fixed exchange rates over free floats. Exchangerate variability could be an impediment to trade as changes in real exchange rates have significanteffects on external trade flows and international investment (IDB, 2002; Rose, 2000; Rose &van Wincoop, 2001). Stable exchange rates instead not only help to “import” monetary stabilityand bring down inflation (Fischer, Sahay, & Vegh, 2002; Ghosh, Gulde, & Wolf, 2003; Rogoff,Husain, Mody, Brooks, & Oomes, 2004), but may also be preferred when capital inflows (inparticular debt) to emerging markets are denominated in foreign currencies (Eichengreen, 2004).When countries’ external debt is denominated in foreign currency, a depreciation of the domesticcurrency implies an increase in real debt (Goldstein & Turner, 2004).2

Until the collapse of the Argentine currency board in December 2001, there was a clear tendencyin Latin America toward formally declared or de-facto pegs to the U.S. dollar, with some countriesgoing so far as to officially dollarize (Ecuador, El Salvador, Guatemala).3 In addition to the reasonsmentioned, Hausmann, Gavin, Pages-Serra, and Stein (1999) attribute this revealed preferencefor fixed exchange rates to the fact that flexible rates tended to be accompanied by higher interestrates, smaller financial systems, a higher sensitivity of domestic rates to international rates, andwage indexation. Therefore, before 1998 most countries resisted large exchange rate movements,even in the presence of considerable shocks.4 For a time, the Argentinean currency board wasgenerally considered a success (Ghosh, Gulde, & Wolf, 2000).

While Latin American countries have historically opted for the dollar peg, growing traderelations with the EU suggest the need for a partial reorientation toward the euro. Mercosurmember countries in particular trade with two major currency blocs and thus need to find anarrangement that takes both of these foreign currencies adequately into account. We reconsider theidea of a parallel currency or dual board, once advocated by former Argentine minister DomingoCavallo (see Gurtner, 2004; Oppers, 2000). A currency board based on the dollar and the eurocould be one way to achieve a better match between trade patterns and exchange rate pegs.

It is evident that such a peg would need to be a joint decision by the Mercosur trading partners.Problems created by the lack of policy coordination between Argentina and Brazil during thetime of the Argentine currency board show that a country’s individual policy actions can havestrong beggar-thy-neighbor effects on its partners and lead to protectionist pressures (Eichengreen,1998; IDB, 2002). A dual currency board may contribute to stabilization of exchange rates withinMercosur.

The paper is organized as follows. The next section briefly reviews Mercosur’s trading pattern,sources of external finance, and tensions from bilateral exchange rate swings within the region.Section 3 develops our proposal for a dual currency board and Section 4 discusses its merits incomparison with alternative regimes. Section 5 shows how such a system could have helped avoidthe kind of collapse suffered by Argentina’s single currency board; and Section 6 concludes.

2 A widely held opposing view is that fixed exchange rate regimes invite speculative attacks (Fischer, 2001). It mayalso be argued that the exchange rate regime is not really that decisive if other policies are stable, predictable and sound(Calvo & Mishkin, 2003; Edwards & Savastano, 1999), while Larrain and Velasco (2001) stress the insulating propertiesof flexible exchange rates. Edwards (2002) argues that the perceived “fear of floating” should rather be understood asrepresenting “optimal floatation” in the sense of an optimal response to exchange rate developments.

3 Panama has been dollarized since 1904.4 This is confirmed for a larger group of countries by Calvo and Reinhart (2002), who establish a general “fear of

floating” in emerging and developing countries. More generally, Levy-Yeyati and Sturzenegger (2005), Reinhart andRogoff (2004), and Rogoff, Husain, Mody, Brooks, and Oomes (2004) report a significant mismatch between declaredand de-facto exchange rate regimes.

M. Busse et al. / North American Journal of Economics and Finance 17 (2006) 349–362 351

2. Mercosur’s interest in fixed exchange rates

In this section, we make the case for fixed exchange rates for Mercosur based on its traderelations with third countries, stressing that the dollar is not necessarily the right anchor currency.Tensions arising from bilateral movements between Brazil and Argentina suggest that regionaltrade agreements may suffer from the absence of a common anchor. Finally, the pattern of externalindebtedness in the region suggests as well that floating rates make countries vulnerable to balancesheet effects (Aizenman, 2005; Goldstein & Turner, 2004).

Generally, since the late 1980s, Latin American economies have seen significant integrationinto the world economy, even though the overall degree of trade openness remains rather lowcompared with other regions (Bouzas & Keifman, 2003). Moreover, the extra-regional componentof openness in Latin America is much higher than its intra-regional counterpart. In 2003, LatinAmerica traded just 4% of its gross domestic product with itself, as against 23.9% with extra-regional trading partners. For comparison, the respective internal and external trade components ofGDP in the European Union were 16.3 and 10.7% in the same year. Nearly 12% of Latin America’sGDP was traded with North America (almost exclusively with the United States), while WesternEurope (i.e., EU-15 and EFTA) accounted for 3.7% (of which 3.3% was trade with the EU).

For Latin America, Mercosur is at the heart of trade relations with Europe, accounting fornearly 50% of the region’s total trade with the European Union (against only 10% of its trade withthe United States). For Mercosur, nearly one-fourth of its total trade is trade with the EU. TheUnited States is the second largest trading partner for Mercosur, accounting for about one-fifth ofits overall trade. Among the individual Mercosur countries, the intensity of external trade linksvaries considerably with the size of the economy (see Table 1).

The various trade agreements under negotiation or envisaged among Latin American integra-tion groups, individual countries and extra-regional trading partners, such as the European Union

Table 1Trade links of Mercosur countries with the EU, the U.S. and each other, 1990 and 2003 (percent of overall trade)

European Union United States Mercosur World (bn $)

1990 2003 1990 2003 1990 2003 1990 2003

ArgentinaExports 30.8 19.8 13.8 9.7 14.8 22.5 12.4 32.1Imports 28.8 26.2 21.5 21.5 21.5 28.2 4.1 12.5

BrazilExports 32.5 24.7 24.6 22.4 4.2 5.8 31.4 77.1Imports 22.3 26 21.1 21.4 10.9 13 24.7 57.7

ParaguayExports 28.1 18.2 4.1 3.2 39.6 47.2 1 1.7Imports 15.3 6.7 12.3 20.9 30.8 53.9 1.3 2.6

UruguayExports 24.5 21.4 9.8 9 35.4 31.7 1.7 2.7Imports 19.2 15.3 10.5 11.1 40.9 41.6 1.3 3.3

MercosurExports 31.7 23.2 20.8 18.2 8.9 11.8 46.4 113.6Imports 22.7 24.9 20.3 20.9 14.4 18.1 31.4 76

Source: IMF Direction of Trade Statistics; own calculation.


Fig. 1. Real effective exchange rate and trade balance, Brazil, Jan. 1995–Dec. 2004. Source: Thomson Datastream andown calculations. *Three-month moving average.

and the United States, are likely to reconfirm and strengthen this trading pattern. This is particu-larly true for the triangular trade relationship between the Mercosur, the EU and the U.S. In thiscontext, the planned Mercosur–EU Free Trade Agreement (FTA) stands out.

The prospective trade agreements of Mercosur with the EU and the USA will tend to deepenintegration among its members and this rising interdependence will increase the vulnerabil-ity of trade and investment flows to exchange rate movements. With high interdependence intrade/investment among countries and highly variable real exchange rates, deeper integrationmight therefore not survive the tensions arising from shifts in competitiveness brought about byexchange rate changes.

This became obvious within Mercosur, when the Brazilian real depreciated by around 40% inearly 1999 against the Argentine peso which was pegged to a rising U.S. dollar. Brazil becamemore competitive and its trade balance improved significantly, after a lag of one to two years,from a deficit of US$ 12.2 billion in 1998 to a surplus of US$ 2.1 billion in 2001 (Fig. 1).

The dollar-bound Argentine peso rose, contributing to an erosion of Argentina’s export perfor-mance in third markets and a loss of competitiveness of domestic firms vis-a-vis imported goods(Fig. 2). Unlike Brazil, Argentina’s trade balance remained roughly unchanged in the period 1998to 2000, indicating that its exporters were not able to compete with Brazilian firms. In 2001,before the collapse of the currency board, Argentina’s trade balance improved, but this was duemainly to the collapse of economic growth and thus imports.5

The loss of relative price competitiveness becomes even more visible if we take a closer lookat exports to the United States, an important trading partner for both Argentina and Brazil. As canbe seen from Table 2, Brazil’s exports to the United States rose by one-third between 1999 and2001, whereas Argentina’s increased by only 7.4%. Moreover, Argentina’s exports to Brazil fellby 22% from 1998 to 2001 (ITC, 2004).

The effects of Argentina’s surging real effective exchange rate were compounded by a reces-sionary environment and further reductions of tariffs in some sensitive sectors. Argentine firms

5 Overall, total imports declined by two-thirds between 2000 and 2002 due to the severe economic crisis.


Fig. 2. Real effective exchange rate and trade balance, Argentina, Jan. 1995–Dec. 2004. Source: Thomson Datastreamand own calculations. *Three-month moving average.

Table 2Total exports of Brazil and Argentina to the U.S., 1999–2001

Country 1999 (US$ billions) 2000 (US$ billions) 2001 (US$ billions) Increase 1999–2001 (%)

Brazil 10.8 13.5 14.4 33.3Argentina 2.7 3.1 2.9 7.4

Source: ITC (2004) and own calculations.

sought protection through a compensatory tariff mechanism, aimed at counteracting the impactof the exchange rate appreciation. Although the Argentine government did not fully accommo-date these requests, it adopted some protectionist measures, including voluntary export restraintsfor meat and iron and steel products and import license requirements for shoes (IDB, 2002).Thus, Brazil’s sharp devaluation created severe economic and political tensions between the twoMercosur members.

The conflict between Argentina and Brazil revealed the strong political–economic frictionsthat follow wide exchange rate swings. Accusations of “beggar-thy-neighbor” policy are oftenvoiced when currency values move sharply, and are likely to cause problems for the members ofan integrated market (Eichengreen, 1998; IDB, 2002).

A further factor complicating the situation is that most long-term debt in Latin American coun-tries is denominated in U.S. dollars or euros. In Argentina, for example, the two currencies madeup more than 90% of long-term debt in 2002 (Table 3). The proportions for other Latin Americancountries are similar, with up to 95% in the case of Chile (where the U.S. dollar dominates).

With international capital flows and debt denominated in foreign currency, economies sufferwhen the home currency is devalued or depreciates (Goldstein & Turner, 2004).6 As a conse-

6 As McKinnon (2005) points out, a reverse problem arises if a country’s lending is denominated in foreign currencyand the home currency appreciates.


Table 3Debt composition of Mercosur countries and Chile, 1995 and 2003

Argentina Brazil Chile Paraguay Uruguay

1995 2003 1995 2003 1995 2003 1995 2003 1995 2003

Total debt stock (US$billions)

98.8 166.2 160.5 235.4 22.0 43.2 2.6 3.2 5.3 11.8

Long-term debt (US$billions)

71.3 127.7 129.1 187.5 18.6 35.7 1.8 2.7 4.0 7.9

Currency composition of long-term debt (%)Euro 31.4 9.9 6.1 3.4 6.1Deutsche mark 11.5 5.1 4.5 8.4 6.5French franc 1.3 6.0 0.7 2.5 0.7Japanese yen 9.4 4.4 8.6 7.0 9.5 2.0 21.0 13.7 6.4 3.4U.S. dollar 59.3 61.3 68.2 77.4 42.3 90.2 34.2 64.2 53.8 84.1Multiple currency 13.1 1.9 9.5 4.8 38.0 1.6 32.0 18.0 30.7 6.4All others 5.4 0.9 2.6 0.8 5.0 0.1 1.9 0.8 1.9 0.0

Source: World Bank Global Development Finance 2005.

quence, governments have strong incentives to peg to the currency in which residents are indebted.Moreover, in economies with weak currencies, the private sector often begins to hold and use for-eign currency in domestic transactions as well. Many countries effectively become dollarized asthe public begins to use a foreign currency, mostly the U.S. dollar, as a means of payment aswell, thereby making defense of fixed exchange rates politically more important.7 If the domesticcurrency, in which wages are paid, is devalued against the means of payment, households sufferreal income losses. This enhanced vulnerability to exchange rate swings contributes to the fear offloating. As long as countries are unable to issue debt in their own currencies, this fear is likelyto persist.8

3. A dual currency board for Mercosur

One solution to potential problems arising from external indebtedness and from significantbilateral currency swings would be a common fixed exchange rate. Since undeclared or softpegs might be susceptible to attacks, we think a hard peg, such as a currency board, would bepreferable.9 However, in order to deal with the fact that financial flows are mostly denominatedin dollars, while most trade is with Europe, a dual currency board would be superior to a standardcurrency board.

While currency boards have gone out of fashion after the Argentine debacle, one should notoverlook that they continue to operate quite successfully in some (albeit smaller) countries, such asEstonia and Hong Kong, and are generally less inflationary and more growth friendly than ordinary

7 The process of financial dollarization is analyzed in Ize and Levy-Yeyati (2003). The case of Argentina is discussedby Gurtner (2004).

8 For proposals to solve this problem, see Eichengreen (2004) or Goldstein and Turner (2004).9 Fischer (2001), among others, argues that only polar regimes (hard pegs or free floating) are likely to be viable. This

view is contested by Frankel (1999) and Benassy-Quere and Coeure (2002). However, Bubula and Otker-Robe (2003)find that intermediate regimes are indeed more crisis-prone and Rogoff, Husain, Mody, Brooks, and Oomes (2004) findthat only declared pegs yield a gain in credibility. We argue below that a dual currency board is more credible than a softpeg, but provides more flexibility than a standard hard peg.


pegs or free floats (Ghosh, Gulde, & Wolf, 2000).10 Moreover, the failure of the Argentine boardis due to a number of policy mistakes and not inherent to currency boards.

We, therefore, come back to a proposal by Argentina’s former minister of economics, DomingoCavallo, who suggested the introduction of a dual currency board just prior to the collapse of theArgentine currency board (IDB, 2002; Oppers, 2000).11 Such a currency board would peg thedomestic currency to two foreign currencies, in this case to the U.S. dollar and the euro. Twofactors should make such a dual currency board more credible than the standard version. First, itshould be less vulnerable to exchange rate movements between the currencies of the main tradingpartners, that is the dollar–euro rate, than a standard currency board. Second, it should restrictexchange rate movements between the members of Mercosur to a significant degree. Unlike astandard basket peg, both anchor currencies would have the same importance and weight, makingthe system stable, transparent and simple. With both major international currencies in the “basket,”the problems associated with foreign indebtedness would be sharply reduced. Thus, the trade andfinancial dimensions would be addressed at the same time. A dual currency board could take careof the fact that trade is with two major partners and that financial flows are denominated in majorcurrencies as well.

The main basis of this arrangement would be the central bank’s decision to exchange domesticcurrency at a fixed rate into the two foreign currencies. But unlike the standard case, it would beat the discretion of the central bank to exchange domestic currency into either the dollar or theeuro. It would decide whether to exchange, say, one peso against one dollar or against one euro,depending on the availability of currency reserves, whereas in the standard case the commitmentis only made with reference to one currency so that the central bank has no choice between reservecurrencies.12

By declaring a fixed rate between the domestic currency and both foreign currencies, the centralbank would also implicitly declare a fixed relation at which it would be willing to exchangedollars against euros. Since market participants will arbitrage between the two anchor currencieswhenever market rates diverge from the official rates, the central bank would have to use itsdiscretion to trade only in one currency at the declared rate. There would be a (small) banddefined by transaction costs around the official rate in which no arbitrage would take place.Arbitrage would keep the market rate close to the official rate as long as the central bank hasenough reserves.

An increase in the demand for dollars vis-a-vis the euro would not lead to an appreciationof the dollar as long as market participants could obtain dollar reserves from the central bank.Continuing demand for the dollar would finally exhaust the reserves of the central bank, fromwhich moment onwards it could only change domestic currency against euros at the official rate.The dual currency board would no longer stabilize the bilateral rate between dollars and euros andthe exchange rate would begin to move away from the official rate. As markets exploit arbitrageopportunities, the central bank would find itself frequently on only the dollar or the euro standard,

10 While Devereux (2003) argues that Hong Kong fared worse than, for instance, Singapore with its hard peg after theAsian crisis, Gerlach and Gerlach-Kristen (2005) find that while Singapore was better able to control its inflation, itsuffered similar output effects. See Ghosh, Gulde, and Wolf (2000) for a broad comparison of currency boards to otherregimes.11 Oppers (2000) makes an explicit reference to the bimetallic currency system of the 19th century. Detailed descriptions

of bimetallism can be found in Friedman (1990) and Flandreau (2004).12 As long as the central bank is in possession of both reserve currencies, it should trade in both. But it is important that

it can refuse to deal in any particular currency once its reserves of this particular currency are exhausted.


as reserve holdings of one currency are exhausted. But given the central bank’s right to choosethe currency in which to trade domestic currency against reserves, such arbitrage would not makea dual currency board more vulnerable than the single currency board.

To illustrate, consider the following example: The government declares the peso at 1:1 againstthe euro and also at 1:1 against the dollar and, neglecting transaction costs, it thus also fixes the ratebetween euro and dollar at 1:1. Should the dollar depreciate against the euro in currency markets,market participants will arbitrage by selling dollars against pesos and use the pesos obtained tobuy euros from the central bank. The central bank exchanges pesos against euros until its euroreserves are exhausted, from which point on it honors its promise to exchange the peso againstdollars.13 It loses its euro reserves but increases its dollar reserves while the overall amount ofreserves is unchanged.

Therefore, the central bank will not incur losses due to the reserve switch. Because reservesare always valued at the official rates and the bank only sells at these rates, it will never reportlosses due to a switch of the reserve currency. Consequently, the government will not incur fiscalcosts from a change in the reserves and there is no “run” on the reserves and no “collapse” of thecurrency board. The total stock of reserves, valued at the official rate, remains constant, only itscomposition changes.

Since the country would effectively always be pegged to the relatively depreciated currency,its real exchange rate would remain relatively competitive throughout, and as long as the twoanchor currencies are non-inflationary, the dual currency board would not lead to an increase ininflation due to this exchange rate effect. However, the currency would have to follow the interestrate of the relatively depreciated currency, implying that the domestic interest rate would rise. Inaddition, since the anchor currency can fluctuate, there might be a slightly higher currency riskpremium than under a standard currency board. While these two effects might be viewed as anegative, they are likely to be more than compensated by a positive credibility effect if the countryis not pegged to an overvalued anchor currency.

When relative exchange rate changes between the two anchor currencies move due to realinfluences, such as productivity differences, the dual currency board might even help to stabilizethe domestic economy. If, for instance, the dollar appreciates against the euro because of a positiveproductivity shock, the peso would soon follow the euro rather than the dollar and thereby profitfrom the depreciation of the euro. With a single dollar peg, the peso would appreciate and thusexperience export and output losses.

It is clear, however, that a dual currency board, much like a standard currency board, is nota solution for all macroeconomic problems (Edwards, 2002). A currency board alone does notforce politicians, as the Argentine example demonstrated, to run prudent fiscal policy. It does notstop countries from running up debts that are ultimately not consistent with a fixed exchange rate,and it does not solve the free-rider problems of fiscal federalism.14 In general, currency boardswill only survive if these problems can be solved. Moreover, creating a well-functioning currencyboard is not a “trivial matter” (Ghosh, Gulde, & Wolf, 2000). To avoid deflationary pressure,foreign exchange reserves must be sufficient to broadly cover the monetary base. The currencyboard needs broad political support to rule out self-fulfilling speculative attacks, and a reasonably

13 This should be an automatic process to prevent the central bank itself from arbitraging its dual currency reserves.Otherwise, its credibility might be undermined. In a currency board, the central bank should be considered passive.14 Fiscal policy has been one major reason for the collapse of the Argentine currency board. Obviously, to solve this

problem, other mechanisms would be needed. See Mussa (2002), Bleaney (2004) or Blustein (2005) for descriptions ofArgentina’s fiscal problems.


healthy financial system to be able to do without a lender-of-last-resort. But if the underlyingmacroeconomic problems cannot be solved, any alternative exchange rate system is as likely tosuffer as a currency board (Aizenman, 2005). The dual currency board may have better chances tosucceed, as it should enjoy more credibility and be better able to avoid real overvaluation which isone factor that makes pegs vulnerable and creates adverse expectations. A dual currency board is,therefore, likely to be a more stable middle-ground solution between floating rates and a standardcurrency board.

4. A dual currency board and alternative proposals

A recently much discussed alternative to the currency board is full monetary integration amongMercosur countries (see Eichengreen, 1998; IDB, 2002). However, while we expect an ultimatereturn of Mercosur countries to fixed exchange rates, we do not think that full monetary integrationis desirable, because the Latin American economies do not fulfill the standard criteria developed inthe optimum currency area literature (see Alesina, Barro, & Tenreyro, 2002). Studies comparingLatin America to Europe suggest that the region is not ready to adopt the European model. In acomprehensive study of Latin America, Temprano Arroyo (2003) looks at the traditional criteriaof trade openness, asymmetric shocks, interregional financial integration and labor mobility, andconcludes that the countries of Central America, the Andean Community and Mercosur do notfulfill the requirements of an optimum currency area. Similarly, Larrain and Tavares (2003) showthat the countries in Latin America have a higher degree of real exchange rate variability than couldbe expected, given their geographical closeness and economic characteristics. In comparison withother regions such as Europe or Asia, the region is less integrated and thus more vulnerable toasymmetric shocks.

Focusing especially on Mercosur, Belke and Gros (2002) show that intra-regional exchangerate adjustments are less important than movements against the dollar and the euro. Moreover,exchange rate movements can have a negative effect on employment and investment in the region.Temprano Arroyo (2003) further points out that any regional monetary integration arrangementwould suffer from the absence of an established and credible low-inflation anchor. Without astable anchor, the danger of speculative attacks against member currencies would be high. Bothfindings suggest that a peg to an external currency is superior to regional monetary integrationbased on a regional currency.

The fact that Mercosur countries have economic relations not with one major trading partner,but with several, has led Williamson (2000) to propose a basket peg for individual countries. If allcountries chose such a basket, it would also indirectly stabilize bilateral exchange rates, even if thecountries assign different weights to individual currencies. Differently composed and weightedbaskets would obviously allow for some restricted movement in bilateral rates. Countries shouldobserve, not necessarily openly declared, “monitoring bands” and thereby avoid the buildup ofexchange rate misalignments. We think this solution is not without problems, when analyzed indetail.

One obvious problem is how and which weights to assign to individual currencies? If they arebased on trading weights, then problems arise with respect to financial flows. While financial flowscould also be taken into account, a broad basket would require periodic adjustment of weights toaccount for changes in trade and financial patterns. More problematic still is the fact that such abasket would not be transparent and lack credibility, if there are periodic adjustments of bilateralrates. It would be hard to communicate to financial markets and the public how the basket isdesigned, how weights are assigned, and how they are changed over time. A crucial aspect of any


peg, the credibility that it is supposed to provide, would seriously be undermined by a currencybasket. A dual currency board, instead, would be simple and credible while reflecting, if lessperfectly than an ideal basket, the trade and financial flows of Mercosur countries.

Another advantage of a dual currency board, in comparison to a basket, would be that thecountry follows the relatively weaker currency and can thus preserve its competitiveness. AsWilliamson (2005) describes in some detail, under a basket the country would follow, to somedegree, an appreciating currency and thus lose competitiveness. If, for instance, the dollar and theeuro each have a weight of 50% in a basket and the dollar appreciates by 10% against the euro andother currencies, stabilizing the basket implies that the domestic currency moves up by 5% againstthe euro and other currencies. The dual currency board, instead, allows the domestic currency todepreciate with the euro. A dual currency board is thus better suited to maintain competitivenessthan a basket peg. A dual currency board can be seen as an intermediate exchange rate regime thatprovides the pegging country with a mechanism to follow the weaker of its anchor currencies.Since this change is not at the discretion of the national authority, it would be more credible thana fixed but adjustable currency peg.

Finally, an often-heard proposal is the adoption of inflation targeting by emerging marketcountries (International Monetary Fund, 2006). Advocates argue that inflation targeting allowscountries to design monetary policies to fulfill national requirements, much more than is possiblewith an exchange rate peg. Moreover, inflation targeting should be even more credible than apeg, because there would be no conflict between domestic and external requirements. Although anumber of emerging market economies have successfully adopted this strategy, we are skeptical.If a country is hit by large shocks, it is not clear that inflation targeting is really more crediblethan alternative instruments. It may be more flexible in the sense of allowing temporal deviationsfrom the target (something that a peg does not allow), but this could also undermine credibility.Moreover, it is not clear that all Mercosur countries fulfill the requirements for successful infla-tion targeting.15 The main problem, however, is that national inflation targeting does not stabilizeexchange rates with trading partners and within the region and that it is not a solution to the prob-lem of foreign currency denominated financial flows. As long as these issues remain important,inflation targeting is unlikely to become a solution for many emerging market economies.

We, therefore, think that a dual currency board represents a superior alternative. To demonstratethe political–economic implications of a currency board, we consider next how Argentina wouldhave fared if such a system had been in place, and how it might have helped prevent Argentina’sfinancial collapse.

5. Argentina under a dual currency board

To illustrate the beneficial effects of a dual currency board for Argentina in comparison tothe actual currency board based exclusively on the U.S. dollar, we compute changes in the realeffective exchange rate for that country in the period 1999 to 2001, assuming two different bilateralvalues for the euro–dollar rate. As can be seen from Fig. 3, using a dual currency board with aconversion rate of $1 and D 1, Argentina could have avoided the appreciation of its currency,partly caused by the strong dollar in that period. The peso would have left the dollar peg in early2000 and then followed the euro downwards against the dollar. By late 2001, the peso would have

15 Among the chief concerns are the absence of fiscal dominance and of sufficiently developed financial markets, thenecessary technical abilities and the institutional credibility of the central bank (Masson, Savastano, and Sharma, 1997).


Fig. 3. Real effective exchange rate of Argentinean peso under hypothetical dual $/D currency board, 1999–2001. Source:Thomson Datastream and own calculations. Note: Calculations assume no changes in consumer prices or trade flows. Thedual currency board conversion rates were set at D 1 = $1 and D 1 = $1.1.

ended up 10 to 12 points below its level under the dollar peg. Under a euro price of 1.1 dollars,the peso would have shifted earlier to the euro as the anchor currency, followed the euro in itsdownward trend beginning in 1999, and would have ended up at about 20% lower in 2001. Thispattern would presumably have been reflected in an improvement in the trade balance and thusin a higher level of aggregate demand, thereby alleviating the negative effects of the recession inArgentina.

Moreover, as Table 1 has shown, about a quarter of Argentina’s trade is with other Mercosurcountries. If all Mercosur countries would have been members of a common dual currency boardwith the euro and the dollar, Argentina’s current account would have improved even more thanFig. 3 suggests, because the peso would not have appreciated against member currencies, all ofwhich would have moved slightly against the dollar.

Because the switch from one currency to another is a function of the implied exchange ratebetween the dollar and the euro, the choice of the implicit bilateral rate between the two anchorcurrencies is important. It is crucial to choose the “right” conversion rates into the two anchorcurrencies, because if the conversion rate of the domestic currency deviates from market rates, thecountry would quickly find itself in a single currency board. Implementing a truly dual currencyboard requires finding an implicit rate of conversion that corresponds to a relatively stable marketrate, which is not easy in the case of the volatile euro/dollar exchange rate.16

However, rates may be chosen strategically to reflect the fact that an economy is alreadysignificantly dollarized. Choosing the rate in a way that ties the economy to the dollar most ofthe time would accommodate orientation towards the dollar. Only a very strong appreciation ofthe dollar would then lead to a switch to the euro. That way, the dual currency board could stillserve as a safety valve, avoiding excessive losses of competitiveness (such as Argentina sufferedin 1999), while still making the dollar the dominant currency for the country.

16 Estimates for the equilibrium rate between the euro and the dollar are surveyed in Stein (2001).


Depending on national interests, it is possible for Mercosur countries to pursue different strate-gies concerning the choice of bilateral rates. Countries could even have slightly different bilateralconversion rates for euros and dollars, although this would invite arbitrage, while at the same timerestricting bilateral exchange rate movements to some degree. Even if the official rates betweenthe dollar and the euro diverge across countries, there would be a maximum variation implicit forbilateral rates between Mercosur members, depending on how much their official rates against aparticular currency differ. If the market rates of anchor currencies diverged too much, all countrieswould eventually find themselves on the same anchor currency. Such a dual currency board could,therefore, also be a first step towards regional currency arrangements followed later by other formsof regional cooperation, such as a regional stabilization fund.

6. Conclusions

The exchange rate remains an important variable for emerging economies and most of them,including those in Latin America, do not seem to be willing to live with freely floating rates.However, currency boards and other, less hard, pegs have been discredited by the collapse ofthe currency board in Argentina. This has led many observers to advocate free floating, on thegrounds that fixed rates are inherently vulnerable to speculative attacks.

In this paper we have argued that this conclusion may not be warranted. In particular, the factthat financial flows and external debt are denominated in foreign currency and that exchange rateswings are a political–economic obstacle for trade integration may make some fixed exchangerate arrangements attractive for emerging economies. One option is a modified currency board,particularly for countries that are not exclusively tied to one currency in their trade and financialorientation. The dual currency board, proposed by Argentina’s economics minister Domingo Cav-allo before the collapse of Argentina’s currency board, offers a possibility. It could simultaneouslyprovide a stabilizing anchor for domestic policy, be credible, and accommodate trading patternsthat are not exclusively oriented to either the dollar or the euro.

Such a solution would work only if the mistakes made under the original currency board inArgentina are not repeated. As in all other cases of a peg, this presupposes fiscal discipline.The fact that the Argentine board collapsed is probably more a manifestation of general policyinconsistencies than of a fundamental weakness of currency boards. We, therefore, believe thatcurrency boards in general are more workable arrangements than they are currently perceived tobe. Thus, a dual currency board could be a much more appropriate system for Mercosur countriesthan a standard currency board.

A dual currency board is unlikely to be a general solution for all emerging market countries. Itis particularly useful in the case of Mercosur, because the trade patterns of member countries areoriented towards two major currency areas, their financial flows are denominated in one majorcurrency, and they have an interest in minimizing exchange rates movements among them.

Acknowledgements

We thank Lilia Cavallari, Helge Berger, participants of the CESifo-Delphi conference inMunich, and two referees for comments and suggestions.

References

Aizenman, J. (2005). Financial liberalization in Latin America in the 1990s: A reassessment. World Economy, 28, 959–983.


Alesina, A., Barro, R., & Tenreyro, S. (2002). Optimal currency areas. NBER Macroeconomics Annual, 17, 301–345.Belke, A., & Gros, D. (2002). Monetary integration in the Southern Cone. North American Journal of Economics and

Finance, 13, 323–349.Benassy-Quere, A., & Coeure, B. (2002). The survival of intermediate exchange rate regimes. CEPII working paper

2002-07.Bleaney, M. (2004). Argentina’s currency board collapse: Weak policy or bad luck? The World Economy, 27(5), 699–

714.Blustein, P. (2005). And the money kept rolling in (and out): Wall Street, the IMF, and the bankrupting of Argentina. New

York: Public Affairs.Bouzas, R., & Keifman, S. (2003). Making trade liberalization work. In P.-P. Kuczynski & J. Williamson (Eds.), After the

Washington consensus – restarting growth and reform in Latin America (pp. 157–179). Washington, DC: Institute forInternational Economics.

Bubula, A., & Otker-Robe, I. (2003). Are pegged and intermediate exchange rate regimes more crisis prone? IMF workingpaper 03/223.

Calvo, G., & Mishkin, F. (2003, Fall). The mirage of exchange rate regimes for emerging market economies. Journal ofEconomic Perspectives, 17, 99–118.

Calvo, G., & Reinhart, C. (2002). Fear of floating. Quarterly Journal of Economics, 117, 379–408.Devereux, M. B. (2003). A tale of two currencies: The Asian crisis and the exchange rate regimes of Hong Kong and

Singapore. Review of International Economics, 11, 38–54.Edwards, S. (2002). The great exchange rate debate after Argentina. NBER working paper 9257.Edwards, S., & Savastano, M. (1999). Exchange rates in emerging economies: What do we know? What do we need to

know? NBER working paper 7228.Eichengreen, B. (1998). Does Mercosur need a common currency? NBER working paper 6821.Eichengreen, B. (2004). Financial instability. In B. Lomburg (Ed.), Global crises, global solutions (pp. 251–280). Cam-

bridge: Cambridge University Press.Fischer, S. (2001, Spring). Exchange rate regimes: Is the bipolar view correct? Journal of Economic Perspectives, 15,

3–24.Fischer, S., Sahay, R., & Vegh, C. (2002). Modern hyper-and high inflations. Journal of Economic Literature, 40, 837–880.Flandreau, M. (2004). The glitter of gold. Oxford: Oxford University Press.Frankel, J. A. (1999). No single currency regime is right for all countries or at all times. Princeton Essays in International

Finance, 215.Friedman, M. (1990). The crime of 1873. Journal of Political Economy, 98, 1159–1194.Gerlach, S., & Gerlach-Kristen, P. (2005). Monetary policy regimes and macroeconomic outcomes: Hong Kong and

Singapore. BIS and Swiss National Bank. Mimeo.Goldstein, M., & Turner, P. (2004). Controlling currency mismatches in emerging markets. Washington, DC: Institute for

International Economics.Ghosh, A., Gulde, A.-M., & Wolf, H. (2000). Currency boards: More than a quick fix? Economic Policy, 31, 269–335.Ghosh, A., Gulde, A.-M., & Wolf, H. (2003). Exchange rate regimes: Choices and consequences. Cambridge: MIT-Press.Gurtner, F. (2004). Why did Argentina’s currency board collapse. The World Economy, 27(5), 679–698.Hausmann, R., Gavin, M., Pages-Serra, C., & Stein, E. (1999). Financial turmoil and the choice of exchange rate regime.

IDB working paper 400.Inter-American Development Bank (2002). Beyond borders: The new regionalism in Latin America. Washington, DC:

IDB.International Monetary Fund (2006). Inflation targeting and the IMF. Washington, DC: IMF.ITC (2004). Trade analysis system PC-TAS 1998–2002. ITC (International Trade Center) and United Nations Statistics

Division. Trade data on CD-ROM.Ize, A., & Levy-Yeyati, E. (2003). Financial dollarization: Where do we stand? Journal of International Economics, 59(2),

323–347.Larrain, F., & Tavares, J. (2003). Regional currencies versus dollarization: Options for Asia and the Americas. Journal of

Policy Reform, 6(1), 35–49.Larrain, F., & Velasco, A. (2001). Exchange-rate policy in emerging-market economies: The case for floating. Princeton

Essays in International Economics, 224.Levy-Yeyati, E., & Sturzenegger, F. (2005). Classifying exchange rate regimes: Deeds vs. words. European Economic

Review, 49, 1603–1635.Masson, P., Savastano, M., & Sharma, S. (1997). The scope for inflation targeting in developing countries. IMF working

paper 97/130.


McKinnon, R. (2005). Exchange rates under the East Asian dollar standard: Living with conflicted virtue. Cambridge,MA: MIT-Press.

Mussa, M. (2002). Argentina and the fund: From triumph to tragedy. Washington, DC: Institute for International Eco-nomics.

Oppers, S. (2000). Dual currency boards—A proposal for currency stability. IMF working paper 00/199.Reinhart, C., & Rogoff, K. (2004). The modern history of exchange rate arrangements: A reinterpretation. Quarterly

Journal of Economics, 119, 1–48.Rogoff, K., Husain, A., Mody, A., Brooks, R., & Oomes, N. (2004). Evolution and performance of exchange rate regimes.

IMF occasional paper 229.Rose, A. (2000). One money, one market: Estimating the effect of common currencies on trade. Economic Policy, 30,

9–45.Rose, A., & van Wincoop, E. (2001). National money as a barrier to international trade: The real case for currency union.

American Economic Review, 91(2), 386–390.Stein, J. (2001). The equilibrium value of the euro/$ U.S. exchange rate: An evaluation of research. Mimeo.Temprano Arroyo, H. (2003). Latin America’s integration processes in the light of the EU’s experience with EMU. In

P. van der Haegen & J. Vinals (Eds.), Regional integration in Europe and Latin America (pp. 65–130). Aldershot:Ashgate.

Williamson, J. (2000). Exchange rate regimes for emerging markets: Reviving the intermediate option. Washington, DC:Institute for International Economics.

Williamson, J. (2005). A currency basket for East Asia, not just China. Policy Briefs in International Economics, 05-1.Washington, DC: Institute for International Economics.

between two poles: a dual currency board for mercosur

Documents