SEVERAL FACTORS associated with the macroeconomic instability of previous decades have favored the presence of currency substitution in many Latin American countries. Most prominent among the countries are Argentina, Bolivia, Peru, and Uruguay, Currency substitution has taken the form of cash holdings of dollars and of foreign deposits not within the reach of local fiscal authorities. Lately, some of these countries, mainly Argentina and Peru, have been experiencing a repatriation of foreign assets, money that is being deposited in the local financial system. Since the repatriation, both countries have experienced a credit boom, high current account deficits, and real exchange rate appreciation. A summary of recent changes in monetary aggregates in Argentina and Peru, highlighting the currency substitution process, is shown in Tables 1 and 2.
|June 1989||March 1991||March 1992|
|Peso monetary base||708||4,580||8,576|
|Other liabilities, net||373||–787||–991|
|Percent of GDP||2.4||2.7||5.0|
|Credit in pesos||909||2,632||5,400|
|Credit in dollars||0||3,180||6,900|
|Percent of GDP||0.2||1.6||2.9|
|M2: Currency plus peso deposits||3,066||7,501||13,950|
|Percent of GDP||4.5||5.1||8.2|
|M2 plus dollar deposits||3,637||10,792||21,840|
|Percent of GDP||5.4||7.3||12.8|
|Percent of GDP||1.3||3.9||7.2|
|GDP in U.S. dollars||68,000||147,000||170,000|
Following the hyperinflation of 1989–90, the stabilization packages of Peru and Argentina validated the ongoing currency substitution by allowing local commercial banks to hold dollar deposits for residents and to lend the proceeds domestically, subject to reserve requirements. As credibility in the stabilization plan increased, residents started transferring their foreign currency deposits into domestic banks. As those funds were lent locally, a fraction came back to the banks as new deposits and, because of the fractional reserve system, were lent again, giving rise to the “argendollars” and “perudollars.”
The transaction described above, in its first impact, only changes the physical location of the resident’s money stock: from deposits in Miami to deposits in Buenos Aires or Lima, which remain in dollars and in the same amounts. There is, therefore, no initial impact on the money supply or money demand, defined to include both local currency and dollars. However, those dollars deposited in Latin America, which were previously lent in the United States, can be lent locally, giving rise to secondary money and credit creation that is bound to have macroeconomic implications, particularly for the current account and the real exchange rate.
|September 1990||March 1992|
|Sol monetary base||663||936|
|Dollar deposits of banks||157||839|
|Other liabilities, net||–393||–360|
|Credit in soles||650||822|
|Credit in dollars||597||1,745|
|Percent of GDP||0.7||1.3|
|M2: Currency plus sol deposits||865||1,876|
|Percent of GDP||2.3||3.6|
|M2 plus dollar deposits||1,567||4,570|
|Percent of GDP||4.2||8.7|
|Percent of GDP||3.4||4.9|
|GDP in U.S. dollars||36,691||52,324|
From the perspective of the Argentine money supply, a dollar deposited in Miami and lent locally is the same as a dollar deposited in Argentina, subject to a 100 percent reserve requirement (with the central bank reinvesting the reserves abroad). However, by shifting the location of the deposit, the credit to the foreigner is converted into a credit to a resident. Unless the fraction not subject to reserve requirements is immediately spent abroad, the local supply of dollar deposits is bound to increase owing to the standard money multiplier process: dollars lent locally come back to local banks as new deposits, which are lent again, and so on, until all of the original inflow of high–powered dollars is spent as either reserves, cash holdings, or a current account deficit. Since there is no reason for money demand to increase, it is clear that monetary equilibrium will be restored only when the excess money supply allowed by the multiplier is lost through current account deficits or when banks immediately redeposit the dollars abroad, in what would constitute an offshore market.
In countries emerging from hyperinflation, such as Argentina and Peru, there is a practically unlimited demand for credit, since credit is likely to have all but evaporated during the inflation. In addition, severe credit constraints were applied to vast segments of the market that had no access to international or local borrowing, such as consumer or mortgage credit, mainly because of the high degree of macroeconomic uncertainty that prevailed. After the stabilization, consumer credit and mortgages could thus be granted at extremely high rates because of pent–up demand, and banks encountered few problems in lending the proceeds from the new dollar deposits. It is also clear that the banks have had no incentive to reinvest those funds overseas, even if they were allowed to do so. Parallel to the credit boom, these countries also experienced significant appreciation of their real exchange rates as well as a deterioration in their current accounts. This paper argues that at least part of this currency appreciation and current account deterioration may have been caused by the creation of local dollars made possible by the repatriation of foreign deposits under a fractional reserve system.
Other factors have also been mentioned as contributing to the boom after stabilization: Rodriguez (1982) focuses on the reduction in the real interest rate resulting from price rigidities and adaptive expectations; Calvo (1986) points to the lack of credibility in the stabilization plan; Helpman and Razin (1987) concentrate on the wealth effects resulting from the reduction in the inflation tax. An empirical analysis of the different hypotheses for several Latin American stabilizations has been conducted by Reinhart and Vegh (1992), and a general presentation of the issues can be found in Kiguel and Liviatan (1991). This paper’s contribution is its analysis of the money supply and credit effects deriving from portfolio shifts under currency substitution.
The capital inflows that generated the macroeconomic disturbances of the late 1980s were a response to higher money demand (see Calvo (1991a)). In an economy subject to currency substitution, capital inflows might arise not only because of a global excess demand for money but also because of a portfolio shift among currency denominations or a shift in the location of foreign currency deposits. This paper therefore addresses not the factors that give rise to currency substitution but rather the money supply and credit effects derived from a change in the location of foreign deposits.1
I. Money Supply Process Under Currency Substitution
Consider a situation where domestic residents hold local and foreign money as both cash and deposits at home and abroad. The exchange rate is fixed by the central bank and equal to unity. The relevant financial assets are defined as follows: C denotes the cash holdings of pesos; C* denotes the cash holdings of dollars; D denotes the local deposits of pesos; D* denotes the local deposits of dollars; and F* denotes the dollar deposits held abroad. Total liquidity L is the sum of these assets:
Each asset’s share in total liquidity is assumed constant and equal to c, c*, d, d* and f* respectively. The shares total to 1. Using this framework, it is possible to analyze the effects of a shift from F* (deposits in Miami) to either D* (dollar deposits in Buenos Aires) or D (peso deposits in Buenos Aires).
The central bank imposes reserve requirements at rate r on peso deposits and r* on local dollar deposits. The central bank balance sheet implies
where R represents reserves, and
The total demand for money is proportional to nominal GDP:
where k is the real demand for money, p is the price level, and Q is real GDP. Assuming k, p, and Q are constant, then L = Lo, a constant. From equations (2) and (3),
Substituting the desired asset ratios, reserves can be shown as a function of reserve ratios and nominal money demand:
The total stock of assets held against foreigners is the sum of reserves, cash holdings of dollars, and dollars deposited abroad:
Similarly, the total stock of bank’s credit is the sum of the peso and local dollar deposits that are not subject to reserve requirements:
Now to analyze the effects of a portfolio shift, assume a shift that takes the form
Consider the simple case in which the reserve requirement is the same for peso and dollar deposits, so
where K is the initial capital inflow;
In the case of Argentina, the reserve requirement on time deposits (in pesos or dollars) is 7 percent. Therefore, a $1 million portfolio shift away from foreign deposits into the local financial system would increase reserves by $70,000, increase credit by $930,000, and decrease the net foreign assets position by $930,000. In Peru, marginal reserve requirements are higher, close to 50 percent, thus reducing the effects of the capital inflow.
The change in the net foreign assets position allowed by the money supply multiplier must equal the accumulated surpluses in the current account during the adjustment process. In the case of a portfolio shift into local deposits, the effect must be an accumulated deficit in the current account, To validate such a transitional current account deficit, an appreciation of the real exchange rate is necessary. This temporary real appreciation is reversed as soon as the capital inflow is fully absorbed through financial intermediation, a process bound to produce some adjustment costs related to price inflexibility. This is the main argument for capital controls.
The increase in local credit encouraged by the capital inflow equals the extra spending that can now take place in the economy. Under full employment, this extra demand will be met with imports through a current account deficit. Basically, the instrumentation of the “argendollar” market allows for the creation of dollars that are as good for local holders as real dollars but at a fraction of the cost. A dollar held in Miami costs $1, whereas a dollar held in Buenos Aires costs only 70⊄, the reserve requirement. The 93⊄ difference, therefore, can be spent without affecting what moneyholders consider to be their total liquidity. The net foreign assets position of the country is affected, however, as local dollar deposits are not accounted for in this scenario.
For the country as a whole, this operation reduces the net foreign assets position. a concern if a reversal in the portfolio composition is possible. If a reversal did occur, a current account surplus would be necessary to obtain “real” dollars to deposit in Miami.
The mechanics of the money multiplier have operated clearly in Argentina and Peru. As of February 1992, there are dollar–denominated deposits of $7.9 billion in Argentina, of which banks hold $920 million in reserve requirements at the central bank and $450 million in cash; the remaining $6.5 billion is invested in loans to local residents. The stock of dollar credit in February 1991 was a mere $2.8 billion, thus increasing by $3.7 billion in one year. Although many other factors affected the macroeconomic balance during 1991 (such as an incipient remonetization in pesos and a significant trade liberalization), it may be revealing to note that the current account showed a $4.4 billion deterioration relative to the previous year, a size similar to the increase in dollar credits ($3.7 billion) from February 1991 to February 1992. In Peru, the increase in credit during the six quarters after stabilization in September 1990 was $1.3 billion, of which $1.1 billion became new credit in the “perudollar” system. The deterioration in the current account relative to the previous six quarters was $1.7 billion, again roughly matching the change in the current account.
The capital inflows generated by a portfolio shift, then, cause a deterioration of the current account by as much as would occur when a foreigner opened a deposit account in the local market. In that case, from a $1 deposit, only r* will remain as reserves, and the rest will be lost through a current account deficit. A capital inflow generated by an excess demand for money, by contrast, might cause a simultaneous improvement in both the current and capital accounts as the public reduces expenditure in response to the excess demand. In this case, the increase in money demand will cause reserves to rise by
It is therefore important when determining any association between capital inflows and the current account to ascertain whether the capital inflows are supply or demand determined. Capital inflows motivated by lower foreign interest rates or portfolio reallocation are supply determined and associated with current account deficits. Capital inflows resulting from excess demand for money are demand determined and associated with current account surpluses.
II. Policy Implications
When evaluating the policy implications of capital inflows from a portfolio shift, an important consideration is the asymmetry in real exchange rate behavior: it is relatively easy to appreciate but socially costly to depreciate. Real appreciation is obtained during a period of capital inflows, which expand credit and economic activity, allowing for higher prices relative to the exchange rate and the current account deficit. For the real exchange rate to depreciate, prices must fall back to their initial level or the nominal exchange rate must be devalued. Under a fixed exchange rate regime, such as in Argentina, a nominal devaluation is seen as an abandonment of the ongoing stabilization strategy and may induce a portfolio shift away from the local currency. Such a shift can seriously destabilize an economy.
In the absence of complete information about the adjustment process, the lower real exchange rate can mislead economic agents, who may make decisions under the assumption that the rate will remain there. The new dollar loans made by banks may use collateral assets valued at inflated dollar prices (because of the real appreciation), and loan recipients may have inflated dollar incomes. Those high dollar values are likely to fall when the real exchange rate depreciates. These are normal risks in well–functioning capital markets, but in Argentina and Peru the speed with which local credit is expanding may create some added instability.
Argentines have generally held most of their financial wealth abroad, where it has been safely invested. During the unstable 1980s, local banks all but abandoned credit to the private sector and concentrated on acquiring government paper. After the, Law of Convertibility was implemented in April 1991 (establishing a currency board), Argentines started to transfer their foreign deposits back to Argentina. Note that this is not an increase in the demand for money, simply a change in its location. This process occurred at a time when virtually no consumer credit had been available for a decade. The potential for credit expansion was enormous. The total stock of bank credit at the bottom of the crisis was $900 million. Since then it has increased to about $13 billion. In Peru, since the stabilization started, the dollar value of the stock of credit has doubled, from $1.2 billion in September 1990 to $2.6 billion in March 1992, almost half of which came as credit in dollars under the new “perudollar” system.
The credit boom increased asset prices and the prices of nontradables, allowing for dollar prices in Argentina to increase by 127 percent during 1990–92. In Peru, the dollar value of consumer prices increased by 81 percent during the post–stabilization period (September 1990 to March 1992). As the value of collateral and household income increased in dollar terms, it has become safer for banks to grant consumer credit in dollars. One possible problem, however, is that the dollar value of loan collateral and of wages may be well above their long–run sustainable values. Banks, therefore, may have a serious collection problem if the real exchange rate falls to a lower long–run equilibrium level after the portfolio shift is absorbed. Furthermore, Argentine and Peruvian labor laws do not allow for downward flexibility of nominal wages, implying that a real devaluation will have to occur through a nominal devaluation or a severe recession. These prospects may generate a capital outflow because of the threat to currency stability.
Recently, a supply shock may have compounded the problem of the portfolio shift: foreign investment funds, in response to lower U.S. interest rates, have started purchasing high–yield assets in several Latin American markets. There are no data, however, on the associated capital inflow. Additionally, governments have embarked on privatization programs, which may have contributed to the currency overvaluation by selling assets to foreigners and using the foreign exchange proceeds to finance domestic spending.
There is nothing intrinsically wrong with expanding the supply of credit in economies that are severely credit constrained, like Argentina and Peru. The problem is that the new credit has not been coming from domestic savings but from accumulated stocks of foreign savings. In the absence of a parallel increase in money demand, expansion of credit must be offset by foreign imports. which generates the real overvaluation. A common misconception in Argentina, for example, is that many of the country’s problems would be solved if Argentines would repatriate their foreign savings. In a credit–thirsty economy, such as Argentina, if the entire stock of foreign savings were to return instantly, it would be immediately lent locally, meaning that the whole stock of foreign savings would have to be immediately spent on foreign goods if macroeconomic balance were to be achieved. Thus, the country would run a current account deficit equal to all the foreign savings of the past decade. Clearly, this is not an ideal situation. Banks receiving the dollar deposits should graduate their local lending, taking into consideration the long–run relative price structure. The rest should be reinvested abroad, as it would be in an offshore market. Initially the only impact of the capital inflow should he that Argentines handle their dollar accounts from Buenos Aires instead of Miami.
Authorities in Argentina do not seem to have recognized this problem. A general pardon was recently issued for those who wanted to repatriate previously undeclared foreign savings. To do so, the funds are deposited in a local bank at a basically zero interest rate for 180 days. The banks, by the same decree, must lend these funds for investment purposes at no more than a 10 percent interest rate. According to the pardon, banks would lend $20 billion over a period of 180 days; even for a credit–thirsty economy, it is unwise to lend 15 percent of GDP on a 180–day basis. In the end, the pardon failed, and only half a billion dollars was presented.3
To slow the absorption of credit, higher marginal reserve requirements (nonremunerated) could be imposed on the part of the dollar deposits that is locally lent, and banks could be allowed to reinvest the unused part of the deposits overseas. These steps would drastically reduce the deposit rates paid on dollars and also the amount of new credit being granted. Marginal reserve requirements should be gradually reduced, as the ability of the economy to absorb the new credit without sharp relative price changes improves. The economy should be open to international trade, and downward wage flexibility should be strengthened, (in spite of the recent reforms, imports to Argentina are still 8 percent of GDP, and some quotas and high tariffs remain. A similar situation is present in Peru, where imports are 7.4 percent of GDP.)
It may be convenient for reserve requirements on deposits denominated in the local currency to be the same as those on deposits denominated in dollars. Otherwise, discrimination in reserve requirements could prevent an economy’s integration into international capital markets. Also, depositors would not be discouraged from bringing in dollars and placing them in peso deposits, the net effect on all macroeconomic variables being the same as if the initial deposit had been opened in dollars. In fact, if
It may be argued that, in an open economy with a fully convertible currency, credit cannot be controlled: any individual is free to borrow directly abroad and spend the currency locally. The fact is that much of the recent credit boom may be going to creditors who have not had access to the international market. Because large corporations have had continuous access to the international market, it is hard to believe they are borrowing locally at the prevailing high interest rates. The temporary reserve requirements should be seen as a measure aimed at slowing down the rapid expansion in consumer credit, a market that is still perceived to be blocked from the international market.
Other alternatives could also slow down credit growth. One is generating fiscal surpluses equal to the capital inflows, the proceeds of which are used to purchase dollars that could not be spent locally. Another alternative is to sterilize fully the monetary impact of the capital inflows through central bank intervention. In this case, the central bank could follow a domestic credit target for the local financial system. However, intervention implies issuing bonds or remunerated reserve requirements at the prevailing local dollar interest rates, which is inconsistent with a nonexpansionary fiscal policy (on the perils of sterilization, see Calva (1991b)).
In an economy operating under currency substitution, shifts in the denomination of currency holdings or shifts in the location of foreign currency holdings can affect economic performance. A shift from dollar deposits abroad to deposits in the local system, in pesos or in dollars, increases the supply of credit to the financial system with no corresponding increase in money demand. Given an initial situation of tight credit, an increase in credit results in a current account deficit associated with the “temporary” real currency appreciation, which can be difficult to reverse. This situation differs from one arising from an excess demand for money, in which a general reduction in expenditures can lead to both capital inflows and current account surpluses.
Data from Argentina and Peru show that the capital inflows that followed their stabilization programs have been associated with a significant worsening of their current accounts, supporting the hypothesis that the flows were supply induced by portfolio relocations or foreign investors responding to lower interest rates in the United States.
An increase in temporary marginal reserve requirements (nonremunerated) is one alternative for slowing down the rapid credit expansion caused by the repatriation of foreign assets. In the case of dollar deposits in the local financial system, higher reserve requirements should apply only to that part of deposits that is lent locally. For overseas operations, reserve requirements should he at rates compatible with international competition. It is also suggested that local taxes on financial intermediation should not be imposed on dollar deposits that are reinvested overseas by local banks. Otherwise, deposit rates for local dollar deposits cannot compete internationally, and the repatriation of assets could be hampered. The marginal reserve requirements should be lowered as monetization advances, or as the ability of the economy to withstand trade deficits without substantial relative price swings improves.
It also sounds reasonable that, before imposing any restrictions on private sector behavior, the government should consider its own policies as they contribute to the credit expansion. Specifically, the government should examine the privatization processes that have attracted foreign funds to several Latin American countries. For example, in 1991 the Argentine government locally spent about $2 billion in foreign funds derived from privatization and is expected to spend an additional $3–4 billion in 1992 from the same sources. This $4 billion capital inflow owing to government policy easily compares with the $3.8 billion in “argendollar” deposits experienced during 1991.
Calvo, Guillermo A., “Temporary Stabilization: Predetermined Exchange Rates,”Journal of Political Economy,Vol. 94 (1986), pp. 1319–29.
Calvo, Guillermo A., (1991a), Inflation and Financial Reform (unpublished: Washington: International Monetary Fund, 1991).
Calvo, Guillermo A., (1991b), “The Perils of Sterilization,”IMF Staff Papers,Vol. 38 (Washington: International Monetary Fund, 1991).
Calvo, Guillermo A., and Carlos A.Rodriguez, “A Model of Exchange Rate Determination Under Currency Substitution and Rational Expectations,”Journal of Political Economy,Vol. 85 (1977), pp. 617–625.
Calvo, Guillermo A., LeonardoLeiderman, and CarmenReinhart, “Capital Inflows and Real Exchange Rate Appreciation in Latin America: The Role of External Factors,”Staff Papers,International Monetary Fund (March1993), pp. 1–31.
Calvo, Guillermo A., andCarlos A.Vêgh, “Currency Substitution in Developing Countries.”Revista de Analisis Económico,Vol. 7 (June1992). pp. 3–28.
Guidotti, Pablo, andCarlos A.Rodríguez, “Doilarization in Latin America: Gresham’s Law in Reverse,”Staff Papers,International Monetary Fund (September1992), pp. 518–44.
Helpman, Elhanan, and AssafRazin, “Exchange Rate Management: Intertemporal Tradeoffs.”American Economic Review,Vol. 77 (March1987), pp. 107–123.
Kenen, Peter, “Financial Opening and the Exchange Rate Regime,” (unpublished; Washington: International Monetary Fund, Research Department,1992).
Kiguel, Miguel, and NissanLiviatan, “The Business Cycle Associated with Exchange Rate Based Stabilization.” (unpublished; Washington: World Bank, 1991).
Reinhart, Carmen, andCarlos A.Vegh, “Nominal Interest Rates, Consumption Booms and Lack of Credibility: A Quantitative Examination,” (unpublished; Washington: International Monetary Fund, Research Department,1992).
Carlos Alfredo Rodriguez is a professor at the Centro de Estudios Macroecondmicos de Argentina and holds a Ph.D. from the University of Chicago. This paper was written while he was a Visiting Scholar with the IMF’s Research Department. The author is indebted to Guillermo Calvo, Leonardo Leiderman, Donald Mathieson, and Carlos Végh for helpful discussions on the subject.
As mentioned above, credibility in the ongoing stabilization effort and relaxation of capital controls may be among the factors explaining the reversal in the public’s locational preference for their currency holdings (see Kenen (1992)). A theoretical framework for understanding currency substitution is presented in Guidotti and Rodriguez (1992). The demand–side implications of a shift between local and foreign money is in Calvo and Rodriguez (1977). A general survey of currency substitution issues is presented in Calvo and Vegh (1992).
The role of external factors in determining the recent experience of real exchange rate appreciation in Latin America is examined in detail in Calvo, Leiderman, and Reinhart (1993).
Another potential problem in the Argentine situation is that banks cannot. by regulation, invest abroad the funds they receive as dollar deposits; they must lend them locally. Since local dollar rates for prime customers are currently 20–25 percent, and consumer credit rates range up to 40–60 percent, this regulation is not binding. (These rates are much higher than those that could be obtained by investing the funds abroad.)