WSJ Editorial. How About a Single Currency for Mercosur?
August 28, 1998
By SEBASTIAN EDWARDS
Earlier this year, Argentina's President Carlos Menem suggested that
Mercosur--the trade pact formed by Argentina, Brazil, Uruguay and
Paraguay--should have a common currency. Most observers dismissed the
idea as far-fetched and impractical. Now, however, it is time to take this
proposal seriously. In fact, Brazil's salvation, and future, may well be
intricately linked to the implementation of this plan.
After the collapse of the Russian ruble, Brazil, with its huge fiscal deficit,
obscenely high interest rates, slow growth, quasi-fixed currency, and
burgeoning short-term debt, looks particularly vulnerable. Under attack by
global speculators, Brazil's international reserves are declining, and in an
effort to attract fresh foreign financing, the authorities have reversed
restrictions on short-term capital inflows that were put in place only last
March. As Brazilian risk increases, so does the country's cost of borrowing.
The resulting high interest rates are contributing to an ever growing fiscal
deficit, and continue to choke the economy.
Since last week's Russian meltdown, there have been rumors that the
administration of Brazilian President Fernando Henrique Cardoso is only
playing for time, and that the real might be devalued immediately after the
October presidential election. This would be a grave mistake.
As the experiences of Mexico, East Asia and Russia have decisively shown,
in this era of global capital mobility there is no such thing as an orderly
devaluation. A country that devalues it's currency invariably suffers the
wrath of international investors, and is forced to engineer massive
adjustment programs that result in increased unemployment, rapid inflation
and social unrest. Not even the International Monetary Fund, once
considered to be the world's financial doctor, has been able to help
devaluing countries.
With its huge international reserves--about $70 billion--Brazil still has time
to avoid a major crisis. The problem is that, in light of the Russian debacle,
market participants are becoming increasingly impatient and jittery. Brazil's
fuse is getting shorter.
In evaluating Brazil's options it is useful to look at its neighbor to the south,
Argentina. In 1991, after two rounds of hyperinflation, Argentina
implemented a new monetary system based on a fixed, one-to-one,
exchange rate to the U.S. dollar, free capital mobility and strict constraints
on central bank behavior. Under this "convertibility" system, 100% of
Argentina's monetary base is backed with foreign exchange, and the central
bank is forbidden from granting credit to the government. This system has
been supplemented with high liquidity requirements on local banks, giving
stability to the financial system, and an international credit line that can
provide liquidity in a crisis.
In spite of initial international skepticism, the convertibility law has served
Argentina very well. Inflation has disappeared, growth has resumed, and
unemployment--although still high--is declining. More impressively, perhaps,
interest rates have remained very low; indeed at 8% per year the
government's cost of borrowing is less than half that of Brazil's.
These wonderful things have not come for free. In the aftermath of the
Mexican crisis of December 1994, Argentina's international reserves
dipped, generating a liquidity squeeze. Growth plummeted and
unemployment went up. By staying the course, however, the country was
able rapidly to regain credibility, attracting, once again, foreign investors.
Argentina is now one of the strongest emerging economies.
The adoption of a common currency for Mercosur, based on the Argentine
convertibility system, would provide much needed stability to Brazil. The
most important short-run effect would be a rapid decline in Brazilian interest
rates from their current 20% per annum, to levels similar to prevailing
Argentine rates. By reducing the cost of servicing the domestic debt, lower
interest rates would immediately help lower Brazil's fiscal deficit. According
to my own computations, these lower interest rate costs would help reduce
Brazil's public sector imbalance from its current 7% of gross domestic
product, to a still high but more manageable 3.2% of GDP.
Of course this will still not be enough. For this program to be successful,
Brazil would have to implement a number of measures rapidly to further
reduce the fiscal deficit. Some of the required fiscal policies--such as the
administrative reform that would allow the government to reduce the size of
the bureaucracy--are already in the pipeline, but have not been implemented
due to political reasons. It would also be necessary to adopt Argentine
policies aimed at maintaining a strong banking sector.
Moreover, it would be necessary to enact deep labor market reforms that
would reduce labor costs, encourage employment and increase labor
market flexibility. This would ease the (potential) costs of this fixed
exchange rate system under certain conditions. These reforms are politically
difficult to implement--in spite of valiant efforts by the economic team,
Argentina still has not done it--but their approval would help reduce the
trade-off between stability and the country's capacity to absorb external
shocks.
Brazil's $70 billion in international reserves are higher than both its monetary
base, currently at $33 billion, and M1 ($36 billion), making the adoption of
a Argentine-style monetary system technically feasible.
An independent Mercosur Central Bank would have to be created.
Deciding who would run this new monetary institution would not be easy,
and one could imagine that, just as in the case of the European Monetary
Union, petty politics and nationalistic interest would affect the process. In
the end, however, a technical criteria should prevail, and Pedro Pou, the
current governor of Argentina's Central Bank, should get the job for the first
term.
Brazil has enormous economic potential. So much so, that according to a
recent study by A.T. Kearney's Global Business Policy Council, Brazil is
second only to the U.S. among countries considered as attractive markets
for global corporate investors. It would be a tragedy if this potential is
derailed by a currency crisis and the ensuing macroeconomic chaos. It is
time for the Brazilian leadership to take truly creative and lasting measures
to ensure economic stability. Although by no means a panacea, adopting
President Menem's idea of a common currency for Mercosur would go a
long way towards achieving that goal.
Mr. Edwards is professor of international economics at UCLA's
Anderson Graduate School of Management.
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