Argentina considers replacing peso with dollar

The euro may just be one of the first of a series of currency unions, as the trend towards fewer currencies and economic integration accelerates. Or at least that is the prediction of Mr Stanley Fischer, deputy managing director of the IMF.

Within weeks of the birth of the euro the Argentine central bank has presented a blueprint to its government on how to get rid of its currency, the peso, and replace it with the US dollar. There is talk that this could be the beginning of a more dramatic move across Latin America. A radical step along these lines would be likely to prompt other Latin American countries to do the same - ditch their own currencies and take on the dollar.

The idea that there is room only for freely floating currencies and full currency unions - and not for anything in between - has been gaining credence in recent times. Informal - and even formal - currency alignments have not fared at all well since the collapse of the European Monetary System in 1992. Currency pressures in Mexico and more recently Russia, the Far East and Brazil have merely reaffirmed the point.

Argentina already has a currency board which locks the peso to the dollar, making the system dramatically more fixed than the peg which Brazil and a number of Far Eastern countries desperately failed to hold onto. Large amounts of dollars are held at the central banks and most mortgages are also denominated in dollars.

The basic idea of a currency board is that it issues its domestic currency only in exchange for the reserve currency. In Argentina's case pesos are issued in exchange for dollars. This means that the authorities already have only an extremely limited control of monetary policy. Many investors argue that, given the record of central banks, this can only be a good thing.

But a full-scale move to adopt the dollar would still be radical; it would effectively give the US Federal Reserve full control over the Argentine economy as it would be the only one with the power to print money. Another problem for Argentina's central bank would be the loss of so-called "seniorage", which in general terms is the amount of money a government makes on issuing bonds less the cost of issuing currency. And of course it would also do away with the concept of a lender of last resort.

All 11 euro zone countries signed up for just such a loss of sovereignty in joining the new currency. But there are major differences, chief among them the already somewhat developed political co-ordination among member-states and a degree of control over the ultimate central bank, with all countries getting a seat on the board.

Under the negotiations already reported to have taken place between the Argentines and Washington the proposal would appear to be the creation of a treaty where any country in the region could sign up.

Argentine officials are reported as insisting that the so-called "dollarisation" deal has been under consideration for some time and is in no way a short term response to the problems in Brazil. But it is also almost certainly true that the authorities are tired of paying a huge risk premium in terms of interest just to get foreigners to buy their government bonds. In other words it costs them a lot to borrow money, despite a low fiscal deficit and one of the world's lowest inflation rates.

But as the Economist points out, by merely talking about the idea the president, Mr Carlos Menem, and Mr Roque Fernandez, the economy minister, may have made the move unnecessary, by boosting confidence in the peso.

It is also likely that should such a deal go ahead, the Hong Kong dollar could come under sustained pressure. After all, it is the one other currency most investors think of when they think of currency boards.

Of course, Brazil is just the latest country to prove that an exchange rate peg is more than vulnerable in times of turmoil. But according to the director of the Harvard Institute of International Development Mr Jeffrey Sachs, this need not be the case. He argues that both Israel in 1985 and Poland in 1989 successfully moved to flexible regimes, having initially established a pegged rate. Brazil's problem is similar to Mexico's and to Russia's in that all found it politically convenient to hold onto an overvalued exchange rate for longer than they probably should - at least with the benefit of hindsight. Also, all were helped by the IMF.

Most governments like an overvalued rate as it means cheap consumer goods as well as higher real wages in urban areas in particular. And the benefits of moving to a more flexible regime are not always apparent until disaster strikes or is at least narrowly averted.

The other important point, should the dollarisation of Latin America go ahead, is how it will affect the model for Europe. There is already talk that it could become a model for accession to the euro for eastern European countries. After all many of the countries of eastern Europe have been operating currency pegs of one sort or another, particularly to the deutschmark. That effectively means they are already loosely pegged to the euro. This could, it is thought, run parallel with Agenda 2000 and the enlargement of the EU.

But conversely it is also probably true that the chance of the dollar replacing the peso is likely to depend to some extent on the success of the euro which is not yet entirely guaranteed.