COMMENT & ANALYSIS: A way out for Argentina: The currency board cannot survive much longer. Ricardo Hausmann says it is time for a radical alternative.

It is almost too late to avoid a catastrophe in Argentina. The economy is in a tailspin, destroying jobs, tax revenues and political support. The government has been forced to default on commitments to its workers, pensioners and provincial governments in a valiant attempt to continue paying the public debt. Markets do not think this can go on: dollar bonds are trading at default discounts, while the price of peso bonds reflects the expected collapse of the currency regime. Sky-high interest rates make fiscal solvency, private investment and economic recovery impossible.

Historians and economists will spend the next decade arguing about the causes of the Argentine crisis. The question now is how to get out of it. Argentina's well structured public debt and its sound banks have delayed the collapse, giving policymakers time to think. But the extra time has not produced a solution. Some urge default. Others propose floating the currency. Still others favour both.

The problem is that dollar liabilities and depreciation are an explosive mix, since they worsen the balance sheets of borrowers and can cause widespread bankruptcies, as happened in Ecuador and Indonesia.
Faced with these choices, the government has tried to find creative ways to reduce the debt burden and gradually gain competitiveness. So far these have not worked. This week it will announce another debt swap, like the one offered in May, designed to lower the interest burden but this time offering guarantees financed by the international financial institutions. The strategy may have run out of time.

The workable alternative has two main ingredients: first, de-dollarisation of the foreign debt, the financial system and the domestic contractual environment; second, a floating exchange rate anchored by strict inflation targets.

Under this plan, Argentina would convert the dollar-denominated assets and liabilities of the banking system and public debt excluding obligations to the International Monetary Fund and multilateral banks into Chilean-style inflation-indexed pesos, at today's exchange rate of one peso for one dollar. All other contractual terms, including maturity and interest rates, would remain the same. An independent body (why not the IMF?) would credibly calculate the price index to be used for these purposes.

Achieving credibility of monetary policy would also be critical. Floating plus inflation targets can achieve this, as the experience of Mexico, Chile and scores of developed countries shows. There is no reason why Argentina should be different, once the harmful fiscal effects of dollar debts have been eliminated.

The plan would also include a tight fiscal policy, framed by an IMF programme with significant financial support. As in Brazil in 1999, low demand, the absence of currency mismatches and a sound fiscal programme would keep inflation low.

Investors should prefer this strategy to a traditional debt write-down. As the needed real exchange rate depreciation takes place, the face value of the new indexed-peso debt should decline substantially in dollar terms. But this real depreciation is likely to be temporary. When the time comes to repay debt - something that, given the eight- year average maturity of Argentina's debt, is well into the future - the real exchange rate may well exceed current levels, in which case there will be no write-down. This is more than a theoretical possibility: Mexico's real exchange rate plummeted during the Tequila crisis of 1994 but today it is stronger than it was before the crisis.

Moreover, Argentina's real exchange rate would tend to appreciate in good times and depreciate in bad times, which would make debt service move in tandem with the repayment capacity of the country. Holders of the new indexed-peso bonds would be in possession of a safer asset. The plan also protects the stability of the banking system: loans are made affordable to companies, so that depositors do not need to worry so much about bank insolvency. It would also eliminate much of the tension on trade and integration policies in Argentina and Mercosur. With a more flexible ex-change rate system, and one more similar to that of its neighbours, Argentina could embrace free trade.

This strategy is not without risks. Inflation has to be kept under control. Depositors and investors need to understand and accept the new inflation-indexed instruments. Legal challenges from local and foreign investors will have to be overcome. Next year would be very difficult, although less so than under alternative scenarios. But after putting this programme into place Argentina will be left with a Chilean-style monetary regime, a healthy banking system and a competitive economy. Those are sound foundations on which to regain growth, credibility and, most important, hope.

The writer is professor of economic development at the Kennedy School of Government at Harvard University. A longer version of this article is at http://www.ksg.harvard.edu/news/opeds/www.ft.com/hausmann