A Tale of Two Defaults

BRUSSELS – Once upon a time, there was a country plagued by large deficits, high inflation, and decades of economic stagnation. When economic problems once again became particularly acute, the country’s leadership embraced a radical approach to achieving price stability.

A new currency was introduced and pegged to the US dollar at a one-to-one exchange rate. A new law stipulated that this quasi-monetary union was to last forever. Moreover, the economy was opened, state enterprises were privatized, and the country participated in an important regional free-trade initiative.

Initially, the new arrangement worked very well. Growth returned, and confidence among foreign investors was such that large inflows of foreign direct investment, especially in the banking sector, arrived.

But, after about 10 years, the success story turned bitter. The region’s dominant trading partner devalued, and the US dollar appreciated considerably. The country thus had problems exporting. It developed external deficits and growth slowed.