The figure displays an initial rise of NFA in 1991, followed by a steady decline between 1993 and 2001, during which the NFA/GDP ratio falls by over 20 percentage points. The decline proceeds at a particularly fast pace after 1997. In the face of a stagnant productivity differential, as shown above, this deterioration in the NFA position is the driving force behind the steady depreciation of the equilibrium REER in the late 1990s.

The falling NFA/GDP position is largely a reflection of the rising trend in Argentina's foreign liabilities relative to GDP over the late 1990s, which resulted from the combination of substantial current account deficits - particularly large in 1997-99 - and, in the final years of the decade, a persistent growth deterioration. It is true that by 1999-2000 Argentina's current account imbalance, while large, was not far above the region's norm -- at least if the wide surpluses of the oil importing countries are excluded from the comparison. But Argentina's deficits were being incurred in the midst of a severe recession with escalating unemployment. This suggests that the full-employment current account deficit would have been much bigger than that actually observed. 1<sup>9</sup> In the next section we examine how these persistent current account imbalances relate to the fiscal gaps that developed over the decade.

Our empirical frarnework allows us to reassess the role of external shocks in the misalignment of the Argentine peso. In particular, we can gauge the impact of changes in the real exchange rates of third currencies. It has been argued that much of the overvaluation of the peso can be attributed to the appreciation of the U.S. dollar in the late 1990s relative to the currencies of major trading partners of Argentina - especially the Euro --, and also to the Brazilian devaluation of 1999, which abruptly reduced Argentina's competitiveness vis-a-vis its top trading partner.<sup>2 0</sup> Arguably, these are not 'external shocks' in the s,trict sense of the tern, but self-inflicted ones resulting from Argentina's choice of currency regime - they are a result of 'pegging to the wrong currency'.

We can assess the contribution of these factors to the overvaluation of the peso by decomposing the latter iinto three parts. The first one is due to the divergence in fundamentals between Argentina and the U.S., which causes the equilibrium REERs of the dollar and the peso to diverge. This reflects primarily tle pursuance of policies inconsistent with the dollar peg, which must eventually lead to misalignment if the peg is 'right' for the Argentinean economy. In turn, the other two components reflect the inadequacy of the dollar peg itself. One is just the overvaluation of the dollar, which is translated to the peso through the dollar peg. The other results from changes in the real exchange rates of third currencies whose weight in Argentina's total trade is different from their weight in the UJ.S. total trade - clearly the case of the Brazilian real.<sup>21</sup> Note

> **19** This point is underscored by Roubini (2001).

> 20 In contrast, adverse terms of trade shocks had presumably a very modest impact on the extent of misalignment of the peso. As already discussed, in 1998-99 Argentina's terms of trade declined by some 11 percent. However, the shock was only temporary, and was reversed in 2000. In addition, the decline followed a terms -of-trade windfaLlI in 1995-96.

> **21** See Alberola, L6pez and Serven (2003) for further details on this decomposition.

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