Intermediation Spreads in a Dual Currency Economy-Argentina in the 1990sWP/98/90-EAWP/98/90 Since the onset of the currency board arrangement in early 1991, interest rates on bank deposits in Argentina have gradually converged to international levels. Yet, a similar convergence has not been observed for lending interest rates, which stand well above OECD levels. This is widely perceived as having had a detrimental impact on employment in Argentina and on the external competitiveness of its domestic industry, as most firms have continued to rely on local banks for their financing. This paper examines the determinants of the spread between deposit and lending interest rates in Argentina, seeking to answer two main questions. First, why have banking spreads remained relatively high despite the uninterrupted operation of the currency board arrangement for seven years now and the far-reaching liberalization and financial sector reforms that have boosted banking sector productivity? Second, why has there been a significant gap between interest rate spreads in domestic currency and those in foreign currency transactions, given that banks and the general public are virtually free to intermediate in either currency? To identify the contribution of banks. operating costs and financial policy variables to intermediation spreads, this paper develops a partial equilibrium model of the banking industry in a dual currency economy with imperfectly competitive credit markets, and estimates it empirically. The evidence indicates that high intermediation spreads in Argentina persist as a result of (1) high administrative costs stemming from the low monetization of the economy, inefficiencies of the payments system, and limited consolidation of the financial system; (2) credit risk and sizable provisioning expenses associated with the large stock of non-performing loans, which partly reflect institutional barriers to the dissemination of credit information; and (3) market segmentation between domestic and foreign currency borrowers. Based on these results, the paper discusses a number of policy recommendations to reduce further banking spreads in Argentina. |