Argentina

Background

Prior to the Lost Decade of the 1980s, Argentina was a wealthy Latin American nation characterized by a high standard of living, solid technological infrastructure, high literacy and an escalating GDP. Production declines and poor economic output in the 1980s left Argentina, like many Latin American countries, dealing with outrageous external debts and inflation. Latin America, in the 1990s, adopted several radical changes, headed for liberalization. These changes called for liberalizing trade and privatization. In efforts to stimulate economic growth Argentina negotiated with the IMF, who agreed to short term loan assistance, under the condition that a new government replaces the existing military regime. With the newly elected Raul Alfonsín and support and respect from the U.S., in 1991 Argentina managed to match the peso to the U.S. dollar allowing limited monetary growth strictly to the reserves. The IMF initially supported policies implementing the fixed-currency policy, valuing the rate of one peso to one US dollar. This strategy worked initially as inflation in Argentina temporarily diminished. Furthermore, up until 1995, the country’s real GDP was growing constantly to reach 7% growth in 1995. Moreover, Argentina was considered an apparent paragon of reform and stabilization. Since 1997, however, both external and internal factors contributed to its steadily declining economic performance which unfolded into the tragedy of 2001. From 1999 onward, economic crises in Mexico, Brazil and several other countries further deteriorated Argentina’s economic conditions. As the US experienced inflation and the dollar devalued, so did the peso. Doubts increased worldwide that Argentina would be able to pay her debts, not to mention, sustain the value of the peso at the value of the U.S. dollar. By 2001 treasuries plummeted, and there were colossal withdrawals from banks, further dwindling consumer and investor optimism. The Argentine government’s plans to attain a "zero deficit", to stabilize the distressed banking system, and to refurbish economic growth was lacking and the country was facing a surplus of economic problems. The government's inability to implement reforms and restore growth increased skepticism among critics of Fernando de la Rúa’s administration in 2001. This, combined with well-founded doubts about Argentina's ability to meet its upcoming debt payments, resulted in an economic crisis in November and December 2000.

The IMF role

Argentina was plunged into a devastating economic crisis in December 2001/January 2002, when a partial deposit freeze, a partial default on public debt, and an abandonment of the fixed exchange rate led to a collapse in output, high levels of unemployment, and political and social turmoil. These events have raised questions regarding the country's relationship with the IMF because they happened while its economic policies were under the close scrutiny of an IMF-supported program. The first and overwhelmingly most important cause of the country's economic troubles was the government's decision to maintain the fixed rate of one peso for one U.S. dollar. Over the last few years, the U.S. dollar has been overvalued. This made the Argentine peso overvalued as well. But it gets catastrophically worse for a country that has committed itself -- as Argentina did -- to a fixed exchange rate. When investors start to believe that the peso is going to fall, they demand ever-higher interest rates. These exorbitant interest rates are crippling to the economy. This is the main reason that Argentina has not been able to recover from its four-year recession. To maintain an overvalued currency, a country needs large reserves of dollars: the government has to guarantee that everyone who wants to exchange a peso for a dollar can get one. The IMF's role here was crucial: It arranged massive amounts of loans -- including $40 billion a year ago -- to support the Argentine peso. This was the IMF's second fatal error. To appreciate its severity, imagine the United States borrowing $1.4 trillion -- 70 percent of our federal budget -- just to prop up our overvalued dollar. It did not take long for Argentina to pile up a foreign debt that was literally impossible to pay back. If all that weren't enough, the Fund made its loans conditional on a "zero-deficit" policy for Argentine government. But it is neither necessary nor desirable for a government to balance its budget during a recession, when tax revenues typically fall, and social spending rises. Although the IMF did not explicitly coerce the government to run fiscal deficits, it did not press Argentina authorities hard enough to be more responsible. Not only had that, but it continuously ignored the deficit targets which were not met by Argentina in half of the cases. It either granted waivers, or used to increase the targets in order for the government to be in the limits. Instead of suspending loan packages, the IMF opted to grant additional loans and extend repayment and target deficit dates.

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The situation deteriorated especially during the second half of 2000 as the recession continued. Analysts became pessimistic and began discussing a possible default on the sovereign debt of the country. At that point in time, Argentina was the largest borrower on the international credit markets. Yet in December 2000 it received an extraordinarily big support, beyond the normal practices of the IMF. By the summer 2001 this “last resort” was obviously failing, but amazingly, the country enjoyed another $9 billion in loans from the Fund, as the disbursement was the second largest in the history of the Fund. This could not help the government, however, and by September 2001, it was already clear that the catastrophe was inevitable. This was evident to everyone, and is improbable that IMF officials did not realize the gravity of the situation. Another injection would do no more but postpone the disaster for a couple of months. So did happen. These policies, repeated over and over, did not spur economic growth in Argentina, but instead lead to depreciation of the sovereign bonds, ongoing inflation, high unemployment, and the collapse of the bank system.

The End

Argentina, often hailed as the model country or the poster child for the IMF, bore out this mantra in 2001, when Argentina declared itself in an economic crisis. There were massive riots, people ransacked the banks, and foreign businesses were attacked. In the aftermath, at least thirty people died. Argentina for years had sustained massive borrowing from the IMF. Most of the reforms and policies the IMF imposed would have helped to liberalize the economy; however, after “two decades of misguided recommendations and nearly continuous funding, the IMF's involvement in Argentina actually strengthened the power of political vested interests at the expense of economic growth.” The Argentine government tried to halt the recession and repay IMF loans by increasing taxes and decreasing spending. Increasing taxes and decreasing public spending during times of fiscal austerity is devastating to the poor. But the loans from the IMF included deep cuts in government spending so that Argentina would have the ability to repay. So the Argentine government remained steadfast in their commitment to repay the loans, maintain the value of the peso, continue heavy taxation and cut social spending. The IMF backed this strategy claiming that delayed or defaulted debt payments could lead to unstable markets and escalate financial problems in neighboring countries. Unfortunately this ongoing tax and spend policy resulted in severe social consequences: steady declines in industrial production and GDP and staggering unemployment rates.

The Convertability Plan

In the late 1980’s Argentina collapsed to hyperinflation. (Hausmanm and Velasco) In 1990, the new president Carlos Menen appointed Domingo Cavallo as the Minister of Economy to combat the problem. In 1991, he introduced the Convertibility Plan into the monetary system. The system was a mixture of currency board and central banking features. The main reforms were a fixed exchange rate with an anchor currency and unrestricted convertibility into and out of the anchor currency. The anchor currency was the United States dollar; the plan fixed the dollar peso exchange rate at one peso per dollar. Also, the board was required to keep net reserves of 100 percent or more of its monetary liabilities, held in foreign assets only. (Hanke) the dollar-peso parity was “supposed to stop the endless revaluation of the dollar denominated external debt, thereby allowing Argentina’s ruling classes to become citizens of the world “financial community.” (Halevi) The strategy worked; annual inflation fell, trade barriers were reduced, and foreign investment increased through massive privatization of state-run companies. From 1991 to 1994 the reforms helped to increase GDP per capita (measured in dollars) to increase by 72.8%. (Hanke)

The fixed currency worked to stabilize Argentinean economy; however the problem was that “the argentines adopted a currency whose exchange rate bore little relation to their own economic conditions.” By doing this, Argentina had essentially ceded control over its monetary policy, and its currency could not adjust to domestic fluctuations. Trouble came in the mid 1990’s when world economies experienced crisis, and Argentina had to accept the unfavorable consequences of external shocks. (Hausmanm and Velasco)

External Shocks

Mexico

The Mexican ‘Tequila Crisis’ of 1995 had a large impact on Argentinean investment. Mexico, like Argentina, had an overvalued fixed exchange rate and a non-independent Central Bank. Foreign reserves supporting the Mexican peso declined thorough out 1994 because investors feared that the peg against the US dollar could not be maintained. Therefore Mexico had to devalue its currency by 50 percent in one week. (Grabrielsen) Fearing that the same would happen in Argentina, financial flows from abroad and investment collapsed, and massive bank runs caused the demand for deposits in the banking system to fall; this combination caused a recession by 3%. (Halevi, Hausmanm and Velasco) However, Argentina was able to stabilize, exports kept growing with out a disruptive devaluation like Mexico, moral hazard fell, and banks were able regain deposits. (Hausmanm and Velasco)

East Asia

Unfortunately, Argentina was again troubled in 1997, when the East Asian crisis caused a decline in trade for Argentinean goods. This was followed by the Russian crisis in 1998 which caused the world financial markets to dry up after the Russian debt repayment default. By this point, there was decline in flows of investment to emerging market economies similar to the situation after the Mexican crisis, in Argentina investment was falling and capital costs were increasing.

Brazil

The biggest problem to hit was the Brazilian devaluation of January 1999. Brazil abandoned it fluctuating exchange rate and massively depreciated its currency. Brazilian exports became extremely cheap; the prices of Argentinean goods were constrained by the fixed exchange rate rigidity and could not compete with the cheap Brazilian goods. The problem was that the Brazilian devaluation caused an appreciation in the Argentinean nominal exchange rate by 27%.

Effects:

Exports from Argentina fell drastically; “export volume growth which had averaged over 14% a year between 1993 and September 1998, stalled and never managed to recover its earlier dynamism.” (Hausmanm and Velasco) “Lower export earnings limited the currency’s ability to earn foreign currency to repay dollar denominated debts.” (BBC) Financial speculation and the consequences of an impending debt default caused risk interest rates to increase when it became obvious that Argentina could not generate minimal net flow of funds from abroad. (Halevi)

Forward rates reflected an expected devaluation of the peso, and interest rates in pesos shot up to 40-60 percent. Concern about the consequences of a default also spilled over into the banking system, reflected by withdrawal of deposits and interest rates in dollars of 20-30 percent. (Hanke)

The peso-dollar parity could not be maintained. (Halevi) In 2002, the peso was worth a quarter.

Description

Graph

Domestic Conditions

In addition, domestically, the government budget deficit kept growing; taxes were increased to combat the situation. A financial transaction tax was increased to .6% on bank debit and credits. Argentineans, already bearing a heavy tax burden did not pay the increase. The increased tax rate was expected to raise tax revenue, in contrast, revenue fell and provoked the recession even more. (Hanke)

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Works Cited

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BBC News. “Q&A: Argentina's economic crisis”. <http://news.bbc.co.uk/1/hi/business/1721061.stm>

Gabrielsen, Trond. “Case study: Banking Crisis Mexico”. Initiative for Policy Dialogue. <http://www2.gsb.columbia.edu/ipd/j_bankingMXN.html>

Halevi, Joseph. “The Argentine Crisis”. Monthly Review. Vol 53 no 11April 2002.

Hanke , Steve H. “Argentina's Boom and Bust”. Liberty Magazine, April 2002.

Hanke , Steve H. “Argentina's Current Political-Economic Crisis.” Forbes Global April 16, 2001.

Hausmanm, Ricardo and Andres Velasco. “Hard Money’s Soft Underbelly: Understanding the Argentine Crisis”. Brookings Trade Forum, 2002. <http://muse.jhu.edu/journals/brookings_trade_forum/v2002/2002.1hausmann.html>

Ending the Convertibility Plan

Several different options were proposed to end the Convertibility Plan in hopes of ending Argentina’s recession.

Float

This policy implements a flexible exchange rate, where the vale of Argentina’s peso would be able to vary according to the foreign exchange market. This policy allows the depreciation of the peso, which will restore trade competition lost due to the overvaluation of the peso under the Convertibility Plan. Though some disadvantages might be present in the short-run, long-run economic stability will be obtained. Since the nominal exchange rate can be controlled negative domestic and external shocks to the economy can be mitigated.

Disadvantages:

Domestic inflation could result if nominal depreciation is greater than what is needed to restore trade competition. If agents start to doubt the credibility of the monetary system, their expectations could lead to hyper-inflation

Disorderly balance sheet effects can also occur if the nominal depreciation forces the currency value below desired levels.

Balance Sheet Effect

Concretionary monetary policy ==>(?P s) ==> (?net worth) ==> (? adverse selection),(? moral hazard) ==> (? lending)
==> (?investment) ==> (?Y)

Dollarization

With the dollarization method, Argentina would abandon its domestic currency, the peso, and adopt the dollar, which would then be used for all contracts and transitions. Debates over exchange rates and exports offer two distinct policy options to pursue: One method of dollarization proposed adopting the dollar at current parity. This is thought to limit negative balance sheet effects and unwanted bankruptcies; however, there are several disadvantages with the dollarization at current parity method:

1. Long-term balance sheet effects will still arise due to inevitable external shocks that will affect relative prices. Over time balance sheet effects will be the same as those produced with a floating or devaluing policy option.

2. With a flexible exchange rate, depreciation can be reflected in nominal terms; however, if the currency is dollarized the exchange rate will be fixed, and real depreciation will be reflected in the relative prices of domestic goods. It is thought that economic agents could be able easily adjust to the slow moving depreciation accompanied with dollarization, but this will have negative effects. Firms will perceive lower prices for future products and will decide to reduce output and investment

3. Dolarization would require sever capital and exchange controls as well as bank freezes to be maintained in order to accomplish an orderly restructuring of domestic and foreign claims. This has been cause for protest in the past

Showing Argentina's ability to dollarize

Description

Dollarization after the peso has been devalued produces results similar to adopting a flexible exchange rate. Exports would become cheaper and more attractive to foreign buyers, and net exports would increase. Argentina would gain increases in foreign exchange reserves, granting them the ability to act as a lender of last resort or manage public debt. It would provide liquid reserves for risks faced by banks and the government accompanying the dolarization. Disadvantages include balance sheet effect, causing financial instabilities and large-scale bankruptcies.

Bank failures

Description

Debt restructuring

Debt restructuring methods would be required to limit bankruptcies resulting from the increasing amount of real debt associated with dollarization. If Argentina were to dollarize after a devaluation in currency, banks and government agencies would incur losses. Government spending would increase, as the government aided banks and other institutions in financial distress. This would merely transfer debt obligations between the government, banks and households. For debt restructuring to take a real effect, debt service payments made to foreign holders must be reduced in real terms. One solution is a capital levy, placed on foreign holdings of government debt

Private debt restructuring is difficult because the losses private investors incur as a result to dolarization is dependent on the size of the real depreciation of the currency for each specific firm. A policy that would reduce the real value of dollar debts would be optimal; One method is the Hausman proposal, converts dollar debts into domestic currency debts and then indexes the returns of these claims to the inflation rate.“This way, the cost of any real depreciation, that would have increased the real burden for the holders of this dollar debt, is shifted instead to the creditors/holders of these claims.” (Roubini 8)

What actually happened

Argentina ended the peg in January of 2002. They chose to float the peso in February. The exchange rate dropped significantly, causing real GDP to also fall; however, the economy stabilized as planned, and Argentina is currently enjoying economic growth. In 2005 Argentina achieved a budget surplus and was able to pay off all loans from the IMF earlier than contracted. Increasing economic growth has incited domestic demand but also has caused increased inflation, which reached 12.3 percent in 2005.

[https:www.cia.gov/cia/publications/factbook/geos/ar.html source and other data]

References

De la Torre, Augusto, et al. Living and Dying with Hard Pegs: The Rise and Fall of Argentina’s Currency Board. Economia, Spring 2003. http://muse.jhu.edu/journals/economia/v003/3.2torre.html

Mishkin, Frederic S. The Economics of Money, Banking and Financial Markets. New York: Columbia University, 2007.

Roubini, Nouriel. Should Argentina Dollarize or Float? New York: Stern School of Business, 2001.

Velde, Francois R. and Marcelo Veracierto. Dollarization in Argentina. Economic Perspectives, 1999. http://web.nps.navy.mil/~relooney/3040_642.pdf