Table of Contents
Events Leading to Crisis 2
Private and Public Sectors of Argentina in the Crisis 6
Public sector 6
Private Sector 8
During Crisis 9
The Role of the IMF in the Argentina Economy 14
Lessons Learned 16
Events Leading to Crisis
Even though Argentina’s economy did not fall into crisis until 2000, the events of the 1990’s will be discussed. The government’s actions during these times contributed to Argentina’s fall in the year 2000.
Very dissatisfied by Argentina’s poor economic state and unsuccessful attempts at curbing hyperinflation through the 1970’s and 1980’s, Economics Minister Domingo Cavallo and Argentine President Carlos Menem created a new regime for Argentine in the early 1990’s. The goals of the 1991 “anti-inflationary” policy were to reduce the government’s budget deficit and to make the Argentine government more competitive internationally. The following elements were included in the policy:
The creation a new currency, called the new peso worth 10,000 australs;
Reduction in budget deficit by reducing public spending, reforming the tax system, and cracking down on tax evasion;
Reduction on tariffs and removal of various import restrictions to promote foreign trade and competition;
The Convertibility Law was the most significant contributing factor to the success of the 1991 reform. For this reason it is discussed in further detail.
On April 1, 1991, Argentina’s Congress enacted the Convertibility Law. This law was a fixed exchange parity between the United States dollar and Argentina peso with the main goal of correcting hyperinflation and installing confidence in the country. Under this law, Argentina legally adopted a currency board, which guaranteed the convertibility of an Argentine peso to an American dollar at a one-to-one fixed rate. This limited the printing of pesos only to an amount necessary to purchase dollars in the foreign exchange market. Each peso in circulation was backed by a U.S. dollar and monetary policy was forcibly constrained to uphold that promise.
Between 1991 and 1994, the Argentina economy experienced price stability, and strong growth. The currency board was considered as highly successful up to that point in time. The problem of hyperinflation experienced previous to the currency board was corrected immediately (for example, 1345 percent in 1990). Trade barriers were reduced and GDP per capita (measured in dollars) increased by 72.8 percent during this period.
The US dollar experiences a prolonged period of real appreciation, resulting in similar appreciation of the Argentine peso relative to its trading partners, such as Brazil (Add Chart of Trade Balance). The dollar rose sharply against the Japanese yen after 1995. After the crises in Southeast Asia in 1997 and 1998, the dollar rose against the respective currencies, and against the European currencies in 1999 and 2000.
Moreover, the peso’s one-for-one peg to the U.S. dollar implied that since the U.S dollar was strong during this period, the peso would also be strong. This made Argentina’s economy uncompetitive, consequently slowing growth because the fixed exchange rate made it impossible to increase competitiveness by traditional currency devaluation. The Brazilian real depreciated by about 40 percent relative to the U.S. dollar and the Argentine peso, thus sharply increasing the real exchange rate of the peso and further intensifying Argentina’s current account problems.
Wage increases kept the cost of production in Argentina high and the terms of trade moved against Argentina. World prices for its exports declined relative to the prices for its imports, thus depressing exports and encouraging imports. As well, when Brazil (main trade partner–Mercosur) devalued its currency, the exchange terms were affected and interest rates in Argentina rose. As a result bilateral trade with Brazil dropped.
“The currency board achieved its goal of price stability. During the first part of the 1990s, the Argentine inflation rate was essentially zero-indeed, the CPI in the fourth quarter of 1999 was slightly lower than in the fourth quarter of 1995. The real economy also performed well for much of the 1990s: Real GDP grew at an average rate of 5.87% per year from 1990 to 1998, an impressive rate…. By the mid 1990s, the 1991 reform package was widely viewed as a resounding success. In the latter part of the 1990s, however, Argentina slipped into recession, with real GDP falling by 3.4% in 1999 and the unemployment rate rising well into the double digits.”(1-Crisis in Argentina)
Throughout most of the 1990s, Argentina ran large current account deficits, leading its foreign debt to grow about one-half of a year’s GDP. The financial sector was especially vulnerable with growing exposure of the banking system to default on the government, increased difficulties of companies to pay their debts, and with exchange risk weakening it very considerably.
In attempting to stimulate the economy through increased spending, higher wages for government workers, and incurring larger costs in a major reform of the social security system, the Argentine government’s budget deficits grew again. Thus with an increased need to borrow, the government found the public unwilling to buy government debt. The government raised funds by coercing private banks into making loans to the government. This led depositors to withdrawal their funds because these forced loans would likely threaten the financial health of these private banks.
With Argentina’s prolonged recession in the third quarter of 1998 and unemployment beginning to rise, there became a fear of floating. However, the existence of the Convertibility law generated more confidence among the economic agents due to fear of hyperinflation and initial achievements of the conversion plan. Conversion is very vulnerable to a drain of capitals; when capital ceases to flow in, international reserves fall and current account deficits are lower. A reduction in its international reserves increases the risk and vulnerability of the country. A contraction of the current account deficit leads to a drop in employment and production. This occurs because the large capital inflows are compensated by current account deficits or an accumulation of international reserves, possibly pushing countries into insolvency or reducing their production, generally together with a crisis in the financial sector. In Argentina, capital inflows came to a stop and began to flow out again.
Argentinean negotiable goods ceased to be profitable and there was a shift towards non-negotiable goods. Also, resources were constantly required to maintain demand, yet demand weakened by the fact that the capital gradually diminished. For it to function, it needs adequate movements of capital free from sudden jolts. This is something that is very difficult to achieve in a setting in which financial movements are very volatile.
On December 10, 1999, Fernando de la Rua became Argentina’s president. He campaigned on promises to save the economy and end corruption after the 10-year rule of the Peronist President Carlos Menem; however, things went from bad to worse. His administration’s new economic plan, approved by the IMF, was supposed to lower interest rates and produce a boom by raising taxes, which was meant to reduce the government’s deficit. The timing was wrong, as world interest rates were on the rise. As a result, Argentina’s rates also rose and the economy slumped further into recession. Argentina was headed for a crisis of confidence, one that would plunge the economy into a deeper recession and cause debt-servicing problems. By the end of decade, capital was becoming more and more scarce and the final blow was the withdrawal of the support of the IMF in December of 2001.
The average economy is typically divided into two large sectors, the public and private sectors. The public sector, or government in Argentina, played a role in the currency crisis, which crippled the economy from 2000. As a result of the government’s actions, or lack thereof, the private sector was negatively affected.
The public sector in Argentina has had a variety of problems, which were a precursor to the eventual currency crisis. In the 1980’s, Argentina, as well as other Latin countries, suffered through a period of extreme economic instability. A debt crisis arose which led to hyperinflation in these countries. This period of instability led the government, or more particularly President Carlos Menem, in 1989 to enact a major restructuring of a number of policies in Argentina. These policies included tax reform privatization, trade liberalization, deregulation and the adoption of a currency board. *footnote*
In an effort to curb hyperinflation, a new law was created which would tie the Argentina peso to the American dollar. In April of 1991, the government enacted the Convertibility Law. As stated previously, this law created a currency board which guaranteed the convertibility of the peso currency to the U.S. dollar currency at a one-to-one fixed exchange rate. In essence, the new law provided that each peso that circulated in the Argentina economy would be backed by a U.S. dollar. The Argentina economy sees growth in GDP and the currency board is viewed as successful in curbing hyperinflation and stimulating the economy.
Argentina’s GDP grew by an average of 5.8 percent per year between 1990-1998. Although this was viewed as an economic success, Argentina had been running large current account deficits throughout most of the 1990’s. This led its foreign debt to grow to roughly one-half of a year’s GDP. Debt measures during this period were not very effective and continued to allow Argentina to increase its indebtedness on the foreign market. A source of this problem could be tied to the government’s decision to use a currency board and peg the peso to the U.S. dollar. Between 1995-1999, the American dollar experienced an extended period of real appreciation. This effectively meant that the peso was overvalued. As a result, Argentina continued to increase its imports, increasing its foreign debt. *footnote* However, as a result, Argentinean goods become more expensive on the world market, and growth slowed as products became uncompetitive.
Government budget deficits have always been a problem in Argentina, and it was evident that this problem had not disappeared with the new government. In the late 1990’s, Argentina once again slipped into a recession, with GDP decreasing by 3.4 percent. The unemployment rate also skyrocketed, moving well into the double digits. The fiscal system was also a mess in the country as a result of the government’s lack of stringent rules on tax evasion. According to Steve Hanke (2002), tax rates were sky high and the wedge between gross labour costs and net wages was about 42 percent. *footnote* However, although the tax rates were enormous on the citizens of Argentina, the high rates of tax evasion and legal loopholes allowed the rich in Argentina to pay low taxes. Nancy Birdall (2002) says that an IMF study suggests that the average effective tax rates for the richest ten percent of households is below ten percent. *footnote* Levels of spending in Argentina were high and increased as the late 1990’s approached. Combined with tax revenues that were lower than what should have been expected, created even greater budget deficits, causing Argentina to borrow more money to stay solvent.
In an attempt to counter the growing recession in the country, the government tried to stimulate the economy by increasing spending, higher wages for government workers, and a large-scale reform of the social security system. A negative reaction followed from the citizens of the country. With an increasing need to support the level of spending, the government looked to the public to purchase debt. However, the government found the public unwilling to purchase more debt. The government then turned to the banks in the country for loans. In effect, the government coerced the banks into supplying loans to support their spending activities. Citizens with money deposited in these banks became increasingly worried about the risk that could affect them. As a result, the depositors began to withdraw their money from the system. The government wanted to decrease the flow of funds exiting the banks, so in December 2001, the government imposed a “corralito.” Essentially, the corralito imposed a limit of $1000 that a citizen could withdraw from their account in a month. *footnote* This caused even greater uncertainty in the minds of depositors. The recession worsened as interest payments on foreign debt increased, and riots in the country began to occur. At this point, Argentina was unable to service its foreign debt payments and announced that it would discontinue payments on the debt, an estimated $155 billion. The default was the largest in world history.
In January 2002, Argentina’s government finally abandoned the currency board and let the peso float relative to the U.S. dollar. The value of the peso quickly devalued in relation to the dollar, losing half its value by February 1, 2002. This was essential in trying to improve exports, and the current account balance. The devaluation and currency crisis has had significant effects on the private sector of the economy.
Argentina’s private sector has experienced some difficult times as a result of privatization. In the early 1990’s, Carlos Menem’s privatization policies had caused many people to lose their jobs. This was the beginning of the recession in Argentina in the private sector. Many of the privatized companies were utility companies and the prices for such services began to increase. Argentina’s recession grew worse as demand for these services decreased. A decline in the demand for these expensive services caused the companies to continue to lay off workers. The impact this had on the government was significant. Many of these companies became insolvent, and the government was left with shrinking tax revenues. This made the debt burden of the government even greater as their tax revenues became smaller. *footnote*
As well as the government privatized companies; corporate companies within Argentina were affected by the downturn in the economy. A series of negative shocks and economic policies in place at the time caused companies to suffer a reduction in demand. As a result, they had to reduce production as well as prices. A decrease in profit margins occurred. Because Argentina was unable to devaluate its currency (because it was linked to the U.S. dollar) for international trade, it was difficult for products to be competitive on the open market. Companies that wanted to maintain a profit margin would have to look to reduce production or administration costs.
A significant implication of Argentina’s decision to abandon the currency board is the effect it will have corporate or privatized company’s debt. Currently, the value of the Argentina peso is 0.494 per U.S. dollar.*footnote* By halving the value of the peso, it doubles the number of pesos needed to pay any dollar of foreign debt. A sudden increase in the real value of the loans is expected to cause default on loans by companies. *footnote*
*find value of Argentina peso as at march 28,2003. *
There are five important reasons as to why Argentina reached such a large level of indebtedness.
First, Argentina has always had difficulties in ensuring efficient tax collection. Without properly collecting tax revenues, Argentina is unable to effectively control its debt. Argentina has had very little success in raising tax revenues of more than 20 percent of GDP. This figure is substantially lower than the tax revenues of 50 percent of GDP that several European nations experience. In addition, the provinces of Argentina are continually experiencing deficits and often request the aid of the central government. This means that any revenue the provinces collect is allocated towards spending and none is allocated towards debt servicing. As a result, the tax base for debt servicing must come from tax revenues collected by the central government after funds have been transferred to the provinces.
Second, it is important to note that a substantial amount of both government and private sector debt was denominated in foreign currency. As a result, Argentina had to persuade their creditors it was capable of both raising sufficient fiscal revenues to service debt and convert these revenues into foreign exchange with an exchange rate that was rigidly pegged to the U.S. dollar. Furthermore, Argentina’s total external debt rose massively from $62 billion at the end of 1992 to $142 billion by the end of 1998, more than doubling during a period when Argentina’s nominal GDP rose by about a quarter.
Third, the behaviour of Argentina’s debt is a concern. It is noted that Argentina’s debt to GDP ratio increased from 29 percent to 41 percent during a period of generally good economic prosperity. This increase signals incapacity to maintain responsible fiscal discipline. As a result, Argentina did not succeed in achieving the satisfactory management of its debt, which would make its economic sustainability credible. This is especially significant since Argentina has had a record of persistent difficulties in this area.
Fourth, Argentina was vulnerable to external economic shocks that might impact fiscal stability. In 1999, the collapse of Brazil’s crawling peg exchange rate had a negative impact on Argentina. As a result, real GDP in Argentina fell, leading to a lowering in the overall price level and to a decrease in nominal GDP. This weak economic environment led to the budget deficit widening. There was fear that the public debt was increasing to unsustainable levels.
Fifth, if for any reason the capital market changes its perspectives or feelings, Argentina would be severely affected. An increase in interest rates and greater difficulties in gaining access to external credits would, in turn, begin to change the expectations of the market. This gives rise to the “herd effect”, which was, indeed, what happened.
By the end of 2001, Argentinean society exploded and provoked the largest social protests of recent years. This deadly protest ended with the bringing down of President Fernando de la Rua on December 21. (TIMELINE: ARGENTINA’S ECONOMIC CRISIS) During the week following the protest, a moratorium was declared on the external debt and the convertibility plan was ended. Argentina announced it would cease payments on its $155 billion foreign debt.(CRISIS IN ARGENTINA)
The following timeline outlines the events during the crisis:
President de la Rua took power of Argentina in December 1999 when the economy was already in recession and public debt was mounting. Argentina’s exports had been hurt significantly earlier in the year from the devaluation of Brazil’s currency. De la Rua’s government tried to gain confidence and bring upon growth through fiscal adjustment.
In March, the IMF agrees to a three year $7.2 billion stand-by arrangement with Argentina conditioned on a strict fiscal adjustment and the assumption of 3.5 percent GDP growth in 2000. The actual growth was 0.5 percent. In May, the government announces $1 billion in budget cuts in hopes that fiscal responsibility will bring renewed confidence in the economy. In December, the government announces a $40 billion multilateral assistance package organized by the IMF.
On January 12, Argentina’s continued poor performance prompts the IMF to augment the March 2000 agreement by $7 billion as part of a $40 billion assistance package involving the Inter-American Development Bank, the World Bank, Spain and private lenders. The agreement assumes GDP will grow at a rate of 2.5 percent while it actually falls by 5 percent.
In June, the government announces a $29.5 billion voluntary debt restructuring in which short-term debt is exchanged for new debt with longer maturities and higher interest rates. The next month in July, the Argentine Congress passes the “Zero Deficit Law,” requiring a balanced budget by the fourth quarter of 2001. With the commitment to the Zero Deficit Law, the IMF augments its March 2000 agreement for a second time, increasing lending commitment by another $7.2 billion in September. In October, the use of provincial bonds as “scrip” to pay public salaries becomes more widespread as federal revenue transfers decline.
In November, Argentina conducts a second debt swap, exchanging $60 billion of bonds with interest rates of 11-12 percent for extended maturity notes carrying interest rates of 7 percent. International bond rating agencies consider it an effective default. By the end of November, a run on the banks begins. Central bank reserves fall by $2 billion in one day.
One measure to combat the runs on the banks was the corralito. Essentially, the corralito was restrictions placed upon banks that would limit the amount savers could withdrawal. The corralito limited withdrawals by depositors to $1000 a month. (CRISIS IN ARGENTINA) With imminent devaluations coming, people began to withdrawal their savings on a massive scale in order to protect themselves. These withdrawals resulted in a crisis in the financial sector. The public viewed this as the last straw and began to protest over bank withdrawal limitations. After all, they were suffering from high unemployment rates, decreased public salaries/wages and limits on using their own financial resources.
However, if the government did not take this action the result would have been much worse. The financial system would have collapsed leaving the banks bankrupt, huge devaluations, a return to inflation and the demonetarization of the economy. Other events in December include:
Argentina announces it can no longer guarantee payment on foreign debt
Government announces unemployment rate reaches near record high of 18 percent, unions call nationwide strike
Rioting in major cities over deep budget cuts, government declares state of siege
Resignation of President de la Rua on December 20
Liquidity standards for banks are relaxed
2002 began with the swearing in of Senator Duhalde as President. He blames Argentina’s economic problems on the free-market system and vows to change economic course. Except for debt moratorium, new economic policies are unclear. On January 6, the currency board is ended and a plan to devalue the currency is introduced. On January 10, 2002, the peso lost 29 percent of its value. By February 1, the exchange rate was at 0.494 dollars per peso. Essentially, halving the value of the peso doubled the number of pesos needed to pay any dollar amount of debt owed to foreign investors. (CRISIS IN ARGENTINA) This increase in the total amount of debt has contributed to the default of many loans. Other elements of the economic plan include: converting all debts up to $100 000 to pesos (passing on devaluation costs to creditors); capital and bank account controls; a new tax on oil to compensate creditors for the losses that will ensue; renegotiating public debt, and a balanced budget.
Furthermore, the government would repeatedly declare “exchange holidays” in which exchanges were prohibited for a few days to prevent massive devaluation and a drain of capital.
The Role of the IMF in the Argentina Economy
The International Monetary Fund (IMF) had a large and often criticised role in the Argentinean economy over the country’s years of troubles. One objective of the IMF is to ensure exchange stability. The IMF is a strong regulatory body that exerts considerable influence. In the case of Argentina, the Fund did not pressure Argentina enough to manage a prudent fiscal policy, while Argentina’s main concern focused on the exchange rate policy.
In order for Argentina to maintain its artificially overvalued currency, it needed to maintain large reserves of dollars. This is because when a country has to maintain its currency, the government has to guarantee that everyone who wants to exchange a peso for a dollar will get one. Therefore, the IMF arranged massive loans to Argentina in order for the country to maintain their large cash reserves, including a $40 billion loan in 2001. Loans such as this from the IMF supported the Argentinean program until the year-end of 2001, even though Argentina was not achieving the fiscal goals from 1999 to 2001. The IMF feared that if it suspended its support to Argentina, it would cause an economic collapse. Despite this worry, the IMF suspended its loans to the Argentinean government on December 5, 2001 thus, deepening the Argentinean crisis and sending a clear, negative message to international investors (lessening confidence).
The IMF’s loans were contingent upon a zero deficit. Argentina complied with the restriction and received funding from the IMF. However, instilling a zero deficit rule during a recession only adds to the contraction of the economy.
However, extending such large loans to the Argentine government exacerbated the government’s debt during its recessionary time. It resulted in a pile up of foreign debt that was literally impossible to pay. Inevitably, Argentina defaulted on its billions of dollars of loans from the IMF, causing problems in its relationship with the Fund as is still seen today. In light of such criticisms, the IMF claimed that it was always against Argentine’s fixed exchange rate and the massive loans they provided to support this program. Officials from the IMF state the only reason they went along with these policies was to please the Argentinean government. This proves the severity of the Argentinean crisis, and pertinent parties involved were trying to place blame on each other as a reason for these problems.
Contagion occurs when the effects of a crisis in one country spreads to another country due to the linkages between countries as seen through the globalization of financial markets. As evidenced earlier, Argentina was effected by contagion from fallouts such as the Mexican crisis, the Asian crisis, and the Russian crisis.
One reason Argentina's crisis has been contained is that Argentina does not have a lot of trade. For example, ten percent of Brazil's exports go to Argentina, but these exports comprise only one percent of Brazil's overall economic output. The second reason for the containment of the crisis is because markets well anticipated the crisis. It has been documented that because Argentina’s economic recession and financial crisis was so long in the making, investors had time to prepare. For example, when Mexico's problems occurred in 1994, professional investors were caught completely off guard and many had to sell solid investments in Chile (contagion), for instance, to raise cash.
Another concern stemming from the Argentina crisis is the future for trading. It is possible that the current crisis may weaken the prospects for Mercosur, which is a trading arrangement among Argentina, Brazil, Paraguay, and Uruguay. Another possibility that also remains is that the crisis may destroy any chance for a general Free Trade Area of the Americas. This is a significant effect because trade is crucial for a country’s economic development.
There are ten very important lessons that should be learned from the Argentine crisis. They are outlined as follows:
First, a fixed exchange rate system is a bad idea that is likely to lead to an overvalued exchange rate, a currency crisis, and widespread defaults. A floating exchange rate determined by the market is the only way to avoid these problems.
It is very risky to have substantial foreign borrowing in dollars. This is particularly true of short-term debt, but is also a problem with longer-term borrowing. Other forms of capital inflow, in particular portfolio equity investments and direct investments in plant and equipment, do not raise the problems associated with debt.
The opening of the economy to trade, the encouragement of foreign direct investment, and the privatizing of state-owned firms are desirable policies. These policies did not contribute to the crisis rather they were favourable policies.
Not all financial crises are caused by moral hazard in the management of banks. The Argentinean system was well regulated and supervised and was able to withstand a severe and prolonged recession, without major incidents and with a rising level of deposits until February 2001.
Liability dollarization can seriously amplify the cost of crises because crises are usually accompanied by large swings in the real exchange rate, which increases the domestic cost of dollar-denominated debt. When maintaining flexible exchange rates, policies should be developed to increase the market for domestic currency denominated assets both at home and in the international market.
Countries should be more willing to pay the costs of ensuring a well functioning payment system in times of crisis, and governments should consider the impact of their crises management initiatives on the stability of the payment system. This is important because when the system fails, it causes an enormous contraction in economic activity and complicates fiscal solvency and limits the ability of the government to solve the crisis.
In systemic crises, parent companies are less likely to support their subsidiaries, especially when the loss of capital can be attributed to government decisions. Therefore, it is important to assess the effect of banks’ ownership structure in times of crises.
This crisis has also provided new evidence on the enduring lesson on the problems caused by the public sector commercial banks. These banks tend to exert political influence in the allocation of credit, thus weakening their ability to retain the respect of depositors.
It is important to match the maturity of debt and assets. Lengthening the maturity of public debt is important to avoid rollover problems when the decline in deposits occurs during a systemic crisis. The increased maturity of the debt complicates banking crisis management.
Currency crises may induce the adoption of exchange rate controls as a temporary measure to contain the decline of the exchange rate and the loss of bank liquidity. Efforts should be made to coordinate actions of different central banks on how to deal with liquidity problems faced by specific banks in different jurisdictions.
Until 1997, the Argentinean economy functioned relatively well in terms of per capita growth. However, after 1997, Argentina was negatively affected by a series on external shocks. These external shocks led to Argentina falling into a deep recession. Argentina was especially vulnerable to these shocks as a result of the combination of the convertibility plan and inflexible wages, deficient fiscal management, a highly dollarized financial system and the presence of, and extreme sensitivity to external shocks.
There were no reforms put in place that would allow adequate management of transfers and finances to the provinces. Argentina should have applied careful fiscal management to ensure credibility and confidence in its economy.
By 2001, Argentina was faced with a difficult situation- default. Argentina ended up defaulting on $155 billion worth of debt.