External debt is not made up solely of sovereign bonds, but given Argentina’s immature financial market, one can assume that these bonds made up an important component of total debt; a conservative estimate would be around 50%.76 We do know that Argentina’s bond issues increased dramatically during this period. From 1993 to 1997 Argentina issued seven sovereign bonds that would later default. All of these were given a B1 initial rating, and had to pay, on average, a coupon rate of 10%.77 The total defaulted value of these bonds was around US$6.228 billion.78 In one year alone, 2001, the total value of the defaulted bonds amounted to roughly US$ 82 billion.79 Hence, we can conclude that there were sufficient sovereign bonds issued while Argentina’s privatization program was at its heyday to make Cavallo’s argument feasible. In the following chapter, once Cavallo’s argument is fully understood, I will utilize behavioral economics as a model to understand his claims.
It is evident that Cavallo believed that privatization stimulated further international borrowing and Argentina’s data figures support this argument, but it seems that his argument was not consistently the same in the long run. In fact, an analysis of the body of his publications over the decade shows that privatization was linked to two distinct periods. The first was during 1992 when Argentina agreed to the Brady Bonds program and reentered the international debt market. The second was after 1992, when the country actively used its ability to indebt itself in order to maintain its peso to dollar parity.
Period I: Brady Plan Agreement
Cavallo expresses his thoughts on Argentina’s involvement with the Brady Plan in several of his publications ranging from 1997 to 2007, using less technical and more personal language on how Argentina eventually renegotiated its outstanding debt in 1992. Cavallo claimed that when Argentina underwent its major changes in March 1991, notably convertibility and privatization, it had little support from the international community. Particularly, he recalls that David Mulford, Nicholas Brady’s undersecretary, told him that all of Argentina’s reforms were going to fail one month after they had been initiated.80 This did not happen. Instead, Argentina’s reforms showed fiscal and inflationary promise. Upon visiting Argentina only 4 or 5 months later, Mulford was so impressed by the reality of the reforms that he pushed for the country to undertake the Brady Plan.
In this rendition of Argentina’s history, privatization was being bundled up with the country’s other reforms, namely convertibility and fiscal austerity. Most importantly, the results of these policies seem to have influenced Mulford’s decision to allow the country to reenter the borrowing market. In this case, privatization is seemingly playing a reduced role in Cavallo’s explanation of the Brady bonds, especially when compared to his 1997 paper. But I will not limit this analysis to only one speech, as it is an exception in his traditionally privatization-borrowing focused accounts. Instead, I will explain how Cavallo publicly delivered results about Argentina’s fiscal reality, the one that impressed Mulford so much in 1991. In a speech given that very same year, Cavallo broadcast to the Argentine nation the first quarter results of the convertibility law, and the other changes applied by his ministry. Although admittedly this was a different audience, one can imagine him presenting the information to Mulford in a similar manner.
In the speech centered on Argentina’s ability to reach a balanced budget in the first quarter of 1991, Cavallo explained that it had been done through an accumulation of US$6.8 billion in standard revenue, which consisted mostly of taxes and exports, and US$600 million from sales of nationalized businesses. He determined that the total cost was of US$7.4 billion, finally declaring that Argentina had spent as much as it had earned. Cavallo concluded his message by adding that he expected little change in the fiscal situation in the upcoming months.81 The choice to emphasize privatizations, which made up less than 10% of Argentina’s total revenue in the first quarter, is interesting and revealing. It becomes clear that this was the key policy for Cavallo’s plan. Argentina’s reforms included convertibility, tax cuts, and reduction of tariffs, all of which either lowered the country’s revenue, or increased its spending. Without privatization it would have been challenging for the country to undergo such drastic policy changes while maintaining a balanced fiscal budget. In the end, it was this fiscal reality that encouraged international parties, such as the US Treasury and the IMF, to reassess Argentina’s creditworthiness. Ultimately, privatization was central to Cavallo’s pitch of Argentina’s experience. Conceivably, a similar pitch by Cavallo centralized around privatization, allowed Argentina to renegotiate its debt agreements and be reintegrated with international borrowing markets.
Although at first it may not have seemed as clear, it becomes apparent that, for Cavallo and potentially for Argentina, privatization played a fundamental role in the Brady agreements. That is to say, privatization influenced the country’s ability to borrow during the 90s; it was not, as existing analyses have it, simply another way of raising capital (see page 13/14 above for that argument). However, privatization did even more than enable the country to participate in the scheme designed by Nicolas Brady. In fact, privatization enabled the country to do without the Brady bonds. As Cavallo himself put it in 1997, “in June 1994, the authorities decided to accept the IMF recommendation not to make use of the last two scheduled [Brady] purchases since there had been a substantial increase in Argentina’s voluntary access to international capital markets.”82 This shows how Argentina had quickly moved away from the debt-relief part of the plan and had begun borrowing in the open market. The data provided in page 36 supports this observation. After agreeing to the Brady bonds in 1992, Argentina’s external debt increased by around 15% for two consecutive years. Debt accumulation slowed down in 1995 with the Mexican crisis, but then picked up again in 1996 until the 1998 recession. The dramatic increase in external debt demonstrates the country’s active involvement in the international capital markets. After signing a plan that was supposed to reduce Argentina’s debt payments, almost paradoxically, the country began to once again borrow heavily from international creditors. The following section will analyze Cavallo’s thoughts on how privatization influenced this open market borrowing.
Period II: Borrowing for Convertibility
Understanding Cavallo’s thoughts on the influence that privatization had on borrowing in general is more challenging than comprehending his take on the relationship between privatization and the Brady bonds. The challenge arises, at least partially, because borrowing was a policy that Argentine governments carried out over many years, making it less of a highlight in Cavallo’s publications than the Brady Plan — a once-in-a-lifetime agreement to reenter debt markets. Nevertheless, an in-depth reading of his materials provides enough information to discern his opinion on the subject.
Let us begin with an outline of what we already know. In the section titled Lessons from Argentina’s Privatization Experience, Cavallo explained that privatization drove further borrowing in the international market, an idea that can be further confirmed through an analysis of his publications. In his first speeches as Finance Minister, Cavallo pressed on the notion of Argentina shifting its borrowing attitude and becoming more integrated in international markets. For example, in a presentation to a group of economists in late 1991, he stated that “Argentina had opened up again to the world, [and that] at a more practical level, trade and capital flows were now once more substantially unrestricted”, and thus could flow into the country.83 In the first years of his ministry, Cavallo envisioned an Argentina with access to capital markets — recall that in 1991 the Brady Plan was yet to be signed — his focus was therefore on reintroducing the country to these markets, though being still unsure as to how to proceed.
By 1993, the situation had changed in Argentina’s favor. According to Cavallo, privatization played a part in garnering the attention of international investors and lenders, an idea he proposed during an interview with an American think tank in 1993. The attention resulted in high levels of investment, both direct and indirect, into Argentina. There were substantial direct investments in telecommunications, electricity, gas, and petroleum. The indirect investment, usually in the form of bond purchases, allowed the public sector to improve the roads and highways.84
Cavallo’s thoughts on privatization become clearer in his latter publications. In an interview granted in 2002, six years after he resigned, when discussing Argentina in midst of the Mexican crisis, Cavallo explained what he believed were the key changes the country needed to make in the 90s, and how he had enforced them. For him, Argentina had to open its “economy to the rest of the world, and to work for a larger share of foreign trade, and bring foreign investment into the economy, and to recreate a climate of investment in general” in order to improve its macroeconomic conditions.85 Argentina enforced these changes through the implementation of reforms, which started, but did not end, with the convertibility program. In this interview, Cavallo also spoke almost exclusively about the privatization of state assets, hinting that this was the key reform that Argentina undertook to achieve its goals, which included increased foreign investment and the recreation of a climate of investment. He claimed that, for “financial markets, Argentina was seen in those days as the second successful case of the deregulation, privatization, and stabilization.”86 In his view, the financial markets had responded particularly well to the policy of privatization, in fact only highlighting this in this interview.
The number of times that he mentions this relationship over the years demonstrates that Cavallo believed that privatization was once again fueling Argentina’s ability to borrow, as the capital markets were enamored by the country’s reform. It is a consistent theme in his publications, independent of their date and their intended audience. But how did he see this relationship actually working? And why did Argentina have to borrow so much? Cavallo provides some answers to this question in yet another interview. In explaining how Argentina recovered from the Mexican (Tequila) crisis of 1994-5, Cavallo puts it as follows:
“So what we did at that time in March, April ’95, just a few weeks before a very important presidential election, was to force privatizations of provincial banks, most of the provincial banks, and get foreign money through the IMF, the World Bank, the IDB [Inter-American Development Bank], and also private banks, foreign and local private banks that added funds to demonstrate that we did have ability to control the situation. And we were successful. Actually, in a few months, Argentina started to get capital back into the economy, and deposits in the banking system started to increase.”87 During such a crisis, borrowing was paramount to the survival of Argentina’s convertibility program, which in turn was paramount to the country’s economic stability. The low trade surplus, at times even a trade deficit, worsened during times of crisis. This meant that the country was incapable of accumulating dollar reserves through traditional means such as exports. To make matters worse, international lenders became apprehensive and began to pull their investments from the country.88 The privatization of the banks, in this instance, played a fundamental role in facilitating Argentina’s access to international capital markets. The policy worked to instigate a response from international institutions, which provided liquidity (capital) to the country. This liquidity, in the form of loans, allowed dollars to continue flowing into Argentina and reassured private lenders who began to reinvest in the country. All this translated into maintenance of convertibility, which was dependent on Argentina’s dollar reserves. This begins to answer the questions posed above. Argentina needed to borrow, as well as to privatize, in order to bring dollars into the economy.
Cavallo’s comments above, as well as our knowledge of Argentina’s convertibility and fiscal programs, give us clues regarding the workings of the privatization-borrowing relationship. Let us now turn to a fiscal evaluation of Argentina’s net position during the 1990s, particularly at times of crisis, such as the one in 1995. Let us also copy Cavallo’s framework from his speech in 1991, covered on page 38 of this thesis. In the midst of the Tequila crisis, Cavallo claims that Argentina’s first initiative was to privatize provincial banks. The result was the bolstering of the country’s fiscal position, in an operation like the one described in the 1991 convertibility speech. The policy provided Argentina with much needed dollars, thus aiding the maintenance of convertibility. More importantly, fiscal construction increased the chances of the country receiving funding from the IMF. After all, the institution was adamant on promoting fiscal responsibility.89 By the second quarter of 1995, IMF involvement had become a reality, as the organization put together an impressive financial package that stopped a bank run in Argentina.90 Privatizing the banks contributed to Argentina receiving these loans. Beyond the fiscal relief that the sale of the assets (banks) provided, it demonstrated that Argentina could maintain its convertibility plan, its stability, and its growth throughout a crisis with additional capital. The IMF loan, in turn, “was a catalyzer for additional funding from the World Bank and the Inter-American Development Bank.”91 The support of these institutions improved the market perception of Argentina’s economy, more specifically in terms of its ability to repay its sovereign debt. Therefore, the privatization of a set of assets effectively led to Argentina, once again, being capable of borrowing in international capital markets, as lenders started to invest once more.
But this was not only the case during economic downturns. Throughout the 1990s Argentina needed dollars to maintain its convertibility program. According to Cavallo, Argentina privatized its assets, driving borrowing. The country received support from the IMF at least in part as a result of privatization’s rewards. This support, according to Cavallo, translated into good credibility, which resulted in further loans from other international institutions and private lenders.92 Thus, Argentina utilized privatization as the first project that led to follow-up initiatives, all of which had the end result of signaling the country’s economic stability. This stability was dependent on the confidence of international organizations, such as the IMF, the World Bank, and the IBD, which consistently backed up Argentina during the 1990s. It also served to reassure foreign lenders, who kept on extending credit to the country, allowing for the convertibility program to continue.
The next sections will be devoted to developing a model to explain Cavallo’s thoughts, as well as demonstrating that privatization and borrowing have in fact a historic relationship under his ministry, one that can be proven through an analysis of one of his policies rather than his rhetoric.
Behavioral Economics as Model For Cavallo’s Argument
Behavioral economics and behavioral finance, both subfields of traditional economics, deal with identifying the psychological underpinnings of human behavior in relation to economic analysis and the workings of the market. As the study of the Argentinean case seems to have been so intricately linked to its economic leader, these subfields can help explain the arguments set forth by Cavallo. This section will be devoted to using behavioral tools, particularly feedback loops, to support his ideas. It must be noted, however, that in doing so I do not claim that what Cavallo’s accounts set forth should be considered a certainty. Rather, I merely present an alternative analytical framework, suggesting that behavioral economics may help explain/support the minister’s thoughts on the privatization-borrowing relationship.
One of the main contributions of behavioral economics to the field as a whole was the criticism of the efficient markets hypothesis (EMH). Robert J Shiller, a Nobel Prize winner in economics, led the efforts against disproving EMH, which had been used as one of the fundamental assumption for a majority of the financial models we use today. EMH essentially claims “that the price Pt of a share (or of a portfolio of shares representing an index) equals the mathematical expectation, conditional on all information available at the time, of the present value P*t of actual subsequent dividends accruing to that share (or portfolio of shares). P*t is not known at time t and has to be forecast. Efficient markets say that price equals the optimal forecast of it.”93 In layman terms, the formula assumes that financial markets have efficient information and, as a consequence, can achieve returns that are above the average market returns. Shiller however, disagreed with this proposition. Instead, he demonstrated that if we look back at the stock market and trace the expected present value with perfect information, the result would be far off from the actual returns that occurred. The simplest way to demonstrate this variation is graphically as is shown below:
In explaining this phenomenon, Shiller turned to “developing models of human psychology as it relates to the financial markets.”95 The main model that emerged out of this thought experiment was feedback loops. An example of one is a price-to-price feedback loop, which can be explained as follows: when speculative prices go up and create successes for some investors, they attract public attention, promote word-of-mouth enthusiasm or market sentiments, and heighten expectations for further price increases. In his papers, Shiller backs up this model through the use of psychological experiments. Additionally, he discusses two derivations of the feedback loop. The first, that the model includes a “distributed lag with exponentially declining weights on past price changes through time”.96 This means “that people react gradually to price changes over months or years, not just to yesterday’s price change.”97 The second, that “a disturbance in some demand factor other than feedback can in certain cases be amplified, at least for some time, because it changes price and thus affects future prices through the distributed lag.”98
Now let us utilize this model, as well as Cavallo’s thoughts to create a feedback loop for Argentina’s bonds. In order to do so effectively we will need to make some simplifying assumptions. These are: 1) IMF and other international lenders respond solely to Argentina’s fiscal position on a quarterly basis when deciding to give out loans, 2) individual lenders actions are strongly correlated to those of the IMF and other international lenders.
As the graph above shows and as I have previously explained, Argentina began issuing bonds again, in late 1992. Previously, I showed that Cavallo believed that privatization was key in allowing Argentina to reenter the borrowing markets. If we take the assumptions of this feedback loop model to be true then this argument is in fact reinforced. The IMF and other institutional lenders were assumed to only consider a country’s fiscal position on a quarterly basis. Let us take the case of Argentina in 1991 quarter 3, when Cavallo announced the results of convertibility over the radio. The table below demonstrates the country’s fiscal position with the terms being used explained in the footnote below:
From this table it is clear that privatization was vital to achieving a balanced budget, and therefore important in maintaining Argentina’s dollar reserves, which in turn upheld convertibility. Argentina perpetuated a fiscally balanced budget like the one shown above until 1992, when it was allowed to reenter the borrowing markets. A feedback loop was already forming, but we must also look at what happened after Argentina began to borrow in order to understand the loop in its entirety.
From 1992 until the Mexican crisis in 1995, Argentina’s bonds remained at a relatively stable price, the spread staying below 1,000 points from the US bonds (see graph above). The mechanism at play here was very much aligned with feedback loops. From our calculations, it appears that privatizations were yielding Argentina around US$555 million per month. This means that the country was earning around US$1.5 billion per quarter through the sale of its assets. Beyond privatizations and convertibility, Argentina was undergoing other important policy changes, particularly tax cuts and reduction of tariffs. The result of these was a reduction in government revenue and an increase in government expenditure. Thus, by 1993 Argentina was in a situation as follows: