Argentina had grown at an average rate of 6.7 percent per year between 1991 and 1997 (Hausmann and Velasco 2002). During the period of 1991-97 the Argentine economy experienced high growth and low inflation levels. This high growth was only interrupted in 1995, when the country experienced a recession due to the Mexican peso crisis. This rapid growth disguised vulnerability in the fiscal and banking systems, which, coupled with poor policy responses, worsened economic circumstances (Perry and Serven 2004). In addition, rigidity imposed by the currency board created a vulnerability in the exchange rate regime. As the dot-com boom in the US unraveled, Argentina entered crisis.
A series of external shocks hit the Argentine economy at the end of the 1990s (Chudnovsky and Lopez 2007). In 1997, the Asian crisis resulted in a temporary increase in risk spreads and a decrease in the terms of trade for Argentina. In 1998, the Russian crisis followed causing a tightening of credit and Brazil, Argentina’s main trading partner, was in recession. Still, Argentina was perceived to be under control as it faced these negative shocks (Hausmann and Velasco 2002). During 1998, Argentina saw a decline in the terms of trade, a decrease in private investment, and a more rapid decrease in economic activity. By the end of that year, export prices were about 20 percent lower than at their peak two years prior.
In 1999, Argentina faced another negative shock due to the depreciation of the Brazilian real. This caused greater downward pressure on Argentine exports. The appreciation of the US dollar also had a negative effect on Argentina’s exports to Europe and the US. Even with these negative shocks, Argentina saw a short-lived increase in economic growth in the last quarter of 1999. The IMF issued a news brief commending Argentina’s policies (Hausmann and Velasco 2002).
Causes of the Crisis
The glow of growth was short-lived. In January of 2000, new President Fernando de la Rua took office. The economy stagnated again and tax revenues began to fall. What is more, the government was increasingly deeper in debt. The external public debt was contracted, for the most part, in dollars (Lischinsky 2003). External public debt would rise to 30 percent of GDP by late 2000, while external public and private debt were even higher (Figure 7.4).
In response, Economic Minister Jose Luis Machinea implemented the impuestazo, a tax increase meant to decrease the financial deficit and in turn ease the private sector’s concerns about debt sustainability. Unfortunately, the actual economic impact was negative, since citizens reduced their economic activity just after the announcement of the tax increase, even before taxes had actually increased. The decreases in economic activity led to a decrease in tax revenues which worsened the fiscal deficit. This had the result of increasing country risk as uncertainty of debt sustainability
Figure 7.4 External debt stocks ($ of gross national income)
climbed. As a result, investment declined, causing economic activity to fall even further (Powell 2002).
Argentina was already vulnerable to external shocks, due to the rigidity of the exchange rate, the weak fiscal situation, and the fragility of the banking system. The rigidity inherent in the currency board arrangement prevented the free use of monetary policy in countering recession, and policy mechanisms became dependent on fiscal policy. Through the currency board, each peso in the economy was backed by a dollar and fully convertible. The currency board arrangement worked against the economy as exports became decreasingly competitive.
Macroeconomic stabilization was left to fiscal policy (IMF 2003). Argentina’s fiscal spending was uncoordinated and over budget, and the increasing size of fiscal spending overshadowed the currency board arrangement which required the country to adjust fiscal policy according to money available after a fixed exchange rate was taken into account. This, however, could not be upheld. Money supply was dependent on foreign exchange earnings which, when they fell due to peso overvaluation, translated into low liquidity in the banking system. Hence saving and investment were dampened (Desai 2003). Nor could the exchange rate be painlessly devalued, since both the private and public sectors held a large amount of dollar-denominated debt (Hausmann and Velasco 2002).
The banking system was vulnerable since dollar-denominated bank loans were heavily extended to borrowers with peso-denominated incomes (De Krivoy 2003). Banks were also forced to invest in government bonds, which lost market value. As the economic climate worsened, bank runs occurred, especially in the two major publicly owned banks. Later “pesification” of bank assets and liabilities wiped out much capital in the banking system.
Fiscal policy was not overly effective, especially since Argentina had a fiscal system in which the central government set policies that were not necessarily in agreement with policies at the provincial level (IMF 2003). With a complex fiscal transfer system and little incentive for provinces to raise their own funds, Argentina’s fiscal system faced challenges. Provinces had autonomy over spending and faced incentives to minimize tax transfers to the central government. In addition, government employment was much larger than average for middle-income countries and became a source of fiscal stress (Krueger 2002). Transfers to provinces comprised 30 percent of the budget, social security benefits comprised 30 percent, and interest payments comprised 10 percent, leaving little room to use fiscal policy where needed (IMF 2003). Sharply increasing public debt stemmed from the transition costs of the social security system, recession, and recognition of existing debts (Hausmann and Velasco 2002). With a problematic fiscal transfer system and yearly extra-budgetary spending due to tight fiscal constraints, Argentina’s fiscal position declined.
Argentina’s inability to reduce the fiscal deficit during the growth years led to the dilemma of choosing to maintain the exchange rate and suffer from deflation or float their currency which would cause immediate effects in its ability to pay their debts (Perry and Serven 2004). Alberola et al. (2003) find evidence that the peso became overvalued as the dollar peg appreciated relative to Argentina’s main Latin American trading partner currencies. Appreciation was also caused by domestic wage and price rigidity (Desai 2003). All of these elements set the stage for potential debt default and a descent into crisis by late 2000.
Events of the Crisis
Argentina’s crisis started in November 2000, as investors grew fearful of default on a mounting foreign debt (Desai 2003). The government became concerned that capital flight would occur en masse as default fears increased. In response, Economic Minister Machinea was able to negotiate a $30 billion support package, called the blindaje, $15 billion of which came from the IMF. The blindaje reverted deposit withdrawal until March 2001. Support from the IMF was conditional on Argentina meeting certain fiscal targets, greatly reducing fiscal spending. Although the announcement eased economic conditions, the economy did not show signs of recovery, and fiscal performance was unable to meet the targets set by the IMF.
On March 21, 2001, Machinea resigned, and was replaced by Ricardo Lopez Murphy as Economic Minister. Lopez Murphy focused on the need to reduce the deficit and proposed a program to reduce public expenditure. The decision was not well received by the political system or the public, since it was perceived as harmful to the public, and Lopez Murphy was forced to resign just two weeks after he had been appointed. He was replaced by Domingo Cavallo, the original architect of the convertibility plan of 1990. This political churning did not reassure foreign investors. Capital outflows put pressure on the dollar-peso peg.
Cavallo attempted to stimulate the economy through a number of policies such as: relaxing monetary policy, subsidizing certain economic sectors, implementing a financial tax (in order to reduce deficit) and increasing flexibility of the exchange rate regime. Efforts were made to reduce barriers to entering domestic industry for foreign investors. Associated taxes and import duties on capital goods were eliminated (Desai 2003). To increase flexibility in the convertibility law, the introduction of the euro into the currency basket was proposed, a measure that the central bank’s President publicly opposed.
The resignation of Economic Minister Domingo Cavallo and President Fernando de la Rua added to the climate of uncertainty and worsened matters (BBC 2001). The resignation of Cavallo followed in quick succession the resignations of Jose Luis Machinea in March 2001 and Lopez Murphy that same month. The political climate led to reduced private sector spending (IMF 2003). IMF austerity measures forced Argentina to end budget deficits and cut state salaries and pensions, while private pensions were converted to government bonds (BBC 2001). Citizens protested such measures, and several members of the National Cabinet resigned (Cavallo 2002).
Country risk continued rising toward unsustainable levels, and therefore the Megacanje (megaswap) was introduced in June of 2001. The Megacanje exchanged government debt with shorter maturities for longer-maturity debt, and while it was able to improve liquidity risk, it also worsened solvency. On June 15, a de facto dual exchange rate on foreign versus domestic transactions was announced (IMF 2003). This new regime allowed the inclusion of the euro into the country basket for trade-related goods while keeping the exchange rate fixed for financial transactions. Banks’ assets and liabilities were converted from dollars to pesos, which shifted devaluation to the banking system. At the same time, banks were required to pay out foreign exchange term deposits at the prevailing market exchange rate. The new regime caused concerns in the private sector since there was uncertainty about the IMF’s reaction to the new plan. Argentina held that the new regime was not a dual exchange rate but a system that allowed for the subsidization of exports while it placed tariffs on imports.
On July 15, the government announced a reduction of 13 percent in government employees’ salaries and individual pensions and a “zero-deficit” policy. Although the government employees had benefited from a policy committed to maintaining government employment, this announcement worsened the economic climate and financial markets reacted extremely unfavorably. Country risk continued to increase dramatically and this caused a continued decrease in bank deposits, owing to an increase in capital flight. On August 21, Argentina reached an agreement with the IMF, which included around $5 billion to increase bank reserves. By September, bank deposits had stabilized but the bank runs and the high- risk spreads caused a credit crunch, and once the poor fiscal revenue figures were announced for that month, risk spreads increased even further.
By November it was clear that Argentina would need to undergo another debt restructuring, but how it could achieve this was still unclear. Controls that limited deposit withdrawals and the outflow of capital were put in place, and were known as the corralito. The corralito attempted to “corral” capital flight and bank runs. Despite these controls, financial collapse could not be avoided. The currency collapsed in 2001 due to an overvalued exchange rate and the presence of foreign-denominated debt, along with an unfavorable trade imbalance in which the country could not earn enough foreign exchange to pay the interest on its debt (Feldstein 2002). The government was forced to default on its debt and devalue the peso. Since many businesses borrowed in dollars, they were unable to repay their loans. With banks exposed to government debt as well as foreign exchange shocks, bank runs ensued, and a day after bank runs began, on December 1, 2001, Cavallo restricted the amount of money the public could withdraw.
Public debt had greatly increased and at the end of 2001, the government defaulted on most of its public debt, representing the largest default on sovereign debt in history (Helleiner 2005). Banks were forced to “pesify” dollar-denominated loans, and dollar-denominated time deposits were coverted to pesos at a rate of 1.4 pesos to the dollar (Latin American Shadow Financial Regulatory Committee 2002). The government also suspended collection of private debt for six months.
With the onset of capital flow reversals from Russia in 1999 during the Russian crisis, the larger South American economies suffered, but unlike other Latin American countries, Argentina entered a prolonged
Figure 7.5 Net private capital inflows (billions of US current dollars)
recession. GDP was in a steady decline through 2002. IMF assistance was extended in 2003, to repay international financial institutions. The value of banks’ assets deteriorated as a result of measures implemented to resolve the crisis. Argentina continued to restructure more than $100 billion of debt owed to foreign and domestic investors (Hornbeck 2004). By early 2005, bondholders had taken a 70 percent cut on their holdings (Helleiner 2005). In Figure 7.5, we show net private capital inflows in Argentina and Brazil.
Outcomes of the Crisis
The main culprits of the Argentine crisis have been identified as weak fiscal policy, with poor tax collection capability, and mounting overvaluation of the peso (Krueger 2002). Fiscal issues were presented due to lack of discipline at the provincial level, while the wage bill for public sector employees at the federal level increased and outpaced wage growth for private sector employees. In addition, Argentina’s currency board arrangement was not as strong as had been projected, and became a liability as the economy deteriorated and monetary policy could not be used to combat recession.
Neither Argentina nor the IMF was aware of these growing weaknesses in the 1990s. Instead, Argentina was lauded for implementing measures to reduce inflation. As was stated in an IMF news brief (IMF 1995): “The IMF management welcomes the strong actions taken by Argentina. In the context of unsettled international financial markets, they demonstrate the firm commitment of the authorities to raise domestic savings, and to maintain fiscal and financial equilibrium and price stability.” Even though attempts were made to stave off the crisis once it began (for example, imposing capital controls to prevent capital flight), crisis occurred and Argentina was forced to default on $132 billion of its debt and undergo debt restructuring for some time after the crisis ended.
Political Economy of the Argentine Crisis
Argentina, led by President Carlos Menem, had been a celebrated example of how Washington Consensus policies should be applied, but the status and the ideal were stripped away as the nation entered crisis. Fernando de la Rua succeeded Menem in December 1999 as President, but by 2001 the public was highly discontented with his leadership, which included austerity measures. His political party lost seats in the Argentine National Congress in October 2001. De la Rua was forced to step down in December 2001 due to domestic rioting and anger expressed by foreign bondholders after the corralito was implemented. Protests in the Plaza de Mayo had become deadly.
The short-lived administration of Interim President Adolfo Rodriguez Saa defaulted on much of the public debt, and lost political support in his attempt to implement a controlled currency devaluation. He was forced to resign after one week in office. Eduardo Duhalde was appointed President for the rest of de la Rua’s term. He announced a plan to end the currency board and devalue the currency for major foreign commercial transactions, and adopt a floating rate for all other transactions. Debts were converted to pesos at a devalued rate. Larger dollar bank accounts were frozen for one year. Growth resumed in late 2002.
However, much damage was already done. Politicians were viewed as breaking the trust between the government and its citizens, and were seen as responsible for increasing poverty and unemployment. The economy had been stabilized but remained extremely fragile. The public was concerned about Argentina’s repayment of debt to the IMF, which was later restructured by President Nestor Kirchner in 2003 and then canceled in 2005.