Table of Contents
Events Leading to Crisis 1
1995-1999 2
Private and Public Sectors of Argentina in the Crisis 5
Public sector 5
Private Sector 7
During Crisis 8
1999 10
2000 11
2001 11
2002 12
The Role of the IMF in the Argentina Economy 13
Contagion 14
Lessons Learned 15
Conclusion 17
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;
· “Convertibility Law”.
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.
1995-1999
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.
Private and Public Sectors of Argentina in the Crisis
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.
Public sector
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.
Private Sector
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*