Argentina Hopes for April

Page Summary

In a sad paraphrase of an old song, it may indeed be time to cry for Argentina. After a heyday of economic growth in the 90s, the country gained recent notoriety by defaulting on $155 billion in public debt, the largest such default by any country in history.

In a sad paraphrase of an old song, it may indeed be time to cry for Argentina. After a heyday of economic growth in the 90s, the country gained recent notoriety by defaulting on $155 billion in public debt, the largest such default by any country in history. On March 8, The Financial Times of London reported that Argentina hopes, by April, to reach agreement with the International Monetary Fund (IMF) for billions in aid to help resolve the financial crisis.

The massive default was only the latest development in Argentina’s economic nightmare.  Unemployment exceeds 25 percent; the peso has been devalued by nearly 50%; and per capita income (measured at current exchange rates) has shrunk from $7000 just a few months ago to $3,500 today.  And perhaps worst of all the government has, in effect seized its citizens’ savings by putting a freeze on bank withdrawals, threatening the very core of its democratic foundations.

By all rights Argentina should be one of the world’s richest countries.  It has vast natural resources, a well-developed infrastructure of highways, electricity and communication networks, and a well-educated and not overly large population.  Until recently it was held up as a model of free-market prosperity.  What went wrong?  How does a country that grew at an average annual rate of 6.1% from 1991-1997 enter the 21st century with daily street protests and looting by both the poor and middle classes? 

There is debate over which problems played the biggest role in Argentina’s decline and whether there are specific culprits to blame, but there’s little disagreement over identification of the events and policies that contributed to the nation’s current distress. 

Lack of monetary flexibility hurt trade

In the early 1990s, in an effort to control hyperinflation, the Argentine government tied the peso to the US dollar at par value and restricted the money supply to the level of hard currency reserves.  This requirement has, in practical terms, two important effects.  First – and the key to controlling inflation – is that the Argentine government can only increase the money supply if it increases its reserve holdings of U.S. dollars.  No longer can it run the printing presses at will.  Additionally, the requirement means that even as the value of the U.S. dollar fluctuates on the international market, the peso and the dollar always trade 1-for-1. 

The good news is that the policy was successful in restraining the government from printing money to pay its bills.  Inflation was brought under control, helping to lay a foundation for the phenomenal growth rates of the 90s. 

The bad news is that tying the peso to the dollar reduced the ability of the Argentine economy to adapt to changing circumstances of world trade.  The major case in point is that trade with Brazil, Argentina’s main trading partner, has been hurt by changes in the value of the American dollar – and hence, of the Argentine peso.  It works like this:

  •   Over the past few years the U.S. dollar has gained value relative to other currencies, one of which is the Brazilian real.  (Translation:  It now takes more reals to buy American dollars.)
  •   Since the value of the Argentine peso is tied to the dollar . . . ?  Right!  It now takes more reals to buy pesos and Brazilians have to spend more reals to buy Argentine products.  As supply and demand analysis predicts, when goods produced in Argentina increased in price relative to those in Brazil, Argentine exports to Brazil declined. 
  •   Decreased production of exports means unemployment for Argentineans and less tax revenue to fund government spending.

Lack of fiscal restraint increased debt

Unfortunately, the efforts to control inflation in the early 1990’s through monetary policy were not matched by the same restraint in fiscal policy.  Because of liberal welfare programs and laws that guaranteed the provinces a set portion of the federal budget, government spending far out-stripped revenues.  As the government slipped deeper into debt, it financed spending by issuing bonds.  In hindsight, the path to economic disaster is both predictable and glaringly clear:

  •   Mounting government debt and falling tax revenue led to
  •   rising interest rates (as government bonds competed with other investments for savers’ dollars), which in turn led to
  •   reduced willingness on the part of businesses to borrow, which resulted in
  •   reduced investment in new plant and equipment and reduced productivity growth.

Lack of confidence created financial panic

The decline in exports coupled with high interest rates dragged the economy into a business slowdown that became a full-blown recession in the late 90s.  Tied to the dollar, the peso could not adjust in value.  The par-value policy prevented the drop in prices that would have helped business by increasing sales and revitalizing the export market. 

The perceived weakness of the peso coupled with the rising debt triggered a bank run in which $15 billion was withdrawn from Argentine banks between July and November, 2001.  Much of this money was sent to accounts in other countries, and some was simply held privately for safe keeping, but the important point is that all of it was taken out of the banking system.  This additional reduction of the pool of deposits available to borrowers put further upward pressure on interest rates. 

Lack of trust undermined government efficacy.

Despite multiple reforms in the last decades of the 20th century, Argentine government continues to live out its heritage of corruption.  Unable to establish and maintain a secure rule of law, the national government finds itself increasingly unable to collect the tax revenue it needs to continue operating.  Particularly in the provinces, government spending is characterized by corruption, and the toll in public trust and compliance is increasingly evident.  Tax evasion is rampant. 

The Argentine default and subsequent plea to the IMF are, in simplest terms, the result of a loss of confidence in the ability of the Argentine economy to produce enough to repay the government’s debt.  The loss of confidence is comprehensive, including not only foreign investors and the IMF, but as the street riots attest, by the Argentine citizens themselves.

Can Argentina recover?  While the country pins its hopes on the IMF, the problems are bigger than even a $155 billion loan default.  The eventual health of the economy depends on the how the nation answers the questions that probe the reasons for, and not just the symptoms of its economic nightmare.

  •   How will Argentina achieve currency stability?  Should it adopt the dollar?  “The issue of dollarizing Latin American currencies is examined in further detail at (www.globalarchive.ft.com/globalarchive/article.html?id=020221001545&query=argentina+crisis)
  •   What steps are necessary to make Argentine industry (and prices) competitive again in the world market?
  •   What must happen to encourage Argentine citizens to bring back into the country’s banking system the estimated $100 billion dollars they hold in foreign banks?
  •   Can government reform enough to restore the public trust?

The answers to these questions are by no means clear, but it is clear that an IMF bailout is not a miracle cure for Argentina’s ailing economy.”

References:

Discussion Questions

  1. If the dollar gains in value relative to the Brazilian Real it takes more Reals to get a dollar and the American goods a dollar will buy.  American goods become more expensive in Brazil. 
  • If the value of the dollar rises and the peso is at par value with the dollar, what happens to the price of Argentine-produced goods in Brazil?
  • If the value of the dollar rises and the peso is at par value with the dollar, what happens to the price of Brazilian-produced goods in Argentina?
  • If the peso is at par value with the dollar, is it good for Argentina if the value of the dollar falls?
  1. Since the Argentine government released the peso from the tie to the dollar a few weeks ago the peso has fallen to trading at two pesos to one dollar.  Do you think this is good for the Argentine economy or bad for it?  Why?
  1. Why are foreigners reluctant to put money in Argentine banks or invest in Argentine companies?  Would the IMF loan eliminate their reluctance?  Why or why not?
  1. What policies could the Argentine government adopt or what changes could it make to restore the foreign and domestic confidence necessary for the economy to recover?

Teacher notes:

  1. If the dollar gains in value relative to the Brazilian Real it takes more Reals to get a dollar and the American goods a dollar will buy.  American goods become more expensive in Brazil. 
  • If the value of the dollar rises and the peso is at par value with the dollar, what happens to the price of Argentine-produced goods in Brazil?
  • If the value of the dollar rises and the peso is at par value with the dollar, what happens to the price of Brazilian-produced goods in Argentina?
  • If the peso is at par value with the dollar, is it good for Argentina if the value of the dollar falls?

If the dollar rises with the peso at par value the price of Argentine-produced goods will go up in Brazil, thus making the Argentine goods less attractive to Brazilians.  Conversely, the price of Brazilian-produced goods will go down in Argentina, making the Brazilian goods more attractive to Argentine consumers.With the peso and dollar at par a fall in the dollar makes the price of Argentine-produced goods lower on world markets, but it also means that the price of other imported goods will rise in Argentina.

  1. Since the Argentine government released the peso from the tie to the dollar a few weeks ago the peso has fallen to trading at two pesos to one dollar.  Do you think this is good for the Argentine economy or bad for it?  Why?

The effect of the fall in the value of the peso is good for the economy in that the lower prices of export goods should increase demand for Argentine products and therefore increase employment and income in Argentina.  However, it will have two negative effects on specific individuals.  First, it means that any pesos you were holding or had in the bank are worth one-half as much as they were in terms of the dollar and many other currencies.  Second, it means that any U.S. produced goods for sale in Argentina are now priced twice as high as they were before.

  1. Why are foreigners reluctant to put money in Argentine banks or invest in Argentine companies?  Would the IMF loan eliminate their reluctance?  Why or why not?

The uncertainty will make foreigners reluctant to put money in Argentine banks or invest in Argentine companies.  Uncertainty of the future value of the peso, the interest rate and the health of the economy are disincentives to putting money into the country at this time.  The IMF loan should help eliminate the reluctance because it will serve to stabilize or lower the interest rates in the country and thus stimulate the economy and it should help stabilize the value of the peso.  However, uncertainty will remain high until the government has demonstrated that it is ready to take the necessary internal steps to help stabilize the economy.

  1. What policies could the Argentine government adopt or what changes could it make to restore the foreign and domestic confidence necessary for the economy to recover?

As noted above, the IMF loan will help instill confidence not only because it will put much needed reserves back into the banking system, but also because the IMF loan will send a signal that the government has taken some of the steps toward stabilizing the economy.  But beyond the IMF loan the government must exercise more fiscal restraint and put a balanced budget in place, increase the flow of tax revenues by cracking down on tax evasion and corruption in the tax system and encourage investment through lower interest rates and a stable banking system.