Financial Crisis in Argentina in 2001-2002

Background:

Argentina has witnessed cycles of economic and political instability, financial crises, and economic loss. In 2001-02, the country went through economic dark days which is considered to be one of its worst in history. Argentina, with a decline in productivity, high inflation, debt obligation default by the government, the collapse of the currency system, paralyzed banking system, massive devaluation of the Peso (Argentina currency) which was initially at parity with the US dollar, high rate of employment, and big-budget deficit and dangerous disequilibrium in the balance of payment, was heading to economic shutdown.

According to Dr. Roy C. Nelson’s analysis of the crisis in his lecture material, a once prosperous country considered to be one of the richest countries in the world, exporting primary commodities like beef and wheat, prior to the era of Juan Peron in 1945, went through seasons of economic decline and loss of natural comparative advantage and political instability characterized by misrule by the military before the advent of democratic governance that started with Juan Peron.

Juan Perón's era from 1946 to 1955 left a legacy of Populism which has become a mainstay of social economy practice in Argentina refused to go away even when the political system has evolved from one political system a more polarized political system. Juan Peron's era was less than a decade and was long gone the template of running government based on the socialist-populist ideology continued to frame the socio-economic and political structures reality of Argentina.

The Populist era initiated by Juan Perón introduced social security and nationalistic policies, diversified Argentina's economy to industrialization in addition to existing thriving agriculture and primary export and heavy spending on social security and welfare, heavy spending on infrastructure to create jobs, activated trade protectionism policy, creating state-owned enterprise (SOE), organized workers into labor union that state can control.

Juan Peron's economic model which is inefficient and expensive to maintain resulted in the perpetual budget deficit. And Juan Peron's remedy to the budget deficit was sales of government bonds and the printing of money. The practice of printing of currency to cover the budget deficit and the resultant inflation was sustained till Peron was overthrown by the military in 1955. This practice or variant of it was sustained throughout the military era and the third term of Juan Peron/Isabel from 1973. Inflation marginally improved during the short spell of Peron's third but a return to Peron's core economic model of intervention and lack of discipline in fiscal policy plunged the economy back to the inflation regime. Even subsequent changes of political parties in government could not steer the economy from a crisis driven by large money-financed deficits and high inflation.

Attempts of budget-cutting and market reform by President Raúl Alfonsín of the UCR party (1983-1989) had limited success due to his inability to tick the boxes for a leader that can effect a reform.

Carlos Menem First Term in Office (1989-1995) and Convertibility Plan

Carlos Menem inherited an economy with hyperinflation and a budget deficit that had characterized Argentina's economy for decades. What did Carlos Menem do to deal with the situation he met on the ground? He introduced economic reforms including the popular Convertibility Plan.

Domingo Cavallo, the economic minister in the Menem government, was the ideologist behind the Convertibility Plan which was sanctioned by the Argentina congress in 1991. The intention of this plan was to ensure fiscal and monetary policy discipline which was lacking in Argentine and it was an effective attempt to curb inflation and budget deficit problems which the previous government could not solve through by traditional approach of printing money (not backed up by real economic activities) and excessive debt through sales of government bond.

Convertibility plan established Currency Board with stringent rules that constrained Central bank to deploy inflation targeted monetary. It fixed the dollar-peso exchange rate at 1 Argentina peso per US dollar.

In addition to the convertibility plan that stopped the printing of currency as a way of funding the budget deficit, President Carlos Menem also tackled the root cause of the budget deficit by the privatization of major SOEs including the state-owned YPF S.A. that were cost centers to Argentine government Energy Company, improve tax collection and slashed other expenses in subsidies. All these efforts corrected the budget deficit and improved investors’ confidence in Argentina's economy there creating a massive capital inflow for the economy in that era.

Carlos Menem, through the Domingo Cavallo convertibility plan, privatization of SOEs, improvement of in tax collection, and reduction in other expenses in subsidies succeeded in defeating the hyperinflation bringing it down from about 3000% a year to less 1% a year, and this was effective and enviable that Brazil copied the currency pegging policy in 1994 pegging Brazil Real to US dollar in 1:1 ratio which also helped Brazil to end its inflation problem at that time.

It was argued that the combined effect did not have despite these impressive results, there were also negative side effects on social issues, such as increased unemployment, unequal income distribution, and decreased wage rates. Unemployment increased from 6.1% in 1991 to 15% in 2000 as the fixed exchange rate increased foreign price competition and forced local firms to invest in more advanced technologies that required less labor and higher productivity

Carlos Menem's Second Term bid in 1994 and the onset of the new economic crisis in Argentina

Carlos stabilized Argentina's economy and stimulated growth for a large part of it expected one term in the office but in the quest for power and bid to ride on the wave of his own success Carlo Menem hatched the idea of doing one more term in the office which was in contrary with the constitution; a president could only serve one term in the office.

The desperation to realize this idea pushed Carlos Menem to push for a constitution review that will allow him to run for a second term in the office. What did this portend for Argentina's politics and economy?

According to Roy Nelson in his lecture material, Carlos Menem entered into a secret re-election deal with the provincial government who had an influence on the congress through their representation in the congress. The deal was to give up 70% of the revenue in tax collection by the federal government to the provincial government in exchange for a review of the constitution to favor Carlos Menem re-election bid.

This political move by Menem set the stage for the imminent economic crisis that Argentina witnessed in 2001-2003.

The economic implication of this was that the Federal government would be short on revenue and this would return the country to the budget deficit era that it was recently rescued from by the celebrated convertibility plan, privatization, and other budget deficit reduction policies..

Causes and events leading to the crisis:

The fragility of the benefits of neoliberal reform carried out by Menem, too much focus on the internal economic environment (ignoring the economic event in US and the Latin America region, especially in Brazil and Mexico), and the wrong political ‘deal’ that Carlos Menem had toward the end of it the first term set pace for spiral negative economic impact that Argentina witnessed between 2001 and 2012.

Nelson suggested a framework for assessing prospects for the financial crisis in an economy and political and economic events in 1999 were ticking boxes for an imminent financial crisis for Argentina. The constitution review deal that saw the federal government giving up 70% of tax revenue to states caused a budget deficit growing above the tipping point of 5% of GDP.

The inflexible exchange rate by pegging Peso to US dollar when the dollar was getting stronger thereby making peso to be equally getting stronger thereby making the Argentina goods to be expensive both for local and export markets. While an appreciation of the Argentinian peso was indeed needed, pegging it to the US dollar meant that it overshot the mark. This caused a big deficit current account balance for the Argentine creating balance of payment imbalance making Argentina to be desperate for foreign capital inflow which was not forthcoming like in the previous years of the Menem era in the first term.

The economic woo of Argentina was also aggravated as a result of the devaluation of Brazil's real making its product much cheaper for Argentine considering the fact that Brazil can export it goods to Argentine at zero tariffs in line with an agreement under the Mercosur trade agreement.

The pressure on Argentina's economy from the budget deficit, increase in debt profile and current account deficit continue to grow until it reached the crescendo in the fall of 1999 when creditors began to lose lost confidence the country's ability to meet up with its debt obligations to its creditor. This triggered a deeper social economic issue of a high unemployment rate which rose above 15%, the collapse of consumer spending, capital outflow, and a negative balance of payment. By end of 2000, the parity of Argentina's Peso to US dollar was not sustainable and there was a currency collapse which heightened the situation and needs for urgent assistance from IMF.

IMF Conditions:

The basis and process leading to IMF providing financial support to Argentina during its recession experience have generated debate among analysts highlighting the weakness of IMF in enforcing its traditional conditionality in giving financial support to member countries in recession and balance of payment crisis. It has been extensively argued that IMF showed favoritism in Argentina's Stand-by arrangement of 2000. The trigger condition for such an arrangement was not apparent in this case.

According to the indicting report by the Independent Evaluation Office (IEO) set up by IMF to review its role in the Argentina crisis, IMF failed in its responsibility to impose the required conditionality and was also weak in its surveillance role in the loan advanced to Argentina.

There was a paucity of structural reform in the IMF program for Argentina; only two of such namely tax reform and social security reform were included as conditions for the first three disbursements in early 2000 and 2001. The report stated that not a single performance criterion was in the subsequent arrangements. The absence of required strong structural conditionality in the arrangement with Argentina did not make the country to be concerned with its lack of progress with its structural reform programs.

The report also stated that IMF also errs by not having an exit strategy and contingency plan in place being aware of the high probability of not achieving the set objectives with the original program especially in the risky political environment of Argentina at that time. IMF made three decisions on exceptional financial support totaling $22 billion for Argentina between Jan. - September 2001, however, in December 2001 IMF stopped its financial support for Argentina after a review of the effectiveness of the program. Argentina had persistently derailed from the naturally required reform through IMF did not put reform as a conditionality for the disbursement. And this frustrated IMF as the financial crisis of Argentina was getting worse despite the huge loan that was already advanced.

IMF's decision to put a plug on the financial support to Argentina made the government of Argentina to seek new cooperation with IMF with a commitment to fulfill the conditionality. This gave IMF another opportunity to review the economic situation and to propose the conditionality that was the world financial institution believed will help Argentina to fix the problem.

Impact of IMF Conditions

According to Dr. Nelson Roy in his lecture material, some of the proposed IMF conditions to continue with its financial support for Argentina were fundamental to the prevailing political situation in Argentina at that time but they are much needed to reverse the tumbling Argentina economy.

The first and most difficult of those conditions is a reversal of the financial relationship the national government had with provincial governments. The previous administration (Carlos Menem era) had carried out a constitution review that conceded 70% of tax revenue collection by the national government to provincial governments. This is to address the acute budget deficit problem. The new president could have the challenge to fulfil this condition of IMF as it will also require a change of the constitution to be sanctioned by a 2/3 of majority in the congress.

Other conditions were:

• One major problem Argentina had was the huge budget deficit. And IMF put this as a condition for Argentina to maintain a budget surplus of more than 3%.
• Renegotiation with government creditors especially the bondholders (the government of Carlos Menem had defaulted in paying the bondholder due to the chronic economic situation and the government's inability to pay). IMF was willing to deal if the president Nestor Kirchner can secure an agreement with not less than 70% of bondholders on the loan repayment.
• Elimination of tax on exports. Carlos Menem introduced a tax on export from Argentina in a drive to increase government revenue but did more hurt than good; it made export from Argentina not to be competitive thereby creating more negative current account balances for the country.
• Renegotiation of contracts with private utility companies. The currency collapse, Argentina's Peso devaluation, and loss of people purchasing power made their not to be sustainable. IMF requested the Argentine government to the utility tariff, which was regulated, to be renegotiated with the service providers.

According to Dr. Roy Nelson's lecture on the subject using the Pakenham model to assess the ability of a leader to push through reform, Nestor Kirchner ticked all the boxes for a leader that pushes through a reform through the reforms as requested by IMF as conditionality for the financial support for Argentina, but considering the social-political risks these reforms carried and the negative impact, it could have on the election bid of Kirchner’s wife who he was proposing to succeed him Kirchner took Heterodox alternative.

Resolution of the Crisis

Nestor Kirchner turned to Hugo Chavez for a loan instead of fulfilling the stringent IMF conditions. He was able to secure a loan of $9.5 billion without any condition to pay off the entire Argentina indebtedness to IMF. This gave Argentina's economy a breather, having devalued the currency to improve the export solving the current account deficit problem.

Nestor went further to introduce other heterodox policies like currency manipulation (keeping Peso weak by printing currency) to sustain the export boom after the payment of the IMF loan, an intervention plan of price control to keep the inflation in check, and social welfare program as a palliative measure to cushion the effect of the high unemployment rate

Conclusion:

Argentina has a history of inconsistent economic performance. From rapid economic growth in the 1800s and early 1900s leveraging on its comparative advantage of exporting primary commodities like beef and wheat becoming one of the wealthiest nations in the world to the economic successes in the late 1900s and early 2000s with intermittent interruption of crisis in between.

Huge potential Argentina has, by virtue of its natural resources, its geographical location in the Latin American region with the Mercosur trade agreement having access to a massive market, and proximity to the US economy, cannot be harnessed due to the ‘aggressive’ nature of Argentina political system. The populist philosophy and policies still persist but there is no clear-cut long-term national plan as a big picture that successive governments can run with. Most of the Argentine problems can be argue to be more of internality occasioned by a toxic political environment and apparent bad fiscal and monetary policies than externality.

The lack of national consensus on the long-term direction for Argentina's economy in the modern era is a major setback for a consistent positive economic performance in Argentina. And this is supported by events that led 2001-2012 economic crisis with economic growth in a couple of years before then economic crisis a few years down the road. It is expected that this cycle will still continue until there is a consensus on the long-term plan for Argentina's economy. The case also points to the oversight of the IMF in managing the crisis in Argentina. This gives the critics of IMF something to chew and enjoy. The debate on the role of IMF and the morality of supporting Argentina without usual IMF structural reforms conditionality is still on

Reference:

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