FRBSF Economic Letter
2002-31; October 18, 2002
Learning from Argentina’s Crisis
Since December 2001, Argentina has suspended payments on its external
debt, restricted bank deposit withdrawals, and abandoned a currency board
arrangement that had pegged the peso to the U.S. dollar since 1991. Argentina
faces inflation of over 70% this year and an economic contraction that
rivals the U.S.'s Great Depression. These developments have surprised
many observers because for most of the 1990s Argentina was considered
a model of successful economic policy. Indeed, many thought that the instability
that had characterized the Argentine economy for much of its history was
a thing of the past.
Could Argentina's crisis have been anticipated and avoided? This Economic
Letter observes that the recent events in Argentina were not entirely
unpredictable, as they were associated with rapid increases in public
and external debt that cast doubt on the sustainability of borrowing.
Conditions that accentuated vulnerability to crises are also highlighted.
Prelude
For most of the 1990s, Argentina was seen as a model of successful policymaking.
By pegging its exchange rate to the dollar under a currency board type
arrangement in 1991, Argentina ended hyperinflation, reducing inflation
rates to single-digit levels. The banking sector in Argentina, traditionally
weak, was strengthened considerably, in part because of an increase in
foreign bank entry. A 1998 World Bank financial sector review rated Argentina
second only to Singapore among emerging markets in the quality of its
bank supervision (Perry and Serven 2002). Greater economic stability attracted
foreign investment inflows, contributing to an acceleration in economic
growth; indeed, even as lenders withdrew their financing in East Asia
in 1997, capital inflows continued to Argentina.
Things began to turn sour in 1999. The collapse of the Brazilian currency
led to sharp declines in export revenues, and economic growth was negative
for three years in a row. Nevertheless, with some brief exceptions, financial
markets remained relatively undisturbed until 2001, when uncertainty about
the growing public debt and the persistent economic contraction led to
very sharp increases in the yields investors demanded to hold Argentine
government bonds. Uncertainty extended to the durability of the currency
peg and the ability of the financial system to make good on dollar liabilities
that were backed to a significant extent by peso assets, including government
debt. The result was massive deposit withdrawals from the banking system.
In response to these developments, in December 2001, Argentina suspended
payments on its external debt and restricted deposit withdrawals (the
"corralito"). In January 2002, it abandoned its peg to
the U.S. dollar. Reflecting continuing uncertainty about financial conditions,
interest rates have continued to rise and the currency has depreciated
356% against the U.S. dollar in the year to September 20. The impact of
the Argentine crisis has been severe. Output is forecast to decline 15%
and inflation to rise to 72% in 2002 (Latin America Consensus Forecasts,
September 16, 2002).
What caused Argentina's crisis?
Many observers have explained the crisis in terms of the deficiencies
of Argentina's peg to the U.S. dollar under a type of currency board arrangement.
While the currency board did play a role, it also can be argued that the
main cause of the crisis was Argentina's persistent inability to reduce
its high public and external debts. These made the economy vulnerable
to adverse economic shocks and shifts in market sentiment.
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Figure 1
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Figure 1 illustrates the trend in the public debt/GDP ratio in Argentina
since 1995, as reported by the International Monetary Fund (IMF) (2002a,
p. 19). This ratio measures the total amount of public debt relative to
the ability of the economy to produce (taxable) income to service it.
In the figures, the thick solid line shows the actual path while the thinner
solid lines and dashed lines represent alternative scenarios anticipated
by the IMF first under a 1998 Extended Fund Facility (EFF) program and
then under a 2000 Stand-by Arrangement (SBA). (For descriptions of these
financing arrangements, see IMF 2002b.) The figure reveals that Argentina's
public debt/GDP ratio rose rapidly, from 35% in 1995 to nearly 65% in
2001. It is also apparent that under IMF consultations, it was consistently
anticipated that Argentina's public debt/GDP ratio would stabilize or
fall, but this did not happen. The actual path of the public debt/GDP
ratio far exceeded the IMF projections in five different reviews between
1998 and 2000.
Argentina's experience stands in contrast to South Korea's, where a
financial crisis in 1997-1998 forced the government to intervene to rescue
failing banks and led to a rescheduling of its external debt. In South
Korea, the public debt/GDP ratio rose sharply, from over 10% in 1997 to
over 30% in 2000, but then declined (IMF 2002a, p. 18). However, even
at its peak, South Korea's public debt/GDP ratio was less than half Argentina's,
and the path of the debt remained below that projected by the IMF in three
separate reviews.
There is no unambiguous threshold at which public debt becomes unsustainable,
and Argentina's public debt/GDP ratio of 65% in 2001 was still lower than
that observed in some European countries. However, given the history of
defaults and macroeconomic instability in emerging markets like Argentina,
their threshold sustainable public debt may be much lower than in advanced
economies. Furthermore, limitations on tax collection capability imply
that a higher public debt/GDP ratio makes emerging markets more vulnerable
to adverse shifts in market sentiment that raise the cost of funds. In
line with this, large spikes in the yield on public debt occur in emerging
markets that are rarely seen in advanced economies.
For example, between January and November 2001, investor uncertainty
raised the yield on an Argentine 10-year government bond (denominated
in U.S. dollars) about 20 percentage points, to around 35%, signaling
the growing unwillingness of investors to hold Argentine debt. (There
were also brief spikes in yields on Argentine debt in 1996 and in late
1998 to early 1999. See Mussa 2002, Figure 3.1, which uses a different
but related measure.) Such a sharp rise in the interest rate, as well
as a default and (self-fulfilling) crisis, is more likely if the public
debt/GDP ratio is 65% (as in Argentina) than if it is around 30% (as in
South Korea).
Argentina also was vulnerable because its capital account was open and
there was a large amount of borrowing in foreign currency from abroad.
A large external debt made Argentina vulnerable to default not only in
the event that interest rates rose, but also in the event that the currency
depreciated sharply, as this increased the repayment burden in domestic
currency.
Argentina's external debt profile in 1990 and 2000 may be assessed using
two alternative measures, the external debt/GDP and the external debt/export
ratios. As external debt typically has to be serviced in foreign currency,
the external debt/GDP ratio is a more informative measure of the size
of the debt relative to payment capacity if output can easily be shifted
to earn more exports. Otherwise, the debt/export ratio provides a better
indicator. By either measure, Argentina's debt rose significantly between
1990 and 2000: the external debt/GDP ratio rose from 44% to 51%, and the
external debt/exports rose from 421% to 471%.
To put some perspective on the vulnerability implied by these numbers,
consider the IMF's report (2002a), which finds that the probability of
a debt crisis (involving payment arrears or debt rescheduling) rises to
about 15%-20% for countries with external debt/GDP ratios above 40% (from
around 2%-5% when debt is below the threshold). The likelihood of a crisis
also rises when the external debt/export ratio is high. Argentina's exports
of goods and services are quite low, about 10% of GDP, implying very high
external debt/export ratios that accentuate its vulnerability to external
debt crises. Once again, the contrast with South Korea is informative.
From 1990 to 2000, South Korea's external debt/export ratio rose from
48% to 78%, but it still remained orders of magnitudes below Argentina's
ratio.
Why did Argentina's debt ratios rise?
Argentina's debt ratios rose for at least two reasons. First, primary
fiscal surpluses (government revenues minus expenditures exclusive of
interest payments on the debt) were not large enough to cover interest
payments and also retire some of the outstanding public debt. Between
1991 and 2000, Argentina's primary surpluses averaged 0.14% of GDP. These
surpluses were remarkable achievements, given Argentina's past history,
but they were still well below interest payments, which averaged 2.4%
of GDP over this period. There were significant obstacles to reducing
expenditures and raising revenues. On the expenditure side, the government
was a large employer (Krueger 2002) and, for political reasons, found
it hard to cut its wage bill. The central government also found it hard
to control spending by provincial governments, whose liabilities it was
eventually forced to assume. At the same time, revenues were adversely
affected by difficulties in tax collection and, after 1999, by falling
output and rising unemployment.
Second, export growth (and therefore economic growth) was not sufficiently
robust to improve the country's ability to meet its debt obligations and
lower debt/GDP ratios. In the 1990s, the dollar value of Argentina's exports
of goods and services grew at 7.7% a year, less than the nearly 9% growth
in its external debt and well below the rate of growth of exports in Asian
economies such as South Korea or Malaysia (10%-11%). Export growth has
been dampened by Argentina's trade barriers, which remain relatively high
outside the Southern Cone common market area of Mercosur, of which
Argentina is a member. These trade barriers have increased since the crisis
broke out. Exports also suffered following the 1999 collapse of the Brazilian
real because Argentina's rigid currency board arrangement produced an
overvalued currency. Indeed, the focus on maintaining a rigid peg at all
costs appears to have diverted attention away from the risks of not paying
attention to real sector fundamentals.
Conclusions
In the view of some observers, Argentina's debt position would have been
sustainable if only market uncertainty had not triggered a crisis. While
there is some truth to this view, it does not take into account the fact
that Argentina could have reduced its vulnerability to potentially destabilizing
shifts in market sentiment by aggressively reducing its public and external
debts. This is illustrated by the contrasting experiences of Argentina
and Asian economies like South Korea. With much lower debt levels, the
latter is less likely to experience adverse shifts in market sentiment
and is less vulnerable to them should they occur.
Cutting Argentina's public debt requires reductions in government spending,
tax reforms designed to increase government revenues, and policies to
stimulate export growth over the medium to long run. The successful adoption
of such policies is the key challenge facing Argentina and a number of
other emerging economies, and it is an important prerequisite for achieving
stability in a globalized economy.
Ramon Moreno
Research Advisor
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