Economics Update (July-December 1996)

A Hefty Price for Argentina's
Sluggish Recovery

Despite the drawbacks of high unemployment and slow economic recovery, Argentina's new economy minister, Roque Fernández, looks set to continue the austerity measures of his predecessor, writes Julia Holman, economic analyst at the Atlanta Fed.

he Argentine economy is slowly recovering from the severe recession of 1995 caused by the spillover effects of the Mexican peso crisis. In the four months following the December 1994 Mexican peso devaluation, Argentina experienced a staggering $8 billion in capital flight. This outflow, in conjunction with former economy minister Domingo Cavallo's Convertibility Plan (which fixes the exchange rate at one to one to the U.S. dollar and prohibits monetary growth that is not fully backed by foreign exchange reserves), resulted in a sharp monetary contraction and higher interest rates.

After posting four years of annual gross domestic product (GDP) growth averaging 7.7 percent, Argentina's economy contracted by 4.4 percent in 1995. Slow growth is now returning but will likely remain below precrisis levels in the near future.

Sticking to the Plan

Despite its drawbacks, the Convertibility Plan looks set to remain the bedrock of Argentina's economic policy because of its stunning success in reducing inflation, which fell from nearly 2,300 percent in 1990 to 1.6 percent in 1995.

And although the negative short-term effects of maintaining the Convertibility Plan are significant?namely, slow growth and very high (17 percent) unemployment?it appears that the new economy minister, former central bank president Roque Fernández, believes the long-term benefits outweigh the disadvantages. In August 1996 Fernández announced a deficit reduction plan?which the Argentine press called the "severest austerity package in years"?consisting of substantial tax increases, an end to several value-added tax exemptions, and the elimination of Cavallo's industrial and export-promotion incentives. Thereafter the International Monetary Fund (IMF) approved changes proposed by Argentina to the economic targets, initially set for a $1.2 billion standby loan. The IMF raised the $2.5 billion deficit ceiling originally negotiated for 1996 to $6 billion and pegged the 1997 deficit to $3 billion.

Investors seem to agree that the Convertibility Plan is the best option. The entire $8 billion that fled Argentina's banking system in early 1995 has returned, and foreign reserves are now higher than before the Mexican crisis. An additional indication of investor confidence is Argentina's recent tapping of the international capital markets, with Deutschmark, yen, lira and Swiss franc issues.

New minister, same policies

Although international investors and the IMF may approve of President Carlos Menem's economic policies, some in Argentina are having second thoughts. In late July Menem fired Cavallo amidst mass public demonstrations against the fiscal austerity measures, slow growth, and continued high unemployment. Public protest has continued, culminating in a 36-hour general strike by the trade unions in late September. This action followed a similar strike in August that paralyzed much of the country.

Despite this turmoil, the choice of Fernández provoked little negative reaction from the markets. This response seems largely due to the market's assessment that Cavallo's policies, not necessarily Cavallo, are crucial to economic policy-making credibility.

But by adopting similar policies, Fernández will likely encounter similar short-term troubles?high unemployment, deepening popular protest, and slow economic growth. For now, strong international capital flows and the perceived credibility of economic policy point to improving long-term prospects.

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