The End of Convertibility
Argentina appeared to have found the solution to its financial problems with the implementation of the Convertibility Plan in 1991. However, in the following years the picture changed from rosy to troubled, and today Argentina is in the midst of a severe recession. What role did convertibility play in the country’s current economic predicament?
rior to its current crisis Argentina seemed to be in an enviable position; after undergoing structural reform, the country had made a break with its troubled financial past. The centerpiece of this reform, the Convertibility Plan, linked the Argentine peso to the U.S. dollar at one-to-one parity. After convertibility’s introduction in April 1991, the Argentine economy prospered as its gross domestic product (GDP) grew rapidly, inflation was subdued and foreign investment flowed into the country. The Argentine economy was hit with series of external shocks beginning with the 1995 Mexican peso crisis, however, and the rigidities and limitations of the Convertibility Plan became apparent.
A recession followed and the Convertibility Plan was finally scrapped in January 2002. By early March the peso had lost more than 50 percent of its value, and the Argentine government was struggling to put together a viable economic recovery plan.
The Convertibility Plan
On the heels of the debt crisis and a series of failed stabilization programs in the 1980s, the Argentine economy went through a severe recession and hyperinflation. In 1989 GDP shrank 6.9 percent and the inflation rate was more than 3,000 percent. Economy Minister Domingo Cavallo’s 1991 Convertibility Plan fixed the exchange rate at one Argentine peso per U.S. dollar and required the central bank to back two-thirds of the monetary base with international reserves.
As a quasi-currency-board arrangement (that is, domestic currency can be issued only in exchange for a specified foreign currency at a fixed rate) the Convertibility Plan eliminated the possibility of inflationary financing of fiscal deficits and limited the role of the central bank as lender of last resort. In other words, fixing the exchange rate meant that monetary policy could no longer be an instrument for other economic policies.
Convertibility provided instant credibility in that it prevented the government from printing money to finance deficit spending, a policy that had led to hyperinflation in the past. The sustainability of the Convertibility Plan depended upon fiscal discipline, a stable financial sector to support investment and savings, and a positive balance of international reserves.
The Convertibility Plan was accompanied by reforms that sought to strengthen the financial sector and open the economy to international capital markets. Tax reform and the privatization of public enterprises were aimed toward creating a more efficient public sector while trade liberalization brought the reduction of tariffs and elimination of import quotas. To promote trade, Argentina joined with Brazil, Paraguay and Uruguay to form the Mercosur customs union. Renewed investor confidence in Argentina was demonstrated as the government was once again able to raise capital through international financial markets.
Strengthening the banking sector was fundamental to the Convertibility Plan’s success because convertibility imposed strict limitations on the central bank’s ability to act as the lender of last resort. Consequently, the government initiated a series of reforms that encouraged competition, strengthened supervision and regulation, and invited foreign entry into the banking sector. In addition, because of Argentina’s past history of macroeconomic volatility, central bank regulations imposed capital requirements that were stricter than international banking standards. Many officials argued that the presence of foreign banks would provide depositors with an extra level of confidence, and by 2001 nine of the 10 largest private banks were foreign-owned.
Volatile economic growth
From 1991 through 2000 the Argentine economy grew an average of 4.2 percent per year. During the same period inflation fell from 171 percent to deflation of 0.9 percent, and the interest rate paid on deposits fell from 61.7 percent to 8 percent. As Argentina opened to the international economy, exports increased 5.1 percent per year on average between 1992 and 2000.
By 1994 large state-owned firms in the telecommunications, airline, railway, petroleum, steel and defense sectors were all privatized. Unlike Mexico and Chile, Argentina did not exclude strategic sectors such as petroleum and mining from its privatization program. Attracted by the sale of state-owned firms, foreign direct investment averaged $7.8 billion between 1991 and 2000, 11 times greater than average foreign direct investment between 1980 and 1990.
The revenues from the privatization process enabled the government to run fiscal surpluses in 1992 and 1993. But in 1994 the fiscal deficit began to rise, financed by increased borrowing. In fact, total external debt rose 130 percent between 1991 and 2001 to $150 billion. The total external debt to GDP ratio increased from 33 percent of GDP to 55 percent of GDP in the same period (see chart 1).
Vulnerability to external shocks
A series of economic shocks beginning in 1995 made convertibility’s limitations apparent. Early that year, following Mexico’s devaluation of its currency in December 1994, Argentina experienced a run on bank deposits, a loss of international reserves and, ultimately, a recession. The drop in business confidence and the economic slowdown led to adoption of a tough adjustment program involving tax increases and a drastic reduction in government expenditures. Several financial reforms were introduced that, along with multilateral commitments, restored investor confidence.
Real GDP declined 2.8 percent in 1995, but the economy recovered in 1996. The growing fiscal deficits of the country’s provinces — which had never undergone structural adjustment — then became a growing concern for the federal government. Imposing austerity upon the provinces, however, met with stiff political resistance, and provincial debt rose to over $23 billion by the end of 2001.
Additional shocks occurred in 1998 with the Asian and Russian crises and again in 1999 when Brazil devalued its currency. Initially the devaluation of the real raised some doubts in Argentina about the sustainability of the country’s currency board system, which now faced renewed competitive pressure from its Mercosur partner Brazil. Brazilian exports realized benefits from a cheaper real while Argentine exports were tied to a steadily appreciating dollar.
Yet Argentina’s successful emergence from the Mexican peso crisis, the strength of the financial system, the country’s continued access to international financial markets and the government’s steadfast commitment to the currency board were all signs that convertibility could withstand the crisis. President Carlos Menem talked openly of the possibility of dollarization, and recognition of the costs of a devaluation in a highly dollarized economy led many to believe that Argentina would dollarize its economy before it would ever devalue its currency.
However, as debt levels continued to climb, the government’s loose fiscal policy began to undermine confidence in convertibility. The unwillingness of the government to address the fiscal problem — compounded by the recession that began in late 1998 and the fact that 1999 was an election year — led to uncertainty, a loss of credibility among investors, and capital outflows. The country risk premium increased, hurting the performance of domestic financial markets and raising the cost of accessing funds in the international markets. All of these factors exacerbated the recession. In December 2000 the International Monetary Fund (IMF) approved a $39.7 billion package of financial assistance designed to restore credibility to Argentina’s economic program.
President Fernando De la Rua, elected in 1999, expected that the new funds and accompanying structural reform measures would reduce the country risk premium. Reforms were largely scuttled, however, by resistance from labor unions and provincial governors. By late 2000 investor concern about the government’s ability to repay its foreign debt caused Argentina’s risk premium to rise again.
Chronology of the collapse
While it is difficult to pinpoint one event as the starting point of Argentina’s downward spiral, the political crisis within the De la Rua administration commenced in earnest when Vice President Carlos Alvarez resigned in October 2000 in protest of the president’s handling of a senate bribery scandal. Financial markets fell sharply because of concern over a break-up of the ruling Alianza coalition. Two months later, Argentina secured the aforementioned assistance from the IMF. By the end of January 2001, the package appeared to have been successful as capital returned to the country and central bank reserves grew by $1.3 billion.
Unfortunately, confidence in Argentina quickly eroded again in February when the Turkish financial crisis erupted and Argentine Central Bank President Pedro Pou was accused of malfeasance in prosecuting money-laundering cases. In March Finance Minister Jose Luis Machinea resigned and was replaced by Ricardo López Murphy, who resigned after less than two weeks in office out of frustration with the lack of political backing for his austerity plan. Domingo Cavallo, the original architect of convertibility, succeeded López Murphy. Cavallo was granted special policy-making authority to implement financial, fiscal and administrative reforms. His return, viewed by many as the last, best hope for rescuing Argentina, was initially well-received.
Cavallo almost immediately eroded this goodwill by making proposals to tinker with the Convertibility Plan. He suggested linking the peso to a currency basket composed of both the dollar and the euro; the arrangement would take effect if and when the euro achieved parity with the dollar. The logic behind the proposal was that the peso would be less adversely affected by the dollar’s appreciation if the peso were linked to an average of the dollar and the euro.
Although this plan would not have gone into effect until an unspecified future date, it was interpreted as a sign that the government no longer held convertibility sacrosanct and that devaluation was now possible. In effect, Cavallo’s future plan had done irreparable damage to the Convertibility Plan’s reputation. The spread of Argentine long-term bonds over U.S. Treasuries surged to 1,500 basis points in April 2001, the highest level since Brazil’s January 1999 devaluation of the real (see chart 2).
The downward slide
In another effort to boost confidence, bring down interest rates and provide breathing room for the economy to recover, the government initiated a $29.5 billion debt swap in June that was designed to save $16.4 billion over five years. Initial market reaction was positive, and bond spreads dropped to 700 basis points. The swap, however, did nothing to alleviate the growing fiscal burden, and, as tax revenue fell, fears grew over whether or not Argentina could meet its short-term obligations. Banks were hit with another wave of withdrawals (see chart 3), and bond spreads rose sharply. In response the government implemented the zero-deficit policy, which called for an immediate end to fiscal deficits via budget cuts and tax hikes. This plan included an unpopular 13 percent cut in public sector salaries and in pensions of over $500 per month.
The already reeling De la Rua administration was weakened even further when the opposition Peronist party won a resounding victory over the ruling Alianza coalition in the October 2001 legislative elections. The government announced yet another debt swap of $16 billion worth of high-yield government bonds held by local banks and pension funds for lower-paying securities guaranteed by tax revenue. Though the debt-swap was considered voluntary, bondholders had no choice but to participate since they would clearly be worse off in a default.
In November the government announced that another debt swap for up to $53 billion worth of foreign-held debt would be held in two to three months, saving the government $4 billion. By this time, though, Argentina had lost all international credibility as investors began to see the debt swaps as thinly veiled defaults. Bond spreads surged past 3,000 basis points, and bank deposits fell an additional $7 billion in October and November (to a total of $67.5 billion).
The final blow came in early December 2001. After the IMF refused to release a $1.2 billion dollar funding tranche, the government announced restrictions on bank withdrawals to halt the accelerating run on deposits. Violent protests erupted, and Domingo Cavallo and Fernando De la Rua resigned. Interim President Adolfo Rodríguez Saá then announced the largest sovereign default in history: Argentina would no longer pay interest or principal on its $150 billion total external debt. Ten-plus years of convertibility ended in early January 2002 when newly sworn-in President Eduardo Duhalde announced that the Argentine congress would repeal the Convertibility Law. By February the peso was set to float freely against the dollar, although the government reserved the right to intervene in the foreign exchange market when it deemed it necessary.
Repercussions of the collapse
The economic, financial and social costs of the collapse of convertibility have been drastic and will endure for many years. While U.S. trade exposure with Argentina is limited (in 2000 just 0.6 percent of U.S. exports went to Argentina), the Argentine collapse raises a series of questions about the future of reform in the region. Still unclear is what impact the Argentine crisis will have on investment in Latin America. While limited financial market contagion thus far is a hopeful sign for the future, the risk of contagion in the region could increase if the crisis endures for a long period.
The impact on foreign direct investment is also uncertain. For example, in recent years the strong foreign presence in the Argentine banking sector was believed to have strengthened the financial sector. The foreign banks’ reluctance to recapitalize their local subsidiaries in the wake of the devaluation, however, raises new questions about their willingness to commit to a particular country or region in the face of an adverse shock.
Finally, while it is clear that Argentina did not fully implement its reform agenda (most notably with respect to fiscal and labor reforms), the crisis in a country that was once considered the model reformer could conceivably generate a backlash against the process of structural reform in the region.
Upcoming elections in Colombia, Ecuador and Brazil will provide some indication of what impact, if any, the Argentine crisis might have on policy debates in other countries. Meanwhile, the Argentine government is working (with assistance from the IMF and other multilateral lending agencies) to construct a viable economic recovery program in the wake of convertibility’s demise. Argentina’s return to growth and stability will likely take some time as most analysts forecasts project a sharp economic contraction in 2002.
This article was written by Myriam Quispe-Agnoli and Stephen Kay of the Atlanta Fed’s Latin America Research Group.