Jason Marshall, MPP

Summary of the Crisis

The 2001-2002 Argentine Financial Crisis was the culmination of an overreaction to a history of hyperinflation, an unwillingness to address needed structural reforms, and a macro-economic strategy that left Argentina totally exposed to external shocks and swings in global capital flows. While just a decade earlier Argentina was the darling of the international community, it entered the new millennium with a massive contraction in output and the largest ever foreign debt default.

The seeds of the crisis could arguably be traced back to the 1970s, when skyrocketing oil prices and an unwillingness to undergo necessary austerity measures caused Argentina to go heavily into dollar-denominated debt. The 1980s, often referred to as “The Lost Decade” were characterized by declining GDP and shrinking U.S. exports. These exports were critical since they were paid in the dollars needed to pay off these external debts. Argentina was able to avoid default by rescheduling a large portion of their foreign debt under the U.S.-backed Brady Plan and monetized the domestic debt by massively reflating their currency in 1989.

Understanding that repeated self-inflicted hyperinflation was not a prudent macro-economic strategy, the government under President Carlos Menem and Minister of Economy Domingo Cavallo introduced orthodox economic policies centered around the Convertibility Plan (CP). The CP pegged the peso 1:1 against the dollar, guaranteed unlimited exchange between pesos and dollars, and required the Banco Central de la República Argentina to hold 1:1 dollar reserves against its domestic monetary liabilities. Furthermore, the International Monetary Fund (IMF) provided four successive financing agreements and extensive technical assistance during the 1990s.

Argentina’s darling status was born out of their perceived stability emanating from the CP combined with the IMF involvement and oversight. President Menem oversaw several years of solid GDP growth and a massive inflow of cheap foreign credit. However, various structural flaws ultimately eroded Argentina’s fiscal situation: Buenos Aires was responsible for paying the debts of the localities, which incentivized excessive debt taking and make reform nearly impossible. An exceptionally strong unionized labor force made much-needed labor market reforms impossible, making Argentine exports uncompetitive; and the affordability of foreign capital was far too tempting for a nation that was not heeding the lessons of the past two decades, as evidenced by their external debt-to-export ratio of 400%.

Argentina responded to the 1994-95 Mexican Peso Crisis by consolidating their banking system, strengthening reserve requirements, and improving oversight. However, little was done to improve the structural flaws, so when Argentina was hit with a deep recession in 1998, their fiscal position deteriorated. A reluctance to abandon the currency board limited their monetary policy options, and a series of external shocks emanating from Russia, Brazil, and the Long Term Capital Management Hedge Fund shut Argentina out of the international markets they had become so dependent on.

Argentina trudged on for three more years by using a series of maturity swaps, IMF programs, and by loosening their reserve requirements. However, investor sentiment never recovered, making borrowing more and more expensive. The banking system, which had previously been a source of stability in the domestic economy, was hit by a run on deposits in November 2001. The government responded with a 1,000 peso a month limitation on withdrawals. Chaos and riots were followed by the IMF withholding a $1.24 billion loan installment. Shortly after, Argentina defaulted on $132 billion of debt, and the currency board finally disbanded in January of 2002. With the currency board disbanded, the Argentine Peso plummeted in value, essentially wiping out domestic savings and forcing thousands of companies and individuals into bankruptcy, unable to service their dollar-denominated debt with the now-devalued peso.

Lessons Learned

Any lessons transferred from Argentina to general knowledge should be taken with a grain of salt, as no two crises are the same. That being said, the following generalizations can be drawn.

The first is to prioritize underlying structural problems over simple macro-level data. Argentina produced extremely positive 6% annual GDP growth from the implementation of the CP through 1997, and kept its overall debt levels in check. However, the GDP growth masked the high levels of increased borrowing that could not be tampered in an economic downturn. The lack of labor reforms, federal-provincial relationships, cronyism, pensions, and exposure to external factors should have been a clear warning sign.

Secondly, the Argentine case shows the danger of sloughing off needed reforms during periods of high growth. Removing the peso from the pegged system would have caused it to depreciate against the dollar at any time. However, during periods of growth, it would not be subject to the capital flight that ensued in 2001-02. Contagion from the Mexican Peso Crisis failed to teach the right lesson; rather than being assured, President Menem ought to have been worried that the economy was so heavily affected in the first place.  

Finally, Argentina shows the danger of relying on fickle foreign capital flows. Argentina did not heed the lessons from the oil crises of the 1970s, choosing to support their fiscal deficit with external financing. Receiving attractive spreads versus U.S. Treasuries incentivized this policy, but left them exposed when investor sentiment changed in the aftermath of external crises. This pattern of supplanting domestic savings with foreign capital is still seen today in Latin America, and its implications are yet to be seen. Portfolio investing must be more heavily scrutinized as compared to foreign direct investment and private bank lending, as its high level of liquidity allows investors to exit the marketplace at the first sign of worry. Just as prudential banking regulation involves ‘stress-testing’ institutions, so must international institutions.

Conclusion

The 2001 Argentine Financial Crisis showed the fallacy of false expectations. Cheap credit could not compensate for sound macro-economic policies, and while eliminating hyperinflation by propping up the peso was welcome, it was unsustainable. Had Argentina undertaken the necessary structural measures when the economy was in a non-crisis condition from 1992-1994, the shocks would have been minor. Instead, a deteriorating fiscal situation became unsustainable when foreign capital stopped coming in.