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Argentina’s Elections — Truth or Dare?

What is yet to be done to resolve Argentina’s economic crisis?

April 25, 2003

Credit: Alexandru Nika

There was enough blame to go around, but the leading cause for the country's economic demise had been the adoption of the currency board in 1991.

The exchange rate regime, which fixed the Argentine peso to the U.S. dollar at a rate of 1:1 — and which required that local currency was fully backed by Argentina's international reserves — had, and still has, its defenders.

Yet, their arguments have been thoroughly discredited over the last ten years. A currency board is almost always a suboptimal exchange rate mechanism in a world of open current and capital accounts.

Coincidentally, this is a lesson that even the infinitely more prosperous Hong Kong — which maintains a similar peg of its currency to the U.S. dollar —is beginning to learn.

What the case of Argentina proved conclusively is that the currency board is a recipe for disaster for a country which tries to emerge from hyper-inflation, depends on fresh foreign capital inflows every year and is highly indebted. All three of these conditions were met by Argentina in 1991.

The currency board brought Argentina an instantaneously overvalued currency and left it subject to the vagaries of global financial markets.

As a result, every external shock — whether in Mexico in 1994/95, Russia in 1998 or Brazil in 1999 — had severe and unavoidable recessionary consequences for Argentina and required ever-growing IMF bailouts.

The chaotic ending of this experiment was predictable — and, in fact, predicted by some observers, although the vast majority of market players had bought into the concept.

Argentines almost uniformly and defiantly rejected any criticism, implying that their detractors misunderstood the salutary nature of currency boards — and, for that matter, of the gold standard.

In some sense, Argentines were not to blame for their self-denial. After all, the concept boasted the staunch support of multilateral institutions, above all the International Monetary Fund. This is one more reason why these institutions too should pay a financial price in Argentina's restructuring.

This coming Sunday, nearly a year and a half after the beginning of the end, Argentines will go to the polls to elect a new president, replacing four interim presidents since Fernando de la Rúa. The race is the most contested in Argentine history. The top four candidates are polled neck-to-neck, all within the margin of error.

Former President Carlos Menem, who is running for a third term, implemented economic reforms that modernized the Argentine economy during his two terms (1989-1999). But he is also responsible for the adoption of the fateful currency board, a system which he defends to this day. The favorite, Mr. Menem still enjoys considerable popularity as well as good relations with business and some support abroad.

The campaign of Néstor Kirchner, governor of the tiny Argentine province of Santa Cruz, got a shot in the arm two weeks ago when current Minister of the Economy, Roberto Lavagna, threw his support behind him. However, Kirchner struggles with a charisma deficit.

Another candidate is Adolfo Rodriguez Saá. He had a historic opportunity to pull Argentina away from the abyss when he became interim President following de la Rúa's resignation. Surprisingly, he threw in the towel after less than a week in office.

Finally, there is the dark horse, Ricardo López Murphy, who served for a few weeks as Minister of the Economy in the waning months of the de la Rúa Administration.

His popularity on Wall Street may be his biggest handicap during the election or thereafter, should he pull off a stunning upset.

Controversy over his Chicago-based schooling may impede his ability to create national consensus in this deeply divided country.

It is almost certain that a run-off race on May 18 will be necessary to determine who will take over from current President Eduardo Duhalde on May 25.

It also seems certain that the new president will govern with a very weak mandate, not an ideal platform considering the challenges he faces.

President Eduardo Duhalde and his Minister of the Economy Roberto Lavagna have done a decent job in stabilizing the Argentine economy against the background of an unprecedented financial, social and political crisis. Predictably, 2002 was a dismal year, with the country's GDP contracting by some 13%.

Lately, however, a weak peso has allowed exports to grow again, international reserves have increased and many of the capital controls that were implemented during the crisis have recently been lifted.

The new government faces huge challenges, however. About 60% of Argentina's population now lives below the poverty line — and crime is on the rise in this once nearly crime-free country.

Sustainable growth is a pre-condition to deal with these pressing social issues. To accomplish this, the new government must – above all – address the country's payment default.

Past crises have taught us some valuable lessons in this regard. The 1989 U.S. Brady Plan was critical in dealing with Latin America's debt crisis that had begun with the Mexican debt moratorium seven years earlier.

Essentially, the Brady Plan shifted the debt crisis from the U.S. banking sector to international capital markets. Many bank loans to Latin American countries were converted into bonds, whose principal repayments were guaranteed by zero-coupon U.S. treasury bonds.

This allowed the region to regain access to financing — and it set in motion macroeconomic reforms throughout Latin America. However, there was one major flaw to the Brady Plan: In most cases, the plan did very little in terms of actual debt reduction for most Latin American borrowers.

Argentine debt restructuring must mean that investors accept serious haircuts. Former President Menem is the only candidate who promises bondholders full repayment of all outstanding principal.

Although this might please international investors, it is unrealistic and not in the best interest of either Argentina — or its investors. Longer maturities and lower interest rates alone are not going to suffice to keep Argentina's economy solvent. One important component of the restructuring, therefore, has to be debt forgiveness.

There is very little harm in this. Bondholders have already provisioned against the defaulted instruments — and therefore have absorbed the financial pain of default.

Also, the argument that debt forgiveness would create moral hazard — meaning an incentive for other countries to follow the Argentine example is not convincing. The political anarchy and the unimaginable social costs that followed the Argentine default are a clear deterrent for willful imitation.

It should also be considered to convert some of the foreign currency denominated bonds into peso-denominated bonds. This would help to develop a local capital market, while establishing important benchmarks. It may even re-inject some confidence in financial intermediation in Argentina.

Third, all parties have to make sure that they develop a debt profile for the country that avoids lumpiness — a situation where repayments in any given year are excessively high compared to other years. This enhances the predictability and manageability of future financing requirements of debt service.

Finally, one could consider developing a private-sector based Brady Plan, since it is unlikely that a U.S. Treasury sponsored plan based on highly structured instruments will be forthcoming.

None of this will be easy to accomplish. Negotiations are difficult — because of the political confusion that still exists in Argentina. There is also a lack of collective action clauses, in effect allowing even the smallest bondholder to scuttle a deal agreed to by all.

Yet, resolving the Argentine default is a win-win-win situation and it should be on the top of the agenda of all parties involved.