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S. Harikumar

IN THE last week of December 2001, Argentina made the biggest-ever sovereign debt default ($152 billion) in the history of global financial markets. Unlike the Mexican crisis (1994-95), salvaged by US dollar-pumping operations, the devastating contagion effect spread by the South Asian crisis (1996-97) and the tremors in the currency market of Russia (1998) and Brazil (1999-2000), Argentina's default did not create too many ripples in the market as the world was preoccupied with fighting the recession and analysts had already factored in the peso's fall.

The currency board system, highlighted as the prime cause of Argentina's problem, was introduced in 1991 as a tool to tame inflation of above 5,000 per cent. The mechanism did effectively contain inflation but engendered other troubles.

In a typical currency board, on the onset of inflation the resident has the freedom to switch over to the reserve currency (say, the dollar) resulting in a reduction in demand for the local currency and raising the interest rate. This raises the demand for the local currency. If it does not, the country slips into recession, bringing down interest rates and inflation levels and, thus, equilibrium is achieved.

In the Argentinean currency board system, each peso in circulation is backed by a dollar in reserve. By entering into this system the country lost control over monetary policy. Consequently, the peso's circulation began drying up at the rate of 28 per cent per year. The austerity measures of the federal government, along with the zero deficit budget strategy, resulted in the reduction of federal assistance to the provincial governments. To tide over this situation provincial governments began printing their own bonds in different nomenclatures to pay off bills and wages. Added to these woes was the recession of the last 43 months. The real year-to-year GDP growth was on the decline since 1998. The public debt to GDP percentage reached 46 per cent at a real interest rate level of 10 per cent. The rise in dollar price and the depreciation of the currencies of competing countries made Argentinean goods uncompetitive in the export market. Argentina also experimented with the currency board by changing the reserve component and tried to bring the euro into the board, allowing scope for implicit devaluation. The fall in tax revenues, increasing federal and provincial debt and the drying up of FDI/FII funds also complicated matters. Locked into an overvalued exchange rate with an inflexible monetary mechanism, Argentina was unable to use interest rate cuts to stimulate the economy. With the IMF and the US unwilling to enter the fray without a fine print on reforms preceded by a default and devaluation, the debt default was inevitable.

With the peso's fall becoming unavoidable, the dollarisation of the national currency was considered. It might have given the beleaguered economy immediate relief but would not have saved the nation from enduring recession. However, for an economy largely driven by international consumption, considering that exports to the US constitute only 1 per cent, private financing is down by 10 per cent of GDP and with the dollar' strengthening, this option was found unviable. It is believed that there may not be enough dollars to replace the approximately 10 billion pesos in circulation.

The other option was to allow the market to decide the peso value. Once the peso is freely floated there will be a sharp depreciation in the currency. The peso is being traded at 2:1 to the dollar in the one-year forward market giving room for depreciation to the tune of 50 per cent. A sharp fall in the peso will affect the banking system as debt repayment will become costlier, especially to Argentina which has a dollar-denominated debt of $97 billion. Alarm bells have already started ringing in the credit derivative market, particularly among those who are long in `default swap' instruments.

Considering this situation, Argentina decided to go in for a new currency, the Argentino, while maintaining the dollar-peso peg. The new currency, linked to one peso rate, will pay wages and infuse liquidity immediately. By doing this, the government wants to facilitate a real depreciation of currency while the fall in salaries in dollar terms will be compensated by monetisation. This strategy is aimed at reviving the economy.

Argentina's crisis will cast a shadow over the performance of other Latin American economies, particularly Brazil, which has strong trade relations with Argentina. The apparent country-risk perception is visible from the Emerging Market Bond Index sovereign yield spread (EMBI+). The dollar-denominated Argentinean bond spread, hovering around 6 per cent in December 1999, has now reached 40 per cent over identical US treasury bills while for Brazil it has touched 8.8 per cent — more than the average EMBI+ premium of major Latin American countries. Though Brazil's inflation level is within the IMF target, its currency has shown signs of weakness with the crisis brewing in Latin America.

The political instability in the country is apparent with two changes in presidents in a month and unemployment at a painful 20 per cent. About 2,000 persons slip below the poverty line daily, and the government has no option but to abandon IMF-prescribed `austerity measures'. The government's immediate priority must be to bring in liquidity and facilitate a safe landing for its domestic currency.

However, for the long term, a transparent privatisation programme, effective tax-collection mechanism, a stronger banking system and a corruption-free regime are prerequisites. Argentina's need of the hour is a strong leadership that can adopt a pragmatic approach towards economic policy to deliver culturally-compatible economic reforms that will give a shot in its arm.

(The author is with the Industrial Finance Branch, International Banking Division, Corporation Bank, Pune.)

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