“The Latin American Economies: Crises and Reforms”

Always Argentina? Always the same? The financial crises of 1982, 2002, and 2014. An

analysis of its causes.

David Dingus

Göttingen, 11403109

d.dingus@stud.uni-goettingen.de

December 12, 2014

Supervisor: Dr. Felictas Nowak

Table of Contents

1. Introduction 1

2. Economic Theory 2

2.1 IS-LM Model 2

2.2 Mundell-Fleming Model 2

2.3 Balance Sheets 4

2.4 Currency Devaluation 6

3. The Debt Crisis of 1982 6

3.1 Macroeconomic Conditions of the Lenders 7

3.2 Rising Interest Rates 8

3.3 Bank Regulating 9

3.4 Conclusion on the 1982 Crisis 10

4. The 90’s and the Introduction of the Currency Board 11

4.1 The Convertibility Plan and the Currency Board 11

4.2 The Mexican Crisis 11

4.3 Economic Phases under a Currency Peg 12

4.4 The Russian Crisis 13

4.5 Impact of Trade and the Devaluation of the Brazilian Real 13

4.6 Capital Flight 14

5. Analysis of the Debt Crisis of 2002 15

5.1 Use of Debt 15

5.2 Capital Flow Cycles 15

5.3 Debt as Consumption and Debt in the Provinces 16

5.4 Overvaluation 17

5.5 Conclusion on the debt Crisis of 2002 18

6. The Debt Crisis of 2014 19

7. Closing Remarks 20

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Table of Figures

Figure 1. IS-LM Model - Impact of Monetary Policy 3

Figure 2. IS-LM Model - Impact of Fiscal Policy 3

Figure 3. Mundell-Fleming Model 3

Figure 4. Mundell-Fleming Model - Fiscal Expansion - Floating Currency 3

Figure 5. Mundell-Fleming Model - Monetary Expansion - Floating Currency 3

Figure 6. Mundell-Fleming Model - Monetary Expansion - Fixed Currency 3

Figure 7. Central Bank Balance Sheet 4

Figure 8. Monetary Policy under Perfect Capital Mobility 5

Figure 9. Fiscal Policy under Perfect Capital Mobility 5

Table 1. The Mundell-Fleming Model: Summary of Policy Effects 6

Figure 10. U.S. Crude-Oil Refiner Acquisition Costs, 1970-1988 7

Figure 11. Monthly Commodity and Consumer Prices, 1970-1994 8

Figure 12. Total Latin American Debt Outstanding, 1970-1989 8

Figure 13. Monthly Treasury Bill Rate (3-month), 1970-1994 8

Table 2. Economic Phases Under a Currency Peg 13

Table 3. Argentina’s Trade Structure, 2001 14

Figure 14. Argentina: Capital Market Indicators, 1994-2001 14

Table 4. Capital Flows - Theoretical Correlation 16

Table 5. Amplitude of the Capital Flow Cycle 16

Figure 15. Actual and Equilibrium REER 18

Figure 16. Sources of Cumulative Peso Overvaluation 1997-2001 18

Table A1. Argentina - Economic Indicators Appendix 23

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Abstract

In the last 30 years Argentina has faced 2 debt crises with a third looming. While all

three have resulted in an inability to repay loans, the causes leading up to each individual

crisis has been very different. In the 1982 crisis a large debt at variable interest rates was to

blame as the country was no longer able to meet its debt obligations as interest rates

increased. In 2002 Argentina had an overvalued currency, which it could not properly

devalue as a result of its currency peg and small trading sector. This was further

exacerbated by its pro-cyclical capital flows, and use of debt for consumption rather than

investment. Amidst a recession, the devaluation of the Brazilian Real set into motion the

inevitable as the country saw major capital flight and it was once again unable to meet its

loan obligations. Argentina has seen a small recovery from external demand for its

agricultural products, after abandoning the currency peg and devaluing its currency.

However, its debt from the past threatens another crises as it is still unable to service these

large loans.

1. Introduction

After nearly a century of economic turmoil, the question of whether or not

Argentina will ever change for the better remains. It may be thought that Argentina

continues to be a hopeless prospect in investment, riddled by repetitive mistakes that

culminate in near repeated collapse. However, this is not the case as every crisis has been

unique and the result of varying factors.

In light of the 2008 financial collapse, the importance of these crises has become

more apparent as we seek to better understand their causes in order to prevent them in the

future. In the course of writing this paper, I became aware of the striking similarities in

lacks banking practices and how they affected the crises in Argentina and the 2008

financial crisis. Moreover, the economic climates in one country, and especially the OECD,

have direct economic and social impacts on the developing world. While this paper is not

an analysis of banking regulations, I hope to encourage you to consider these complex

relationships and their far reaching outcomes.

In the following, we will examine the conditions in which these economic crises

happened beginning in section 2 with the Mundell-Fleming Model and how it relates to

capital flows through balance sheets under the constraints of a fixed exchanged rate. In

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section 3 we will look at the debt crisis of 1982 beginning with the macroeconomic climate

of the lending nations including interest rates, bank regulations and how these factors

culminated in the crisis and its outcomes. Next, in section 4 we look at the 90’s and the

Convertibility Plan, followed by a study of the economic trends under a currency peg that

were confirmed by the Mexican and Russian Crises, and finally the effects of the Brazilian

Real devaluation and capital flows. In section 5 we take a closer look at the crisis in 2002

and how the large debt burden was further impacted by its misuse, the overvaluation of the

currency, and its conclusion resulting in the collapse of the currency regime. Then, in

Section 6 we briefly look at how the combination of the present economic recession with

the unpaid loans from the crisis in 2002 threaten another crisis. Finally, Section 7 raises the

question of whether banking regulations had an impact on these crises and encourages

further research so that we may prevent them from happening again in Argentina or other

developing countries.

2. Economic Theory

Before we examine the specifics in Argentina it is important to understand the

Mundell-Fleming Model with respect to capital flows.

2.1 IS-LM Model

First, let us review the IS (investment-savings) - LM (liquidity preference-money

supply) model. In Figure 1 we see that under the IS-LM Model expansionary monetary

policy causes the LM curve to shift outward, lowering interest rates and increasing output

or income in terms of GDP. Figure 2 shows the effects of expansionary fiscal policy or an

increase in government spending. As the government spends more money, GDP increases

by that amount, meaning an outward shift of the IS curve, which results in increasing

interest rates. However, this is considering nominal interest rates. The results change once

we consider real interest rates, exchange rates, and an open economy. Here we will

consider the effects of different exchange rate regimes.

2.2 Mundell-Fleming Model

Under the Mundell-Fleming Model we now also consider net exports in addition to

the market for goods and services. To represent this graphically we consider the nominal

exchange rate in relation to output. In this model the IS curve is derived from the

Keynesian cross and net-exports, while the LM curve is derived from the intersection of

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Figure 1. IS-LM Model - Impact of Monetary Policy (Natarajan 2012)

Figure 2. IS-LM Model - Impact of Fiscal Policy (Natarajan 2012)

Figure 3. Mundell-Fleming Model (Sanders 2008) Figure 4. Mundell-Fleming Model - Fiscal Expansion - Floating Currency (Sanders 2008)

Figure 6. Mundell-Fleming Model - Monetary Expansion - Fixed Currency (Sanders 2008)

Figure 5. Mundell-Fleming Model - Monetary Expansion - Floating Currency (Sanders 2008)

the nominal interest rate and the LM curve. Here the curve is vertical because it is

independent of the exchange rate.

Now consider an economy with a floating exchange rate, where the exchange rate

is determined by the international market. In this economy fiscal policy has no effect on

GDP. In Figure 4 we that the IS curve still shifts outwards, however this also means that

the nominal exchange rate increases. In turn, the cost of said country’s exports increase,

which results in a decrease in demand, and any gains in GDP in terms of government

spending are negated by a decrease in revenue from exports, making fiscal policy

ineffective in an economy with a floating exchange rate. However, monetary policy is very

effective under a floating exchange rate. In Figure 5 we can see that by increasing the

money supply, the LM curve shifts outwards. This causes the exchange rate to fall, making

exports cheaper and therefore more will be demanded, resulting in an increase in GDP.

Under a fixed exchange rate the opposite holds true. In this case, fiscal policy

actually can have an affect on output. In Figure 6, the government increases spending

leading to an outward shift of the IS curve, and because the government has also promised

to maintain the exchange rate, it must shift out the LM curve by increasing the money

supply. The net result is that output grows while the exchange rate remains constant. On

the other hand monetary supply will have no effect under a fixed exchange rage because

arbitrage will ensure the exchange rate returns to the set level, due to the central bank

restricting or increasing the money supply. However, a country may decide to revalue

(increase) or devalue (decrease) its currency permanently. This is very difficult to do and

results in negative internal and external effects that are best to be minimised as we will see

in the case of Argentina.

2.3 Balance Sheets

The next aspect to consider is the

central bank’s balance sheet and how the

supply of money is determined by the

formula M = mH where M is the money

supply, m is the money multiplier, and H is

high powered money, base money, or

monetary base. Figure 7 visualises the

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Figure 7. Central Bank Balance Sheet (Rivera-Batiz 1994)

structure of the central bank’s balance sheet where liabilities are made up of cash and bank

deposits and assets are comprised of IR (International Reserves) and DC (Domestic

Credit). H is equal to liabilities and because assets must equal liabilities we can write that

H = IR + DC. Note that domestic credit includes government bonds, bill, and loans to other

banks, but the central bank does not loan directly to individuals. Under a fixed exchange

rate, the government has vowed to keep the currency valued at a specific rate and therefore

must use IR to maintain the required H and monetary supply. In this way, the central bank

cannot control IR, but must act as the market demands. This means that when capital

inflows increase, IR is increasing. This increases the money supply of foreign currency

relative to the domestic currency causing the exchange rate to appreciate. In order to

balance the supply of money, the central bank must decrease DC. On the other hand if

capital outflows increase (a decrease in IR) the money supply would shrink and the central

bank must increase DC, this process is known as sterilisation. In this way, the central bank

does not have the ability to control IR as it wishes, leaving it only DC to control. This is

important as DC must act inversely to IR to

maintain a currency peg. When DC cannot be

adequately adjusted an undervaluation or

overvaluation of the domestic currency may

result depending on other factors including

trade.

To further illustrate this we revisit

monetary expansion as shown in Figure 8. Here

we see that increasing DC results in large

capital outflows, or a decrease in IR in order to

return to i*. In other words H = DC + IR

remains constant and any effort to increase

output by increasing the money supply only

depletes international reserves. Once again, we

conclude that monetary policy is ineffective

under a fixed exchange rate.

Figure 9 again confirms the effectiveness

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Figure 8. Monetary Policy under Perfect Capital

Figure 9. Fiscal Policy under Perfect Capital Mobility (Rivera-Batiz 1994)

of fiscal policy under a fixed exchange rate. When government spending is increased, the

IS curve shifts outward, because this would cause the interest rate and exchange rate to

increase, the central bank must respond by increasing the monetary supply by increasing

IR, leading to capital inflows, and causing the return to i* but with an increase in output.

2.4 Currency Devaluation

Finally, for the case of Argentina it is important to understand the purpose and

effects of devaluation. The positive effect of devaluation is the relative price effect.

Because the domestic currency has been devalued, said country’s exports are now cheaper,

so exports should increase leading to growth. Additionally, more domestic products will be

consumed as people shift away from more expensive imported goods.

Table 1 summarises the outcomes of various policy tools under different exchange

rate regimes. It can be concluded that under a fixed exchange rate fiscal expansion will

increase output with no change in net exports. On the other hand monetary expansion will

have no effect. Finally, should a devaluation be implemented we can expect an increase in

output and net exports as a result of the new lower exchange rate. While a fiscal expansion

under a floating currency would have the same result, a monetary expansion would have a

significant impact on the outcome. Under monetary expansion output would increase

significantly, while the exchange rate decreases, and net exports increase. In effect,

monetary expansion under the floating currency acts much the same way, only larger than a

devaluation of the currency under a fixed currency exchange regime.

3. The Debt Crisis of 1982

The increasing government expenditures of WWII were able to pull the United

States out of the Great Depression. The period following the war saw the establishment of

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Table 1. The Mundell-Fleming Model: Summary of Policy Effects (Mankiw 2010)

many international institutions with a new emphasis placed on the expansion of

development aid. This coupled with the Marshall Plan, set into motion a period of

economic expansion in many parts of the world. This created demand for more goods, and

Argentina was no exception as it saw demand for its agricultural products increase.

Meanwhile development loans were being issued with the idea of helping to accelerate the

development process, while providing profit for the lenders, wealthy developed countries.

Marsh et al. (2014) notes that while Argentina saw an average growth rate of 6 percent by

1950, commodity prices in Argentina began to fall in the early 1950’s and in combination

with the President’s decision to nationalise a British owned rail system scared of investors.

Marsh et al. go on to note that by 1952 inflation had starting increasing significantly. By

1955 the president was ousted only to be followed by frequent government turnover in the

form of various military coups and governments, further increasing economic instability

and by 1976 inflation since 1950 had reached over 600 percent (Marsh et al. 2014).

3.1 Macroeconomic Conditions of the Lenders

However, this high rate of inflation cannot solely be attributed to domestic issues,

one must also consider the macroeconomic issues of the lender countries, especially the US

and the UK. The UK had already been in economic downturn by the 1970’s and the US

would soon join them as well. The primary reason being the oil crises of the 1970’s. The

price of crude oil increased dramatically throughout the period, quadrupling between 1973

and 1974, and would continue for nearly a decade as shown in Figure 10. By 1978 OPEC

had $84 Billion in bank deposits, most of which were in USD (Curry 1997). These large

deposits were being rechanneled in the form of loans to developing countries that were oil-

importing, as a result of increasing USD

reserves.

Additionally, the increase in the price

of crude caused the price of commodities to

increase as seen in Figure 11. This was

particularly harmful to developing countries

like Argentina who had a trade deficit and

consumed many foreign goods, while also

seeing demand for their exports decrease.

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Figure 10. U.S. Crude-Oil Refiner Acquisition Costs, 1970-1988 (Curry 1997, p. 193)

This is because as the cost of living

continued to rise for Argentina there was

also a recession resulting from the

increasing energy prices, which further

decreased demand for Argentine goods and

reduced their income.

3.2 Rising Interest Rates

As a result of decreasing income,

along with the increasing capital in the

international markets, Argentina saw

increasing capital flows, debt in Argentina

and Latin America increased amidst

political instability, see Figure 12. An

estimated 2/3 of all loans in these

developing countries had been issued at

variable rates, which were tied to LIBOR,

London Interbank Offering Rate (Curry

1997). Initially these loans were at low

interest rates, as a result of the large money supply, but inflation was extremely high in the

lending nations. In Figure 13 we can see how interest rates in the US remained between 4

to 8 percent for most of the 1970’s. Then by 1978 interest rates began increasing almost

hitting 16 percent and inflation came down. However, the second oil crisis of 1979 would

send inflation soaring again and interest rates

down for a brief moment before reaching

record highs.

In 1981 Ronald Reagan would

become president of the United States,

inheriting a country with high unemployment,

low growth, and high inflation. According to

Henderschott and Peek (1989) his goals

including reducing inflation, deregulation,

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Figure 11. Monthly Commodity and Consumer Prices, 1970-1994 (Curry 1997, p. 194)

Figure 12. Total Latin American Debt Outstanding, 1970-1989 (Curry 1997, p. 194)

Figure 13. Monthly Treasury Bill Rate (3-month), 1970-1994 (Curry 1997, p. 205)

cutting taxes, and increasing military spending while reducing non-defence spending. His

primary goal was to get control over inflation by restricting the money supply. This period

of restrictive monetary policy would last most of the decade in the US and the UK. While

Reagan was successful in bringing down US inflation rates from an average high of 13.5

percent in 1980, back down to a more manageable average rate of 3.2 percent by 1983, this

also increased rates on loans in the developing world (Curry 1997).

It became clear to some that these developing countries may have difficulty

servicing their loans, not only because of the shear size of their loan debt, but also because

the interest payments alone had grown so large. By 1982 the restrictive monetary policies

of the United States and the UK caused the interest rates of loans in dollars to reach an all

time high of 16 percent as depicted in Figure 13. High interest rates and stagnant exports

made debt-service commitments impossible to meet. Further fuelling the crisis was the

increasing amount of debt continuing to be issued and how it was being used. ‘Many

scholars point to another factor the compounded the debt-service problems: most of the

new bank loans to the LDCs from 1979 to 1982 went to cover accrued interest on existing

debt and/or to maintain levels of consumption, rather than for productive

investments’ (Curry 1997, p. 205-206). In sum, concerns over meeting debt obligations

were solved through the issue of additional debt rather than reform.

Additionally, income from exports had grown stagnant as commodity prices took a

dip in 1982 as shown in Figure 11. Not only were debt obligations in Argentina hard to

meet because of high interest rates and stagnant income, but also because this debt had

been issued in USD. Marsh et al. (2014) cites that the Debt in USD became increasingly

difficult to service as the dollar appreciated by 17 percent in 1982 coupled with rising

inflation in Argentina, passing 600 percent by 1976 since 1950. By the end of 1982

Argentina was in negotiations to restructure its debt. Unfortunately the financial crises

along with domestic issues of political instability would not see Argentina recover in the

decade. By 1989, Marsh et al. notes that inflation would reach 5000 percent since 1950, as

public payrolls swelled as tax revenue stalled.

3.3 Bank Regulating

The financial crisis of 1982 that had affected a large portion of countries in Latin

America did not come as a complete surprise. In this same period, LDC loans made up a

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larger portion of banks portfolios as banks sought these loans to replace their dwindling

customers in their domestic markets. Bank regulators saw this and issued “warning” letters

to banks with LDC loans warning of the high risk and asking them to exercise restraint.

1979 would see the creation of a new committee to evaluating the risk of US banks to

foreign debt. The Interagency Country Exposure Review Committee (ICERC) was made

up of a members from the OCC and the FDIC, but in the end this system proved

ineffective. ‘...the U.S. General Accounting Office suggested in 1982 that the “special

comments by bank examiners have had little impact in restraining the growth of specially

commented exposures”’(Curry 1997, p. 203).

Unfortunately, the only effective action of the OCC, did not prevent the crisis, but

rather encouraged it. Curry (1997) reports in his argument that the OCC altered the

interpretation of a previous standing statue in 1979 where a bank is not allowed to issue

debt to a single borrower in excess of 10 percent of the bank’s capital. The new

interpretation stated: ‘public sector borrowers did not have to be counted as part of a single

entity if each borrower had the “means to service its debt” and if the “purpose of the loan

involved the borrower’s business.” It is worth notting that many banks had already

exceeded the 10 percent requirement’ (Curry 1997, p. 204).

3.4 Conclusion on the 1982 Crisis

In conclusion, the debt crisis of 1982 was the result of LDCs taking on too much

debt at flexible interest rates that would increase as a result of the restrictive monetary

policy in the US and the UK. More broadly, large deposits of USD from oil producing

countries as a result of the oil embargoes of 1973 and 1978, encouraged banks to rechannel

this money in the form of loans to LDCs, and replace the profitability losses in the

domestic market with profit from new emerging international markets. Loans were issued

at flexible low rates as inflation rose dramatically in the 1970’s as a result of the increase in

oil prices and other commodities. In an effort to curb high inflation in the US, Reagan’s

policy of restricting the money supply increased interest rates and the LDC’s found that

they could no longer service their loans. Initially, more loans were issued, but eventually

many countries including Argentina found themselves in default. Regulating had proven to

be ineffective, and many argued that US banks were too big too fail. ‘US bank regulators,

given the choice between creating panic in the banking system or going way on requiring

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our banks to set aside reserves for Latin American debt, had chose the latter

course’ (Seidman 1993, p. 123). The US banking system was saved, but the remainder of

the decade would only see the renegotiation of loan debt for Argentina and the other LDCs.

In 1989 Nicholas Brady, the secretary of the treasury, would create a plan moving from

debt rescheduling to debt relief (Curry T, 1997). In total, the agreement is believed to have

reduced outstanding debt of the LDCs between 1989 and 1994 by 32 percent (Cline 1995,

p. 234).

4. The 90’s and the Introduction of the Currency Board

The period following the debt crisis of 1982 saw Argentina face years of

mismanagement and hyperinflation even though many failed policy measures such as the

Austral Plan had been implemented in an attempt to regain control of the economy

(Edwards 2002).

4.1 The Convertibility Plan and the Currency Board

In 2001 the Convertibility Plan was set into motion with the aid of the IMF. Under

this plan the Argentine Peso returned as the currency, replacing the short lived Australe

(1985-1991) and was fixed to the U.S. dollar at a 1 to 1 ratio in a currency-board like

arrangement. Finally, economic stability was on track in Argentina. Capital inflows began

and increased substantially as Argentina entered into the boom phase (Woodruff 2005).

Table A1 in the Appendix shows various economic indicators from Argentina. In much of

the 80’s inflation remained a key problem. In 1991 annual inflation was at 84 percent, but

declined to 17.5 percent following the Convertibility Plan and would continue to decline

until 2002. ‘After the adoption of the Convertibility Plan, sterilisation was achieved

quickly, and with the aid of structural reforms, the economy grew at an average rate of 6

percent per year through 1997’ (IEO 2003, p. 2). Argentina was heralded as the poster child

for stabilisation, economic growth and market-oriented reforms by the IMF.

4.2 The Mexican Crisis

In 1995 the Mexican crisis brought the ability of a currency regime into question.

As the result of multiple internal and external shocks, along with political instability, the

currency peg moved to the top of its range (Perry & Serven 2003). The inability of the

currency regime to use monetary policy to fix the mix-match in the exchange rate, resulted

in its eventual dissolution. The Mexican Peso became a free floating currency almost

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overnight and questions about the viability of a currency board came into question (Perry

& Serven 2003). As capital inflows dried up due to worries about the viability of the

currency peg in Argentina, the country suffered a mild recession in relation to others in the

region, interest rates increased sharply, output fell, and unemployment rose to over 18

percent (IEO 2003). However a recovery quickly took place and was seen as a testament to

the robustness and credibility of the currency regime in Argentina. Capital inflows resumed

and ‘a new wave of dollar-denominated borrowing ensued, fuelled in part by provincial

governments refinancing debts to employees and suppliers accumulated during the

“Tequilla Crisis”’ (Woodruff 2005, p. 20). This is an important point as from Table A1 we

can see the balance sheets of both the federal government and the provinces, and although

the government had positive moments, we see that the situation of the provinces was much

more alarming. While the debt was being used to cover debt on the federal level, it was an

even worse situation in the provinces. This situation of the provinces acting independently

and in a fiscally irresponsible way, would only further fuel the pending recession. Only a

short time later another recession would begin in 1998 as a result of the Russian crisis.

4.3 Economic phases under a Currency Peg

Woodruff (2005) summaries the stages of an economy under a currency peg by

describing threes economic phases the country usually goes through beginning with boom,

then gloom, and finally doom as shown in Table 2. Woodruff also argues that once the

currency peg is established a boom phase begins in which capital flows into the country,

controlling inflation of the domestic currency, accumulating dollar liabilities and assets in

the domestic currency. Domestic inflation occurs and the price of goods gradually increase

due to the increase in the money supply. Eventually prices cause exports to lose their

competitiveness on the international market and imports flood the market since they are

cheaper in relative terms. The country is faced with prospect of either devaluing the

currency or enacting protectionist or export subsidising policies. By delaying the

devaluation process the country then faces the gloom faze in which capital flows revers out

of the country causing the money supply to decrease and making it more difficult for the

country to cover its debt obligations. If the country continues to avoid the devaluation of its

currency or exit the currency peg, the Doom phase begins. Capital inflows continue to

decrease, but at an increasing rate, possibly further causing the domestic currency to

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overvalued if sterilisation cannot

take place fast enough.. At this

point a country’s next action is

largely dependent upon its asset

situation. If domestic currency

assets are liquid, devaluation

may be delayed as long as it is

practical, but if domestic

currency assets are illiquid the

devaluation is usually delayed

until there is a self-sustaining

general flight from currency.

It is important to note that capital inflows represent debt from abroad in this case in

USD. A devaluation of the domestic currency would in effect make the debt burden even

larger as they would have to pay even more in domestic currency for their debt obligations.

4.4 The Russian Crisis

We can see this model of boom, gloom, and doom play out in Russia and then

Argentina. In August-September of 1998, Russia would default on its debt, and like

Mexico it quickly abandoned its peg to the dollar in an effort to quickly devalue its

currency. Woodruff (2005) argues that Russia was quick to act because its domestic

currency assets were relatively liquid and its loans in USD made up less than half of all

loans. This resulted in the drying up of capital inflows for Argentina and created a

recession again, Argentina had re-entered into the gloom phase of Woodruff’s argument,

but it was not eager to devalue its currency given its large debt in USD, which was around

70 percent of all debt. ‘In Argentina, leaders fought devaluation until very many more

liquid peso positions had been unwound. They did so in the interests of businesses with

illiquid peso-denominated assets but dollar liabilities, for whom devaluation meant

financial destruction’ (Woodruff 2005, p. 5).

4.5 Impact of Trade and the Devaluation of the Brazilian Real

The situation was made worse when the Brazilian Real was devalued in 1999.

Brazil was a key trading partner accounting for 25 percent of all trade as shown in Table 3.

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Table 2. Economic Phases Under a Currency Peg (Woodruff, D 2005, p. 8)

The depreciation of the Real meant that

Brazil could no longer afford as many

Argentine goods, while at the same time

Brazilian goods became more competitive

relative to Argentina’s on the international

market, decreasing the demand for

Argentine goods.

This led to even greater problems as

it further increased the overvaluation of the Argentine Peso. According to Perry and Serven

(2003), the Peso was overvalued by approximately 20 percent in 1999 and the devaluation

of the Real accounted for roughly half of that value or 11 percent. However, Perry and

Serven point out that Argentina isn't as reliant on trade and declines in trade amounted to

only 5 percent of GDP, which is why the reduction in imports and exports were shown to

be a smaller contributing factor.

4.6 Capital Flight

As the recession deepened following the devaluation of the Brazilian Real, capital

flows began decreasing. In figure 14 we can see the strong decrease in capital flows

depicted by a sharp increase in spreads of Argentine bonds over U.S. treasuries. ‘The IMF

responded by providing exceptional financial support. Uneven implementation of promised

fiscal adjustment and reforms, a worsening global macroeconomic environment, and

political instability, however, led to the complete loss of market access and intensified

capital flight by the second quarter of 2001’ (IEO 2003, p. 3). Argentinians in fear of

loosing their deposits again, began withdrawing their deposits prompting a bank run. In

total, 12.6 billion dollars in reserves were

lost along with 12.9 billion dollars in

deposits in 2001 (Melvin 2003). In

December 2001 the government

instituted caps on withdrawals, thereby

taking the Argentinian banking system

out of compliance with IMF policies. As

a result the IMF suspended disbursements

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Figure 14. Argentina: Capital Market Indicators, 1994-2001 (Geithner, T 2003, p.41)

Table 3. Argentina’s Trade Structure, 2001 (Perry, G & Serven, L 2003, p.17)

and the country partially defaulted on its debt-servicing obligations. In January of 2002 the

country abandoned the convertibility regime, and devalued its currency. By the end of the

year, the economy contracted by 20 percent since 1998 (IEO 2003).

5. Analysis of the Debt Crisis of 2002

By 2001 Argentina was experiencing not only a debt crises, but also a banking and

currency crises. The collapse of the currency board in 2002 was the result of many factors.

It has been argued that the causes have been the issuance of too much debt, the misuse of

that debt, and the overvaluation of the currency.

5.1 Use of debt

While it is clear in Table A1 that Argentina took on massive amounts of debt that it

would have trouble paying off in the future, Geithner (2003) argues that is the way in

which that debt was used was the main problem: ‘instead of building up fiscal cushions

during the boom period, (Argentina) had accumulated considerable amounts of

debt’ (Geithner 2003, p. 10). In other words even though the country was receiving large

capital inflows following the establishment of the currency board in the form of loans, the

government still spent more money than its income from tax revenue and loans. In table A1

we can see how the current account remained negative for much of the 90’s, as debt

continued to accumulate as real primary spending grew by 5.5 percent per year between

1993-1998. Geithner argues that while this expansionary policy can help stimulate further

growth, a lower rate of primary spending growth at 3 percent per year would have been

more prudent as it would have been below the debt ratio and reducing the governments

needs in servicing its future debt. Unfortunately, Geithner says that the 90’s gave an overly

optimistic view of growth for Argentina and many other developing countries with some

observers, including the IMF, forecasting permanent growth of 5 percent per year.

5.2 Capital Flow Cycles

This kind of government spending is extremely worrisome as it is the opposite

response one would expect as it goes against the economic principles of the lending

nations. In general, there are 3 different methods in managing capital flows:

countercyclical, procyclical, and acyclical summarised in Table 4. In a countercyclical

cycle, capital inflows change in the opposite direction of the economy. When the economy

is contracting, capital flows increase, meaning the country borrows from abroad to stabilise

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the economy. Conversely, when the

economy is doing well, capital inflows

decrease as the country repays its loans.

Under a procyclical cycle, capital inflows

move with the direction of the economy.

In this case, when the economy is doing well more money is borrowed from abroad, and

during economic contraction capital inflows decrease. Intuition would tell us that

countercyclical capital flows would make more sense as the economy would remain stable

over the long run, whereas procyclical capital flows would only serve to exacerbate

business cycles making economies appear to grow faster in good times as funds increase

due to the availability of loans, while inversely causing economies to contract deeper as

their are no funds in the form of loans available in bad times.

Looking at developing countries in general we find that many are indeed

procyclical as governments go through periods of high spending during good times and try

to cut budget deficits and increase interest rates further making the situation worse in bad

times. Furthermore, Kaminsky, Reinhart and Vegh (2004) find that while wealthy countries

may have continuous access to capital markets, poorer and developing countries have

increased access during good times and reduced access during bad. In other words,

developing countries take as much as they can get during good times, for fear that capital

will dry up during economic turmoil. This is confirmed in Table 5 where we see that while

Capital inflows are pro cyclical for all countries. We also see that capital inflows are largest

for middle-income countries during good times, and consequently these countries have the

largest proportionate decrease in available capital during bad times. As such, Perry and

Serven (2003) found that while capital flows did not necessarily bring about the crisis of

2002, the procyclical nature of capital flows in Argentina made the situation worse.

5.3 Debt as Consumption and Debt in the Provinces

In addition, we can see how much

of the growth during boom times was

being used for consumption rather than for

debt reduction or savings. Referring to

Table A1, consumption increased at almost

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Table 4. Capital Flows - Theoretical Correlation (Kaminsky, Reinhart & Vegh 2004, p.4)

Table 5. Amplitude of the Capital Flow Cycle (Kaminsky, Reinhart & Vegh 2004, p.21)

the same rate as growth in GDP while the debt burden continued to grow, possibly

indicating a misuse of that debt. Investment also increased, but we can see how it increases

in good times and decreases in the key bad periods of 1995 (the Mexican/Tequila crisis)

and 1999 (the devaluation of the Real). This volatile reaction of investment in relation to

the business cycle confirms that Argentina was acting in a procyclical way and thereby

further exacerbating its economic turmoil. An increase in investment and government

expenditure during bad times, meaning that it would have acted counter cyclically, may

have helped to lessen the depth of these recessions. However, as previously mentioned, we

can see that IR grew at a slower rate during these periods, meaning capital inflows

decreased, confirming our previous finding that capital markets dry up during bedtimes for

middle-income countries.

Upon closure examination we can see that while the federal governments acted in a

procyclical manner, provincial governments seemed to be acting acyclical, in that there

overall balances seem to act independent of the current economic climate initially in the

1990’s. Comparing the overall balances of the provincial governments with those from the

federal governments we see that while the federal governments balance grew during good

climates, the provinces first decreased their deficits and then further increased them. After

the Mexican crisis, which had caused a slight recession, we can see that the provincial

governments acted in accordance with the federal government, both maintaining large

deficits. However the size of the deficit of the provincial governments in relation to the

federal government kept growing, increasing considerably after 1999. From this we can

conclude that not only was debt being using in the wrong manner, but also that there were

clear management issues in the provinces who were unable to achieve balanced budgets

even in the best of times.

5.4 Overvaluation

From figure 15 we an see that the Peso appreciated in the beginning of the 1990’s

while remaining close to its equilibrium, slightly below equilibrium levels until 1997,

when it started to become overvalued. The currency continued to be increasingly

overvalued reaching an overvaluation of nearly 50 percent in 2001 (Perry & Serven 2003).

This enabled the country to continue taking on debt at a higher rate than had the currency

been devalued to represent its true value. In this way, Argentina was not only increasing its

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debt in nominal terms, but further

increasing it in real terms as the debt would

cost more to repay in the event of a

devaluation. At the same time, Argentina

became increasingly reluctant to devalue its

currency as the debt grew, further

exacerbating the situation.

In Figure 16 we can see that the

currency overvaluation is comprised of inconsistent fundamentals that are attributed to

increasing public deficits, the increasingly overvalued dollar, and also the devaluation of

the Real. Perry and Serven (2003) suggest that Argentina had chosen the wrong peg and

point out that under a currency peg, the only way to combat the overvaluation with a

change in the real-exchange rate would be for a change in price levels. Such a change

would only be possible through economic

recession and question the credibility of

the peg itself. Other methods such as in

terms of trade were not possible due to

Argentina’s relatively small export sector

that it could not expand under the

currency regime due its high prices to

begin with.

In effect, the devaluing of the Real set into motion the overvaluation of the Peso,

which was further compounded by an overvalued dollar. This caused Argentina to take on

more debt, compounding the debt as the Peso became increasingly overvalued. There was

no way out but to devalue, and ironically the debt itself that had caused the problem was

what made the government so reluctant to devalue its currency as it would make it even

more expensive.

5.5 Conclusion on the 2002 Crisis

Concluding, the debt crisis of 2002 was set into motion by an ever increasing debt

load. Unlike the crisis in 1982 where interest rates had played a key role, the crisis in 2002

was caused by the debt itself and in the central bank's inability to correct for the

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Figure 15. Actual and Equilibrium REER (Perry & Serven 2003, p.18)

Figure 16. Sources of Cumulative Peso Overvaluation, 1997-2001 (Perry & Serven 2003, p.24)

overvaluation of the Peso under the currency peg, which only further increased its debt

burden. Like most developing countries, Argentina found new stability under the currency

peg as inflation returned to normal levels and growth began. As is typical for most middle-

income countries, Argentina followed procyclical capital flows, meaning they received

large inflows during boom times only to have them dry up during economic recessions.

This served to further enhance the bad times and make the good times look better.

Moreover, the money during the boom times was not used as a cushion and invested for

future growth, but instead it was used for consumption further increasing its vulnerability.

Because the Peso had been pegged to the dollar, arguably the wrong currency peg,

Argentine goods were not competitive enough to allow for the trade sector to grow. While

the trade sector itself is not responsible for the crisis of 2002, its lack of expansion meant

that Argentina couldn’t use it as a recovery mechanism. Furthermore, as the currency

became increasingly overvalued the government was limited in what mechanisms it could

use to correct the real exchange rate under the currency regime. This very currency regime

combined with the lack of continued confidence in the Peso saw debt held in USD grow to

over 70 percent. Making the only option of devaluing the currency less desirable.

Eventually, a prolonged economic recession caused bank runs as confidence

dwindled, forcing the country to abandon the peg and devalue its currency. Argentina

partially defaulted on its loan obligations of 100 billion dollars, the largest sovereign debt

default in history (Marsh et al. 2014). It began renegotiating the loan amounts and in the

last decade has seen a slight economic recovery driven by demand of its agricultural

products from Europe and China (Marsh et al. 2014).

6. The Debt Crisis of 2014

In the period following the debt crises of 2002, Marsh et al (2014) notes that

Argentina has seen some growth due to demand from China in large part from soy. At the

same time Marsh et al. cites that the government has continued unsound fiscal and

monetary policy that include expansion of social welfare programs, and the printing of new

money leading to high inflation rates once more. Many predict an economic contraction for

this year, though not as large as the one in 2002.

Unfortunately a court case in the United States have caused those fears to deepen.

Zarroli (2014) describes how following the financial crisis many hedge funds in the United

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States purchased Argentine bonds at a fraction of face value often for 15 to 20 cents on the

dollar. Zarolli points out that these funds generally specialise in distressed debt as they

stand to make large gains should they rebound. In total this case comes to 1.33 billion

dollars.

On June 16, 2014 the US Supreme court published that it will not hear the case

previously ruled by a New York Federal Judge that ordered the Argentine government to

pay back the debt, and that it must be paid before all other outstanding loans (Zarroli

2014). The Argentine government is especially worried because it might imply that another

15 billion dollars in loans would have to be repaid (LA Newsletters 2014). This threat

combined with the impending recession have increased fears of the beginning of another

financial crisis for Argentina as it is unable to pay for the debt from the past.

7. Closing Remarks

While each crisis was unique, all share the underlying principle in that the country

had too much debt and was no longer able to meet loan obligations. Under the first crisis,

had interest rates been fixed and loan amounts smaller, the crises may have been avoided,

as the debt burden would have been smaller in initial terms and it would not have grown so

large as interest rates increased. In the 1990’s Argentina was given large loans and when

the country faced economic catastrophe the IMF was quick to distribute another large loan

in 2001. In the end this only further increased the debt burden that now has come to the

forefront in 2014 after a brief moment of recovery. Had the lending banks in the US and

the IMF been more heavily regulated by tying prudential indicators more closely to loan

amounts and interest rates, these and other crises might have been avoided.

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Appendix

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Table A1. Argentina - Economic Indicators (IEO 2003, p.18)