Argentina Financial Crisis 1999-2002

The Argentine Crisis – A Report A Study of Macro-economic Factors

For the subject of Business Environment

Group No. 27 Abhineythri V. (PGP-10-094), Arpan Anand (PGP-10-106), Pradeep Tewani (PGP-10-145),

Shahji Chabbra (PGP-10-163), Shruti Parija (PGP-10-167), Vineet Nandan (PGP-10-178) PGDM 2010-12

SP Jain Institute of Management & Research, Mumbai

©Group 27: Abhineythri V., Arpan Anand, Pradeep Tewani, Shahji Chabbra, Shruti Parija, Vineet Nandan

The Argentine Crisis –A Report

1. History of the Argentine Economy

Argentina is the third largest economy in Latin America behind Brazil & Mexico. It was one of the world’s wealthiest countries in the early 20th century. It benefits from rich natural resources and highly literate population. It has an export oriented agricultural sector and a well diversified industrial base. But Argentina has had a series of fiscal, monetary and economic problems and faced political instability throughout its history. After it achieved freedom from Spain in 1810, the states of Argentina fought amongst themselves. There was no stable nationwide government till 1862. During 1891, Argentina suffered from a severe financial crisis, which was the biggest crisis which Argentina ever faced till that time. Then the 2 World Wars also hurt Argentina badly and hampered its growth, which was otherwise somewhat smooth in the first half of the 20th century and till 1975. Till early 1980s, Argentina also suffered from political problems with Military Junta snatching the power from the democratically elected governments time and again. However, wiping off of Military junta in 1983 and change of political regime in 1989 led to a prosperous period for the Argentine economy. It grew well from 1991 to 1998 only to face economic crisis, continual fiscal and current account deficits, high inflation, and escalating external debt and capital outflow during 1999 to 2002. Argentina came out of all the financial troubles by the end of 2002 before getting exposed to the worldwide recession in the last few years.

2. Introduction of the Argentine Crisis 1999-2002

The crisis began in 1999 when the Argentine economy started shrinking, i.e. the GDP

of the country started falling. It fell for three consecutive years till 2002, with the highest drop being about 15% in one single quarter in 2002. Besides that, Argentina also suffered from rapid depreciation of its currency, Peso. There was very high rate of inflation and increasing unemployment. The wage rates also fell drastically during this period, which led to further rise of poverty. At one point of time, there was a run on the banks and people had no trust in their economy. All these factors led to public unrest and there were riots as well. One of the factors which added fuel to the fire was the prolonged political instability in Argentina. The reasons for this crisis could be dated back to 1980s when the foundation was laid by the



increasing government debt and Latin America Debt crisis. All this came to an end after a few bold moves by the Argentine government in 2002 and the economy regained normalcy in 2003.

3. Road to Crisis

i. It all started in 1980’s

Between 1976 and 1983, Argentina was being ruled by a military government,

known as National Reorganization Process. During this period, the military junta relied on huge borrowings from abroad and that too, at high risk. However, these debts were not put to productive use. During their rein, Latin America faced a sever debt crisis as the debts raised by the three biggest economies of Latin America exceeded their earning power and they were not able to repay it. This put a lot of pressure on the three nations, including Argentina. Thus, the incomes dropped. Argentina was still trying to come out of the Latin America Debt crisis which had left it with huge foreign debts. Besides that, the Military control resulted in unresolved political pressures that led to government spending more than it could raise by taxation and borrowing from financial markets. Argentina replace Peso with Australes as its currency in 1983. Inflation was too much to handle in 1989 and thus as a remedy the closed market economy opened to privatization, deregulations, liberalization and tax cuts through the newly appointed President, Menem.

ii. Argentina’s Convertibility Law

In the late 1980’s, there was huge hyperinflation prevailing in the economy. People

had lost faith in their new currency, Australes. They started rejecting this currency and demanded payments in US Dollars. In order to combat this situation, the Argentina government introduced the Convertibility law in 1991 which pegged its currency Austral to US Dollars in the ratio of 10000 Australes per US Dollar. It enabled the citizens to go to a bank and convert any amount of domestic currency to dollars. Later on, Australes were replaced with Peso as the official currency of Argentina and it was pegged in the ratio of 1:1 with the American Dollar. This convertibility law had the following features:-



a) A fixed exchange rate with the anchor currency, i.e. US dollar b) Unrestricted convertibility between the domestic and the anchor currency c) Net reserves of at least 100% of the board’ monetary liabilities, i.e. the

government had to maintain a foreign reserve in dollars equal in amount to the money floating in the economy

This system led to acceptance of the domestic currency and thus, control on hyperinflation. This led to a bi-monetary system in which both the currencies became equally important and dollar denominated loans, bank deposits and transactions became widespread. Though, it had a flipside too. Since Argentina imports became pretty cheap, imports rose exorbitantly post 1991. Huge volume of dollars used to flow out of the economy. Therefore, in order to maintain a 100% foreign reserve ratio, the government had to raise foreign loans. This resulted in mounting government debts during the 1990’s.

4. Why did it all happen?

The Argentine Crisis of 1999 could be attributed to the following three main reasons:-

i. Devaluation of Brazilian Real and Fall in Exports

Following the financial crisis in most of Latin America and Russia, the entire world was in a state of low confidence on putting money in this part of the world. The period was also preceded by a crisis in Asia. This led to the fall in foreign investments in emerging economies of the world. Brazil which was a close trade partner with Argentina was deeply hit by this. Brazil plunged into economic stagnation and devalued its currency to get itself out of the crisis. The dollar was unusually strong. Since the Argentine Peso was pegged with dollar, it also started appreciating. This routed the exports from and investments into Argentina to Brazil. This made the products of Brazil cheaper than those of Argentina. The situation was further aggravated by the rising interest rates by banks in the country. Thus, the foreign world which used to import goods from Argentina shifted to Brazil for their requirements. So Argentina’s exports and foreign investments dried up. Since exports formed a major portion of their GDP, it affected the economically severely.

ii. Tax increase in 2000 and High level of Unemployment :

In 2000,when the economy started slowing down, the government opted to increase

taxes in all forms (tax on retirement benefits, asset tax, tax on salary and taxes on cars, beverages and tobacco).This was considered to be the only solution to curb the increasing



fiscal deficit. However, the decision reduced confidence in the economy and discouraged the growth of the private sector. Private companies raised the prices of the utilities very high, so inflation zoomed up. Since the exports went down due to devaluation of Brazil’s Real, the companies lost their business and had to cut their production, thus, were forced to lay off even more people. All this in unison led to huge job cuts in the private sector. Unemployment rates rose considerable leading to social unrest. The government changed and the new ministry imposed a financial transaction tax in mid 2001. This tax was a fee payable on every bank deposit or withdrawal and every sale of stock. This was again in the lines of increasing tax revenues. But instead of bringing in the projected revenues, it further reduced the confidence and discouraged growth. The government also introduced a bill to switch the exchange rate link of a peso-dollar to a peso- dollar and euro in a 50:50 combination. This brought in fear in the convertibility system which had been the base of the economy since 1989.

iii. Extensive Government Debt:

The Argentine government did extensive borrowing from foreign as well as domestic

sources. It was required to maintain the 1:1 ratio between Peso and Dollar. As explained above, the economic policies applied by the new government increased the interest rates in the country. This led to an increase in the risk perception/premium of its debts. The international bond rating agencies downgraded Argentina’s debt. The high level of debt pushed up the domestic interest rates. Due to this, the cost of borrowing shot up for the businesses. This high cost of funding forced many businesses to shut down, thus, impacting not only the GDP growth rate but also the levels of unemployment and poverty. The country was in a huge “debt trap” since at such high interest rates, the debts would surpass the repaying capacity of the economy.

Source: WallStreet Journal

Source: Stratfor Global Intelligence



5. Economic Indicators

The table below shows the key economic indicator for Argentina from 1989 to 2002.

This data will help in understanding the crisis better.

Economic indicators for Argentina: 1989-2002

Year GDP

(bn pesos)

Pesos per dollar

Real GDP growth%

Inflation: CPI (%)

Unemployment rate (%)

Poverty rate (%)

Average wage /hour

1989 3.24 0.18 -8.8 4,923.50 7.1 47.3 -1990 68.9 0.56 -3.7 1,343.90 6.3 33.7 11991 181 1 11.2 84 6 21.5 2.491992 227 1 10.5 17.5 7 17.8 3.181993 237 1 4.5 7.4 9.3 16.8 3.581994 257 1 4.4 3.9 12.1 19 3.771995 258 1 -4.1 1.6 16.6 24.8 3.91996 272 1 4.2 0.1 17.3 27.9 4.031997 293 1 6.7 0.3 13.7 26 4.071998 299 1 2.5 0.7 12.4 25.9 4.121999 284 1 -4.6 -1.8 13.8 26.7 4.162000 284 1 -1.7 -0.7 14.7 28.9 4.232001 269 1 -7 -1.5 18.3 38.3 4.292002 342 3.36 -10.8 41 23.6 57.5 4.6

6. What happened in those 3 years: 1999-2002?

Argentina faced many severe issues during

these 3 years, which aggravated the state of their economy. Here is a snapshot of what exactly happened during the crisis:-

i. Real gross domestic product (GDP) fell 28% from 1998 to 2002

ii. By 1999, GDP dropped 4% and the country entered a recession, which



lasted three years, ending in a collapse.

iii. Over estimation of tax revenues in 1999

iv. In Jan 2001, there was a “Run on Banks” and everyone wanted to withdraw their money from the banks in fear of currency deregulation and loss of value.

v. Government froze the accounts for 12 months and only minor withdrawals were allowed.

vi. Public anger and protest followed and resulted in huge public demonstrations and public unrest

vii. During the last week of 2001, the government defaulted on the larger part of the public debt of about 132 billion.

viii. Inflation reached to 41% in 2002. ix. Unemployment rose from 12 % in 1998 to 24% in 2002. x. Poverty rate rose from 26% in 1998 to 58% in 2002

xi. In real terms (adjusted for inflation), wages fell 23.7% in 2002

7. The Recovery

Argentina had to take some really harsh steps to come out of the crisis. Inflation and

growing government debt was the main concern for the government. The best way out of this troubled situation was to deregulate the currency. Following are the steps which the government took in order to retain normalcy in the economy:-

i. Deregulation of currency and end of convertibility

In January 2002, the Argentine government abandoned the 1-to-1 peso dollar parity

which was in effect for more than a decade. This was a very tough decision for the government since it had many drawbacks in the short run, though the plan was sure to succeed in the long run. Initially, the government did not leave the currency at the mercy of the unregulated market completely and set a provisional exchange rate at 1.4 pesos per dollar. Apart from this, the government also asked banks to seize all the dollar denominated savings accounts and



convert them into domestic currency accounts. This move angered the citizens but the government didn’t pull back the measures. After a few months, the currency was left to float freely. Peso depreciated to 4 Peso per dollar.

ii. Increase in exports and reduction in imports

Since Peso depreciated, Argentine goods became cheaper for the outside world. This

boosted the exports. At the same time, imports became much costlier and the citizens preferred domestic goods to imported goods. This helped the governments cause in more ways than one. This resulted in increase in domestic production, thus, a decrease in unemployment and poverty levels.

iii. Supportive Government Policies

The government introduced a lot of measures to boost the domestic economy. Apart

from encouraging import substitution, i.e. encouraging people to consume local goods than foreign ones, it also made easy credit available to the businesses. The government set aside funds for social welfare. It also made new provisions to improve tax collection mechanism. Besides all this, the government controlled its expenditure in the other fields. The government also set up controls to avoid short term speculative foreign investments from entering into the economy.

iv. Administration of Currency Revaluation

Deregulation of Peso resulted in healthy imports, and thus, inflow of dollars into the

economy. Also, the image of Argentina improved in the international markets and huge amounts of investments started pouring in into the economy. Since the imports were costly, this inflow of dollar remained in the economy, thus, resulting in depreciation of dollar and corresponding appreciation in Peso, with the exchange rate reaching 3 pesos to a dollar. At this point, the government entered into the picture and started buying dollars from the market and adding it to the forex reserves. This led to huge amount of Pesos entering into the market which could have led to inflation. To avoid this, the government issued bonds to suck out liquidity from the markets. This process was very much similar to what happens under the Market Stabilization Scheme (MSS) in India.

v. Reviving World Economy

One positive factor that helped Argentina come out clean was the timing of the crisis

itself. The government’s efforts in reviving the economy were aided by the global economic upturn around the period that fuelled a boom in oil, metals and food which helped Argentine exports.



8. What Happened Thereafter

After all the steps taken by the government, the third largest economy in Latin

America sailed out of the troubled waters. Following are the results of the processes that took place between 1999 and 2002:-

i. Return of Growth:

The GDP jumped 8.8% in 2003, 9.0% in 2004, 9.2% in 2005, 8.5% in 2006 and 8.7% in 2007. The average wages have increased 17% annually since 2002.

ii. Repayment of IMF loans

In 2005, Argentina shifted to a policy of “Indebtedness” towards IMF and decided to

repay total amount of loan in order to achieve independence from the restrictions IMF started imposing lately. On Dec 15, 2005, Argentina paid its entire debt of 9.8 billion USD to IMF through its foreign currency reserves, although the payment was due in 2008

iii. Debt Restructuring

By 2005, 76% of the defaulted bonds were exchanged by others, of a much lower

nominal value (25–35% of the original) and at longer terms. The government enjoyed triple benefits of this restructuring. The face value of the bonds and the interest rate (coupon) were reduced, thus, reducing the interest burden of the government. Also the maturity period of the new bonds was longer which gave the government a long buffer period.

9. IMF’s Criticism

The International Monetary Fund was severely criticized for

some of the steps it took in tackling the Argentine crisis. Following are the criticisms it faced:-

i. IMF sanctioned a loan to Argentina in March 2000 and again extended it in August. Many experts criticized IMF stating that such sanctions will further delay the much needed economic reforms from the Argentina government.

ii. IMF showed a very soft stance initially towards Argentina. Whenever IMF grants loan to a country, it enforces some control on the



fiscal policy of that country. In case of Argentina, it didn’t force Argentina to go for debt restructuring at an earlier stage or make changes in Fiscal policies.

iii. The authorities of the IMF at times expressed harsh criticism of the discounts and actively lobbied for the private creditors, although IMF suffered no discounts in its part of Argentine Debt.

10. Concerns still prevailing in Argentine Economy:

i. High rate of inflation:

There is a discrepancy between official estimates and by private Economists. The

official rates stand at 7.7% (2009 estimated) and 8.6% (2008 estimated). These official estimates lack credibility as many non official estimates claim inflation to be as high as 22% in 2008.

ii. Unemployment:

Although Unemployment has been brought down but it still hovered around 8.7% in

2009 (estimated) which is still a cause for concern. In 2008, it stood at 7.9% (estimated). These figures are based on private estimates. Official estimates put unemployment at 8.4% in 2009, and 7.3% in 2008, but the official figures lack credibility.

iii. Unequal Distribution of wealth:

There is a very uneven distribution of wealth in Argentina. The wealthiest 10% of the

population receives 31 times more income than the poorest 10%. The lowest 10% share 1.2% of the total income and the people in the highest 10% bracket share 32.6% among themselves. The figures are for the year 2009.

11. Conclusion

The Argentine was a classic example of monetary and fiscal policies going haywire

and pushing the economy into a deep crisis. It enjoyed the short term benefits of the fixed currency rate regime which it adopted in 1991 but failed to foresee the long term drawbacks of the policy. The political instability added fuel to the fire. Frequent changes in the government made it tougher for the economy to pull itself out, especially when every



subsequent government had major differences in ideologies and policies. It took strict actions on the part of the government to bring the nation back on track. Experts say that Greece also committed some similar mistakes and is in a huge crisis today. Again, the international institutions had to come to rescue Greece. It’s high time when economies learnt from each other’s mistake and make decisions cautiously.

© Group 27 | PGDM 2010-2012

SP Jain Institute of Management & Research

Bhavan’s Campus | Andheri (W) | Mumbai | India

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Argentina Financial Crisis 1999-2002

Economy & Finance