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IESG: Argentina ECONOMIC REFORM & THE RECENT CRISIS IN ARGENTINA The Function of Dollarisation Economic Reform under Alfonsin & Menem The Impact of the Currency Board The December 2001 Crisis Where To Now? IESG: Argentina THE FUNCTION OF DOLLARISATION Eichengreen in the Journal of Money Credit & Banking (2002) discusses credibility and the sequencing of reform and Dollarisation: Ecuador – Dollarisation then reform. Recognition that dollarisation necessary for domestic reform to be credible. Argentina – reform then effective dollarisation. Use of exchange rate link to ‘lock-in initial reforms. IESG: Argentina ECONOMIC REFORM UNDER ALFONSIN & MEMEM Democracy was restored in 1986 with the election of Radical President Raul Alfonsin after a decade of political repression and economic dislocation including rampant hyperinflation and stagnant economic growth. Alfonsin initiated limited structural reform and attempted to end hyperinflation. Much of the reform programme was undermined or blocked by the Peronists. The failure of Alfonsin’s reforms led to the election of Peronist Carlos Menem in 1990 (and 1994). It was Menem who (unexpectedly) implemented significant and far-reaching structural reforms: IESG: Argentina ECONOMIC REFORM UNDER MENEM Cuts in Federal/State expenditure and transferring control of the money supply to the Central Bank. Significant trade liberalisation, including major tariff cuts and the removal of import quotas and export taxes. Exchange rate reform to introduce currency stability. Argentina had 3 different currencies 1976-1990. The Peso was ‘dollarised’, supported by a currency board. Extensive state ownership (federal and provincial) of enterprises and military firms were privatised to cut subsidies and raise revenues. The deregulation of the labour market through the reform of contract laws so as to increase labour market flexibility. The removal of price controls, including wage indexation. IESG: Argentina THE ARGENTINIAN CURRENCY BOARD The Argentinian Peso was linked to the US Dollar at par value (1:1) from 1991 until December 2001 via a currency board. This was effective (rather than actual) Dollarisation with the domestic Peso money supply restricted to the level of hard currency reserves. Ecuador did Dollarise in 1999. IESG: Argentina DOLLARISATION OF THE ARGENTINIAN PESO Dollarisation is the substitution of a hard currency usually the $US - for a weak domestic one with the objective of restoring economic stability and credibility. It has several important effects: Strict control of the money supply (backed by reserves). The elimination of hyperinflation. The significant reduction in the risk of exchange rate devaluation. Interest rates determined by the US Federal Reserve (plus a risk premium). IESG: Argentina ARGENTINA’S ECONOMIC PERFORMANCE 1991-98 The Argentinian economy enjoyed good growth between 1991 and 1998, averaging 6.2% - the strongest in Latin America. The only poor year being 1995 when the economy was affected by contagion from the Mexican Tequila Crisis. This was accompanied by a significant growth in exports, from $12bn to $27bn. This would have been even greater in the absence of agricultural protectionism in the US and EU (grains and beef). The continued return of capital held abroad (capital flight) together with new inflows of international capital (FDI and portfolio) stimulated domestic investment. Funds invested in equities, new ventures and recent privatisation offerings. IESG: Argentina THE IMPACT OF THE $US LINK The Appreciation of the $US The link with the $US came at the beginning of the long economic boom of the 1990s – strong appreciation against all international currencies. US Productivity Growth US productivity also grew substantially, requiring Argentina to cut prices significantly to maintain its competitiveness in $US (as well as other currencies). IESG: Argentina OTHER EVENTS IN LATIN AMERICA The Mexican Tequila Crisis Mexico’s crisis and devaluation 1995 had contagion effects as foreign investors (temporarily) withdrew their funds from Latin America, including Argentina. This led to a sharp fall in growth (-2.8%) in 1995, the collapse of several banks and greater domestic financial regulation. The 1999 Brazilian Devaluation From 1991, Argentina a member of Mercosur, the South American common market, together with Brazil and Uruguay (now also Paraguay). In January 1999, Brazil devalued the Real by more than 40%, making many of Argentina’s exports uncompetitive over night. As Argentina’s largest trade partner, this exacerbated the impact of the Dollar appreciation. IESG: Argentina THE INTERNAL IMPACT OF THE $US LINK Declining Competitiveness & Deflation The international strength of the US Dollar reduced the competitiveness of Argentina’s exports in its major markets (except the US), exacerbated by the Brazilian devaluation. Because of the $US link, this loss of competitiveness could only be rectified through deflationary price cuts – prices fell by 16.4%, November 94 to September 01. High Real Interest Rates Nominal interest rates were low because of the $US link but falling prices led to higher real interest rates, choking-off new investment. Declining Growth Argentina moved into recession in late 1998 as a result of faltering exports, deflation, high real interest rates and falling investment. Growth in 2001 is estimated at -5% or worse and possibly the same for 2002. IESG: Argentina WHAT PRECIPITATED ARGENTINA’S CRISIS? The trigger for the crisis was the limits imposed on bank withdrawals on 1 December of $1,000 a month. This created a liquidity crisis starving the economy of cash. The limit aimed to prevent a banking collapse after $8bn was withdrawn between July and November. In turn, the run on the banks was caused by Economics Minister Domingo Cavallo’s attempts to finance the financial deficit, having sacked the Governor of the Central Bank. The rigidity of the $US link left few policy instruments available to deal with the problems of deflation, rising unemployment, high interest rates and excessive Government expenditure. IESG: Argentina WHERE TO NOW? Problem of incomplete reform rather than the failure of reform. Restructuring the global financial architecture (IMF). Use of Tobin taxes a la Chile