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TheArgentinebankingcrisesof1995and2001:Anexplorationinto theroleofmacro-prudentialregulations. PabloGuidotti UniversidadTorcuatoDiTella and JuanPabloNicolini FederalReserveBankofMinneapolis Firstdraft,May20th,2016 Abstract ThispaperdealswithtwobankingcrisesthattookplaceinArgentinain1995andin2001,when theeconomywasfunctioningunderafixed-exchangerateregimecalledConvertibility.Thetwo crisistookplaceinadecadeofsignificantreformsinthemacro-prudentialframework.The experiencewascontrasting.Whilethe1995bankingcrisiswasvirulentbutwassuccessfully containedbythepolicyresponse,thebankingsystemcouldnotescapetheeffectsofthe2001 macroeconomiccrisis,eventuallyleadingtodefaultandtheabandonmentofConvertibility.We focusonthemacro-prudentialregulationsputinplace,onthecrisisresponsebythecentralbank, andonsomeimportantinstitutionalreformsdesignedtoresolvemoreefficientlybanking problems.Weanalyzethedynamicsofcrisesand,inparticular,thebehaviorofdepositors,aswell astheeffectsthatthecrisesandtheregulatoryframeworkhadontheevolutionoftheArgentine bankingsystem.Finally,wedwellonwhatadditionalreformsandprudentialregulationscould havepreventedthe2001outcome. 1 Introduction Foralongtime,Argentinahasbeenacasestudyforeconomists.Fordecadesitseconomywas characterizedbystagnation,volatility,fiscalindisciplineandhighinflation,oftengroundedin chronicpoliticalinstability.Asaresult,acountryrichinnaturalresourcesandwidelyperceived withthepotentialofprovidingitscitizenswithahighlivingstandardfellbehindexpectations. In1991,withtheimplementationofConvertibility,historyappearedtochangeasArgentina embarkedinanambitiousreformprogramwhiletacklinginflationheadonanchoredonaquasi currencyboardsystem.Optimismalsocoincidedwiththeadventofglobalizationandasurgeof capitalflowstoemergingmarketeconomies. Argentina’seconomicperformanceduringmostofthe1990swasindeedimpressiveonanumber offronts.Inparticular,theConvertibilityregimewasabletowithstandsuccessfullyasevere bankingcrisisthatoccurredatthebeginningof1995,followingtheMexicandevaluationof December1994.AsanexampleofthehighregardArgentina’sreformsweregeneratinginthe internationalcapitalmarketaswellasintheinternationalofficialcommunity,ontheoccasionof theAnnualMeetingsoftheIMFinOctober1998,theIMF’sManagingDirectorMichelCamdessus described“theexperienceofArgentinainrecentyears”as“exemplary”andstated“Argentinahas astorytotelltheworld:astorywhichisabouttheimportanceoffiscaldiscipline,ofstructural change,andofmonetarypolicyrigorouslymaintained.”1 However,asisbynowwell-known,thestoryhadasourending;Argentinamanagedtobacktrack oncemoreandfellintoaseverecrisisattheendof2001andthebeginningof2002.Thatcrisis wascharacterizedbyatrilogy:defaultonthepublicdebt,currencydevaluation,andmandatory conversionofforeign-currencycontractsintopesos(“pesification”).Thetrilogyslashedthenewly acquiredcredibilityandseriouslydisruptedtheruleoflaw. Inthispaper,wefocusmainlyononeaspectofthereformprocesscarriesoutin1990s,thatof bankingandmacro-prudentialregulation.Althoughtheevolutionofthebankingsystemcannot beentirelydisentangledfromtherestofthemacroeconomy,thereareimportantlessonsthatcan belearnedfromthereformsundertakenaswellasfromthosethatwerenotputinplace.In reviewingthefactsaroundthe1995and2001bankingcrises,weanalyzetheinteractionbetween theprudentialregulationputinplace,thebehaviorofdepositors,thestructureofthebanking sector,andthemacroeconomicpolicyresponse,withparticularemphasisontheroleofthe centralbank. Thepaperisorganizedasfollows.Insection1wesetouttheinitialconditionsthatthe Convertibilityplanof1991encountered.Insection2,wediscusstheregulatoryandsupervisory reformsadoptedintheearly1990s,aswellastheevolutionoftheArgentinefinancialsystemuntil theendof1994whenthesuddendevaluationoftheMexicanPesowouldsetinmotionthefirst episodeoffinancialcontagionthatwouldmarkemergingmarketsinthesecondhalfofthe1990s. Section3analyzesthe1995bankingcrisis,anddiscussestheroleoftheregulatoryframeworkin 1 Seethe“ReportontheEvaluationoftheRoleoftheIMFinArgentina,1991-2001”,issuedbytheIMF’sIndependent EvaluationOfficeonJuly2004. 2 place,andthepolicyresponsethatmadeitpossibletosuccessfullyovercomeavirulentbanking runwithlittlefiscalcosts.Thesectiondiscussesthebehaviorofdepositors.Theevidencesuggests thatthe1995crisisreflectedmainlyinternalweaknessesofthefinancialsystemanditwas overcomebyanefficientpolicyresponsethatdidnotendangeredmacroeconomicstability.In section4wefocusonthelessonsofthe1995crisisandontheregulatorychangesthatwereputin placeasaresult.Weshowthatthe1995crisis,combinedwiththechangesinmacroprudential regulations,hadasignificantimpactonthestructureoftheArgentinebankingsystem.The financialsystembecamemoreresilient,bothintermsofcapitalizationandliquidity.However,as section5discusses,thatgainedstrengthwouldbeseriouslytestedin2001.The2001crisis exemplifiesthat,nomatterhowstrongabankingsystemis,iteventuallycannotsurviveafullblownmacroeconomiccrisis.Thedifferencesbetweenthebehaviorofdepositorsin2001as comparedto1995arestriking. Insections6and7,wedealwiththequestionofwhatmacroprudentialregulationswouldhave helpedtomitigatethe2001/2002crisisoutcome.Inparticular,withthebenefitofhindsight,we trytoanswerthedifficultquestionofwhetherthe2001/2002crisiscouldhavebeenavoidedwith additionalordifferentmacro-prudentialregulations,anddiscussalternativecoursesofactionthat wereavailabletothegovernmentinordertoavoidormitigatethecrisis.Section8concludes. 3 1. Background.Fromhyperinflationtopricestability:theConvertibilityplanof1991. EversincepermanentlyabandoningthegoldstandardaftertheGreatDepression,theArgentine economyexhibitedchronicallyhighinflationrelativetotheUSorEurope.Butextremelyhigh inflationbecameadailyexperienceforArgentineansstartingin1975.Indeed,whiletheaverage yearlyinflationratefrom1960to1974wasaround30%andneverexceeded50%,itwas,on average315%from1975to1991anditreachedamaximumofalmost5000%in1989. Thetechnicalexplanationofthis,asafirstapproximation,isrelativelysimple.Duringthatdecade andahalf,thegovernmenthadrunsustainedandchronicdeficitsthatweremostlyfinancedby moneycreationfromthecentralbank.ThedeficitoverGDPwasonaveragearound7%,witha minimumof2%andamaximumof12%.Inaddition,startingintheearly80´s,thegovernment defaultedonitsdebtanddidnotsettledonanagreementtilltheearly90´s,sotherewasno accesstothecreditmarkettofinancethedeficits.Moneyfinancingwastheonlyavailable alternative.ThereasonwhyArgentinacouldnotmakeafiscalreformandavoidinflationisa deeperquestion,beyondthescopeofthispaper. Asaconsequence,atthebeginningofthe90´sitwasclearwhichbulletwasatthetopofthe agenda:endinginflation.Itmayevenbemoreaccuratetosaythattheagendahadonlythatone bullet.Foravarietyofreasons,themonetaryregimethatwaschosentoendinflationatthetime involvedacurrencyboardthatpeggedthepeso-thelocalcurrency-totheU$dollaratarateof one.ThismonetarystrategywasapprovedbyCongresswhopassedthe“Convertibility”law.The nameofthelaweventuallybecamethebrandnametheeconomicprogramwasgiven. Thecurrencyboardimplied,uptosomelimitedexceptionswewillmentionbelow,thatthecentral bankcouldprintlocalcurrencyonlytoaccumulatereserves,soitwasmakingmoneyfinancingof thedeficitillegal.Thefinancialrelationshipbetweenthetreasuryandthecentralbankwere limitedstrictlytothepurchaseofbonds,markedtomarket,withatightlimit—setinnominal terms—tothegrowthofgovernmentbondsholdingsbythecentralbank.Asabyproduct,the centralbankwasbannedfromissuingitsowndebt. Themainshort-runchallengeforeconomicpolicywasonthefiscalfront:Sinceborrowingwasnot analternativethenewregimewasonlyconsistentwithaneliminationofthefiscaldeficit.Thiswas effectivelywhathappened,with1992and1993witnessingfiscalsurpluses.Then,aBradyplanwas agreedupon,sothegovernmentcouldthenstartfloatingbondsininternationalmarketsand financedthepositivebutsmalldeficitsthatensuedstartingin1994. Theprogramwasremarkablysuccessful:In1992theyearlyinflationratewas17%,andby1994it hadconvergedfrom1993to2001itwasalwaysbelow3%.Itisreasonabletoconjecturethatthe inflexibilityoftheConvertibilityplanwasanimportantcomponenttofostercredibilityonthe currencypegitselfandonthefiscaladjustmentrequiredtomakeitsustainable. Buttheinflexibilitycamewithacost:Byremovingtheabilitytodiscretionallylendtothebanking sectoritrestrictedseverelythelender-of-last-resortcapabilitiesoftheArgentineancentralbank makingitsfinancialsectorpotentiallymorevulnerabletobankruns. 4 Intheory,onecouldimaginethatrestrictionnottobeveryimportant,sincethefiscalauthority couldeventuallyborrow(say,inUSdollars)andusethoseresourcestolendtothecentralbank. ButitisimportanttorememberthattheGovernmentlaunchedtheprogramwhilestillbeingin defaultininternationalmarketsandcomingoutoftwodecadesofchronicdeficits.Thus,neither monetarynorfiscalmeasureswereavailabletoactasalenderoflastresort.Thiswasacriticaland wellacknowledgedpotentialshortcomingtheConvertibilityplanhadsinceitsinception.Itexplains manyofthefeaturesofthebankinglegislationputintoplacerightaftertheConvertibilitylaw. Thelongperiodofveryhighandunstableinflationduringthe80´shadperverseeffectsonthe functioningofthefinancialsector.Withveryhighandextremelyvolatileinflationrates,the bankingsectorcouldbarelyfunctionasanintermediarybetweensavings,thatwerelow,and investment,thatwasevenlower.Itmostlyofferedtransactionalservices.Asaconsequence,total liabilitiesofthebankingsectorwereverylow.InFigure1,wepresenttheevolutionoftotal Figure1:TotalLiabilitiesoftheBankingSector 600 500 TotalLiabiliHesoftheBankingSectorin1982MillionU$ 400 300 200 0 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 100 liabilities(inmillionsof1982USdollars)since1982.Asitcanbeseen,thenumbersareverysmall until1991,theyearinwhichaperiodofspectaculargrowthstarts.Inaddition,duringthe80´s,the reserverequirementontotaldepositswasveryhigh,gettingtoover90%insomeyears.These reservespaidinterestrates.Thismechanismwasyetanotherdistortioncreatedbythefiscal voracityofthegovernmentthatneededfinancingandthereforeusedthebankingsystemasan intermediarybetweendepositorsandthegovernment. Tosummarize,then,duringthe80´s,thebankingsectorwasverysmall,issuingdepositsthat mostlyservedtransactionalpurposes(thematurityofthemajorityofthesedepositswasjusta weekduringmanyyears)andusingthosedepositsmostlytofinancethegovernmentthrough mandatoryremuneratedreserves. Thesearetheinitialconditionsofthebankingsectorthatweanalyzeinthispaper.Thisbanking sectorgrewinasystemwithalimitedlenderoflastresortandwasthereforemoreexposedto bankingpanicsthanmostbankingsectoroftheworldatthetime.Twobankingcrisisensued,as 5 wewillexplainandanalyzeindetailbelow,onein1995theotherin2001.Thosecaneasilybe identifiedinFigure1. 2. Thebankingreformsoftheearly90’sandtheevolutionofthebankingsectortill1994. TheveryrapidsuccesstheConvertibilityplanhadinreducinginflationtoUSlevelsandtheensuing reductioninnominaluncertaintychangedthebusinessmodelforbanks.Newsavinginstruments werecreatedandcredittothedomesticmarketstartedtodevelopasFigure1clearlyshows.At thesametime,thesigningoftheBradyPlanin1993endedtheexternaldebtcrisisthatstartedin 1982andopenedfortheArgentineeconomytheopportunitytoinitiateaprocessofintegrationto the international capital market, and carry on major economic reforms that would produce a significanttransformationinthefunctioningofthebankingsystemanditsregulatoryframework. From a macroeconomic perspective, the sharp reduction—and eventually the elimination—of inflation,alargeincreaseincapitalinflowsandforeigndirectinvestment,andthestrengthening of fiscal policies represent significant achievements for emerging market economies in the first halfofthe90s.2 AsFigure1intheprevioussectionmakesclearthefinancialsystemwasextremelysmallatthe beginningofthe1990sinArgentinaand,followingthemacroeconomicstabilization,it experiencedastrongexpansion.Betweenend-1991andend-1994,depositsincreasedby173% andmorethandoubledaspercentageofGDP.Suchexpansionwouldcontinueatsimilarpacein thesecondhalfofthe90s. Aswementionedabove,amajorpolicyrestrictionfacedbythefinancialsectorwasthevery limitedabilityoftheCentralBanktooperateasalenderoflastresort.Butthereweretwo additionalconcernsthatwererelevantinthiscase. First,asinothercountriesoftheregion,oneofthesalientfeaturesoftheArgentinebanking systemwasitshighlevelofdollarization,onbothsidesofthebalancesheet.3Theshareofdollardenominateddepositsandcreditincreasedsystematicallysincethebeginningofthe1990s.Bythe endof1994,theshareofdepositsandcreditthatwasdollar-denominatedstoodabove55%and above60%,respectively.AscanbeseeninFigure2,dollarizationcontinuedtoincreaseduringthe entiredecade.Itmustbenotedthat,whiledollarizationseemedanaturalresultofthe ConvertibilityregimethatencouragedtheperceptionthatapesohadbecomeequivalenttoaUS dollar,dollarizationposedasignificantbankingrisk.Suchriskderivedfromthefactthatalarge portionofcredit,althoughdenominatedinUSdollars,wasowedbyfirmsandconsumerswhose incomewasdenominatedinpesos,hencegeneratingapotentiallydangerousmismatchinthe eventofalargedevaluation.Aswewillseethiswasacrucialprobleminthemidstofthe20012002crisis. 2 See,forinstance,Guidotti(2007). Guidotti and Rodríguez (1992) and Calvo and Végh (1992) analyze the phenomenon of dollarization in developing countries. 3 6 Figure2.DollarizationoftheFinancialSystem(in%) 75% DollarizaHon 70% 65% 60% CreditDollarizakon 55% DepositsDollarizakon 50% 45% Source:CentralBankofArgentina Second,theArgentinebankingsectorhadinheritedanumberandsizedistributionofinstitutions thatgrewoutofthebankingcrisisof1982.Attheendofthe1970s,Argentinahadexperienceda shortperiodoffinancialderegulation,albeitwithweakbankingsupervision,inwhichthenumber ofbankshadexploded(therewere469institutionsin1980,ofwhich255werenon-banks).After thebankingcrisisof1982(seeFigure1)mostofthenon-banksdisappeared,andasmallerbanking systemevolvedduringtheyearsofhighestinflationrates,mostlyprovidingservicestodefend againsttheerosioninthevalueofmeansofpayments. Thetransformationhadbeensubstantialby1991(therewere212institutionsthen,ofwhichonly 45werenon-banks).However,itwasverynaturaltoexpectthat,inspiteofthedramaticgrowth ofthesector,amajortransformationinthenumberandsizedistributionofinstitutionswouldtake place.Indeed,thisinitialcompositionwouldsufferdramaticchangesduringthe1990s,asthenew regulatoryenvironmentputinplacestartingin1993,andthe1995bankingcrisiswewillanalyzein thenextsection,inducedasignificantfurtherconsolidationoftheArgentinefinancialsystem:By end-2000,therewere90banksinthesystem,andonly19non-banks. Thiswasthescenariofacedbypolicyandregulatoryinstitutionsintheearlyquartersofwhat seemed,atthetime,theperiodinwhichArgentinawouldpermanentlyleavebehinddecadesof instabilityandstagnation. Followingthe1992passingbyCongressofanewcentralbankcharter,Argentinainitiatedawiderangingreformofbankingregulationandsupervision,adaptingtointernationalstandardsbutalso recognizingtheparticularconstraintsimposedbyConvertibilityandthenewmacroeconomicrisks derivingfromthecountry’sincreasingintegrationtoavolatileinternationalcapitalmarket.The newcentralbankchartercontainedsomeimportantlimitations:1)itdidnotprovidefordeposit 7 insurance,althoughdepositswerelegallyrecognizedasseniorclaimsonassets,and2)thelenderof-lastresortfunctionofthecentralbankwasverylimited,initiallysettoamaximumof20%of themonetarybase—latertoincreaseto33%.Furthermore,thecentralbankwasprohibitedfrom issuingdebt,payinginterestonbankreserves,andwasseverelylimitedinitscapacityofproviding financingtotheArgentinetreasury. Inlightofitsnewcharter,theArgentinecentralbankintroducedimportantchangestothebank regulatoryandsupervisorysystembetween1993and1994.4Thefirststepwastodismantlea tightapparatusofforeignexchangeandcapitalcontrolsthathadbeeninplaceduringthe1980s. Suchapparatushaddivertedthesupervisoryresourcesofthecentralbankawayfromthe assessmentandpreventionofbankingandsystemicriskstowardscontrollingthatindividuals, firms,andfinancialinstitutionsfullycompliedwiththevagariesofacomplexadministrative systemofcapitalandexchangerestrictions.Therefore,thecentralbankhadtocarryoutan overhaulingofitsbankingsupervision,hirenewandprofessionallycompetentstaff,andtrainitto adequatelymeetthechallengesstemmingfromtheadoptionofinternationalstandardsinbanking regulation.Suchprocesswascarriedoutwithaspecialassistanceprogramthatthecentralbank setupwiththeUSOfficeoftheComptrolleroftheCurrency(OCC)andtheFederalReserveBank ofNewYork(FRBNY)toprovidetrainingforseniorsupervisorystaffandassistintheadoptionof theCAMELratingsystemforfinancialinstitutions.5 Asregardsregulation,Argentinaadoptedthemaininternationalprudentialstandards, summarizedinthefollowingfivepillars:1)consolidatedbankingsupervision;2)capital requirementsemergingfromthe1988BaselAccord;3)regulationsregardingassessmentofcredit riskandprovisioning;4)limitsonriskconcentration;and5)standardsregardingtransactionsand relationswithrelatedorconnectedparties. Althoughbasedoninternationalstandards,theregulatoryframeworkhadtobeadaptedtothe limitationsimposedbytheabovementionedinitialconditionsoftheArgentineeconomy.In particular,acapitalrequirementof11.5%ofrisk-basedassetswasadopted,avalueabovethe Baselparametersofthetime.Moreover,relativelyhigh(non-remunerated)reserverequirements wereimposedonbanksinrecognitionofthefactthatthecentralbank’slimitedabilitytoactasa lenderoflastresortneededtobecomplementedbynon-encumberedliquidityatbanks.A reserverequirementof43%wasimposedonovernightdeposits—i.e.,depositsatcheckingand savingsaccounts—whilesignificantlyloweranddeclining-according-to-maturityrequirements wereimposedontimedeposits.Therationaleforsuchstructurereflectedaninterestonthepart ofthecentralbanktocreateincentivestolengthenthematurityoftimedeposits,whichwasthen largelyconcentratedat7days. Thefactofthematteristhattheincentivesimbeddedintheabovementionedstructureofreserve requirementsdidnotwork,andthematurityoftimedepositsdidnotlengthen.Asaresult,the 4 See Dujovne y Guidotti (2001) for a detailed analysis of the prudential regulation put in place in the 90s. Various aspectsofbankingregulationandsupervisionarealsodiscussedinGuidotti(1996). 5 CAMELisanacronymthatstandsforCapital,Assetquality,Management,Earnings,andLiquidity,asfiveessentialareas ofevaluationofbankingrisk. 8 centralbankadoptedin1994arelativelyunorthodoxmeasuretoreduceliquidityrisk:itimposeda minimum30-daysmaturityontimedeposits,theonlyinterest-bearingdeposits.Therationalefor suchrestrictionreflectedacoordinationproblem.Nobank,orforthatmatternodepositor,felt confortableinchoosingalongermaturityfortheirdepositsaslongaseverybodyelsestayedata shortermaturity.Simply,theydidn’twanttobelastinlineintheeventofabankrun.Hence,the centralbankactionhadtheeffectofreducingsystemicliquidityriskwithoutaffectingthe individualliquidityriskperception.Infact,depositinterestratesremainedunchangedafterthe adoptionofsuchmeasure,indicatingthatnoadditionalliquiditypremiumhadtobepaidasresult ofthemandatorymaturityextension.Lengtheningmanumilitarythematurityoftimedeposits fromeffectively7daysto30daysprovedenormouslyusefulincontainingtheliquidityeffectsof the1995bankingcrisis,asitslowedbyfourtimesthepaceofthedepositsdrainage. Amongothercomplementaryactionstaken,itisworthmentioningthatalldifferentialtreatment as regards banking regulations between foreign and domestic banks were removed, and the central bank initiated with the OCC a program of joint inspections of branches of US banks in Argentina. Theabove-mentionedreforms,althoughquiterevolutionaryforLatinAmericaatthetime,were stilllargelyatanearlystageofimplementationwhentheso-calledTequilacrisiserupted,following theDecember1994devaluationoftheMexicanPeso.Asthenextsectiondiscusses,the1995 TequilacrisistestedConvertibilityandallthereformsthatweretakingplaceattheprudential regulatoryandsupervisorylevel. 3. Thecrisisof1995andthechangesinregulationduringthecrisis.Keyelementsthatexplain thequickresolutionofthecrisis. FollowingtheMexicandevaluationoccurredattheendofDecember1994,theArgentinebanking systemexperiencedaprofound,buteventuallyrelativelyshort-livedbankingcrisis.Althoughwe willprovidesomeempiricalevidencethathelpsdisentanglingtheextenttowhichthebanking crisisreflectedgeneralmacroeconomicfactorsorreflectedinternalfactorstothefinancialsystem, itsmostimmediatemanifestationwasthesuddenappearanceofrumorsinthesystemthatafew wholesale(investment)bankswerehighlyexposedtogovernmentbonds—whosepriceswere rapidlydecliningbecauseofcontagion—andthatheavylosseswerebeenhiddeninconnected offshorecompanies.6Theseoffshorecompanieswereunknowntothecentralbankinspiteofthe consolidatedsupervisionprinciplethatwasbeingadoptedinthenewregulation,simplybecauseit tooksometimetohaveallfinancialinstitutionstocomplywithit. Forthemost,wholesalebanksweresmallinstitutionshardlyassociatedwithsystemicrisk.But soonenough,interestratesintheinterbankmarket,whichhadincreasedsignificantlyjustafter theMexicandevaluation,collapsed.Themosttypicalindicatorofsystemicliquidityriskhad stoppedtransmittingtherelevantinformation,asitbecameevidentthattheamountof transactionsinthatmarkethadcollapsed—thelendingvolumeintheinterbankmarketfellbyover 6 Attheendof1994therewere34wholesalebanksinthesystem,outofatotalof135privatebanks.Wholesalebanks had very few branches in comparison with retail banks and, hence, represented a small proportion of total bank deposits. 9 50%--indicatingthatthemarkethadfrozeninresponsetoasharpincreaseincounterpartyrisk. Wholesalebankswerebeingrationedoutoftheinterbankmarketandhadnoaccesstoliquidity. Soonafter,stillinearlyJanuary,thefirstindicationsofheavydepositlossesstartedtobecome evident.Depositsfleeingwholesalebankswerenotfromsmallinvestorsbut,rather,fromlarge andmoreinformedinvestors,aswellasotherfromfinancialinstitutionsthathadfundedthe operationsofwholesalebanks.AsshowninFigure3,atthebeginningofthecrisis,wholesale banksstartedfacingseverelosseswhiletherestofthebankingsystemappearedlargely unaffected. Inwasonlyamatteroftimeforpanictostartspreadingfromwholesalebankstoothersmalland medium-sizebanksofdomesticcapital.AsshowninFigure3,depositorsclearlydifferentiated acrossbanks,asforeignbanks—andtolesserextentpublicbanks—werequicklyperceivedassafe heavens.Duringtheentireperiod,depositsatforeignbanksandfederalpublicbanks(e.g.,Banco delaNaciónArgentina)increased,whiledepositsatprivate-domesticandpublic-provincialbanks fell,albeitatamuchslowerpacethanatthewholesalebanksandexhibitingsignificantdifferences acrossthem.Largedomestic-privatebankssufferedsignificantlylessdepositlossesthansmaller banksand,especially,thancooperativebanks,whichhadamuchlesstransparentcorporate governanceandmanagementstructure.Duringthefirstthreemonthsof1995,totaldepositsof theArgentinebankingsystemfellbyanimpressive18%. Figure3.Tequilacrisis–Evolutionofdeposits 160 Nov94=100 140 Foreign 120 100 Wholesale 80 PrivateNakonal 60 Public 40 Source:CentralBankofArgentina The banking crisis required central-bank action on several fronts. On the one hand, there was crisis management. On the other hand, new changes had to be introduced in the prudential regulatoryandsupervisoryframeworktoaccountforthelessonslearnedfromthecrisis.Thenext sectiondealswiththelattersubject. Intermsofcrisismanagement,thefirstchallengefacedbythecentralbankwashowtomanage systemic liquidity. The Argentine central bank resorted initially to a lowering of reserve 10 requirements, but its effect was short lived. In the way they were structured, reserve requirements injected liquidity mostly into large retail banks that held a large proportion of overnight deposits subject to high reserve requirements. But the injection of liquidity did not arrivesignificantlytowholesalebanks.Thesebankswereexperiencingtheheaviestdepositlosses andheldliabilitiesthatmostlywereeithernotsubjecttoreserverequirementsorhadlowreserve requirements.Moreimportantly,wholesalebankswerecutoutoftheinterbankmarket. This situation called for the central bank to act as a lender-of last-resort and extend emergency liquidity to affected banks. However, the crisis unveiled the typical shortcomings that central banksfaceundersystemiccrises,aswellassomeshortcomingsmorespecifictotheConvertibility regimeanditsmonetaryinstitutions.Thefirstwell-knownproblemisthe“stigma”effectofthe lender-of-last- resort function. Especially in a situation where banks face different degrees of deposit losses, banks that need liquidity the most cannot get it in the interbank market and are reluctant to go to the central bank because they fear sending a clear signal that they are in trouble. On the contrary, the only banks that would potentially accept liquidity offered by the centralbankarethehealthybanksthatdon’tneedit. Toresolvetheproblemsofunequaldistributionofliquidityandthestigmaassociatedwithcentralbank emergency lending, a “safety net” was established at the federal public bank Banco de la NaciónArgentina.Thissafetynetwasfundedwithanincreaseintheoverallreserverequirement thatwasdepositedatBancodelaNaciónArgentina,whichinturnmadelendingavailabletothe banksthatrequiredliquidityassistancethroughtheinterbankmarket.Inanyevent,astherunon deposits intensified and spread to a larger number of medium banks, the central bank’s emergencyliquidityprovisionalsoexpanded(Figure4). Figure4.Emergencycentral-bankliquidityassistance 14 Aspercentofcentralbank'sinternakonalreserves 12 10 8 6 4 2 - Nov-94Apr-95 Sep-95 Feb-96 Jul-96 Dec-96May-97Oct-97Mar-98Aug-98 Jan-99 Jun-99 Nov-99Apr-00 Sep-00 Source:CentralBankofArgentina 11 Theemergencyliquidityassistancesituatedthecentralbankveryclosetoreachingeventuallythe legal limit imposed by the 1992 central-bank charter. As Figure 5 shows, the backing of the monetarybasewithbonds,reached18.5%,almostatthe20%legallimit. Figure5.TheTequilaEffect(rightscaleinUSDmillion,leftscalein%) 30,000 30 25,000 25 20,000 20 15,000 15 10,000 10 0 0 -5 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Sep-00 -5,000 Jan-95 Feb-95 Mar-95 Apr-95 May-95 5 Dec-91 Dec-92 Dec-93 Dec-94 5,000 Monetarybase backingwithbonds Internakonal Reserves Bankexternal liquidity Source:CentralBankofArgentina As the crisis deepened, the central bank monitored the liquidity position of all institutions that requiredemergencyliquidityassistanceonadailybasisinordertoestimatehowtobestusethe limited lender-of-last-resort function legally allowed. Notwithstanding, the central bank relaxed both the maturity, as well as the collateral requirements, of the emergency liquidity assistance provided.Inaddition,relyingontheprincipleofsupervisiononaconsolidatedbasis,thecentral bankcrackeddownonconnectedoffshorecompaniesintheArgentinebankingsystemtoimprove transparencyandassessthetruesolvencysituationofasignificantnumberofinstitutions. Buttheabove-mentionedcrisismanagementactionsalonedidnotreversethedepositrun.Soon enough it became clear that the liquidation of some banks was unavoidable and, hence, a profoundpolicydiscussionstartedinrelationtothespeedoftheprocess.Atoneextremeliedthe IMF, recommending a once-and-for-all clean up of the financial system by liquidating about 40 banksinonemove.Butthecentralbank,thoughacknowledgingtheneedtorestructureseveral banks, favored and pushed for significant institutional changes to correct the shortcomings stemmingfromConvertibility. At the worst of the crisis a number of significant reforms to the domestic financial architecture wereputinplacewiththerapidanddecisivesupportfromCongress.InFebruary1995,thecentral bank revised the position imbedded in its 1992 charter, and formally reintroduced a privatelyfunded and limited deposit-insurance scheme to inspire confidence in the banking system and contain the drainage of deposits 7 However, by being privately funded by contributions from 7 Depositinsurancewouldbeprovidedbyanewinstitution,SEDESASA,thatwouldadministerthefundspaidbyall banks,onamonthlybasis,ataraterangingbetween0.015%and0.06%oftheirdeposits,dependingontheCAMEL ratingoftheinstitution—i.e.,theriskiertheinstitutionthehigherwasitsdepositinsurancepremium.Inthenew scheme,depositorswereinsureduptoUSD30.000perperson,providedthattheinterestpaidondepositswaslower 12 withinthebankingsystem,theeffectivenessofnewdepositinsurancewaslimitedatthetimeit was introduced. Nevertheless, it represented a realistic institutional reform that would play an importantroleinthefollowingyears. The most important reform introduced in the midst of the 1995 crisis was the creation of a mechanism for resolving troubled financial institutions. Such reform was introduced through a new article in the Law of Financial Entities—known as art. 35bis—which gave the central bank legal power to extract from certain assets and liabilities from the balance sheet of a bank that enters the process of liquidation. In particular, on the liability side, senior liabilities—deposits, laborobligations,andcentralbankemergencyliquidityloans—couldbeextracted,alongwiththe best quality assets up to an amount equivalent to the extracted liabilities. The residual bank would then be liquidated through normal bankruptcy proceedings in the justice system. The package of extracted assets and liabilities, along with the bank’s employees, could then be auctionedtointerestedbuyersinthefinancialsystem.Asthisrestructuringwasoccurringinthe midstofabankingcrisis,thegovernmentsetupaFiduciaryFundforBankCapitalization,funded by an initial USD 500 million loan from the World Bank, to provide the buyer bank the required regulatory capital—in the form of subordinated or convertible loans—as well as liquidity assistanceifneeded. Therationaleforthisinnovativemechanismwastwofold.Firstly,giventhefiscalconstraintsfaced byArgentina,thebailoutoftroubledfinancialinstitutionscouldresultinahighfiscalcostthatthe capital market could regard as unsustainable and, hence, could weaken the credibility of the Convertibility regime. Secondly, it is well known that as soon as a bank enters liquidation, the value of assets tends to deteriorate rapidly as debtors stop servicing their obligations and the failedbankhasnoresourcestomonitorthedebtors’compliance.Therefore,art.35bisprovided anefficientmechanismtorestructureafailingbankthatwouldprotectthevalueofbankassets and the repayment of senior liabilities with the bank’s existing resources, thus minimizing the fiscalcostofbankclosuresaswellastheirdisruptiveeffectsoncreditandonemployment.8 The results from the application of the Art. 35 bis mechanism were impressive. It was used to resolve 19 private financial institutions between 1995 and 1999. About 97% of the deposits at liquidatedbankswereabsorbedbytheacquiringbank,orbanksyndicateinfewcases.Contraryto the international experience, where the fiscal costs associated with banking crises often exceed 15%ofGDP,thesuccessfulresolutionoftheArgentine1995bankingcrisisrequiredasmallfiscal cost,estimatedatjust0.1%ofGDP.9 In parallel to the resolution of private banks through Art. 35 bis, the government actively promoted the privatization of several provincial public banks. As a result, the number of public banksfellfrom33institutionsattheendof1994to15institutionsbytheendof1999. thanarateestablishedbythecentralbank.Thelatterfeaturewasmeanttodiscouragethephenomenonknownas “gamblingforresurrection”bywhichatroubledbanktriestokeepitsdepositbasebyofferinghigherandhigherinterest rates. 8 9 SeeDeLaTorre(2000)andDujovneandGuidotti(2001)foramoredetaileddescription. SeeGuidotti(1996)andIMF(1998). 13 ArgentinawasclearlythecountrymostaffectedbycontagionfromtheMexicandevaluation,and theConvertibilityregimewasputtoatestbyforeigninvestorsaswellasdepositors.Asaresult, economicactivitycontracted,asevidencedbya2.8%fallinGDPin1995.Moreover,theleading stock market index (Merval) fell by 50% and bond prices fell by 45% reaching their trough on March 8th of 1995. The spread on government bonds over comparable US Treasuries averaged over1400basispointsduringthefirstquarterof1995. In addition to the measures taken by the central bank to cope with the banking crisis, the governmenttookdecisiveactiononthefiscalfront,andsped-uptheprivatizationofseveralstateownedprovincialbanks.10Moreover,inordertoreassureinvestorsaboutthegovernment’sability to meet its financing needs, in mid-March of 1995, the government signed a program with the InternationalMonetaryFund(IMF)thatincludeddisbursementsfromthatinstitutionforUSD2.4 billionandloansfromtheWorldBank(WB)andtheInter-AmericanDevelopmentBank(IADB)for anadditionalUSD2.3billion.Tocomplementtheofficialeffort,anumberofcompaniesandbanks subscribedtheissueoftheArgentinaBond(alsocalledthe“PatrioticBond”)byanadditionalUSD 2billion. The combination of official financing and clear and decisive policy actions by the government producedthedesiredresult:thebankrunceasedandfinancialactivityreturnedtonormallevelsin thesecondhalfof1995. Thebehaviorofdepositors:Acloserlook Oneimportantaspectofthe1995crisisrelatestothebehaviorofdepositorsduringthecrisisand thenatureofrisksthatbroughtitabout.Ifisoftenverydifficulttodisentanglebankingcrises formmacroeconomiccrises,asnomatterwhichonestartsfirsttheareoftenseenasinseparable twins.InthecaseofArgentina,withalonghistoryofeconomicandfinancialinstability,afixed exchange-rateregimesuchasConvertibilitycouldeasilybeperceivedasanaturalcandidateto comeundermarketpressureand,inthatcase,thebankingsystemisanaturalweaklink.Inthis view,thebankingcrisiswouldresultfromalossofconfidenceinthegeneralmacroeconomic frameworkandnotviceversa. However,adifferenthypothesiscouldbeconstructed.Itcouldbearguedthatthe1995crisis reflected,toalargeextent,weaknessesthatwereinternaltotheArgentinefinancialsystem,a systemexperiencingrapidgrowth,inacontextwhereprudentialregulationwasstillatitsinitial stagesofdevelopmentandimplementation. EmpiricalanalysiscarriedoutbyGuidotti(2008)shedslightonthesecompetinghypotheses.His cross-sectionempiricalanalysis(attheindividualbanklevel)focusesonwhatfactorsexplainthe depositrun—occurredbetweenDecember1994andApril1995—and,inparticular,whyitwas differentacrossthevariousfinancialinstitutionsinthesystem. 10 Inadditiontoanumberofexpenditurecuts,includingareductioninpublicsectorwages,thegovernmentincreased the value-added-tax (VAT) rate from 18% to 21%, increased temporarily import tariffs, partially reversed a previous reductioninemployers’laborcontributions,andwidenedthetaxbasefortheVATandincometaxes. 14 Totakeintoaccountthevarioushypothesis,theindependentvariablesincludedtoexplainthe depositlossoccurredbetweenDecember1994andApril1995(i.e.,thedependentvariable)were: 1)theinterestpaidbybanksondepositsbeforethecrisis(atNovember1994);2)theoriginof bankcapital(domesticorforeign);3)themarketshareofthefinancialinstitution(atNovember 1994);and4)theexposureofbankstothepublicsector(atNovember1994). Theempiricalresultsarequiteilluminating.Thecoefficientsoffirstthreeexplanatoryvariablesare statistically highly significant and possess the expected sign.11 Results show that those financial institutions that were paying the highest interest rates on their deposits suffered the heaviest deposits losses. This result is consistent with the hypothesis that depositors were aware of the positive association between interest rates paid and the risk profile of the financial institution. Thus,assoonassystemicriskincreased,depositorsfledwiththehighestintensityfromthebanks theyperceivedasmorerisky. Asregardstheoriginofcapital,resultsalsosuggestthatinternalfactorstothebankingsystem playedthemostsignificantroleinexplainingthebehaviorofdepositors.Bybeingforeign-owned abankwasperceivedasalessriskybank,becauseofthepotentialsupportofheadofficesaswell asbettergovernance.Hence,resultsshowthat—giventheothervariables—depositorstookinto accounttheoriginofcapitalintheirbehavior,andrunfromdomesticbanksbutnotfromforeign banks(seeFigure3). Inasimilarvein,resultsshowthatthesizeofthebankmatteredintheeyesofdepositors.Given theotherexplanatoryvariables,largerbankssufferedlessdepositlossesthansmallerbanks,as measuredbytheirmarketsharebeforethecrisis.Onepossibleinterpretationofthisresultrelates tothewellknowntoo-big-to-failproblem.Largebankswereperceivedashavingsystemic implicationsand,therefore,wereexpectedtobebailedoutbythecentralbankwithhigher probabilitythatthatofsmallbanks.Inthisinterpretation,depositorswouldnotbeconcerned aboutthefiscalcapacityofthegovernmentintheeventabailoutwouldbecomenecessary. Hence,ifthetoo-big-to-failconceptwaspresentintheperceptionofdepositors,thisresultwould supportthehypothesisthatthe1995crisisreflected,toalargerextent,factorsinternaltothe bankingsystemratherthanuncertaintyabouttheArgentinemacroeconomy. Theaboveviewisalsoconsistentwiththelastresult:thattheexposureofbankstothepublic sectorturnedoutnotstatisticallysignificantinexplainingthebehaviorofdepositors.Hence,this resultsupportsthehypothesisthatdepositorsdidnotperceivethefiscalsituation,orapotential defaultonthepublicdebt,tobeasignificantriskindecidingtheirdepositwithdrawals. Insummary,the1995bankingcrisisexhibitedthecharacteristicsofaneventgeneratedlargelyby internalweaknessesofthefinancialsystematatimeofrapidcreditgrowthandachanging regulatoryandsupervisoryenvironment.Inthiscontext,thesuccessfulmanagementofthecrisis reflectedtheroleofthereformsputinplace,whichmadethecrisisresolutionconsistentwith macroeconomicandfiscalsustainability.Thescenariowillbeverydifferentwhen,lateron,wewill analyzethebankingcrisisof2001. 11 Overall, theregressionhasanR2of51.3%. 15 4. Changesinregulationpost-crisisandtheevolutionofthebankingsectorfrom1995to2000. Despite the intensity of the 1995 Tequila crisis, the flexibility shown by the economy and the government’ssuccessinweatheringtheexternalshockwithoutalteringtheConvertibilityregime boostedsignificantlytheinternationalanddomesticconfidenceintheArgentineeconomy.Such confidence translated, for instance, into a significant increase in the inflows of foreign direct investment.ForeigndirectinvestmentthathadtotaledUSD3.6billionin1994almostdoubledin 1996, reaching USD 7 billion. As the Argentine economy recovered, the spread paid by governmentbondsoverUSTreasuriesfellmarkedly.Thespreadongovernmentbondsthathad averaged740basispointsduring1994(i.e.,beforetheTequilacrisis)felltoanaverageof450basis pointsin1997. Fromthelastquarterof1995tothesecondquarterof1998,Argentina’seconomygrewatafast pace.Duringthoseelevenquarters,GDPgrowthaveraged1.8%aquarter,equivalenttoanannual growthrateof7.4%.Asaresult,yearlyGDPgrowthreached5.5%in1996,8.1%in1997,and3.9% in1998. Thefastrecoveryoftheeconomyprovidedtheopportunitytodrawfreshlessonsfromthe1995 financialcrisisandstrengthentheprudentialregulationandsupervisionofthebankingsystem.At thesametime,theregulatorychangesandthecrisisitselfproducedasignificantconsolidationof theArgentinebankingsystem. Asregardsprudentialregulationsthemainchangesintroducedbythecentralbankfollowingthe crisisimpingedonthetwocentralfeaturesofbanking-riskmanagement:capitalandliquidity. Onceagain,thechangesinprudentialregulationfollowedtheevolvingnatureofinternational standards,butalsoreflectedthelessonslearnedfromtherecentexperienceinactualcrisis management. Bankcapitalrequirementswereincreasedfurtheronaccountof,ontheonehand,the introductionofaRiskIndicatorinthedeterminationoftherequiredcapitaland,ontheother hand,theadoptionofcapitalsurchargesreflectingmarketriskandinterest-raterisk,derivedfrom Baselupgradedrecommendations. TheintroductionofaRiskIndicatorwasinstrumentalinraisingthecapitalrequirementtoan effectivelevelof13%to15%ofrisk-basedassets,measuredaccordingtotheBaselmethodology. TheRiskIndicatorwascomputedasafunctionoftheinterestratechargedbybanksontheirloan portfolio.Thus,thehighertheinterestratecharged,thehigherwastheRiskIndicator.TheRisk Indicatorwasthenmultipliedtothebasic11.5%capitalrequirement.12Inaddition,thecentral 12 Although the objective of the Risk Indicator was prudential—so as to require riskier banks to hold more capital, as measured by a market measure such as the interest rate on loans—some observers interpreted this feature as a mechanismtoinduceareductionininterestrateschargedbybanksontheirloans. 16 bankintroducedtheCAMELSratingsinthecomputationofcapitaladequacy,thusrequiringmore capitaltoinstitutionswithlowerratingsfrombankingsupervisors.13 Besidesincreasingthebankcapitalrequirement,theRiskIndicatorintroducedapro-cyclical elementintoit.14Inpractice,possiblyduetothepro-cyclicalnatureofthecapitalrequirement, Argentinebanksexhibitedsignificantexcesscapitalization,rangingfromamaximumof39%in 1996toa32%in2000.Theexcesscapitalizationexhibitedbybanksreflectedaprecautionary motive,asbankersknewthattherequiredcapitalwouldincreaseiftherewereageneralincrease ininterestrates.Interestingly,suchprecautionarybehavioronthepartofbanksendedup compensatingthepro-cyclicalfeatureofthecapitalrequirement. InadditiontotheRiskIndicator,andfollowingtheevolvinginternationaldiscussionleadingto BaselII,capitaladequacyrequirementsweremodifiedtoincorporatesurchargesforinterest-rate risk,andmarketrisk.Themostimportantelementinthesemodificationswasthatgovernment bonds,althoughremainedwithazeroweightintherequirementforcreditrisk,nowbecame subjecttothesurchargeformarketandinterest-raterisk.Giventhatexposuretogovernment bondshadbeenimportantdeterminantsinthelossofconfidenceexperiencedbywholesalebanks inthe1995crisis,thecentralbankdecidedtodepartfromBaselrecommendationsandsubject governmentbondstoacapitalrequirement.Inparticular,governmentbondshadacapital surchargethatfluctuatedbetween1%and5%,dependingontheirmodifiedduration. Recognizingtheimportanceofbankliquiditywhenthecentralbank’sabilitytoactasasystemic lenderoflastresortislimited,theadoptionofMinimumLiquidityRequirements(MLR)constituted thesecondpillarofthepost-1995ofthemacro-prudentialframework. Duringthe1995bankingcrisis,thepolicyofloweringreserverequirementshadplayedan importantroleincomplementingtheemergencyliquidityextendedbythecentralbank.However, thatexperienceshowedimportantshortcomingofhowthereserverequirementsweredesigned. Inparticular,thefactthatreserverequirementswerehighoncheckingandovernightsavings accounts,butmuchlowerontimedeposits,generatedanunequaldistributionofliquidityinthe system.Moreover,timedepositsshowedamuchhigherpropensitytofleethanovernight accountsthatwheremostlytransactionalinnature.Hence,liquiditywasparkedinthewrong placeand,asarguedearlier,theinterbankmarketprovedtobeapoorchanneloftransmissionof liquidityacrossinstitutionsinasystemiccrisis. Twoadditionalshortcomingswerealsoworthconsidering.Firstly,asmandatedbythecentral bankcharter,reserverequirementswerenon-remunerated.Hence,increasingliquidity requirementsonfinancialinstitutionsincreasedthecostoffunding.15Secondly,bybeing 13 CAMELSisthesecond-generationofCAMEL,andaddsasixthcomponenttotheoriginalratingtoassessthebank’s sensitivitytomarketandinterest-raterisk.Themultiplicativefactorenteringthecomputationofthecapitalrequirement thatwasassociatedwiththeCAMELSratingsvariedfrom0.97foraninstitutionrated1(thehighestrating)upto1.15for aninstitutionrated5(theworstrating). 14 TheRiskIndicatorwasnottheonlypro-cyclicalfactorinthecapitalrequirement.Alsothesurchargeformarketrisk playedasimilarrole. 15 See Fernandez and Guidotti (1999), and Guidotti (2003) for an analysis of the effects of capital and liquidity requirementsonthebankingsystem,andonlendinganddepositinterestrates. 17 depositedatthecentralbank,reserverequirementswherenotregardedasentirelyrisk-freeby thecapitalmarket. Therefore,attheendof1995,reserverequirementswerereplacedbythenewlycreatedMLR. MLRcouldbemetthroughthreemaincomponents:1)reposongovernmentbondswiththe centralbank;2)holdingsofforeigngovernmentbondswithacreditratingnotbelowAandother selectedforeignassetsofsimilarcharacteristics;and3)stand-byone-yearlettersofcreditwith foreignfinancialinstitutionsratedAAorhigher,upto20%oftheMLR.Inordertoensurethat MLRconstitutedunencumberedliquidityand,inparticular,toavoidback-to-backloans,Deutsche Bank(NewYorkbranch)waschosenasthemandatorycustodian,withacontractthatcouldbe monitoredbytheArgentinecentralbank. Tocomplementsystemicliquidity,thecentralbanksetupacontingentrepolinewithanumberof largeinternationalbanks,usingitsgovernmentbondholdings.AsshowninFigure6,systemic liquidityincreasedwiththevariousmeasuresdescribedabovetoover28%oftotaldepositsofthe Argentinefinancialsystem.TheadoptionofMLRandthecontingentrepolineconstituteda centralfeatureonthecentralbank’sstrategyinstrengtheningthefinancialsystem’sresilienceto facevolatility.16 Figure6.SystemicLiquidity(as%oftotaldeposits) 35 28 RepoProgram Liquiditybills 21 Repos 14 Depositsabroad 7 Depositsat CentralBank 0 1994 1995 1996 1997 1998 1999 2000 Source:CentralBankofArgentina The financial system’s internal weaknesses exposed by the 1995 banking crisis, and the vast reform of macro-prudential regulations, were critical factors in explaining the extensive restructuring and consolidation that occurs in the Argentine banking system after 1995. Such restructuringandconsolidationmodernizedthebankingsystemandstrengtheneditssolvencyand liquidity. 16 SeeGuidotti(2003)foradiscussionofhowtobuildaliquidity-managementstrategyinemergingmarketeconomies. 18 TwomainfactsillustratetheextentoftheconsolidationthattookplaceintheArgentinefinancial systemafter1995bankingcrisis.Firstly,thetotalnumberoffinancialinstitutionsfellsharply,from 212 in 1992 to 109 by end-2000. Secondly, reflecting the significant process of privatization at provincialpublicbanks,thetotalnumberofpublicbanksfallsfrom33atend-1994to14atend2000.Table1illustratesthemainfeaturesoftheconsolidationprocessthattookplaceafter1995. Table1.Depositsshare(in%) Source:CentralBankofArgentina Theshareofthetenlargestbanksintotaldepositsincreasedfrom35%in1995to51%in2001. Moreover,theshareofforeignbanksintotaldepositsexpandedasaresultofanumberof acquisitionsoccurredbetween1996and1998,inparticulartheacquisitionoftwolargedomestic banks,BancoRioandBancodeCréditoArgentino,bythetwolargestSpanishbanks,Banco SantanderandBancoBBVA,respectively.Between1995and2001,theshareofforeignbanksin privatedepositsincreasedfrom25%to56%,andfrom21%to48%intotaldeposits. Theincreaseinmarketshareexperiencedbyforeignbankshadanimportantimplicationfor systemicrisk.Undertheassumptionthattheirhomeofficeswouldsupportforeignbanks, systemicliquidityavailabletodealwitheventualdepositlosseswasperceivedtobelargerthan thecoverageratiooftheMLR.AsshowninTable2,notonlysystemicliquidityincreasedbythe adoptionofMLR,itincreasedtoover55%oftotaldepositsoncedepositsatforeignbankswere excludedfromthecomputation.17 Table2.Foreignbanksandsystemicliquidity Source:CentralBankofArgentina. 17 Inthesuccessfulresolutionofits2001crisis,theUruguayangovernmentadoptedthecriterionofplacingonhome officesofforeignbankstheresponsibilityofprovidingliquidityassistancetotheiroperationsinUruguay. 19 Aspreviouslymentioned,thestrongrecoveryexperiencedbytheArgentineeconomyafterthe 1995Tequilacrisisboostedsignificantlytheinternationalanddomesticconfidenceinthe Convertibilityregime.However,the1996-1998periodofstrongeconomicgrowthwasagain interruptedbythefalloutfromtheRussiandefaultinAugust1998.AsRussiadeclaredadefaulton itspublicdebt,Argentinatogetherwithseveralotheremergingmarketeconomieswasaffected severelybythecontagioneffectsstemmingfromtheRussiancrisis.Asaresult,riskspreads increasedagainandeconomicgrowthhalted.TheeffectsoftheRussiandefaultcompoundedasa resultoftheBraziliandevaluationinMarch1999. Duringtheeight-monthperiodmarkedbytheRussianandBraziliancrises—fromAugust1998to March 1999—the risk spread on Argentine bonds averaged 800 basis points reaching a peak of 1100basispointsinSeptember1998.AsillustratedinTable3,theincreaseinriskspreadswasa generalized phenomenon among a large number of emerging market economies and affected Argentina relatively less than Brazil, Mexico, and the group of countries included in JPMorgan’s EmergingMarketsBondIndex+(EMBI+)index. Table3.TheEmergingMarketsBondIndex-PeriodAverage Period EMBI+ Latin Argentina Brazil Mexico Jan ´98 - Jul ´98 535 489 Aug ´98 - Mar ´99 1,210 996 Apr ´99 - Dec ´99 1,069 806 Russia 447 542 413 782 799 1,223 772 5,084 706 943 573 3,527 Source:J.P.Morgan. Note:LatinAmerica,Argentina,Brazil,MexicoandRussiarefertotherespective componentsintheGlobalEMBI+index,expressedinbasispoints. Notwithstanding the increase in risk spreads, bank deposits—unlike what had happened in the 1995crisis—continuedrising,asdidbankcredittotheprivatesector.Thiswasreflectiveofthe investors’ confidence in Argentina’s convertibility system, which had successfully managed the Tequilaeffect. Beyondthevolatilityofriskspreadsonthepublicdebt,confidenceintheArgentineeconomyalso wasreflectedinthefactthatforeigndirectinvestmentcontinuedtoincreaseduringthatperiod. Foreign direct investment amounted to USD 7.3 billion in 1998 and USD 24 billion in 1999, equivalent to 2.4% and 8.5% of GDP, respectively. These foreign direct investment figures comparefavorablywithanannualaverageofUSD6.3billionintheperiod1994-1997.In1999,the current account of the balance of payments displayed a deficit of USD 12 billion, equivalent to 4.2%ofGDP.GiventhatduringthatyearinternationalreservesattheCentralBankincreasedby USD1.5billion,thepresenceofacurrentaccountdeficitwasaclearindicationofthewillingness of foreign residents to increase their holdings of Argentine assets (as well as of the country’s abilitytoattractforeigncapital). Inthesecondhalfof1999,theArgentineeconomywasalreadyrecovering.Industrialproduction increased markedly by 10% in seasonally-adjusted terms —equivalent to an annualized rate of increase of 20%— between June and December 1999, while the year as a whole exhibited an 20 increase in industrial production of 6.6% (measured as the change from December 1998 to December 1999). The favorable perspectives that the Argentine economy was displaying in the secondhalfof1999alsotranslatedintoalowerspreadthatthegovernmenthadtopayoverUS Treasuries compared to the risk spread applying to Brazil (283 basis points higher in December 1999), to Russia (2350 basis points higher), and to the average of Latin America (60 basis points higher in December 1999). The reduction in spreads took place notwithstanding Argentina was facingpresidentialelectionsaftertwoconsecutivetermsinofficebythenPresidentMenem.By theendof1999,theriskspreadongovernmentbonds—measuredbytheArgentinecomponent oftheEMBI+index—hadfallento586basispointsoverUSTreasuries. InOctober1999,acoalition(theAlianza)composedbytwoparties,UniónCívicaRadical(UCR)and Frente País Solidario (Frepaso), beat the traditional Peronist party in the general presidential elections. On December 10, 1999 President Fernando De la Rúa was sworn into office and was met with a very favorable sentiment prevailing among international investors as Argentina was seen as leaving behind the effects of the Russian and Brazilian crises. As a result, in the first quarter of 2000, government’s access to the international capital market was very ample as it issuednewbondsintheamountofUSD4.1billion.Moreover,riskspreadsongovernmentdebt continued to decline to an average level of 538 basis points in March 2000, as measured by the ArgentinecomponentoftheEMBI+index. An important reason behind the market’s optimism was related to the perception that the Argentine economy had strong fundamentals and had displayed in its recent past a remarkable commitmentandabilitytoovercomecrises.Inparticular,thesizesofthepublicdebtandofthe interestbillmeasuredasaproportionofGDPwereperceivedasmanageable,andwerelowerthan thelevelsexhibitedbyotheremergingmarketeconomies.18Argentinainitiatedyear2000witha ratioofpublicdebttoGDPof43%;theaverageinterestratepaidonthepublicdebtwasrelatively low,anannualrateof7.3%.Innominalterms,grosspublicdebtamountedtoUSD121.9billion, andtheinterestbillhadamountedin1999toUSD8.2billion,equivalenttolessthan3%ofGDP. In fact, most analysts at the time considered that Argentina needed only a moderate and attainablefiscaladjustmenttoensuredebtsustainability.AccordingtoanalystsatJPMorgan,for instance, the required adjustment was in the order of 1.6% of GDP while according to Deutsche Bankitwas2.1%.1920Asthesereportswereissued,Argentinawasundertakingafiscaladjustment ofthatorderofmagnitude. However,asArgentina’sdomesticcapitalmarketwassmall,thegovernmentdepended significantlyontheinternationalcapitalmarketforthenecessaryrolloverofitsdebt.Hence,the economywasvulnerabletoshiftsinexternalinvestors’sentimentandinparticulartosudden stopsincapitalinflows.21 18 For instance, Brazil exhibited during year 2000 a ratio of public debt to GDP of approximately 74%, and notwithstandingaprimaryfiscalsurplusof3.5%ofGDP,theinterestbillamountedtoover7%ofGDP. 19 SeeSekiguchiD.,Argentina’sdebtdynamics:Muchadoaboutnotsomuch.September6,2000. 20 SeeGhezzi,P.andL.Leiderman,DebtsustainabilityinLatinAmerica,December20,2000. 21 Thereisbynowavastacademicliteratureonwhat Guillermo Calvo called “sudden stops”.See,forinstance,Calvo (1998),Mendoza(2001),Guidotti,Sturzenegger,andVillar(2004). 21 Inastablemacroeconomiccontextandwithagrowingfinancialsystem,thenewregulatory frameworkposedanimportantchallengeforthebankingbusiness:toexpandthedepositbaseas wellascreditprovisionwouldrequiremorecapital.Iftheadditionalrequiredcapitalwouldnot comefromnewcapitalinjections,thenitwouldhavetocomefromthereinvestmentofprofits.In fact,afterthe1995crisis,newcapitalinjectionswereimprobablefordomesticbanks(unlike foreignbanks),sothatprofitabilitywouldneedtoplayacentralroleinthegrowthofthefinancial industry.Table4showsthemainchangesinthebalancesheetoftheArgentinefinancialsystem after1995. Table4.SimplifiedBalanceSheetoftheFinancialSystem Source:CentralBankofArgentina Thefollowingtrendsareworthmentioning.Ontheliabilitiesside,thesystemexperienceda significantgrowthofdepositsbetween1995and2001.Thedepositsgrowthreflectedincreased confidenceinthebankingsystemafterthesuccessfulmanagementofthe1995crisis.In particular,thelowcostexperiencedbydepositors,aswellasbythestate,inthecrisisresolution contributedtoboostpublicconfidenceinthepost-1995period. Ontheassetside,twomaintrendsappearclearly.Firstly,liquidityandthebanks’exposuretothe publicsectorincreasedtheirshareintotalbankassets,reflectinginparttheeffectsofthenew regulatoryenvironment—i.e.,theintroductionofMLRandtherelativelyfavorabletreatmentof governmentbondsinthecapitalrequirement.Thebanks’exposuretothepublicsectorincreased from15%ofassetsin1995to18%ofassetsin2001.Duringthesameperiod,theshareofbank liquidityintotalassetsincreasedfrom13%to25%,whiletheshareofcredittotheprivatesector declinedfrom49%to35%. 22 BehindthesetrendsliedthefactthattheArgentinefinancialsystemdidnothavehigh profitability.Formostofthepost-1995period,thereturn-on-equity(ROE)wasverylow,ranging between0.6%and6.2%.AlthoughthetenlargestbanksmanagedtoreachROEsbetween8%and 13%,thatprofitabilitycouldnotbesustained,reflectinglargelyhighoperatingcostsandrelatively highlossesfromnon-performingloans.Partoftheproblemwasthat,byinternationalstandards, theArgentinefinancialsystemwassmall. In summary, the new regulatory environment introduced in the 1990s had made the banking systemmoreresilienttoacrisisoriginatedfrominternalfactors—suchasthe1995crisis—dueto its high capital and liquidity requirements. However, high dollarization—not discouraged by the regulatoryframework—impliedapotentiallyhighriskexposuretochangesintheexchangerate, andhighexposuretothepublicsectorimpliedahighriskintheeventofamacroeconomiccrisis thatwasexternaltothesystem.Inaddition,thesystem’slowprofitabilitysheddoubtsaboutthe banks’ ability to generate a dynamic credit growth to the private sector. In these conditions Argentinebankingsystemwouldfacethedifficulteventsof2001,asubjecttowhichwenowturn. 5. The2001bankingcrisis. Uncertainty about the evolution of the Argentine economy, as well as the political dynamics generated within the newly governing coalition that had succeeded the Menem administration after winning the presidential election of end-1999, tested again the resilience of the Argentine banking system at the beginning of 2001. In particular, starting in October 2000, the new governmentfacedasequenceofunsettlingpoliticalevents,summarizedintheresignationofvicepresidentAlvarez(headofoneoftwomainpartiesconformingthecoalition),andsubsequentand traumaticcabinetreshufflesinOctober2000andMarch2001.Partofthepoliticalcrisisstemmed from accusation—within the coalition—of a corruption scheme designed to pass a labor reform throughCongress. TheapparentpoliticalweaknessofthenPresidentDeLaRúawasnotwhatArgentinaneededata timewhenemergingmarketswerestillunderpressure—acrisisinTurkeyhadtakenplaceatthe endof2000—andwhentheConvertibilityregimeseemedparticularlyvulnerabletointernational capital volatility. After the cabinet crisis of March 2001, which led to the replacement of the Economy minister just after 15 days of being in office, prompted the first episode of significant deposits loss in the banking system. Total deposits, which had increased to a level of USD 90 billionattheendofFebruary2001,fellby6.7%inlessthanamonth,andbymid-Maythelosshad reached 7.6%. Although Argentina had secured a USD 40 billion IMF-led emergency assistance packageinDecember2000—so-calledthe“Armor”—thelossofbankdepositsreflecteddwindling confidencebythepublicintheeconomyandinthepoliticalenvironment. RiskspreadsonArgentinegovernmentbonds—asmeasuredbytheEMBI+--increasedby200basis pointsintheperiodApril-JunerelativetothevalueofFebruary2001.Nevertheless,riskspreads remainedbelowthemaximumlevelsreachedduringthe1995TequilacrisisuntilNovember2001. During the first half of 2001, deposits fluctuated. After the initial fall, they increased by 2.6% between mid-May and end-June, to fall again in July. Between July and August, deposits fell by 23 11%.AlthoughinSeptemberdepositsrecoveredby3.3%inresponsetoafurtheraugmentationof theIMFprogram,thedepositlossresumedsoonafter. AsshowninFigure7,thebehaviorofbankdepositsduring2001showedsignificantdifferencesin contrastwiththatobservedduringthe1995crisis.Firstly,thedepositrunin1995hadbeenmore virulent,asittookeightmonthsin2001toreachthe18%depositlossthatin1995hadtakenplace overathree-monthperiod.22 Figure7.The2001crisis–Evolutionofdeposits 105 100 Feb01=100 95 Foreign 90 85 Private Nakonal 80 75 Public 70 65 60 2001/2 2001/3 2001/4 2001/6 2001/7 2001/8 2001/9 Source:CentralBankofArgentina Secondly, in contrast to 1995, deposits fell sharply at public banks in 2001, indicating that fiscal worries were starting to play a significant role in depositors’ minds. In fact, almost half of the deposit loss experienced by the system between March and October is explained by the run on depositsatthetwolargestpublicbanks,BancodelaNaciónArgentinaandBancodelaProvincia deBuenosAires. Thirdly, while foreign banks had increased their deposits during the 1995 crisis, this time they werenolongerconsideredsafeheavensbythepublic.While,bymid-2001,48%oftotaldeposits were placed at branches and subsidiaries of foreign banks, these banks also faced significant depositlosses,albeitatarelativelyslowerpacethandomesticbanks. Althoughthecentralbankprovidedlessemergencyliquidityassistancetobanksthanin1995,in viewofthesubstantiallyhigherbankliquidity,theperceptionofdepositorsfocusedontherapidly deteriorating political situation and on the increasing probability of a full-blown macroeconomic crisisinArgentina. In such an event—if Argentina would default on the public debt and devalue its currency—all banks, domestic or foreign, private or public could face serious solvency issues. As illustrated in 22 Byend-Septemberthecumulativedepositlossstoodat12.9%. 24 Figure 7, the last two months before the imposition of restrictions on deposit withdrawals—socalledcorralito—thedepositrunacceleratedespeciallyatprivatedomesticbanks. Some actions takenby the government in the final days of Convertibility contributed to fuel the deposit run. In particular, a ceiling on the interest rate banks could offer to depositors had the counterproductive effect of increasing the run on domestic banks vis-á-vis foreign banks. Moreover, the introduction of quasi-currencies in several provinces, with the approval of the federal government, rapidly increased the loss of public confidence in the viability of the fixed exchangeratethatwasthecornerstoneoftheConvertibility. 6. Lessonsfromtheexperience:Whichadditionalprudential-regulationmeasurescouldhave helpedinpreventingthe2001crisis? Asarguedintheprevioussections,duringthe1990sArgentinahadstrengthenedsignificantlythe prudentialregulatoryframeworkofitsfinancialsystem.Asaresult,thebankingsystemwashighly capitalizedandheldsignificantliquidityinforeignassets.Hence,itshowedremarkableresilience evenunderthestressingconditionsthatledtothemacroeconomiccrisisof2001. However,eventhoughafterthe1995crisisthegovernmentbecameawareofthesystemicrisks derivingfromtheconnectionbetweensovereigndebtandbankingrisks—andthereforeimposed capitalrequirementsonbank’sgovernmentbondholdings—itwasnotfullyawareofthebalancesheetrisksthatextensivedollarizationposedforthebankingsystemintheeventofadevaluation. Atleast,prudentialregulationsdidnotrecognizethisriskexplicitly. PartoftheproblemwasthatConvertibilitywasdesignedtobeapermanentmonetaryregime. Andinthatcontextdollarizationwasperceivedtoplayausefulroleinaligninggovernment incentivesand,therefore,wasperceivedtocontributingtostrengtheningthecredibilityof convertibility.23 Withthebenefitofhindsightitisclearthattheinadequateattentionpaidbyregulatorsto exchangeraterisksconstitutedthesinglemostimportantweaknessofthebankingregulatory framework.Inparticular,therecourseofbankstodollar-denominatedfundingshouldhavebeen inourviewlimitedtoabank’scapacitytolendtofirmswhoseincomewasgenuinelyearnedin foreigncurrency(e.g.,exporters). Thisispreciselywhathappenedafterthe2001/2002crisis,whenbankcreditdenominatedin foreigncurrencywaslimitedmostlytofundtradefinancing,anddollar-denominateddeposits weresubjecttoveryhighreserverequirements—i.e.,depositedatthecentralbankandinvested ininternationalreserves—and,thus,paidextremelylowinterestrates. Adoptionofsuchregulationinthe1990swouldhavehadprosandcons.Theclearsystemic advantageisthereductionintheperceivedexposureofthebankingsystemtoexchangeraterisk, whichwouldhaveplayedasignificantusefulrolein2001.Thedisadvantageliesinthefactthat peso-denominatedcreditanddepositscarriedhigherinterestratesandlowermaturity.Hence, 23 SeeCalvo(1988)andCalvoandGuidotti(1990)ontheroleofdollarizationinenhancingcredibilityinpricestability. 25 forinstance,thedevelopmentofamortgagecreditmarketwouldhavebeenmuchslowerand moredifficultthanwhatitwasbyrelyingonforeign-currencydenominatedcontracts. Amuchmorerevolutionaryreformwouldhavebeenonethatrequiredamodificationinthe corporatestructureofbanksinordertorecognizethelimitsthatcentralbanksinemerging-market economieshaveinactingaslenderoflastresort.Acriticalobjectiveofcentralbanksduring systemiccrisesistoprotectthepaymentssystem.Hence,apossiblewaytoshieldthepayments systeminasystemicbankingcrisis,asproposedbyGuidotti(2003),istoadoptaspecificcorporate structurethatfacilitatesresolutionwhileisolatingthebank’stransactionalrolefromthe credit/intermediationrolethatentersliquidation.24 Accordingtothisproposal,financialinstitutionswouldbeorganizedaccordingtothefollowing corporatestructure.ABankHoldingCompanywouldown,ataminimum,twoseparate subsidiaries:aPaymentBankandaFinancialSubsidiary.Typically,toimproveexternaldiscipline, BankHoldingCompanieswouldberequiredtoissueatleastbetween20%and30%ofitscapitalin anorganizedexchangemarket. Liabilities of the Payment Bank would be composed of checking accounts, savings accounts, and time deposits up to a maximum per depositors. The maximum amount of time deposits per depositor would be consistent with the amounts covered by the deposit insurance. Thus, the liabilitiesofthePaymentsBankshouldbeconsideredeitherasdirectedrelatedtothepayments system,orconnectedtotheobjectiveofprotectingsmalldepositors. On its asset side, the Payment Bank would only be allowed to hold prime quality (liquid) assets and, except for overdraft on checking accounts, it would also hold the fixed assets related to its transactionalrole.1Primequalityassetswouldinclude:1)foreignassets(publicandprivatewith high credit-risk rating), 2) domestic government bonds, and 3) private domestic assets rated investmentgradeinternationally. TheFinancialSubsidiarywouldcontainallremainingbankingassetandliabilities.Therefore,the Financial Subsidiary would be similar to a normal bank with the exception of the assets and liabilities directly linked to the payments system that are now located at the Payments Bank. Figure8showsthecorporatestructureofatypicalBankHoldingCompany. 24 Guidotti’ s (2003) proposal is a direct precedent of the concept of “living wills”, created in response to the recent globalfinancialcrisis. 1 Emphasisisplacedhereontransparencyinthevaluationofassets.Ofcourse,liquidassetsareprime-qualityassets bydefinition. 26 Figure8:TheBankHoldingCompany Intermsofprudentialregulations,thecapitalrequirementwouldapplytotheBankHolding Company,andapositivecapitalwouldberequiredatthelevelofthePaymentBank,withassets markedtomarket.TheBankHoldingCompanyandtheFinancialSubsidiarywouldbesubjectto theprudentialregulatoryframeworkthatwouldapplynormallytofinancialinstitutions. As regards management, the above-mentioned corporate structure allows for a joint administration of the Payments Bank and the Financial Subsidiary, in order to avoid costly overlappingandduplicationoffunctions.However,acriticalelementoftheproposalisthatthe BankHoldingCompanywouldberequiredtoidentify,exanteandatalltimes,andimplementing contractsaccordingly,aself-containedmanagementstructureforthePaymentsBankincasethe Financial Subsidiary would be liquidated or sold. Hence, for instance, although the branch networkcouldbeoperatedjointly,itwouldneedtoholdseparateaccountingrecords. The above-mentioned state-contingent corporate structure is a natural extension of the instruments—suchasArt.35bis—giventothecentralbanktoresolvebankingproblems.Themain advantagesofsuchcorporatestructureisthatitmaketheprocessofresolutionefficient,without havingtoresorttoexpostemergencymeasures,andwouldenormouslyfacilitatetheprocessof dividingassetsandliabilities. Consider then how the actual mechanics of a liquidation or resolution would work. In the event the financial institution faces illiquidity problems that exceed the central bank’s emergency assistancecapability,suchilliquidityislikelytoappearattheleveloftheFinancialSubsidiary.3In suchanevent,thecentralbankwouldforcetheFinancialSubsidiaryinto“suspension”,whilethe Payments Bank would continue to operate. During the “suspension” period, when assets are valuedatliquidationlevels,andequityandsubordinateddebtmaybemarkeddowntozeroand remainingseniorliabilitieswouldbeconvertedintosharesintheFinancialSubsidiary’sassets,the centralbankwouldbeabletoapplyArt.35bisontheFinancialSubsidiaryandauction,eitherpart or its entirety, to interested buyers. Any residual of assets and liabilities would be sent to final liquidation. 3 Thishappensbecauseoftworeasons:1)becausethePaymentsBankholdsthemostliquidassets;and2)because empirical evidence suggests that transactional deposits tend to be more stable during bank runs in relation to other bankliabilities. 27 Theresolutionprocessdescribedabovehastheadvantageofisolatingthepaymentssystemfrom bank failures, while making efficient the process of transferring assets and liabilities to healthier financial institutions. As most of bank capital is lost in the process, it would be reasonable to expectthatthePaymentsBank,thoughoperative,wouldalsobeauctionedtoprospectivebuyers atthesametime.Inthiscontext,therewouldbecleareconomiesofscaleforabuyertopurchase theremainsoftheFinancialSubsidiarytogetherwiththePaymentsBank. 7. Wasthe2001/2002crisisavoidable?Twopossiblealternativecoursesofaction. Acriticalquestionthatariseswhenevaluatingthecourseofeventsleadingtothe2001/2002crisis is to what extent default could have been avoided and what policy options were open to the governmentatvariouspointsintime.Twopossiblecoursesofactionareexploredinwhatfollows. Lettheexchangeratefloat,paythedebt. In our view, even well into 2001 Argentina could have avoided default by adopting adequate economic policy measures. The key to the first argument we explore lies in the relative priority that should have been given to maintaining the convertibility regime on the one hand, and to avoiding default at all costs on the other hand. All of the alternatives considered by the governmentaswellasbytheIMFtookforgrantedthatConvertibilitywasgoingtobemaintained. Noalternativepolicyoptionswereseriouslyconsidered.Forallthatmatterstheauthoritiesand the international official community treated Convertibility as a taboo and in the end, pushed by political disarray, default led to the repeal of Convertibility materializing the (avoidable) worst possible scenario. In this section we will argue and explain why, even in 2001, Argentina could haveavoideddefaultbyexitingConvertibility. Inordertoelaboratetheaboveargumentwewillstartbyaddressingthreeissuesthattoppedthe list of concerns of investors and analysts as Argentina was entering 2001. The first issue was whetherpublicdebtdynamicsweresustainable.ThesecondissuewaswhetherConvertibilitywas makingArgentinauncompetitiveand,hence,neededalargecorrectionintherealexchangerate. ThethirdissuewaswhetherArgentinawasabletoobtaintherequiredfinancingininternational capital markets to meet its obligations while facing considerable skepticism on the part of investors. Let’sstartwithdebtdynamicsandthestanceoffiscalpolicy.AsArgentinaenteredyear2000,the ratioofpublicdebttoGDPwasabout40%carryinganaverageinterestrateoflessthat7.5%per annum. Hence, by conventional standards, the size of the public debt and of the interest bill measuredasproportionofGDPwereperceivedasmanageableand,indeed,theywerelowerthan the levels exhibited by other emerging market economies. In fact, most analysts at the time consideredthatArgentinaneededamodestfiscaladjustmenttoensuredebtsustainability. Theusualcomputationsperformedbyanalystsinthecapitalmarkettogaugedebtsustainability were favorable and certainly were distant from describing an economy affected by grave or irresolubleproblems.Reportswrittenbyleadinginternationalplayersinthecapitalmarketcanbe cited as examples of what actions—in their view—were needed in order to stabilize over time Argentina’s ratio of debt to GDP. These analyses placed the necessary fiscal adjustment in the 28 primaryfiscalbalanceintherangeof1%to2%ofGDPrelativetotheobservedlevelinyear2000. WhenexaminingArgentina’sfiscalsituation,JPMorgan25statedthat: “A primary surplus of 3.1% of GDP, up from the current 1.5% would be sufficient to stabilize public debt-to-GDP, even assuming that growth remains at the current depressed levels…Alternatively 4.4% nominal GDP growth would stabilize the government’s debt ratio…. It is expensive for Argentina to cover its current financing needs,buttheaverageinterestrateisstilllowat7.9%,anditsincreaseisgradual(pp 1).” AsimilarviewcanbefoundinaresearchpiecepublishedbyDeutscheBank,26wheretheauthors statethat: “The results indicate that a structural primary surplus of 2.9% of GDP is needed to achievesustainability.Thustheadjustmentthatisrequiredinordertostabilizethedebt is an increase in 2.1% of GDP in the structural primary surplus beyond its level in year 2000(pp.4).” Of course, all these analysis were based on assumptions, and a particularly critical one was the rateofeconomicgrowth.InthecaseofJPMorgan,theanalysiswasbasedonanimprovementin theprimarysurplusof0.9%tobecarriedoutgraduallybetween2000and2003,assumingarate ofgrowthof1.8%in2000and3%thereon.UnderthoseassumptionsJPMorganwasprojectinga slightdeclineintheratioofdebttoGDP. In the case of Deutsche Bank the projected rate of growth was similar to JP Morgan’s—2.5% in 2000and3%thereon—buttherequiredfiscaladjustmentwaslargerbecauseDeutsche’sanalysis was based on a higher initial debt stock—50 percent of GDP—on account of implicit debts not includedintheofficialstatistics. Theconclusionsreachedbyacademicswhostudiedex-postArgentina’simplosionarenotdistant fromtheviewsofcapitalmarketparticipantsinyear2000.IntheiranalysisofArgentina’scrisis HausmannandVelasco27alsodismissthefiscalcausebyarguingthat: “…In spite of the strong temptation to blame everything on the politician and their irresponsibility,thesimplefiscalexplanationisalsoinadequate.Thereisnoevidenceofa spendingboom:asashareofGDP,primaryGovernmentexpenditureremainedroughly constant in 1993-2001. True, public debt grew rapidly. But this paper shows the accumulation of debt was driven mainly by the transition costs of the Social Security system, recession, and recognition of preexisting debts, not by a lack of adjustment 28 efforts…” 25 SeeSekiguchi,David.Argentina’sdebtdynamics:Muchadoaboutnotsomuch,September6,2000. SeeGhezzi,P.andL.Leiderman.DebtsustainabilityinLatinAmerica,December20,2000. 27 “Hard money´s soft underbelly: Understanding the Argentine crisis”. Kennedy School of Government. Harvard University.2002. 28 AlsoGuidotti(2006)documentsthesignificantimpacttheSocialSecurityreformonArgentina’sfiscaldynamics. 26 29 Hence,despiterelativelyminorvariations,theprevailingviewwasthatArgentina’sdebtwasnot clearly unsustainable provided the country could resume its economic growth. 29 On this issue, however, there was less agreement. The main question was whether Argentina could shortly resumegrowthwhilemaintainingafixed-exchangerateregimeatamomentwhencapitalmarkets were unsettled, the US dollar had strengthened against other major currencies, and commodity pricesweredepressed.Inthisvein,Calvo,IzquierdoandTalvi(2003)concludedthatadevaluation was inevitable given the size of the external shocks hitting Argentina, and that the government would have had to acquire additional debts because of the balance-sheet effects on the private sector,requiringanadditionalfiscaladjustmentof0.6%ofGDPassuminga50%devaluation. In sum, the concerns regarding fiscal sustainability were not necessarily pointing at fiscal irresponsibility,butwerefocusedonwhethergrowthcouldberesumedunderConvertibility,and onwhetherapossibleexitfromthefixed-exchange-rateregimewasmanageable.Andacritical question here was to evaluate how large a devaluation would have occurred in the case Convertibilitywasabandoned.Theassessmentofhowundervaluedwasthepesowascentralto bothconcerns,anissuetowhichwenowturn. To this effect, we start by examining whether export performance had been weak during Convertibility.AscanbeobservedinTable4,themonetarysystemimplementedbyArgentinain April 1991 coexisted with a strong growth in exports, while the real effective exchange rate30 (weightedbyusingtheexportsbasket)appreciatedonlymoderatelycomparedtoothersuccessful economiesintheregion—despitethefactthatmostofthemhadflexibleexchangerates. Table4.RealEffectiveExchangeRateandExportsChangebetween2000/1991 Selected countries Real Exchange Rate * Real Effective Exchange Rate * Exports Argentina Brazil Chile Colombia Ecuador Mexico Peru Venezuela Average 35% 6% 10% 22% 3% 17% -8% 89% 20% 8% 13% 22% -2% 58% 18% 1% 86% 28% 121% 74% 115% 83% 77% 289% 104% 125% 124% *January2001/Average1991(+)meansREERappreciation,(-)depreciation Source:RealEffectiveExchangeRate–J.P.MorganREERIndex,Exports–IMF.International FinancialStatistics. Between 1991 (the beginning of the Convertibility regime) and January 2001, the real effective exchangerateforArgentinasufferedanappreciationofonly8%.31Thestrongexportperformance displayed by Argentina during Convertibility suggests that the real exchange rate, if moderately appreciated, was not making Argentina uncompetitive in international trade. The growth of exports in the period 1991-2001 reflected mostly the increase in exported volumes, rather than pricechanges.Inparticular,exportsincreasedfromUSD12billionin1991toUSD26.6billionin 29 ItisimportanttostressthattherewasnoconsensusontheroleoffiscalpolicyinArgentina’scrisis.Mussa(2002),for instance,arguesthatfiscalpolicyhadbeentooexpansionaryoncyclicallyadjustedtermsandthatitleadtoanexcessive build-upofpublicdebt. 30 TherealeffectiveexchangeratesfiguresarepublishedinBloombergundertheTickerJBXR. 31 Considering that during that decade productivity improved significantly, such moderate appreciation did not affect Argentina’sexternalcompetitiveness,asshownbyitsexportperformance. 30 2001, at an average annual growth rate of 7.8%. This growth rate can be attributed entirely to export volumes, as the annual change in export prices averaged -0.1% during the period under consideration. However,theevolutionofexportsunderConvertibilitywasnotuniform.Exportperformancewas particularly strong in the period 1994-1998, growing at an average annual rate of 15.1%, in comparison with a much weaker performance both in the initial and the latter years of Convertibility.TheperformanceofArgentina’sexportsalsocomparesfavorablytotheevolutionof world trade flows. In particular, the share of Argentina’s exports in world exports increased by 26%between1991and2001,increasingfrom0.34%in1991to0.43%in2001. IndependentassessmentsundertakenbytheinvestmentbankGoldmanSachsinMarch2000are consistentwiththeabovefindings.TheyshowthatArgentina’srealexchangeratewasovervalued by just 7.6% compared to the equilibrium level that obtained from their own model, compared witha22.7%overvaluationoftheMexicanpesoandoneof9.7%oftheChileanpeso.Withthatin mindGoldmanSachsrecommendedtheirinvestorstotakepositionsintheArgentinepeso.32 The issue whether the Argentine peso was undervalued and by how much has been extensively analyzedintheaftermathofthe2001/2002crisis.Forinstance,Calvo,IzquierdoandTalvi(2003) examined in a simple model the relation between the real exchange rate, the balance of payments,andthedegreeoftradeopenness.Inthatcontextandforasampleofemergingmarket economies, they estimated the adjustment in the real exchange rate required to eliminate a currentaccountdeficitintheeventofasuddenstopincapitalflowssimilartothatoccurredafter the 1998 Russian crisis. In the case of Argentina, the authors estimated that a 46% real depreciation would have been required to eliminate the current account deficit, a figure that comparestoa52.5%realdepreciationrequiredinthecaseofBrazil,anda43%anda32.4%real devaluationsrequiredinthecasesofColombiaandChile,respectively.33 Anotherstudythatfocusedontheovervaluationofthepesoasacauseforthe2001/2002crisis wascarriedoutbytheIMF’sIndependentEvaluationOffice(IEO)in2004.34Interestingly,theIEO finds that while today there appears to be a consensus that the peso was undervalued, such consensusdidnotexistfromthestandpointofyear2000: “…In the spring of 2000, before the further worsening of economic and financial conditionsinArgentinaandbeforethefurtherweakeningoftheeurorelativetothe U:S dollar, there were equally divided views of the peso´s overvaluation. For example, the overvaluation was estimated to be 7% by Goldman Sachs, 13% by JP Morganand17%byDeutscheBank.” 32 SeeGoldmanSachs,March2000. TheCalvo,IzquierdoandTalvi(2003)exercisemaybeconsideredanupperbound,asthecomputedadjustmentwas consistentwithreducingthecurrentaccountdeficittozero.Inlightofwhathappened,privatecapitalflowstoemerging marketsfellby55%in1998comparedtothe1997peak,butdidnodisappear.Intheperiod1998-2002privatecapital flowstoemergingmarketswereonaverage46%smallerincomparisonto1997,andincreasedsharplyagainsince2003 to reach in 2005 a level 75% higher that prior to the Russian crisis. Moreover, considering the depressed levels of commodity prices, using 1998 as the base for the experiment may overestimate the required change in the real exchangerate. 34 “TheIMFandArgentina1991-2001”.IndependentEvaluationOffice,IMF,2004. 33 31 Finally, Hausmann and Velasco (2002) even without estimating the size of the overvaluation concludethatthefixed-exchangerateregimehadamajorroletoplayintheArgentinecrisis: “There is an unmistakable sense then that Argentina did have an exchange rate problem. What is much less clear, however, is whether it had an exchange rate solution available to it. It was the combination of relative price misalignment with increasinglyscarcefinancingthatmadethesituationvulnerable.And,withalarge accumulated dollar debt, both private and public, the competitiveness gains of a potential devaluation had to be weighted against the balance sheet damage it wouldinflict,andtheadditionalmarketaccessthiswouldbring….” Insummary,theArgentineeconomyunderConvertibilitycouldhavebenefitedfromexchangerate flexibility but it can hardly be characterized as an economy in need of a large devaluation. With thispremiseinmind,wenowturntothepolicyactionsthatwereavailabletothegovernmentin order to avoid default, and which were anchored in providing flexibility to the exchange rate by exiting Convertibility. The crucial point here is to establish how Argentina would have had to manage the exit from Convertibility in a context of significant stress in international capital markets.Inourview,aswillbediscussedbelow,thegovernmentcouldhaveexitedconvertibility inanorderlyfashion. AccordingtotheConvertibilityLawthemonetarybasehadtobebackeda100%inliquidforeign assets, limiting the central bank’s ability to act as a lender of last resort to the banking system. However, if the authorities had decided to abandon convertibility when the country still had a significant amount of international reserves at the Central Bank, then it would have had a significant amount of funds that—added to those obtained from multilaterals—would have allowed Argentina to cover all of the debt payment obligations coming due over more than one yearwithouthavingtoissueasingleUSdollarofnewdebtinthecapitalmarket.Thatperiodof timewouldhavelikelybeenenoughtorestoreconfidenceinlocaldepositorsaswellasinforeign investors. TheConvertibilityLawpreventedthecentralbankfromassistingthefinancialsystemuptoalimit established in the law. However, once convertibility was abandoned, the ratio of US dollar reservestothemonetarybasecouldhavebeenreduced,forinstance,upto50%.Moreover,to theextentthattheauthoritieswouldhaveconsideredadoptingasolutionálaUruguayaccording to which banks who chose to do so could reprogram the maturity of their time deposits, the liquidityavailabletothecentralbankcouldhavebeendirectedat,forinstance,coveringuptoa 30%runontransactionaldepositswhileusingtheremainingportiontocoverTreasuryobligations. It is relevant to examine the amount of funds available to the central bank, including those availablefromtheContingentRepoFacilitythatthecentralbankhadcontractedwithagroupof international banks after the Tequila crisis.35 By mid 2001, the amount of funds available under suchfacilityamountedtoUSD1.2billion. 35 Theterm“repo”standsforrepurchaseagreement. 32 In addition to the funds that would have been freed by abandoning convertibility and to those available from the repo facility, the government could have had access to the remaining disbursementsavailableundertheexistingIMFprogram.Takingintoaccounttheamountoffunds disbursedfromtheIMFbetweenJanuary2000andSeptember2001(SDR4.8billion),theavailable credit to Argentina at the time when the last IMF agreement was signed in January 2001 amountedtoSDR12.1billion,equivalenttoUSD15.2billion.Ofthisamount,theIMFdisbursed only SDR 4.9 billion during 2001, remaining available at the year-end about SDR 7.2 billion, equivalenttoapproximatelyUSD9billion. Basedonthesefiguresonecanestimatethetotalamountoffundsavailabletothegovernment— with the already committed IMF support— in order to assure the capital market that it could service its debt for the significant period of time without resorting to new bond issues. Table 5 shows the results of computing the available funds at various relevant dates during 2001. Availablefundsaredefinedastheexcessfundsoverthoserequiredtokeepa50%backingofthe monetary base and to provide the central bank with the additional capacity to provide liquidity assistancetothebankingsystemforanamountequivalentto30%ofalltransactionaldeposits. Table5.AvailableFunds Source:OwncalculationsbasedondatafromCentralBankofArgentinaandtheEconomyMinistry ForthecomputationstwodifferentexchangeratebetweenthePesoandtheUSdollarwereused: theone-to-oneexchangerateprevailingunderconvertibility,andanalternativescenarioofa 100%devaluation.36 The analysis shows that, if the exchange rate had devalued by a 100% had convertibility been abandoned, the government would have had available in June 2001 excess funds for USD 30.4 billion, compared with the USD 18 billion it had under the Convertibility Law. Of course, the amount of excess funds is larger the earlier the exit from Convertibility would have been taken 36 ThePesoultimatelydevaluedbya100%betweenJanuaryandFebruaryof2002,underquitechaoticcircumstancesof default,depositfreezing,and“asymmetric”pesification. 33 during 2001. For instance, if Argentina had exited Convertibility in March 2001, excess funds availableundertheassumptionof100%devaluationwereUSD35.6billion. Thesefiguresneedtobecontrastedwiththegovernment’sfinancingrequirementsatthetime.In thisrespect,theArgentinegovernmenthadexplicitlyadoptedafter1995astrategyoflengthening thematurityofitspublicdebttoreduceliquidityrisk.By2001,theaveragematurityofthepublic debtexceeded8yearsandthesizeoftheyearlygovernment’sfinancingrequirementhadreached USD12billionandwouldbebetweenUSD13and14billioninthefollowingtwoyears.37Hence, theamountofexcessfundsavailabletothegovernmentwaslargeenoughtocoverthefinancing needs of the following year and a half (without issuing new debt), even after allowing for a significantlender-of-lastresortcapabilityinhardcurrency. Withafloatingexchangerateandthefinancingneedscoveredforasignificantperiodoftimein advance, interest rates would likely have fallen and the economy would have resumed growth. Hence, it can be concluded that the government had alternative policy options to avoid default, devaluationandpesification.Attheendofthethirdquarterof2001theCentralBankofArgentina hadastockofinternationalreservesofUSD21.5billionandthebankingsystemheldforeignliquid assetsforanadditionalUSD3.3billion.Moreover,theIMFprograminplacehadstilltodisburse additional funds to the government by USD 9.3 billion. Even in late 2001, such amount of resources provided the government with significant capacity to manage an orderly resolution of the economic crisis without having to resort to unprecedented and arbitrary measures such as asymmetricpesification. Anotherimportantquestionthatwouldhaveariseninthisscenariowasthatofthepotential lossesthatadevaluationwouldhavehadonthebankingsystemandwhatwouldhavebeenthe amountofcapitalthegovernmentcouldhavebeenrequiredtoinjectintothesystem.Inthis respect,onepossibleroutecouldhavebeentoallowfinancialinstitutionsvoluntarilyto restructureforeigncurrencyloansofthoseclientswhoserevenuesderivedmostlyfromthenontradablesector(i.e.services)and,hence,weresubjecttoasignificant(buttemporary)adverse relativepriceshock,andprovidegovernmentfundstorecapitalizethoseinstitutionsthatdidnot havethecapitaltoabsorbtheresultinglosses.Asignificantdistinctionmayhavebedrawnhere betweendomesticandforeignbanks,asthelattergroupwouldhavethecapacitytoabsorblosses providedtheruleoflawwasnotbroken. As shown in Table 6, the stock of bank loans to the private sector denominated in US dollars amountedtoUSD34.7billiononDecember31st,2001whilethestockofforeign-currencydeposits totaled USD 37 billion. On that date, foreign-currency loans provided by foreign banks and foreign-ownedsubsidiariesamountedtoUSD20.6billionwhileforeign-currencyloansprovidedby domesticbanksamountedtoUSD14.1billion. 37 Guidotti(2006)documentsthesignificantlengtheningofdebtmaturityoccurredintheperiod1994-2000. 34 Table6.Dollar-denominatedloansintheArgentinebankingsystemin2001 Source:OwncalculationsbasedondatafromCentralBankofArgentina Moreover,outofthetotalstockofforeign-currencyloanstotheprivatesector,about17.6%was allocatedtothetradablesector.Toreachthisfigure,averyrestrictivedefinitionoftradablesector isused,asitcontainsonlyloanstotheprimarysector(holdingashareof8.7%oftheloans)and manufacturingindustry(holdingashareof9%oftheloans).Assumingthattheproportionof loansdistributedbetweenthetradableandnon-tradablesectorissimilaracrossforeignand domesticbanks,weobtainthatthestockofforeign-currencyloansprovidedbydomesticbanksto thenon-tradablesectorandhouseholdsamountedtoapproximatelyUSD11.6billion. Hence,toobtainanestimateoftherecapitalizationthatwouldhavebeenrequiredbythefinancial system under the above-mentioned scenario, we computed the impact that three different loan restructuring options on bank capital and assumed that the loss faced by domestic banks would haverequiredrecapitalizationinfull(itisimportanttokeepinmindthatsuchrecapitalizationof domesticbanksreflectedthelackofadditionalcapitalofdomesticshareholdersandwouldmost likely have been required independently if banks themselves would have changed ownership or not). AfirstoptionconsideredisoneinwhichtherestructuringoftheUSD11.6billioninloanstothe non-tradablesectorwouldhavelikelyentailedanextensionofmaturityofexistingdollarloansto 5years(withbulletamortization)andareductionofinterestto5%peryear,withagraceperiodof 2yearsinwhichtheinterestcapitalizes.Usingadiscountrateof10%peryear,thereliefreceived byadebtoramountsto32.7%innetpresentvalue,yieldingabankcapitallossofUSD3.1billion.38 Asecondoptionconsideredisonewhereinterestisreducedto4%peryear,andthematurityis extendedto10years,witha2-yeargraceperiodandamortizationsdividedinequalinstallments of12.5%inyears3to10.39Inthisoption,therecapitalizationrequiredwouldhaveamountedto USD3.3billion. 38 Avariationofthisoptionisonewheretheloanrestructuringentailsareductionoftheinterestrateto3%peryear,an extension of maturity to 5 years but with amortization in three installments in years 3, 4, and 5. Using the same discountrate,thisoptionwouldhaveimpliedarecapitalizationofUSD2.6billion. 39 Thisstructurereplicatesthatofthedollar-denominatedbondsthatwereissuedin2002(i.e.,theBoden2012)topay depositorswhosedepositshadbeenfrozenbythegovernment. 35 Ascanbeseen,thepotentialbankinglossesthatcouldhaveemergedfromadevaluation,andthe requiredcapitalization,weremanageableundertheassumptionthattheruleoflawwouldbe maintained. DollarizewithanagreementwiththeFed? WhilethealternativeofexitingConvertibilitywasneverseriouslyconsideredbyArgentine policymakers,afterthe1998Russiandefault,thegovernment—specifically,theeconomyministry andthecentralbank—initiateddiscussionswithUSauthoritiesonaverydifferentexitstrategy: thedesignandimplementationofanArgentine-USMonetaryAgreementthatwouldserveasthe legalframeworkforArgentinatofullyadopttheUSdollarasitsowncurrency.40 ThedollarizationdebateinArgentinareflectedtwocontrastingfactors.Ontheonehand,there wasageneralperceptionthatConvertibilityhadcontributedtosubstantiallyimprove macroeconomicperformanceandhadfacilitatedtheadoptionofanumberofstructuralreformsin connectionwiththegovernment’sobjectiveofincreasingtheeconomy’sintegrationto internationaltradeandfinance.Ontheotherhand,despitethesuccessfulweatheringofthe1995 Tequilacrisis—whichhadstrengthenedsignificantlydomesticandinternationalcredibilityin Convertibility—therewasanincreasingperceptionthatArgentinaremainedvulnerabletofinancial contagion.Hence,thevulnerabilityassociatedwithastillincompletecredibilityinthe Convertibilityregimetranslatedintoasignificantriskpremiumthathadtobepaidongovernment andprivatedebts. Moreover,by1998,theinternationalconsensushadclearlyshiftedinfavoroftheadoptionof flexibleexchangeratebyemergingmarketeconomies.Tobesure,theso-called“bipolar”viewof exchange-rateregimes—thatrecommendedeitherflexibleexchangeratesorveryhardpegswas mostlyadiplomaticefforttoaccountforHongKong‘currencyboardandArgentina’s Convertibility.41 Inthisvein,in1998,theArgentinegovernmentstartedexploringwiththeUSTreasuryandFederal Reservetheimplementationofamonetaryagreementbetweenthetwocountries.4243Inaddition totheadoptionoftheUSdollarasitsowncurrency,thediscussioncontainedanimportant feature:therebateofseigniorage.Themostinnovativeaspectoftheseignioragediscussionwas itsuse.TheArgentinegovernmentenvisagedthattherebateofseignioragefromtheUSTreasury wouldimplyarevenuethatArgentina—thedollarizingcountry—wouldreceivearevenueflowof USdollarsthatcouldinturnbeusedas(AAA-rated)collateraltoobtainaliquidityfacilityfromthe 40 This section is based largely on Guidotti and Powell (2003) that contains a detailed discussion of the dollarization debate. 41 SeeFischer(2001)foradiscussionofthebipolarviewonthechoiceofexchange-rateregimes. 42 Other close observers of the Argentine economy suggested full dollarization as another alternative route for the government to pursue to restore investor confidence and produce a turnaround in the Argentine economy. See, for instance, Steve Hanke, “Argentina’s Current Political-Economic Crisis,” Statement before the Subcommittee on InternationalMonetaryPolicyandTrade,CommitteeonFinancialServices,UnitedStatesHouseofRepresentatives,of March5th,2002.Availableathttp://www.cato.org/testimony/ct-hanke030502.html. 43 The US Senate Banking Committee held hearings on possible dollarization in 1999, see www.banking.senate.gov/docs/reports/dollar.htm. 36 USFederalReservetotheArgentinecentralbank.Thus,suchcreditlinewouldprovidethe ArgentinecentralbankwithaUS-dollarcapacitytoactaslenderoflastresortinpotentialsystemic crises,resolvinganimportantargumentputforwardbycriticsofdollarization:that,under dollarization,thecentralbankwouldloseitscapabilitytoactaslenderoflastresort.44 GuidottiandPowell(2003)estimatedtheamountofseigniorageassociatedwithfulldollarization and the potential size of the liquidity facility that could be obtained by collateralizing its rebate. Although the estimates depend on a number of technical assumptions and the on the discount (risk-free)rateused,GuidottiandPowell(2003)reachedtheconclusionsthatthepotentialsizeof theliquidityfacilitywassignificant.EstimatedataroundUSD20billion—equivalenttoabout7% ofGDP—theliquidityfacilitywouldhavemorethandoubledtheArgentinecentralbank’sabilityto actasalenderoflastresort,whencomparedtowhatwaslegallypossibleunderConvertibility. While full dollarization would not resolve the issue of currency overvaluation—although some arguedthatthegovernmentcouldhavedevaluedbeforedollarizing(theso-calledD&Doption)— themainbenefitfortheeconomywouldaccruefromareductioninthesovereignriskpremium.45 Therefore,animportantfactorweighingonthedecisionwasbyhowmuchsovereignriskwouldbe reduced in the event of dollarization. The estimation of the impact of full dollarization on the sovereignriskpremiumiscomplexastheriskpremiumcontainsbothdevaluationriskanddefault (or credit) risk. Moreover, the two risks certainly may interact. Given the currency mismatches existingintheArgentineeconomy,adevaluationofthecurrency,dependingonitssize,mayforce the sovereign into default. Using different methodologies, Guidotti and Powell (2003) estimated that full dollarization may have reduced the sovereign risk spread between 120 and 325 basis points from a spread of about 600 basis points, namely the potential reduction would range between20%and54%ofthedefaultspread. Thedollarizationdiscussion,althoughitstimulatedawidedebateinpolicyandacademiccircles, both domestically and internationally, required significant political actions to take place both in Argentina and in the US, which involved both Congresses. 46 The timing of the debate was not alignedwithArgentina’spoliticalcalendarastheMenemadministrationwasenteringitslastyear in office, with no possibility of re-election. After a new administration took office at the end of 1999,thediscussionoffulldollarizationwasultimatelyabandoned. 44 WhiletheUSresponsetotheseignioragequestionandtothecollateralizedliquidityfacilitywaspositive,threeissues remained clear from the start: 1) Argentina would get no say whatsoever in the conduct of US monetary policy; ArgentinebankswouldhavenoaccesstothediscountwindowoftheUSFederalReserve;and3)theUSwouldhaveno banking-supervisionresponsibilitiesvis-á-visArgentinebanks. 45 ThereductionintheriskpremiumdirectlyrelatedtotheinterestrateconvergencethatthesouthernEUeconomies, suchasItaly,Portugal,andSpain,hadexperiencedwiththecreationoftheEuro. 46 Aroundthattime,EcuadorandElSalvadorhadunilaterallydollarized. 37 8. Concludingremarks ThispaperhasanalyzedtwobankingcrisesoccurredinArgentinain1995and2001,inthemidstof significantreformsintermsofbankingregulationandsupervision,andinamacroeconomic contextdominatedbya“hardpeg”exchange-rateregimeknownasConvertibility.Asusual, macroeconomicstressandbankingcrisesareeventsthattendtobecloselyassociatedandwhere thedirectionofcausalitytendstobedifficulttoidentify. Thetwocrisesanalyzedinthispaperarearareexamplewhere,fromthebehaviorofdepositors, wecangetlightonthedirectionofcausalitybetweenmacroeconomicstressandbankingcrises. Wehaveshownthat,despitethesignificantreformsputinplaceintheearly1990s,thecrisis experiencedbytheArgentinebankingsysteminearly1995(aftertheDecember1994devaluation oftheMexicanPeso)canbeattributedlargelytointernalweaknessesofthesystem,whichwas stillintheprocessofadaptingtothenewprudentialregulatoryenvironment.Inthatcase,as macroeconomicpolicystayedthecourse,andreformswereconsciouslydesignedtomeetthe limitationsofthelender-of-last-resortfunctionofthecentralbank,aswellastomaintainfiscal sustainability,thebankingcrisiswasvirulentbutshortlivedanditssuccessfulresolutiontranslated intorenewedpublicconfidenceinthesystem. The2001crisisshowsthereverse.Theconsolidationofthebankingsystemandthenewmacroprudentialregulationsimplementedafter1995hadmadethefinancialsystemmoreresilient,both intermsofcapitalizationaswellasintermsofliquidity.However,themacroeconomicsideofthe 2001crisisprovedtobeaninsurmountableobstacleforthefinancialsystem,andthe macroeconomiccrisisledtoabankingcrisisaswell.Aswehavediscussed,Argentinahadpolicy optionsthatcouldhavemitigatedandevenavoidedthe2001crisis,buttheseoptionsnowremain aselementsforanex-postanalysisofthecausesofthecrisis,ratherthanpartofitsfactualhistory. 38 References Calvo, G. (1998), “Capital Flows and Capital-Market Crises: The Simple Economics of Sudden Stops,”JournalofAppliedEconomics.Vol.1,Nbr.1. CalvoG.(1988),"ServicingthePublicDebt:TheRoleofExpectations,"AmericanEconomicReview, September,pp.647-661. CalvoG.,IzquierdoA.andE.Talvi.“Suddenstops,therealexchangerateandfiscalsustainability: Argentina´slessons,“IADB,May2003. 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