Download The Savings Rate in Argentina and the Solow Growth Model

Argentina: Disaster and Recovery
By
Alex Viado
Georgie Webb
Kirsten Noland
April 9, 2007
Country Summary
Since 1976, Argentina has experienced political and economic tumult that would have ruined a
less resilient country. Control of the democratic country was seized by the military in 1976. The
junta’s brutal rule came to end in 1983 and the country returned to democracy. Between 1983
and 2001 Argentina’s economy was subject to a variety of ills including hyperinflation, rising
unemployment, recession, government corruption and a severe lack of transparency. Argentina
created a currency board in 1991 to slow hyperinflation but the board did not act as a lender of
last resort. The board pegged the peso to the US dollar at a rate of one-for-one. Throughout this
period the Argentine government accrued a significant amount of debt, largely due to a lack of
fiscal reform and pension reorganization problems. The economic situation was worsened by
recession, the Corralito policy, and asymmetric pesofication. By 2001, Argentina had entered
into a full-blown debt crisis. The crisis was further exacerbated by high rates of presidential
turnover. The peso was de-pegged from the US dollar in 2002. Argentina agreed to a $12.6BN
bailout from the IMF in 2003.1 Since then, Argentina has experienced an almost miraculous turnaround. Nestor Kirchner gained presidential office in 2003. The balance of the IMF debt was
repaid earlier than expected and the agreement was terminated in 2006. The socially minded
Kirchner’s popularity continues to soar in Argentina but external observers are concerned about
his consolidation of power.
GDP
Argentina entered into a recession in 1998 due to a series of exogenous shocks, most notably the
Mexican financial crisis and Brazilian currency devaluation. The Argentine peso was pegged to
a strong US dollar, which reduced capital inflows during the crises. As the Argentine debt crisis
loomed, real GDP dropped 14.81% from 2000 to 2002.2 There was a sharp turn-around in 2003,
and through 2005 real GDP grew 29.54%. Interestingly, most GDP growth is attributed to a
drop in the exchange rate not increases in consumption or investment.3
Fiscal Policy
The Argentine government ran a series of deficits during the 1990s and throughout the 20012002 financial crisis. The deficit was mainly due to inefficient tax collection and a bad pension
reform program.
After the crisis, Argentina’s central government improved its fiscal performance by instituting
new taxes on financial transactions and exports. The government ran surpluses in 2003 and 2004
as a result of these policies.
The fiscal surpluses of recent years are not only the result of increased revenue. Sharp reductions
in spending took place in 2002, including significant decreases in capital spending and interest
payments. These efforts reduced the real deficit by 70 percent in 2002. Since then, official
Dominguez, Kathryn M.E. and Linda L. Tesar. “International Borrowing and Macroeconomic Performance in
Argentina.” University of Michigan and NBER. Revised February 9, 2006. <http://wwwpersonal.umich.edu/~kathrynd/Dominguez&Tesar_Argentina_NBER2006.pdf> pg. 36.
2
All data is from International Monetary Fund, International Financial Statistics, March 2007 and MECON
Economic Activity Data <http://www.mecon.gov.ar/peconomica/basehome/infoeco_ing.html>.
3
“Argentina: Country Profile 2006.” The Economist Intelligence Unit. pg. 37.
1
1
statistics indicate that real government spending has gradually been increasing since 2003, with
real expenditures now at their pre-crisis levels.
The Intergovernmental Tax System
Argentina has a unique arrangement between the central government and the provincial
governments in administering its tax system. The primary collector of tax revenues in Argentina
is the central government, which is responsible for levying the VAT (Value Added Tax, or
consumption tax), the income tax, and a variety of other taxes. The provincial governments only
collect sales and property taxes. When it comes to spending, however, a significant amount of
the federal revenues are transferred to the provinces in what is called the “coparticipations”
scheme. Under this arrangement, many of the taxes collected by the federal government are
subject to sharing among the provinces. After earmarking revenue for social security and other
discretionary funds, the federal government then issues transfers to the provincial governments.
The amount that each province receives is based on a 1988 law that fixed the percentages of
coparticipated revenues for all provinces.4
There are a number of problems with this tax system, the most significant being the disincentive
for provinces to practice fiscal responsibility. Provincial governments can use the promise of
future transfers as collateral to finance their short-term deficits. While this allows provinces to
spend freely, it obligates the federal government to bail them out when they are suffering from
high levels of indebtedness. This obligation creates an environment of uncertainty for the federal
government, since it leaves open the potential for fiscal crisis at a provincial level to affect fiscal
policy at the federal level, which ultimately places a constraint on the central government’s
ability to conduct its fiscal policy.
The Corralito
As the country’s economy spiraled downwards, people were extracting money from their bank
accounts and transforming them into dollars, in fear of a possible devaluation of the peso.
During this time, bank deposits could be made in US dollars or pesos. On December 3, 2001
President de la Rua instituted the Corralito that restricted weekly bank withdrawals to 250 pesos
per account. Though this was a fiscal policy, it had the effect of restricting capital mobility and
shifting the money supply curve in. This resulted in drastic increases in the interest rate, up to
51% in 2002. Argentina instituted pesoficiation on February 3, 2002. Dollar denominated bank
deposits were converted to pesos at a rate of 1.4. The Corralito ended December 2, 2002.
Monetary Policy
The Convertibility Law, maintained by the currency board, was in effect between 1991 and
2002. With the peso pegged to the dollar, the Central Bank of Argentina ceased to have
responsibility over monetary and exchange rate policy. However, since the peso was allowed to
float, the Central Bank has been active in both roles, as well as resuming its function as a lender
of last resort.
In 2002, the Central Bank of Argentina issued money to part-finance the public-sector debt and
help out banks that were affected by the devaluation of the peso and bank runs. This, obviously,
4
Cuevas, A. Reforming Intergovernmental Fiscal Relations in Argentina. IMF Working Paper WP/03/90, May
2003.
2
can lead to inflation, and so to sterilize the effects, they sold foreign-exchange reserves and
short-term bills.5 International reserves fell from $25.1bn in 2000 to $10.48bn in 2002. Because
of a high rate of increase in the demand for money, these actions did not translate into
inflationary pressures. Under the IMF agreement, the Central Bank targeted monetary
aggregates, keeping net domestic assets at levels consistent with inflation.
By 2004, the Central Bank looked towards targeting a reference interest rate and maintaining a
competitive exchange rate as their key monetary policy goals. The Central Bank has been
successful in targeting the floating exchange rate at 3.1 pesos per dollar, as is indicated in the
data.
Inflation
Money demand growth began to slow over 2003 and 2004, and so the monetary expansion
implied through targeting the exchange rate fed through to higher prices and inflation. Inflation
doubled from 6.1% in 2004, to 12.3% in 2005. Policymakers have been reluctant to tighten
fiscal and monetary policy and therefore slow the growth of the economy. Instead, they have
opted for the decision to induce price controls. However, monetary policy has, in fact, become
less expansionary. The monetary base grew 143% between 2001 and 2002, but this rate slowed
to just 4% by 2005. Money supply absorption policies also remain, including raising the
minimum cash requirements for demand deposits, and eliminating the interest paid on demand
deposits.6
Net Exports
Argentina has had positive net exports since 2001. This has been a combination of two primary
factors, decreasing imports and price appreciation in commodity exports. Argentina’s main
exports are energy, fuels, and agro-industrial products. The devaluation of the peso has also
played an important role by decreasing the amount of goods imported by Argentine consumers.
However, the The Economist Intelligence Unit asserts that the increase in prices among
Argentina’s commodity exports has played more of a role than the devaluation of the peso. 7
Interest Rates
Argentine interest rates before and during the debt crisis were higher than the world interest rate.
High interest rates indicated to investors that Argentina carried investment risk and resulted in
capital outflows. Although Argentina was selling international reserves, which can counteract
the rising interest rate, the policy was insufficient and interest rates soared over 51% in 2002. As
net exports grew and the floating exchange rate stabilized, Argentine interest rates quieted and in
2005 were at 6.16%.
The Savings Rate in Argentina and the Solow Growth Model
The Solow growth model can be used to evaluate the long run economic growth of Argentina, In
particular, the Solow growth model allows us to determine whether the level of savings and
investment in Argentina is at a rate where consumption per capita, and thus the general standard
of living, is also being maximized. Using data from 2004 (the most recent year for which capital
“Argentina: Country Profile 2006.” pg. 34.
Redrado, Martín. Overview of monetary and financial policy in Argentina. December 2006.
7
“Argentina: Country Profile 2006.” pg. 46.
5
6
3
stock data was provided by MECON), it appears that the difference between the marginal
product of capital and depreciation exceeds the long-term growth rate (as measured by the
average of real GDP growth between 1994 and 2004). This finding suggests that Argentina is
below the Golden Rule steady state and that increasing the savings rate would increase
consumption per capita in the long run.
While increasing the savings rate will end up maximizing per capita consumption in the long run,
it also comes with intergenerational problems, as the current generation decreases consumption
per capita. The 2004 data indicates that Argentina is still below the golden rule steady state, with
gross national savings making up 20.6% of GDP, according to MECON. Real consumption per
capita, is still below 2000 pre-crisis levels. Clearly Argentina will face a significant challenge in
the short term if it opts to increase the savings rate in the long-term at the cost of decreasing
consumption in the present.
A number of options for increasing the savings rate that would normally be available to
policymakers are not as viable in Argentina. Deficit reduction (or surplus expansion) is one way
to increase the savings rate. The government has run a surplus the past couple of years, but
increasing the surplus would require cuts to current federal spending or increases in taxes. It is
important for Argentina to maintain a surplus while it still can. Given that real GDP has only
recently recovered to pre-crisis levels, it would be difficult in the short term for the government
to take on measures that could potentially put another short term hit on output. A package of tax
policy reform, however, may be able to provide incentives for private savings without
necessarily increasing the tax burden to individual households.
Policy Recommendations
Inflation
The government is now relying on price agreements with the private sector, and higher export
taxes to curb inflation. Tensions are growing amongst businesses, despite the government
conceding to keep wage agreements from rising above 19%.8 While they may be a useful shortterm policy, price controls impose dangers as they can lead to a misalignment in relative prices.
This often causes a resurgence of inflation once the controls are lifted thereby threatening the
potential for long-term stability.
Traditionally, policies focused on decreasing inflation necessarily mean tightening monetary and
fiscal policies, which using the IS-LM framework, will reduce output. Inflation is inherently a
monetary phenomenon. Therefore, the Central Bank should target higher interest rates to curb
price rises. This will necessarily mean a contraction of the money supply, and a shift of the LM
curve to the left translating into a shift downward of the AD curve resulting in a fall in prices and
output.
Argentina is a small country with an open economy. As such, the tightening of monetary policy
need not be quite as dramatic as it would in a closed economy. The increase in the interest rate
will appreciate the exchange rate, and suppress net exports. Because of the inclusion of net
8
“Argentina: Country Profile 2006.” pg. 35.
4
exports in the open economy model, initial contraction need not be quite as large to have the
same effect.
The theory of rational expectations, however, suggests that as long as the Central Bank clearly
indicates ahead of time that they are targeting higher interest rates so as to reduce inflation, and
this announcement is credible, people will adjust their expectations. In this way, disinflation
need not result in drastic loss of GDP and higher unemployment. The Central Bank of Argentina
is still building its reputation for policy, so consumer’s responses to the announcement may have
a smaller effect.
There are obvious trade-offs in the short run by lowering inflation, resulting in higher
unemployment and a reduction in net exports due to an appreciated exchange rate. However, in
the long run, the relationship between unemployment and inflation ceases to exist, and so it is
important to control this variable now, especially in a volatile economy such as Argentina.
Tax Policy
Argentina is in desperate need of tax reform to keep the economy on track and rebuild social
service infrastructure. Public school buildings and hospitals are physically falling apart and
fiscal policy must address this. One major problem is tax revenues. Argentina, like many
countries, has a high level of evasion which decreases fiscal revenues and prevents investment in
public capital goods. If the government were able to enforce better tax payment it could remedy
the nation’s failing infrastructure. However, in 2005 per capita income was $4,697 USD. Given
this level of poverty, tax reforms that would increase personal tax responsibility would be
difficult to implement. The other problem that arises is that increasing tax revenues could
potentially decrease savings. This would move the country further away from the Solow growth
model’s golden rule steady state.
We recommend that the country perform a comprehensive reform of the tax system.
Specifically, Argentina should focus on tax rates and disincentives for tax payment. The country
should consider if the tax rates are currently too high and perform analysis to determine what
progressive tax rate models would result in higher levels of payment. It may be that the citizens
feel that they are being unfairly burdened with taxes resulting in non-payment. Perhaps if tax
levels were lowered, payment levels would increase. Moreover, the government’s use of tax
money should be more transparent and show citizens that their money is going toward
educational and healthcare infrastructure projects.
Argentina needs to reform the transfer of central government revenues to the provinces. As the
system currently stands, there is no incentive for provinces to be fiscally responsible. If they run
into deficit, the central government will bail them out. We recommend that the central
government limit the level of deficit that each province can incur and insure that provinces’
budgets are balanced over a ten to fifteen year period. Since Argentina’s economy is still on the
rebound, it will require more fiscal flexibility.
5
Appendix
GDP
Year
GDP in Millions of Pesos
Real GDP
% Change Real GDP
In Millions of US Dollars
2000
284,204
2,842.08
n/a
284,346
2001
269,697
2,716.86
-4.04
268,831
2002
312,580
2,421.22
-10.88
102,042
2003
375,910
2,634.27
8.8
129,596
2004
447,307
2,872.88
9.06
154,049
2005
531,939
3,136.43
9.17
183,196
Budget Surplus/Deficit
Year
Deficit(-) or
Surplus
2000
2001
2002
2003
2004
-6,817.60
-8,739.90
-3,463.80
445.90
9,424.40
Budget Surplus/Deficit
12,000.00
10,000.00
8,000.00
6,000.00
Millions of Pesos
4,000.00
2,000.00
Budget Surplus/Deficit
0.00
2000
2001
2002
2003
2004
-2,000.00
-4,000.00
-6,000.00
-8,000.00
-10,000.00
Year
Exchange Rates
Year
Peso/Dollar
2000
0.9995
2001
0.9995
2002
3.06326
2003
2.90063
2004
2.90366
2005
2.90366
2006
3.05431
2001 - Corralito affecting money
supply
r
(M/P)
(M/P)
1
0
B
P
r
LM
1
LM
r
0
r1
1
r2
r0
L(r,Y)
IS
IS
0
1
(M/P
)
Net Exports
Year
Exports
2000
30,937
2001
30,977
2002
86,553
2003
93,869
2004
113,067
Imports
Net
Exports
-32,738
-27,435
-40,010
-53,385
-81,142
2005
130,958
101,306
-1,801
3,542
46,543
40,484
31,925
29,652
In Millions of Pesos
Net Exports
150,000
100,000
Millions of Pesos
50,000
0
2000
2001
2002
2003
-50,000
-100,000
-150,000
Year
2004
2005
Exports
Imports
Net Exports
Net Exports after abandoning the peg

1
2
NX()
NX (1)
NX (2)
(Exporting)
(Importing)
Net Exports
Interest Rates
Year
Argentina Money Market Rate
Argentina Lending Rate
US Lending Rate (Prime Rate)
2000
8.15
11.09
9.23
2001
24.9
27.71
6.92
2002
41.35
51.68
4.68
2003
3.74
19.15
4.12
2004
1.96
6.78
4.34
2005
4.11
6.16
6.19
Interest Rates
60
Interest Rate (in percent)
50
40
US Lending Rate (Prime Rate)
Argentina Lending Rate
30
20
10
0
Year
2000
2001
2002
2003
2004
Year
Solow Growth Model
2004 Calculation of Argentina Steady State
k = capital stock
∂*k = 0.1y (assuming 10% depreciation rate)
MPK * k = 0.2y (assuming capital income is about 20% of GDP – note: assumption made
because no reliable data on Argentina’s capital income could be found through IMF, MECON, or
World Bank sources)
Latest estimate of k in 2004 = 1,269,894,647 (thousands of pesos) (MECON)
= 1,269,894.6 (millions of pesos)
y in 2004 = 447,307
1,269,894.6 / 447,307 = 2.84
k=2.84y
∂k = 0.1y
∂ = 0.1y/2.84y = 0.035
(MPK * k) / k = 0.2y/2.84y = 0.07 = MPK
n + g = 1.7% (average growth for period between 1994 and 2004) = 0.017
MPK – ∂ = 0.035 > 0.017 = n+g (average growth for period between 1994 and 2004)
Year
Consumption
GDP Deflator
Real Consumption
Population
2000
197,044
100
1,970.44
36.9
2001
185,164
98.9
1,872.23
37.27
2002
193,482
129.1
1,498.70
37.64
2003
237,567
142.7
1,664.80
38.01
2004
281,167
155.7
1,805.83
38.37
2005
326,276
169.6
1,923.80
38.75
Consumption Per Capita
Change
5,339.95
4,968.18
-6.96%
5,140.33
3.47%
6,250.12
21.59%
7,327.78
17.24%
8,420.03
14.91%
Real Consumption Per Capita 53.399458 50.2343595 39.8166494 43.7990076
Change
-5.93%
-20.74%
10.00%
Steady-state
output,
depreciation,
population
growth and
tech progress
47.063469 49.6463786
7.45%
5.49%
(+n+g)k*
f(k*)
c*gold
sf(k*)
i*gold
k*
k* gold
(current)
Steady-state capital
per worker, k*
Monetary Policy Recommendation
r
LM1
LM0
BP
IS1
IS0
Y2 Y1 Y0
Y
P
SRAS0
P0
SRAS1
P1
AD0
AD1
Y2
Y0
Y