Special Alert Argentina

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 While our clients are very familiar with our longstanding views that Argentina would eventually face debt servicing problems and that the government would have to devalue the currency in order to correct a serious structural problem, we would like to provide a brief explanation of these views to our new readers, and why we think the latest rescue package is equivalent to throwing good money after bad.

With much fanfare Argentina announced that the IMF will provide another heavy dose of financing to get the economy through the end of this year. The new package consists of about $8 billion in new money, plus a commitment from the US for additional financial resources. Argentina will also explore a restructuring of its external debt in order to reduce the heavy debt service burden.

The announcement of the latest IMF rescue package and the support it has received from key governments as well as from the international financial community reminds us of the fable "The Emperor Who Wore No Clothes." Apparently, no one wants to say that Argentina has a serious debt problem and that an economic recovery will not materialize until there is an adjustment to the currency. Instead, investors, governments, and international financial institutions keep saying that all Argentina needs is financial support to get out of this crisis. However, Argentina has become a frequent emergency borrower, which is indicative of a serious structural problem. In other words, these financial problems have been treated as simply bumps and potholes on the road, which only need a quick fix. In this case, we think that the road is in such bad state of disrepair that another route should be considered.

We think Argentina will eventually have to return to the IMF and the international financial community, to request yet another financial package and a new debt rescheduling. This vicious cycle will continue until the government comes to grip with the fundamental issue of competitiveness.

The key problem facing the economy is lack of competitiveness, which in turn is caused by the fixed exchange rate. The government deficit is only a reflection of the fundamental competitiveness problem. The deficit is in large part caused by falling revenues. The latest rescue package will only add another layer to the already very high debt. The government can only repay its debts by collecting revenues, which in turn can only increase if the economy grows. Unfortunately, the fixed exchange rate has crippled Argentinian firms' ability to compete, which has resulted in a prolonged recession.

There is another dimension to the fixed exchange rate problem. Usually, economic stabilization involves the use of both fiscal and monetary policies. In the case of Argentina, the authorities have only one option, fiscal policy, because the Convertibility Law precludes the movement of interest rates, or monetary policy, to stimulate a recovery. Unfortunately, the government’s need to control spending has also tied the fiscal arm.

The first step to solving the competitive problem is a devaluation. Other measures will have to follow. The government's so-called competitive legislation is a far cry from an incentive to producers. For example, investment tax credits will be ineffective if businesses find or have the expectation that there is no demand for their products.

The latest IMF program is tied to passage of the Law of Zero Deficit. We think the IMF has been shortsighted in its diagnosis by focusing exclusively on fiscal policy, and not on the micro-economic problems of producers. We also think that so much binding legislation – the Convertibility Law and now the Law of Zero Deficit – put a stranglehold on economic policy. Flexibility is the key for optimal government intervention in economic matters.

After three years of crippling recession and a number of years of budget deficits, it can be argued that the Argentine private sector has suffered enough bankruptcies and crowding out. The insistence on reducing the deficit to zero will only worsen the situation. In effect, this is Keynesian economics in reverse: now that the unemployment rate is high, the government wants to increase taxes and cut spending.

As we have said in our StratInfo Quarterly Updates, the financial sector faces significant liquidity problems. The monetary rule that every peso of the monetary based must be backed by a US$ has always given international financial markets a false sense of security. Total deposit liabilities of the banking system are about seven times the monetary base, and these are not backed by US$s. Thus there is a very high risk of a severe liquidity crunch. Without a Central Bank that can act as a lender of last resort, due to the Convertibility Law, the government will need to rely on public sector banks to provide liquidity to the banking system.

Argentina is far from qualifying for dollarization. Such a move would condemn the economy to a very long period of recession/depression. Perhaps in 20 years, as part of a common market agenda, it may make sense to consider a common currency in our hemisphere.

The mini-currency basket, or "canastilla Cavallo" is a badly designed copy of the European Currency Unit. It is a mistake to peg the currency, in this case the peso, to one of the currencies in the basket. We have been predicting a devaluation for some time. Originally we proposed that the Central Bank would simply issue a new regulation allowing commercial banks to negotiate a financial exchange rate. By going to a trade exchange rate, the Ministry of the Economy retains absolute control over the exchange rate, versus a financial rate that would be controlled by the financial markets.

With a devaluation, the government will most likely have to bail out many banks and corporations. This has happened before in other countries throughout the region. For example, the government could establish a fund to swap the banks’ bad loans for government bonds. Nevertheless, there is a delicate issue that a large portion of the banking system is foreign-owned. If these banks have to take a hit, they may then refuse to lend when the economy tries to recover, thus posing even more challenges to the government. But as we have been saying, the longer the government delays the devaluation, the much costlier the remedy. Curiously, some have argued that Argentina cannot devalue since a devaluation would cause many firms to go bankrupt. We think this is a terrible argument. It is equivalent to an insolvent company asking its creditors to lend it more money in order to avoid declaring bankruptcy. In dealing with a devaluation, the government would have to allow for a transition period as debtors are given time to sort out their problems.

Argentina has already gone through a debt restructuring. The so-called swap earlier this year was a euphemism for a restructuring. Most of the debt holders were local pension funds and financial intermediaries, who were "persuaded" to participate. Usually, a debtor has to restructure debt when it is unable to repay according to the original terms and conditions, which was the case with the "swap." By agreeing to the swap, the pension funds may not have acted in the best interest of their affiliates (future retirees).

Despite the cost of the adjustment, a post-devaluation Argentina would face very good prospects in the medium term. The government has implemented many good reforms since April 1991. The economy has strong fundamentals in terms of physical and human resources. A devaluation would result in some very good investment opportunities. Of course, existing equity holders would incur a sizeable capital loss.

On the other hand, a devaluation will inflict additional hardship on the Argentinian people, but unfortunately it cannot be avoided. Social tensions are already reaching the boiling point, due to widespread unemployment. Thus, the status quo is already putting a strain on the social fabric, which could have undesirable political consequences. A devaluation, while imposing an adjustment cost on Argentinians, would eventually trigger an economic recovery, which would then reduce unemployment and lift consumers’ purchasing power. The strength and timing of the recovery would also depend on factors outside the government’s control, such as the state of the world economy. In other words, a recession in the industrial economies at the time of the devaluation of the peso would delay the benefits that would accrue to Argentinian exporters from such a devaluation.