• Case: Argentina Currency Peg and Fiscal Reforms

• Minimum of 1 Internet source

Introduction This case study discusses the economic situation in Argentina from 1973 to 1989. It first focuses on the roots of Argentina’s economic problems and the execution of ineffectual policies during this period. It then examines the basis of the convertibility plan that was implemented in 1991.

Activity Instructions Respond to the following:

• Discuss the possible risks of the U.S. dollar peg. What are the advantages and disadvantages of such a policy?

• Evaluate the effects of the fiscal policies implemented by Menem and Cavallo in connection with the convertibility plan.

When analyzing a case study, all the used references (including the Internet) should appear within the text [e.g. (John Doe, 2008)] and on the references page. You are expected to apply all applicable course concepts, as well as those specific to the chapter from which the case or paper topic is drawn. The analysis should also contain a summary of related current developments obtained through searches on the Internet.

Writing Requirements (APA format)

• 4 pages (approx. 300 words per page), not including title page or references page

• 1-inch margins

• Double spaced

• 12-point Times New Roman font

• Title page with topic and name of student

• References page (minimum of 1 Internet source)

KEL569

©2010 by the Kellogg School of Management, Northwestern University. This case was prepared by Professor Nabil Al-Najjar and Research Assistant Simone Galperti. Cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. To order copies or request permission to reproduce materials, call 800-545-7685 (or 617-783-7600 outside the United States or Canada) or e-mail [email protected] No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Kellogg School of Management.

NABIL AL-NAJJAR

Argentina Currency Peg and Fiscal Reforms (A)

Between 1973 and 1989, Argentina’s per capita income experienced negative growth for the first time in history. Three different economic plans were implemented in attempts to cope with the financial and fiscal problems, but all failed to rescue the country’s economy. Between 1973 and 1975, Juan Peron’s government approached the perennial problem of high inflation with a centralized strategy based on direct government interventions to manage wages and prices through agreements with the private sector. However, persistent public deficits increased public debts and the money supply was massively used to liquidate the debts.1 After Peron’s death in 1975, the government made another effort to control inflation that ended badly: two devaluations ensued in a year and the peso fell from 10 to 30 against the dollar. Eventually inflation returned with large price increases. By the end of 1975, inflation had reached a three-digit rate, making real interest rates negative.

A military government took power and ruled Argentina from 1976 to 1983. The new cabinet believed that inflation (335 percent for retail prices in 1975) was caused by the considerable power of Peronist trade unions through their effect on wages and general labor costs. Consequently, civil liberties and political activism were limited and unions were put under the control of military offices: wages were frozen while prices were allowed to move freely. The management of public finances was improved, and in 1976 the government promised the International Monetary Fund (IMF) it would switch from multiple market-specific exchange rates to a single floating exchange rate. In 1977 stern monetary policies and conservative fiscal policies curbed inflation. However, the inflation rate dropped more than the nominal interest rate. This led to a sharp rise in the real interest rate, which in turn caused a drop in GDP of 3.2 percent in 1978. Furthermore, the monetary policies had only transitory effects and the annual inflation rate reached 175 percent that year. In 1979 a large amount of money entered the country, attracted by high returns on newly issued public debts. Finally, during 1980–1981 a crisis hit Argentina’s bank system. As a consequence of the government’s 1978 promise to guarantee bank deposits, the Central Bank had to pay depositors of liquidated banks. A period of devaluations ensued, causing GDP to fall in 1981 and 1982 and inflation to soar to 344 percent in 1983.

President Raúl Alfonsin governed Argentina from 1983 until 1989. At first, his cabinet tried to fight inflation by directly controlling prices, tariffs, and wages, contradicting IMF recommendations. In the meantime, the government was financing its foreign debts using foreign currency bought from the private sector via the Central Bank, which again fueled inflation, peaking at 627 percent in 1984. In 1985 a promise to use taxes and utilities tariffs, rather than

1 For instance, in April 1973 M1 (physical currency + checking and current accounts) grew at an annual rate of 119 percent.

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ARGENTINA CURRENCY PEG (A) KEL569

2 KELLOGG SCHOOL OF MANAGEMENT

monetary issues, to finance public expenses kept inflation under control (28.4 percent in the second quarter, 3.8 percent in the third, and 2.5 percent in the fourth). By 1986, however, this commitment had lost credibility, and Argentines began to extensively replace australs, the new currency, with dollars not just to store value but also for everyday transactions. After 1988, the government attempted a further economic program, called the Primavera Plan, based again on price and wage agreements and on exchange rate control, with the intervention of the Central Bank. Speculative attacks against the domestic currency intensified. The decade ended with a 3,080 percent annual inflation rate.

The Currency Peg

In 1991 the government led by President Carlos Saul Menem, who had been elected to office in May 1989, introduced a wide-ranging “convertibility plan,” a sweeping overhaul of the economy engineered by the Harvard-educated finance minister, Domingo Felipe Cavallo.

Below are the key facts underlying the new economic policy:

 The plan established a currency board that pegged the local currency to the U.S. dollar at a 1-to-1 ratio, a ratio at which the Central Bank was obliged to convert currency upon demand. It also required that the gold and foreign currency of the Central Bank be sufficient to back 100 percent of the monetary base.2

 The rationale behind convertibility was to send a credible signal to investors regarding Argentina’s commitment to monetary and fiscal discipline and to fight their fear of a recurrence of high inflation rates like those experienced in the 1980s. Argentina voluntarily swore off its right to print money because it had abused the privilege in the past. This restricted the money supply.

 The convertibility plan was credible because, by law, the Central Bank forfeited its right to conduct independent monetary policy even though it could still act on the broader money supply by changing the reserve requirements for banks.

 Argentina’s policymakers believed that the system was naturally balancing: when the peso was overvalued, imports would exceed exports. The Central Bank would convert extra pesos into U.S. dollars (needed to purchase imports) and the money supply would shrink. This in turn would drive up interest rates, pushing down investment and stifling economic activity until a balance between imports and exports could be reestablished.3

 As far as fiscal policy was concerned, Cavallo introduced a number of related reforms:

o A debt reduction plan to reduce foreign debt by 30 percent through 1992.

o Wide-scale privatizations affecting 90 percent of state-owned companies between 1991 and 1994.

2 The monetary base comprises the total amount of a currency that is either circulated in the hands of the public or held in commercial bank deposits in the Central Bank’s reserves. This measure of the money supply typically includes only the most liquid currencies. 3 Rafael Di Tella and Ingrid Vogel, “Argentina’s Convertibility Plan,” Case #9-702-002 (Harvard Business School Publishing, 2004), pp. 5–6.

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KEL569 ARGENTINA CURRENCY PEG (A)

KELLOGG SCHOOL OF MANAGEMENT 3

o Deregulation involving the abolition of all wage and price controls.

o Tax and administrative reform to create a more progressive taxation regime and, importantly, improve collections. As part of this reform, the government guaranteed a minimum amount of revenue for all provinces, regardless of the amount of taxes it was able to collect at the local level.

o Trade reform involving the reduction of tariffs and non-tariff barriers and the strengthening of the Mercosur customs union with Brazil, Paraguay, and Uruguay.

o Pension fund reforms that raised the retirement age and privatized much of the system.

o Labor reform to limit the power of unions and liberalize the market.

Policy Outcomes

The main outcomes of Cavallo’s policies included the following:

 Inflation dropped from 3,000 percent in 1989 to 25 percent in 1992 and to international levels by 1993.

 Argentina’s GDP growth rate jumped from -7 percent in 1989 to a compound annual growth rate of roughly 8 percent from 1990 to 1994 and an overall average of 4.7 percent between 1991 and 1999.

 A restoration of foreign and domestic investors’ confidence in the country resulted in a significant repatriation of the capital they had withdrawn from Argentina to invest in foreign assets. Moreover, foreign direct investments (FDI) increased and banks were flush with new deposits: FDI averaged $7.8 billion between 1991 and 2000, eleven times greater than the average FDI between 1980 and 1990.

 Overall, the country’s risk premiums4 fell, a remarkable testament to the stabilization of the economy. For example, the interest rate paid on deposits fell from 61.7 percent to 8 percent between 1991 and 2000, and the spread on dollar-denominated Argentine government bonds over U.S. Treasuries tended to come down, averaging 3.3 percentage points between 1997 and 1998.

 Current account deficit started to grow, exacerbated by the rise in U.S. interest rates in 1994, which pushed up domestic interest rates through the currency peg. In 1994 the fiscal deficit also began to rise, financed by increased borrowing. In fact, total external debt rose 130 percent between 1991 and 2001 to $150 billion. The total external debt to GDP ratio increased from 33 percent of GDP to 55 percent of GDP in the same period.

4 The risk premium of an asset—e.g., Argentina’s bonds—represents the return in excess of the risk-free rate of return that an investment in that asset is expected to yield. It is a form of compensation for investors who tolerate the extra risk—compared to that of a risk-free asset—in a given investment. For example, if investors judged Argentina’s bonds as riskier than, say, Brazil’s bonds, they would require a higher risk premium on the former than on the latter in order to buy Argentine bonds.

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ARGENTINA CURRENCY PEG (A) KEL569

4 KELLOGG SCHOOL OF MANAGEMENT

 Labor market policies could not prevent an increase in unemployment to 15 percent by 1995, a high rate compared to an average of 4 to 5 percent during the 1980s and 7.3 percent in 1990. The main reasons for this increase were that the opening of the economy and the privatization of public sector firms brought about the introduction of capital- intensive technology, which caused structural changes in labor demand such as skills requirements, while the rigidities of the labor market institutions (such as centralized bargaining, high severance costs, and high wage taxes) limited the ability of the labor supply to adapt to the restructuring of the industrial sector.

 Fiscal reforms also ended in failure. The government-guaranteed minimal revenues allowed provinces to borrow internationally and in essence left the federal government on the hook for the loans. Spending was out of control in the provinces. In addition, there was widespread tax evasion: Argentina was able to collect taxes equaling only 20 percent of GDP, compared to 30 percent in Brazil and 50 percent in European countries. This situation resulted in an ever-growing national debt.

Questions

Give your assessment of Argentina’s government policies, in particular:

1. Discuss the possible risks of the U.S. dollar peg. What are the advantages and disadvantages of such a policy?

2. Evaluate the effects of the fiscal policies implemented by Menem and Cavallo in connection with the convertibility plan.

This document is authorized for use only by Jamie Moreno ([email protected]edu). Copying or posting is an infringement of copyright. Please contact [email protected] or 800-988-0886 for additional copies.