II Boom Years and Buildup of Vulnerabilities: 1992–98
Author: Ms. Christina Daseking, Mr. Atish R. Ghosh, Mr. Timothy D. Lane, and Mr. Alun H. Thomas
Language:
English
Keywords:
OP; regime; debt; crisis; deficit; U.S. dollar; commodity export; Board arrangement; potential GDP; collective bargaining system; Currency boards; Exchange rate arrangements; GDP deflator; Labor markets
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Abstract

Argentina’s 1991 Convertibility Plan seemed to herald a new era of high growth and low inflation, to be founded on disciplined macroeconomic policies and market-oriented structural reform. Real GDP growth, which, on average, had been negative during the 1980s (falling by about ½ percent per year), rebounded sharply to more than 10 percent during the first two years of the stabilization program and more than 5 percent during 1993–94 (Figure 1). After reaching hyperinflationary levels in the late 1980s, inflation fell to single digits by 1993. Capital inflows also began to surge, reflecting newfound confidence in the economy, until the 1995 Tequila crisis interrupted this impressive macroeconomic performance through a sharp reversal of capital flows and a slump in economic activity. However, when Argentina’s monetary conditions eased considerably soon after the crisis, and growth rebounded rapidly to 5 percent in 1996 and 8 percent in 1997, many observers only felt the robustness of Argentina’s economy confirmed.

Argentina’s 1991 Convertibility Plan seemed to herald a new era of high growth and low inflation, to be founded on disciplined macroeconomic policies and market-oriented structural reform. Real GDP growth, which, on average, had been negative during the 1980s (falling by about ½ percent per year), rebounded sharply to more than 10 percent during the first two years of the stabilization program and more than 5 percent during 1993–94 (Figure 1). After reaching hyperinflationary levels in the late 1980s, inflation fell to single digits by 1993. Capital inflows also began to surge, reflecting newfound confidence in the economy, until the 1995 Tequila crisis interrupted this impressive macroeconomic performance through a sharp reversal of capital flows and a slump in economic activity. However, when Argentina’s monetary conditions eased considerably soon after the crisis, and growth rebounded rapidly to 5 percent in 1996 and 8 percent in 1997, many observers only felt the robustness of Argentina’s economy confirmed.

Figure 1.
Figure 1.

Argentina: Key Macroeconomic Indicators

Source: IMF, World Economic Outlook.1 Derived from the financial account of the balance of payments.

Yet underlying this performance were both existing weaknesses and growing vulnerabilities, particularly in the fiscal area, the external and financial sectors, and the labor market. Fiscal performance, while not conspicuously profligate in terms of headline deficit measures, was repeatedly undermined by off-budget expenditures and was too weak throughout the 1990s to prevent a growing reliance on private capital flows to meet the public sector’s steadily rising borrowing needs. Exports, though growing at a solid 8 percent per year between 1990 and 1998, did not keep pace with sharply rising import demand, which grew at an average rate of 25 percent per year over the same period. The relatively small domestic financial sector fostered dependence on foreign debt-creating flows to finance both private and public spending. Finally, despite a good start on structural reforms, by mid-decade these were petering out and were, in some cases, even reversed, leaving important rigidities.

These vulnerabilities took on particular importance in the context of Argentina’s exchange rate regime. While the currency board brought significant benefits, ending decades of high or hyperinflation, it also implied restrictions on the use of monetary policy and the exchange rate as an adjustment tool, putting much of the onus of macroeconomic stabilization on fiscal policy, and requiring greater nominal flexibility of the economy, especially in the labor market, to absorb external shocks. The logic of a currency board is that the institutional and economic costs of abandoning the regime lend credibility to the peg. But this also means that in cases where persistent external and/or public sector deficits have resulted in the buildup of large exposures, a country is trapped in a regime that, by design, constrains the policy choices available to the authorities. At the time of the introduction of the currency board, IMF staff in its analyses expressed misgivings about the viability of the regime in light of concerns about price and wage competitiveness and the conduct of fiscal policy. Over time, despite the vulnerabilities exposed during the Tequila crisis, the IMF staff’s assessment of the currency board regime became more positive.

Public Finances

Despite a booming economy, Argentina’s public finances deteriorated during the 1990s (Table 1). The deterioration was the result of moderate headline deficits, averaging some 1½ percent of GDP over 1992–98, combined with persistent off-budget spending. The latter consisted mainly of court-ordered compensation payments after the social security reform of the early 1990s and arrears to suppliers, and raised average new borrowing requirements above 3 percent of GDP per year over this period. While off-budget expenditures tapered off over time, on-balance primary spending grew strongly, accompanied by rising interest payments. As a result, and with the revenue ratio broadly stable, Argentina’s estimated structural fiscal position deteriorated from approximate balance in 1992 and 1993 to a deficit of 2¾ percent of GDP by 1998.5 While it was not obvious that deficits of this magnitude were a problem, provided that growth rates remained at 5 percent or above, they spelled vulnerability in the event of much slower growth. This was the case because Argentina, instead of building up fiscal cushions during the boom period, had accumulated considerable amounts of new debt.

Table 1.

Fiscal Indicators

(In percent of GDP, unless otherwise indicated)

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Consolidated fiscal accounts of federal and provincial governments.

Actual balance corrected for the economic cycle (i.e., the difference between actual and potential GDP).

The impulse identifies the changes in the fiscal balance that are not due to cyclical fluctuations or changes in interest payments. A positive impulse defines an expansionary policy stance.

Includes various court-ordered compensation payments, including to pensioners and former victims of political prosecution.

For the purpose of deriving the structural balance and the fiscal impulse by the two subsectors of government, revenue and expenditure of the federal government are adjusted to exclude transfers to provinces.

Derived on the basis of a Hodrick-Prescott filter using quarterly GDP data from 1995 onward.

Positive figure indicates GDP above potential.

Spending—both on- and off-budget—was the main driving force behind the deteriorating public debt dynamics during this period. The federal government’s off-budget expenditures explain nearly 9 percentage points of the 10 percentage point increase in the public debt ratio from 31 percent of GDP in 1992 to 41 percent in 1998 (Table 2).6 Capitalized interest and valuation changes were roughly offset by privatization receipts, and both the primary deficit (excluding off-budget activities) as well as the endogenous debt dynamics—arising from the differential between growth and interest rates—had a roughly neutral impact on the debt ratio. This does not mean that budgetary performance was prudent, though: real primary spending (deflated by the GDP deflator) was allowed to grow by a cumulative 35 percent, or 5½ percent a year, during 1993–98.

Table 2.

Public Sector Debt Dynamics

(In percent of GDP, unless otherwise indicated)

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Endogenous debt dynamics result from the interest rate/growth differential and are derived as [(i–π)–g (1 + π)]/(1 + g + π + g π) times previous period debt ratio, with i = nominal effective interest rate; π = growth rate of GDP deflator; and g = real GDP growth rate.

Including valuation changes, capitalized interest, and other debt-creating transactions of provincial governments which added an estimated 0.2 to 0.4 percent of GDP annually to the public debt ratio during 1996–2001.

Defined as fiscal deficit, plus amortization of medium- and long-term debt, plus short-term debt at end of previous period. The federal government has accounted for about 90 percent of public debt over this period.

Derived as nominal interest expenditure divided by previous period debt stock.

Nominal rate minus change in GDP deflator.

Assumes that the effective interest rate on public debt remains unchanged.

Assumes unchanged average maturity of medium- and long-term debt and unchanged share of short-term in total debt.

A more cautious fiscal stance during this period could have greatly improved the public debt dynamics and likely prevented Argentina’s eventual default. This can be illustrated by contrasting the actual debt dynamics with a hypothetical alternative fiscal scenario. For example, if real on-budget spending increases had been limited to 3 percent a year, given the estimated average growth rate of potential GDP during the 1993–2001 period, the public debt ratio would have decreased to 26½ percent of GDP in 1998 even with unchanged off-budget activities (Table 2, bottom panel). Moreover, such a policy would have kept the debt ratio below 35 percent in 2001 (under the realized path of interest rates and GDP growth), thereby greatly reducing the government’s borrowing needs.

Perhaps the most serious misperception underlying policy errors during this period was an overly optimistic view of Argentina’s growth potential. Strong growth performance following the macroeconomic stabilization in the early 1990s, together with structural reforms and low inflation, led most observers—in the IMF, as well as in academia and private markets—to believe that Argentina’s potential growth had increased permanently to as much as 5 percent per year.7 This conclusion seemed to be supported by a rise in labor productivity.8 The economy’s resilience during the Tequila crisis also seemed to confirm that Argentina had entered an era of noninflationary high growth.

In hindsight, the expansion of Argentina’s economy during the 1990s appears to have reflected, in large part, a number of temporary factors. In particular, the high growth of the early 1990s may have reflected the low starting point associated with the adverse economic effects of the hyperinflation of the 1980s. In addition, private consumption—the main contributor to growth during this period—was fueled by a surge of durables consumption that, in turn, spurred private investment. Given the nature of this stock adjustment, once consumers had upgraded their possession of durables, consumption, investment, and growth would tend to return to more normal levels.9 Indeed, recent empirical estimates suggest that Argentina’s potential growth rate was closer to 3 to 3½ percent during this period and lower in 1999–2001 (see Appendix I). Moreover, while the Tequila episode demonstrated the resilience of the economy, it also showed that Argentina’s growth rate remained highly volatile.10 In particular, the crisis demonstrated the tendency for a currency board to bring about a procyclical monetary contraction in response to market pressures; and while Argentina navigated the crisis successfully during the Tequila crisis, the authorities began to deviate from the rigid rules of the currency board—for instance, by engaging in swaps and repurchase agreements to limit the automatic monetary contraction. The skill of the policymakers in facing these pressures made the regime seem more robust than it actually was.

The optimism regarding the country’s growth potential deflected attention from the underlying public debt dynamics. With average effective interest rates of 5 to 6 percent per year, moderately positive inflation rates, and assumed potential real growth of 5 percent, the autonomous debt dynamics appeared benign, fostering complacency about the growing indebtedness. The strength of the growth prospects seemed, at the time, to justify the rapid expansion of real primary spending that took place.

The rising debt ratio, however, generated steadily growing financing needs and vulnerability to adverse shifts in market conditions. As a result of the government’s on- and off-budget activities, as well as the graduated repayment schedule of the 1993 Brady rescheduling—which had brought welcome breathing space during earlier years—the federal government’s gross financing needs nearly doubled in the four years to 1998 to $20 billion or about 25 percent of total private emerging market bond financing. This ratio would rise to more than one-third in 2000–01. Thus, even with adept debt management, evidenced by relatively long average maturities and limited reliance on short-term debt or floating rate instruments, rollover risks rose sharply.11 This left the public finances vulnerable to a shift in market sentiment and to a downturn in economic growth—both of which began to transpire in the second half of 1998.

The room for fiscal maneuver was further reduced by decentralization and structural weaknesses on both the expenditure and the revenue sides. The extensive decentralization of responsibility for public expenditure, combined with an overly complex intergovernmental transfer system and the provinces’ ability to borrow, impeded effective countercyclical policies in the years of high growth and a more forceful response to the rising fiscal pressures in the later years (Box 2). Moreover, with transfers to provinces absorbing some 30 percent of the federal government budget, and, by 1998, social security benefits swallowing another 30 percent, and interest payments another 10 percent, the federal government’s scope for short-term fiscal adjustment was severely constrained. At the same time, revenue performance displayed considerable weakness. Although by 1998 the revenue ratio, at some 24 percent of GDP, had broadly recovered from the effects of the earlier pension reform,12 it remained low in comparison with many other emerging market countries—though not necessarily with countries in the region (Figure 2). More important, as evidenced by a comparison of tax efficiency across countries, the low revenue ratio in Argentina was not so much a reflection of favorable tax rates as of missed opportunities during the 1990s to strengthen the tax base and to curb widespread evasion.13 The narrowness of the tax base and weaknesses in tax administration left limited scope for raising revenues when the budgetary situation later deteriorated.

Figure 2.
Figure 2.

Revenue Performance in Selected Emerging Market Countries, Averages 1996–20001

Sources: IMF, Government Finance Statistics, International Financial Statistics, and World Economic Outlook; and Corporate Taxes 2001–2002, Worldwide Summaries (PricewaterhouseCoopers).1 Includes all countries with investment or speculative grade ratings by Moody’s, Standard and Poor’s or both, as of January 2001, plus Brazil. White bars indicate countries with investment grade rating by at least one of the two rating agencies.2 Derived as value added tax (VAT) revenue in percent of consumption, divided by standard VAT rate.

Argentina’s Intergovernmental Relations1

Argentina’s constitution provides for a significant degree of decentralization of public expenditure responsibilities. Spending by provincial governments, which carry the main responsibility for health and education, hovered at around 11 percent of GDP through the 1990s—some 45 percent of total public sector spending. Revenue generation, in contrast, has been dominated by federal taxes, with provincial governments traditionally collecting less than 4 percent of GDP in tax revenues, largely from their own turnover and property taxes. This imbalance has given rise to a complex system of transfers that has channeled some 6 percent of GDP per year from the federal government to the provinces. In addition, provinces have enjoyed considerable latitude in borrowing, because they are legally able to pledge their income from future transfers as collateral to creditors

This fiscal federal structure gave rise to a number of problems, some of which are common also to other federal systems (the United States, Germany, Switzerland):

  • The spending autonomy of the provinces, combined with their ability to borrow, obstructed efforts to consolidate the public finances. In 1997–99, in particular, when the federal government tightened policies by a cumulative equivalent of 1¼ percentage points of GDP to offset part of the cyclical deterioration, the provinces loosened their policy stance by ¾ percentage point of GDP. During this period, their already bloated payroll (with wage rates often exceeding their private sector equivalent) rose by over 1 percentage point of GDP alongside a surge in public sector employment.

  • The intergovernmental transfer system became overly complex, with different sharing arrangements for different taxes. Frequent adjustment of rules encouraged provinces to press for higher transfers while creating incentives for the federal government to introduce distortive taxes that were not shared (such as the financial transactions tax, initially, and the export tax). As such, the system became a major source of inefficiency and tension in fiscal policy.

  • Provinces had little incentive to improve their own revenue performance in the presence of growing co-participated and discretionary transfers. Indeed, only a small fraction of their rising expenditure was covered by increases in provincial taxes.

  • The revenue-sharing arrangement led to procyclical provincial policies. Particularly in years of fast growth when the economy was operating above its estimated potential (such as 1994 and 1997–98), the provinces added stimulus. Ironically, a temporary replacement of the procyclical system by a flat monthly transfer—negotiated in late 2000 to allow the federal budget to reap the benefits from a new tax package—became effectively a floor on transfers to the provinces in 2001 when revenues fell below their expected level.

1 For a more in-depth discussion of intergovernmental fiscal relations in Argentina, see Cuevas (2003).

Underlying the problems in the public finances were deep-rooted social and political tensions. Up until the early 1990s, Argentina had often resolved such tensions with periodic bouts of high inflation. Since the currency board regime ruled out inflationary finance, and the tensions were not tackled directly, competing claims on economic resources by various social groups ended up being reconciled by rising public sector indebtedness.14 Although Argentina compares fairly well with many other Latin American countries in terms of institutional strength, the widespread perception of corruption—which appears to have risen during the late 1990s while remaining fairly stable in Chile and Mexico and falling considerably in Brazil (Table 3)—only added to the socio-political divisions that made it impossible to garner the necessary support for decisive adjustment when it was needed.15

Table 3.

Ratings of Institutional Strength and Corruption

(scaled from 0 to 10)

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Sources: International Country Risk Guide, Political Risk Services Group;Transparency International.

The rating is the average of the ratings for “law and order,” “freedom from corruption,” “democratic accountability” and “bureaucratic quality.” For each of these categories, higher numbers indicate that institutions are better.

The index is scaled on the degree of cleanliness so that 0 is the most corrupt and 10 is the most clean.

The Structural Setting

External Sector

The export sector’s limited contribution to the economy—accounting for around 10 percent of GDP—was a key weakness of the Argentine economy. First, it limited the ability of the external sector to provide a buffer against swings in domestic demand. When private consumption and investment went into a sharp downturn in mid-1998, the economy could not plausibly export its way out of recession. Second, it made the economy more vulnerable to shifts of investor sentiment in international capital markets. When capital flows were curtailed, the ability to generate export revenues to pay for imports and debt service was limited—a particular concern for international liquidity given that, under the currency board regime, international reserves were needed to back the domestic currency. Third, even with a relatively moderate external debt-to-GDP ratio of less than 50 percent in 1998 (of which about three-fifths was public sector), the low export share implied a precariously high debt-to-export ratio of 455 percent, with debt-service payments alone absorbing three-quarters of annual export earnings (Figure 3). This made external sustainability highly susceptible to any slowdown in export growth. Moreover, to the extent that the real exchange rate was overvalued, the debt-to-GDP ratio was mislead-ingly low. Through late 1998, exports were projected by IMF staff to grow at about 12 percent in 1999 and the debt-to-export ratio was projected to stabilize at 450 percent. In the event, export revenues declined by more than 12 percent and the debt-to-export ratio rose to 530 percent, bringing debt sustainability increasingly into question.

Figure 3.
Figure 3.

External Debt Ratios in Selected Countries, 19981

Source: IMF, World Economic Outlook.1 Includes all countries with investment or speculative grade ratings by Moody’s, Standard and Poor’s or both, as of January 2001, plus Brazil.

One of the factors behind the low export share was the sharp appreciation of the real exchange rate during the early stages of stabilization. Between 1991 and 1993, the CPI-based real effective exchange rate appreciated by almost 25 percent. Although exports grew rapidly during this period, they did so from a very low base, and the real appreciation may have impeded further export expansion and diversification (although this impact was partly offset by a lowering of export taxes in 2002, from about 4 percent of the value of exports to close to zero). While it is impossible to prove that Argentina’s exports would have performed much better under a flexible exchange rate arrangement once trade was liberalized, it is striking that other countries that have undergone major trade liberalizations and were considerably more successful in boosting export shares (such as Spain in the mid-1970s, Chile during the 1970s and 1980s, and Turkey in the early 1980s) have done so in the context of a depreciating real exchange rate (Box 3). From 1993 until 1998, Argentina’s CPI-based competitiveness remained roughly unchanged (Figure 4), while the (less reliable) unit labor cost measure of the real effective exchange rate depreciated by about 30 percent. However, the latter is based on industrial sector wages only, representing a relatively small share of Argentina’s export sector. Moreover, both exchange rate measures fail to capture the “true” competitiveness of Argentine products, to the extent that Mercosur implicitly sheltered the regional market from foreign competition in higher quality goods (see below).

Figure 4.
Figure 4.

Exports, Imports, Terms of Trade, and Real Exchange Rate

Sources: IMF, Information Notice System; INDEC; IBGE; and IMF staff estimates.

Indeed, the concentration of Argentina’s exports in primary products and to Mercosur (Brazil, in particular) represented a major vulnerability. About 20 percent of Argentina’s exports are primary products (and a further 35 percent closely related agricultural manufactures) that are subject to substantial trade barriers, low price elasticities, and wide swings in prices. Between mid-1996 and mid-1998, for example, the world price of Argentina’s commodity exports fell by 25 percent, followed by a further 20 percent decline in 1998 (Figure 5). Argentina’s exports also became highly concentrated geographically during the 1990s, partly as a result of trade diversion toward the Mercosur region, as exports to other markets grew much more slowly. Mercosur was established in 1991, removing tariffs between Argentina, Brazil, Paraguay, and Uruguay, and was followed by a free trade agreement with Chile and Bolivia. In 1991, Mercosur plus Chile and Bolivia accounted for 20 percent of Argentina’s exports; by 1998, that proportion had risen to 45 percent, with Brazil making up two-thirds of this. In addition, some studies of trade patterns suggest that the trade diversion toward Mercosur went hand-in-hand with a shift toward uncompetitive capital intensive goods, and industry-level studies have shown that (most notably for automobiles) quality remained lower, and prices higher, than in the world market.16 The Mercosur trading arrangement may thus have amplified the effect of the peso’s real appreciation by contributing to Argentina’s low export share as well as its vulnerability to adverse commodity price developments and, increasingly, to weaker regional demand, particularly from Brazil.

Figure 5.
Figure 5.

Export Performance

Sources: Authorities; IMF, World Economic Outlook; and IMF staff estimates.1 Equivalent to world import volumes.

Trade Liberalization and Real Exchange Rate Dynamics—Evidence from Other Countries

One of the main factors contributing to a rapid rise in Argentina’s debt-to-export ratio during the 1990s was an inability to substantially increase the country’s export market share when trade was liberalized. The share of exports in GDP rose only slightly over this period, whereas the behavior of the export ratio in a number of countries that started out at Argentina’s level of openness has been much more robust following the liberalization of their trade regimes (see the figure).

In the mid-1970s when Spain changed from an autocratic to a democratic regime, the economy became more open, with increased tourist revenue and capital inflows. Moreover, the 20 percent devaluation of the peso in 1977 and the additional devaluation of 8 percent in 1982 helped to maintain the momentum on export growth although rising labor costs partially undermined this price effect (see figure). Over the 10-year period between 1976 and 1985, the ratio of exports to GDP rose by 10 percentage points to 22 percent. Most of the trade gains between the mid-1970s and mid-1980s occurred in mechanical machinery, motor vehicles, petroleum products, and foodstuffs. Since then the economy has continued to transform itself, associated with a program of deregulation and privatization in the mid-1980s (shipbuilding and steel production) and entry into the European Union (in 1986).

In 1973, Chile’s military government initiated a deep structural reform program with trade liberalization playing a central part. Between 1974 and 1979, the import substitution model was dismantled with all nontariff barriers eliminated in 1976 and a uniform tariff of 10 percent set in 1979. Although the tariff rate rose in the early 1980s associated with the debt crisis, it returned to 11 percent in 1991. Over the 20-year period between 1973 and 1992, the ratio of exports to GDP rose by 30 percentage points to 35 percent, accompanied by considerable product diversification, with the contribution of mining exports falling from over 80 percent during 1960–73 to 46 percent over the 1991–99 period. This performance was boosted by a 50 percent real depreciation of the currency between 1980 and 1991, government assistance in improving supply responses by correcting key market failures, and an active effort to gather information on foreign markets.

uch02fig02

Export Ratios and Real Exchange Rates in Selected Countries

Sources: IMF, Information Notice System; and World Economic Outlook.

New Zealand’s economy is similar to the Argentine economy in many ways, especially in its concentration of natural resource intensive exports. In the early 1970s, natural resources (meat, wool, and dairy) accounted for over 90 percent of New Zealand’s exports, most of which went to the United Kingdom. However, in 1973, when the United Kingdom joined the European Union, New Zealand’s preferential market access vanished and it had to adjust to tougher competition in this market. Historically, New Zealand’s trade regime was dominated by import licenses, which only began to get rolled back in 1979. In 1984, the new government initiated a move to replace licenses with tariffs by selling import licenses to the highest bidder. This policy eventually led to a decline in the tariff rate to 7 percent by 1996–97 (broadly at the level of other OECD countries) from 28 percent in the mid-1980s. At the time of the introduction of the tariffication process the authorities also floated the currency but these policies had little impact on the export ratio over the 1975–95 period, which stayed fairly constant at 30 percent, as the real exchange rate did not vary much over this period. Between 1995 and 2001, however, the export ratio rose by 7 percentage points to 37 percent, while the currency depreciated by 15 percent.

Following a severe exchange rate crisis in the late 1970s, Turkey undertook a structural adjustment program with the objective of transforming its economy from import substitution to export orientation. This objective was to be achieved through real exchange rate depreciation, export subsidies, and import liberalization. Over the period 1981–91 the real exchange rate depreciated by about 20 percent, facilitating a sharp rise in exports. During the early 1980s export credits were given at preferential rates of interest, and tax rebates were also offered until 1989. These policies contributed to a rise in the export ratio from 5 percent to 17 percent of GDP by 1989, with the share of manufactures in total exports rising from 36 to 78 percent over the same period.

It appears that the combination of trade liberalization and real exchange rate depreciation contributed to the strong export performance of Chile, Spain, and Turkey during the 1980s whereas the absence of any noticeable real exchange rate movement in New Zealand hindered this adjustment. This finding suggests that Argentina’s failure to substantially raise its export share during the 1990s may be associated with the currency board, to the extent that it constrained downward adjustments in the real exchange rate.

Argentina’s export performance must also be viewed against the behavior of imports, a major factor contributing to the rise in the external debt ratio during the 1990s. Imports in nominal terms recorded phenomenal growth rates in the early 1990s following Argentina’s trade liberalization program in the late 1980s, when the average tariff rate was reduced from 45 percent to around 10 percent. Therefore, although export receipts grew at about 8 percent per year between 1990 and 1998, they did not keep pace with imports, which grew at an average rate of 25 percent per year over the same period, with particularly high growth rates in the first two years following the macroeconomic stabilization. While the real exchange rate appreciation and tariff reductions doubtless contributed to the import boom, an implied high income elasticity of imports meant that economic growth, while tending to reduce the ratio of the existing stock of debt in relation to GDP, also contributed to the further accumulation of debt through a wider trade deficit.

Financial System

Although Argentina’s domestic financial system was not at the root of its crisis, it contributed to the buildup of vulnerabilities by encouraging heavy reliance on foreign lending and extensive informal dollarization. Notwithstanding significant financial deepening during the 1990s, the financial system in Argentina remained relatively underdeveloped by wider international comparison—though it was roughly comparable to that of Brazil and Mexico. All three Latin American countries rank low in standard measures of financial development, such as equity market capitalization, total domestic credit, private sector credit, and M2—expressed in relation to GDP (Figure 6). Clearly, excessive reliance on the domestic banking sector can also create problems in a crisis, by spreading and magnifying the repercussions of financial shocks to the entire economy (as in Thailand in 1997). But a low level of domestic financial intermediation and little recourse to equity financing, as in Argentina, contributed to excessive reliance on foreign lending and thus a higher risk of liquidity problems.17

Figure 6.
Figure 6.

Indicators of Financial Market Development in Selected Countries, Averages 1997–99

(In percent of GDP)

Sources: World Bank, World Development Indicators; IMF, International Financial Statistics; and IMF staff estimates.1 M2 except for Brazil, France, Germany, Hungary, Mexico, United States (M3), and United Kingdom (M4).

Moreover, notwithstanding a significant strengthening of the Argentine banking system in the course of the 1990s, banks were exposed to a number of risks that subsequently materialized. Argentina’s financial sector underwent a significant transformation during the 1990s, with banking-system efficiency improving strongly as a result of substantial consolidation, privatization, and increased entry of foreign institutions. The consolidation, which halved the number of institutions, went hand-in-hand with improvements in the regulatory framework and strengthened supervision, especially after the Tequila crisis (during which 18 percent of total deposits were withdrawn in the space of three months). Nevertheless, while the banking system that emerged from this transformation was highly liquid and reasonably well capitalized by standard measures, banks’ profitability remained relatively low even before the recession, and high dollarization (despite positive net asset positions) exposed institutions to credit risk in the event of a devaluation—as both corporates and households relying on domestic-currency earnings borrowed extensively in dollars—and to liquidity risk in the event of a systemic bank run.18 Finally, banks’ exposure to the public sector grew steadily from about 10 percent of total assets at the end of 1994 to more than 20 percent at the end of 2000. The large and relatively weak public banks in particular—which accounted for one-third of the system’s total assets but half of all nonperforming loans at the end of 2000—were highly exposed to the government. While such exposures to government debt were not captured by standard measures of capital adequacy, they proved critical in the context of the government default that ultimately occurred. Thus, the banking system was vulnerable to three forms of shocks, all of which eventually materialized: economic downturn, devaluation of the exchange rate, and default by the public sector. Foreign-owned banks had contributed to a strengthening of the banking system, because they were less tied to the domestic economy (and politics) and therefore more robust, but their weaker domestic linkages had a downside. Like other international creditors, foreign-owned banks reduced their exposure when financial risks increased.

Labor Market

Like any fixed exchange rate system, the currency board required flexible domestic prices and wages to mitigate the impact of economic shocks on output and employment. Historically, labor regulation in Argentina has been highly protective of individual workers, imposing high barriers to dismissal and guaranteeing generous fringe benefits. In addition, collective bargaining at the industry level greatly reduced wage flexibility. While motivated by a desire for social cohesion and fairness, these protections were an additional element hampering Argentina’s ability to cope with exogenous shocks.

During the first half of the 1990s, the government embarked on a number of reforms aimed at enhancing labor market flexibility. These reforms took place in three phases: 1991, 1995, and 1998. The first set of reforms in 1991 represented a modest improvement in labor market flexibility, introducing fixed-term contracts and special training contracts for young workers. In 1995, the government, business organizations, and the Confederation of Labor reached agreement on facilitating temporary hiring and more flexible working hours for small and medium-sized firms. As a result of these reforms, the proportion of workers with fixed-term or training contracts increased substantially, from 6 percent of all employees in 1995 to 12 percent by 1997 (see Box 4 for a more detailed evaluation of labor market reforms in Argentina).

But further progress in deregulating the labor market was limited, and some new measures even reversed earlier reforms. In 1996, the government drafted legislation to further increase labor market flexibility and reduce labor costs—decentralizing the collective bargaining process by allowing wage negotiations at the firm rather than at the industry level; removing the ultractividad (a practice whereby collective agreements remain in effect until superseded by new arrangements); and replacing the costly system of severance payments by unemployment insurance based on individual accounts. In the event, the legislation met considerable resistance from unions and in Congress and was abandoned. The new law, passed in September 1998, represented a much-diluted version of the 1996 draft: although it did reduce dismissal costs, it retained the ultractividad, and actually promoted a further centralization of collective bargaining.19 Moreover, while the payroll tax was reduced from 49 percent of gross earnings in the early 1990s to 43 percent by 2000, it remained high by international standards.

Labor Market Reforms: How Much Was Done?

This box evaluates the Argentine labor market across a number of dimensions, including its fluidity, the opportunity cost of job search, the extent of job security regulations, the wage bargaining system, and the level of payroll taxes. It draws on cross-country evidence of the effects of labor market institutions and reforms.

Labor market fluidity

Reemployment rates for those employed on short-term contracts rose dramatically as a result of the 1995 reform, suggesting a fairly fluid labor market. Hopenhayn (2003) has estimated that reemployment rates rose by 40 percent, contributing to a relatively low incidence of long-term unemployment for Argentina during the 1990s (16 percent of unemployed in Argentina versus 45 percent for OECD countries with average unemployment over 10 percent). However, these figures are partly misleading because workers in Argentina move between employment and unemployment at regular intervals. Galiani and Hopenhayn (2003) have found that over a two-year period, 34 percent of Argentine unemployed spend more than one year in unemployment. Therefore, once the reincidence of unemployment spells is taken into account, the incidence of long-term unemployment in Argentina is comparable to the incidence found in European economies.

The opportunity cost of job search

Argentina’s policy of reducing severance pay for small firms in the 1995 reform was a step forward, although it would have been preferable to reduce severance pay across the board rather than to create a separate class of workers on fixed-term contracts. While the introduction of a limited number of fixed-term contracts is likely to increase flows through the labor market (which occurred in Argentina), the impact on unemployment is likely to be minimal because workers tend to switch from one temporary job to another. Blanchard and Landier (2001) found, in a different country context, that this type of reform results in more low productivity entry-level jobs, fewer regular jobs, and lower overall productivity and output.

Job security

Heckman and Pagés (2000) have calculated that Argentina ranks fairly high in terms of job security regulations. This assessment is based on a cost index, defined as the expected future cost of dismissing a worker. For Argentina, the cost is estimated at 25 percent of the annual wage, compared with zero in the United States and 15 percent in Brazil. Among a group of 36 Latin American, Caribbean, and OECD countries, only 12 have higher dismissal costs, including Mexico (26 percent) and Chile (28 percent). Although these figures do not take into account the increase in temporary and fixed-term contracts due to reforms in Argentina in the mid-90s, they still capture the marginal cost of dismissing a tenured worker.

The empirical literature on the effects of employment protection on the labor market and growth is mixed. Despite the existence of employment protection, unprofitable jobs are closed down and profitable ones start up at a reasonable rate in most countries. Some have argued that job security enhances productivity performance because productivity growth is often higher when employees are given some degree of autonomy in decision making (see Levine and Tyson, 1990). On the other hand, Di Tella and MacCulloch (1998) have shown using survey data that labor market flexibility increases employment. Although Argentina is not in their sample, it is possible to get an indirect estimate of the potential effects of less employment protection if we assume that Heckman’s job protection index correlates with their index. Using the calculations of Di Tella and MacCulloch, it is estimated that the potential improvement in the Argentine labor market from increased flexibility could amount to an increase in employment of over 5 percent.

The wage bargaining system

Argentina’s collective bargaining system is characterized by extensive protection and promotion of union activity. In the Argentine model, few unions are granted personeria gremial by the state, a special union status that confers a monopoly in representing workers in collective bargaining and strike. As a result, firm-based unions do not have union status if a higher-level union is organized and this scenario results in collective bargaining taking place at the industry level, generally found to be the least conducive to real wage adjustment (Calmfors and Driffill, 1988; and Thomas, 2002). Nickel and Denny (1990) have shown that the ability of unions to capture quasi rents has negative effects on investment and hence labor productivity. Moreover, Card and Freeman (2002) document that the elimination of Britain’s productivity gap with France and Germany over the 1979–99 period is closely associated with the labor market reforms undertaken in the United Kingdom during the 1980s. In particular, they argue that the elimination of the productivity differential of about 10 percent between union and non-union workers could have contributed a 4.3 percent productivity gain over this period, corresponding to an annual improvement of 0.2 percentage points. Thomas has estimated average output growth differences between countries with flexible and rigid wages over the 1970–98 period and found that the difference was statistically significant at 0.3 percentage points of growth a year.

Payroll taxes

On the association between payroll tax changes and durable employment effects, the empirical evidence for Latin American countries is mixed. Gruber (1995) estimates that the reduced costs of payroll taxation to firms in Chile were fully passed on to workers in the form of higher wages following the pension reform in the early 1980s. In contrast, Edwards and Edwards (2000) argue that the reform might have contributed to lowering the unemployment rate between 2 and 3 percentage points. There are no unique studies for Argentina, but an analysis of the effect of job security and social security contributions on the employment-population ratio among Latin American countries revealed that a 1 percentage point decline in the payroll tax rate would lead to a 0.16 percentage point increase in the employment-population ratio. In Argentina’s case, this would correspond to a 2 percentage point reduction in the unemployment rate following a 5 percent decline in the payroll tax rate, assuming the labor force remained constant. This result is comparable to findings on the Netherlands in the late 1980s and early 1990s by IMF staff, which indicated that the sensitivity of the wage to a 1 percentage point change in payroll taxation was 0.7 and that the sensitivity of employment to a 1 percent change in the real wage was 0.38. Combining these estimates at the average employment-population ratio for the Netherlands during the early 1990s would yield a 0.15 percentage point change for each 1 percent change in the payroll tax rate.

While the empirical analysis of the effects of labor market reform is not particularly robust, it is reasonable to argue that Argentina would have improved its labor market performance considerably if it had made it more flexible and reduced its associated tax burden. In particular, combining an increase in labor market flexibility to U.S. levels with a 5 percentage point reduction in the payroll tax rate could have halved the unemployment rate.

As a result, despite the reforms of the 1990s that boosted labor productivity in the industrial sector and improved cost competitiveness, Argentina’s labor market was not flexible enough to prevent a large rise in the unemployment rate. Labor productivity growth averaged a solid 3 percent a year during 1991–98, with especially strong gains in the industrial sector (Figure 7). The latter was driven by a declining industrial workforce, particularly in the earlier stages of liberalization.20 At the same time, industrial sector wage growth remained restrained, even though Argentina’s collective bargaining system encouraged industry-level agreements—a practice generally found to be the least conducive to real wage moderation21—the nominal wage per worker in the industrial sector declined by 1 percent a year between 1994 and 1998, with unit labor costs falling by about 20 percent over this period.22 However, labor market flexibility continued to be hampered by various legislative barriers, resulting in insufficient job creation. Indeed, although the drop in industrial sector employment in the first half of the 1990s was largely offset by new jobs created in the services sector, this was not sufficient to absorb a rapidly rising labor force. As a consequence, the unemployment rate doubled to 12 percent by 1994 and did not subsequently fall below this level (Figure 8). Moreover, economy-wide productivity growth trickled to zero in the second half of the decade, accompanied by a surge in public sector employment, while employment creation in the private sector was disappointing. In short, while some wage adjustment clearly did take place, it was insufficient to absorb a growing pool of unemployed.

Figure 7.
Figure 7.

Productivity and Wages

Sources: Argentine authorities; and IMF staff estimates.
Figure 8.
Figure 8.

Labor Market Characteristics

Sources: Argentine authorities; INDEC; and IMF staff estimates.1 The sharp fall in other services in late 2000 was the result of redistribution across categories.

Currency Board

The currency board was widely viewed as providing needed monetary stability after a long history of monetized fiscal deficits, high inflation, and low and volatile growth. But it was an inherently risky regime: it sacrificed the ability to use the exchange rate as an adjustment tool and constrained the authorities’ ability to alter monetary policy, with the potential of creating inconsistencies between monetary and fiscal policies and/or procyclical monetary conditions.

Under a currency board arrangement, a government is precluded from money financing of the deficit and would face a static constraint on its budget deficit if it were unable to issue debt. But this was not the case in Argentina, where the government was able to borrow amply both domestically and internationally. Thus, the currency board imposed a direct constraint only on fiscal policy, once creditors became concerned about the government’s solvency and unwilling to provide new financing. These considerations find reflection in recent theories of the “fiscal determination” of the price level, which suggest that a fixed exchange rate regime—a fortiori, a currency board arrangement—is viable only if the dynamics of fiscal policy are sufficiently flexible (Box 5). In the parlance of this literature, a fixed exchange rate requires a “money dominant” regime—that is, fiscal policy must adjust so that the government’s present value budget constraint is expected to be satisfied at a price level consistent with the fixed exchange rate. While this does not rule out the use of fiscal policy as a stabilization tool under a fixed exchange rate regime, it does imply the need for a prudent fiscal policy in good times since any fiscal expansion during a downturn is constrained by the requirement that the public sector’s solvency be satisfied at the given price level.

The currency board arrangement remained viable as long as there was sufficient political will to subordinate fiscal policy to maintaining the peg—in the sense of having a “money dominant” regime. While arguably this was the case during the early years of stabilization, the rising level of public indebtedness suggests that, at least at some point during the decade, Argentina slipped into a “fiscal dominant” regime, ultimately dooming the currency board arrangement.

Fiscal Discipline and the Viability of the Exchange Rate Regime

As noted in the text, under a fixed exchange rate regime, a government that cannot issue debt faces a static constraint on its budget deficit because the exchange rate peg limits monetary financing of the deficit. But Argentina’s public sector could issue debt both domestically and in international capital markets. Of greater relevance, therefore, are the implications of theories of the “fiscal determination” of the price level, as applied to the exchange rate regime.1 This theory emphasizes that a fixed exchange rate regime will be viable only to the extent that the dynamics of the public finances are sufficiently flexible.

The focal point of this literature is the intertemporal budget constraint of the consolidated public sector (including the central bank). A “no-Ponzi game” constraint, which requires that the present value of outstanding obligations be non-positive, implies that:

Dt+MtPt=Et⁢{Σj=0∞⁢(st+j+θt+j)(1+r)j}⁢(1)

where Dt is the nominal stock of outstanding government debt inherited at the beginning of period t, Mt is the nominal stock of money (net of the central bank’s foreign exchange reserves and credit to the economy) inherited at the beginning of period t, P is the price level, s is the primary surplus and θ is central bank seignorage (in real terms), (1 + r) is the economy’s discount factor, and E{•} is the expectations operator.

Assuming that the public sector does not repudiate its obligations (either bonds or base money), the inter-temporal budget constraint (1) must be satisfied. But there are two ways in which this may happen. In a money-dominant regime, the price level is determined, and it is the stream of primary surpluses on the right-hand-side of the equation that must adjust to maintain the government’s solvency. In a fiscal-dominant regime, the stream of future primary surpluses is given, and it is the price level that must adjust to ensure that the government’s present value budget constraint is satisfied.

Under a pegged exchange rate, the domestic price level is determined by the exchange rate (for instance, by purchasing power parity or—more generally—by the requirement that the exchange rate not become uncompetitive) and cannot, in general, adjust to satisfy (1). Therefore, to be viable, an exchange rate peg requires that macroeconomic policies operate under a “money dominant” regime.

The theory has a number of implications that are of direct relevance to Argentina’s experience. In particular, the larger the initial stock of debt, D, the more difficult it is to satisfy the present value budget constraint without an increase in the price level—that is, without a devaluation of the exchange rate. Moreover, to the extent that the price level is required to fall (to restore competitiveness following an increase in the nominal effective exchange rate), the left-hand side of the equation increases, requiring correspondingly larger primary surpluses to satisfy the intertemporal budget constraint.

1 On the fiscal determination of the price level, see Woodford (1994) and (1995); on the application of this theory to the exchange rate regime, see Canzoneri, Cumby, and Diba (1998) who provide a more general formulation of (1) under the assumption that the economy’s discount rate is not constant.

More generally, while the currency board undoubtedly played an essential part in the successful disinflation of the early 1990s, it is questionable whether the regime was an appropriate longer-term arrangement for Argentina. Given the structure of the Argentine economy, including its size, lack of openness, export concentration, and labor market rigidities, the case for maintaining the pegged exchange rate regime beyond the macroeconomic stabilization phase is not compelling. Indeed, a probit analysis of the choice between pegged or floating regimes, based on countries’ structural characteristics, generates an implied probability for a peg in Argentina of only 40–50 percent, compared with an average of about 70 percent for other countries that maintained a peg.23 Moreover, the implied probability is significantly higher (around 90 percent) for most smaller currency board countries, such as Estonia or members of the East Caribbean Central Bank (ECCB), though not for some of the larger, more export-diversified countries with currency boards.

Yet abandoning the currency board would have been far from costless. Part of the currency board’s credibility stemmed from the high cost—both economic and political—of exiting the regime. The most commonly cited costs of exiting a currency board (compared with a simple exchange rate peg) are the legal and institutional changes required. But of greater importance were the implications of the widespread dollarization of assets and liabilities. Dollarization may to some extent have been encouraged by the currency board itself, although the evidence is not conclusive (Box 6). Moreover, dollarization was to some extent encouraged by the financial regulatory framework associated with the currency board: consistent with the premise that the dollarpeso link was permanent and irrevocable, the regulators did not impose restrictions on currency mismatches.24 By the late 1990s, with more than one-half of banks’ assets and liabilities and 90 percent of the public debt denominated in foreign currency (mainly U.S. dollars), abandoning the currency board arrangement would have been extremely disruptive to the economy—as indeed it turned out to be. The loss of policy credibility also tended to discourage an early exit. Indeed, given the various crises afflicting emerging market countries, including the Mexican devaluation in 1994, the Asian crises in 1997–98, the Russian default in 1998, and the Brazilian devaluation in 1998–99, there were relatively few opportunities to exit the regime at a time when there was no turbulence in international capital markets.

Did the Currency Board Contribute to Dollarization?

A commonly asserted proposition is that Argentina’s currency board arrangement contributed to dollarization of the economy, in the sense that a large proportion of the banking system’s assets and liabilities were denominated in dollars (see the Figure). The argument harkens back to the East Asian crisis, where de jure or de facto exchange rate pegs were said to have encouraged dollar-denominated borrowing by reducing nominal exchange rate uncertainty. But neither the theoretical arguments nor the empirical evidence in favor of this proposition is especially compelling.

Dollarization is usually a reaction to monetary instability and a lack of confidence in the domestic currency, which induces individuals to want to hold U.S. dollars or dollar deposits as a store of value. Yet, if an exchange rate peg is credible, it should increase confidence in the domestic currency and thus decrease dollarization. In Argentina, for instance, the currency board arrangement made the peso (almost) “as good as the dollar.” Of course, short of replacing the domestic currency entirely, there will always be some risk premium on the domestic currency. In Argentina, over the period 1993–1998, the spread between peso- and U.S. dollar-denominated loans averaged less than 2 percentage points per year (though it was considerably larger in the immediate aftermath of the Tequila crisis).

One argument is that, to the extent that borrowers believe the peg will be maintained, they have the incentive to borrow in dollars, thus avoiding the risk premium on domestic-currency-denominated loans. In this sense, the fixed exchange rate regime could indeed encourage dollarization. The problem with this argument is that it is not logically consistent: if the peg is indeed credible, households will not want to hold dollar-denominated deposits, on which they receive a lower interest rate. Thus, the argument can normally not account for both extensive dollar-denominated borrowing and widespread holdings of dollar deposits. However, when doubts about the peg encourage holding of dollar deposits, households and firms may still have an incentive to borrow in dollars, if they expect to be bailed out (or simply default) in the event of a large devaluation. (Alternatively, borrowers may have anticipated government intervention to limit their exposure in the event of a devaluation—as indeed happened through the asymmetric pesoization.)

The empirical evidence is equally equivocal. A regression of the share of foreign currency deposits on the exchange rate regime (using a panel dataset of 88 mainly emerging market countries during the 1990s, 606 observations in total) actually yields a negative and statistically significant coefficient estimate for pegged exchange rate regimes. A pegged exchange rate regime is associated with a 12 percentage point lower share of foreign-currency deposits relative to floating regimes (and a 2 percentage point lower share relative to intermediate regimes).1 In contrast to the cross-country experience, in Argentina, the share of foreign-currency deposits to total deposits increased during the 1990s, suggesting that country-specific factors were at play, including, perhaps, the expectation that the government would intervene if the currency board collapsed.

uch02fig06

Indicators of Dollarization

Sources: Central Bank of Argentina; and IMF staff estimates.
1 Not controlling for country-specific effects, the coefficient on pegged regimes is −10.98 (t-statistic: 5.05***), while the coefficient on inflation is 0.44 (t-statistic: 2.76*); controlling for country-fixed effects, the coefficient on the pegged regime dummy becomes–11.98 (t-statistic: 2.07**), where one, two, and three asterisks denote statistical significance at the 10, 5, and 1 percent levels, respectively.

Based on these considerations, it would likely have been desirable to exit the currency board during a non-crisis period, when the exit could have been accomplished in a more orderly way. This would have meant exiting sometime between 1992 and the first half of 1994, or between 1996 and early 1997. But any talk of a possible exit met with fierce resistance: the economy was performing well during those periods, and there was strong support, both by the authorities and the public, for maintaining the currency board. As a result, the country found itself in a quandary, unable to muster the political support to tackle the public debt dynamics and commit unequivocally to a “money dominant” regime, yet unwilling to make a decisive break from the currency board arrangement, which was providing much needed policy credibility and allowing Argentina to continue to tap international capital markets despite its growing indebtedness.

Summary

Despite the boom, the Argentine economy became increasingly vulnerable to crisis during the 1990s. The chief locus of vulnerability was the increase in public sector indebtedness; the main structural deficiencies were the low share and high concentration of exports, the economy’s reliance on external savings, and the lack of labor market flexibility. At the same time, heavy reliance on foreign-currency-denominated borrowing and generally high dollarization raised the stakes associated with an eventual exit from the currency board. These weaknesses, which were not sufficiently addressed in IMF-supported programs during this time, had an importance beyond their individual implications: in combination, and particularly in the context of the currency board regime, they represented growing vulnerability to a sudden downturn—which eventually transpired in the latter half of 1998.

Within Same Series

Other IMF Content

Other Publishers Content

Cover Lessons from the Crisis in Argentina
Lessons from the Crisis in Argentina
Author: Ms. Christina Daseking, Mr. Atish R. Ghosh, Mr. Timothy D. Lane, and Mr. Alun H. Thomas
ISBN:
9781589063594
ISSN:
0251-6365
Publication Date:
10 Feb 2005
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781589063594.084
Pages:
60

Argentina: Key Macroeconomic Indicators

Revenue Performance in Selected Emerging Market Countries, Averages 1996–20001

External Debt Ratios in Selected Countries, 19981

Exports, Imports, Terms of Trade, and Real Exchange Rate

Export Performance

Export Ratios and Real Exchange Rates in Selected Countries

Indicators of Financial Market Development in Selected Countries, Averages 1997–99

(In percent of GDP)

Productivity and Wages

Labor Market Characteristics

Indicators of Dollarization

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