Abstract

In designing an appropriate response to a financial crisis, it is essential to assess the probable macroeconomic consequences, notably the effects on economic activity and inflation. This section reviews the experiences of countries that suffered serious financial and economic crises, including the emerging market crises of the 1990s and the “tablita episode” associated with the Latin American debt crisis of the early 1980s. The evidence shows that these crises had certain common features; in most cases, a reversal of capital flows brought about a sharp contraction in economic activity, stemming from balance sheet effects and the interruption of domestic and external financing flows. At the same time, these forces worked through countries in different ways, depending country-specific factors. This section discusses lessons drawn from this experience in order to help anticipate what might occur in Argentina following the regime change of late 2001.

In designing an appropriate response to a financial crisis, it is essential to assess the probable macroeconomic consequences, notably the effects on economic activity and inflation. This section reviews the experiences of countries that suffered serious financial and economic crises, including the emerging market crises of the 1990s and the “tablita episode” associated with the Latin American debt crisis of the early 1980s. The evidence shows that these crises had certain common features; in most cases, a reversal of capital flows brought about a sharp contraction in economic activity, stemming from balance sheet effects and the interruption of domestic and external financing flows. At the same time, these forces worked through countries in different ways, depending country-specific factors. This section discusses lessons drawn from this experience in order to help anticipate what might occur in Argentina following the regime change of late 2001.

In designing the policy response to a financial crisis, it is essential to assess the probable macroeconomic consequences. This issue was given particular prominence by the experience with the 1997–98 East Asian crisis. In the countries affected by that crisis, initial IMF staff projections for growth and inflation—aligned with the views of the authorities and close to the market consensus—turned out to be highly overoptimistic.1 Partly to avoid repeating this experience, IMF staff projections for Brazil in the context of its 1999 crisis were on the conservative side; however, Brazil’s downturn turned out to be mild in relation to other emerging market crises. This experience suggests that, in anticipating the macroeconomic consequences of a crisis, both the international experience and the specific factors that are likely to differentiate a particular crisis country need to be examined carefully.

This section reviews the experiences of countries that had suffered serious financial crises in the period prior to the regime change in Argentina in December 2001, December 2001,2 with a view to revealing common features that might serve to anticipate outcomes in Argentina itself and in other neighboring countries. The evidence studied shows that, whereas crises have certain common features, their evolution also reflects a number of country-specific factors. The analysis then tries to identify how this information could be used to anticipate what would occur in Argentina following the regime change of late 2001 and the subsequent currency and financial crisis.

The remainder of the section is organized as follows. The next subsection briefly reviews the behavior of output, the current account, and inflation in recent financial crises, including Mexico (1995), Indonesia, Korea, Malaysia, the Philippines, Russia and Thailand (all 1998), and Brazil and Ecuador (1999).3 A brief review of other potentially relevant cases follows—namely, of the tablita episodes in Argentina, Chile, and Uruguay in the early 1980s. The section concludes with a discussion of what were seen (at the time of the writing) as possible implications for Argentina, with emphasis on factors that would mitigate or exacerbate the impact of the change in policy regime.

Crisis Experience in the 1990s

Growth and Current Account Adjustment

Although the experience of financial crises presents a diversity of experience, certain general patterns emerge. With the exception of Brazil, all countries experienced declines in output in the first year of the crisis, but the severity and duration of the output collapse varied markedly—between 5 percent and 13 percent in most cases (Table 3.1). Typically, the output decline was short-lived, with reasonably strong, albeit also varying, recoveries in the second year of the crisis.

Table 3.1.

Real GDP Growth

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Source: IMF, World Economic Outlook database; and IMF staff estimates.

Central to most of these episodes was a sharp swing in the capital account, which forced a large adjustment in the current account balance during the first year of the crisis. This current account adjustment was associated with a decline in domestic demand that exceeded the decline in output. The decline in domestic demand, in turn, was homegrown: a decomposition of the demand-side components of GDP suggests that private sector consumption and investment demand were the main drivers of both the collapse and, in some cases (Brazil, Mexico, Korea), the subsequent recovery of output, although in other cases (Malaysia, Philippines, Russia) the recovery was led by exports (Table 3.2).

Table 3.2.

Contributions to Real GDP Growth

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Source: IMF,World Economic Outlook database; and IMF staff estimates.

In contrast, the external sector was generally supportive of economic activity. In the year of the crisis, the contribution of net exports was positive in virtually all countries, partial mitigating the output effects of the collapse in domestic demand. But in nearly all cases the surge in net exports was primarily the result of severe import compression, with a pickup in export volume growth playing at most a secondary role (Table 3.3). It is notable that these developments occurred in the Asian crisis countries, notwithstanding (1) their strong export orientation (measured by the share of exports in GDP); (2) a sizable real effective depreciation of their currencies (see the next subsection); and (3) an environment of strong global demand.

Table 3.3.

Current Account Adjustment

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Source: IMF, World Economic Outlook database; and IMF staff estimates.

Adverse supply shocks also appear to have played a key role in many of the crises.4 The precise propagation mechanism of the shocks, however, seems to have varied from case to case depending on country-specific factors.

The collapse of both demand and supply was, in turn, a reflection of adverse balance sheet effects of exchange rate changes on corporate and banking sectors with heavy foreign exchange exposures, and of the effects of interest rate changes on highly leveraged balance sheets. The loss of access to external financing together with a domestic credit crunch—reflecting major banking system weaknesses and overall uncertainty as well as high interest rates—deprived the private sector of liquidity and produced a major contraction in economic activity. In the Asian countries, these liquidity effects were exacerbated by very high leverage ratios.5

In Brazil, the crisis country experiencing the shal-lowest downturn, balance sheet effects were mitigated by widespread hedging by the private sector of its exposure to interest rate and exchange rate changes, mainly through holdings of U.S. dollar-and/or interest-rate-indexed public sector debt. While this pattern of exposures contained the adverse effects of the depreciation on the private sector, it necessitated strong fiscal adjustment to offset the adverse effects of the depreciation on public debt dynamics. Thus, the adjustment effort was shifted from the private sector to the public sector. The total adjustment effort, however, was likely unchanged.

In Indonesia, the country experiencing the most prolonged slump, balance sheet effects were much more pervasive because of large unhedged foreign currency exposures of the corporate sector. The absence of an institutional framework for resolving corporate debt problems was exacerbated by other structural weaknesses and was compounded by political turmoil and regional fragmentation within the country.

In virtually all the episodes of capital account crises, macroeconomic policies contributed to the resolution of the crisis. In countries that overcame the crisis quickly, substantial scope existed to ease monetary and fiscal policies. For instance, in Korea and Thailand, after a period of hesitation in monetary policy (during which money and credit aggregates continued to increase rapidly), overnight interest rates were boosted to peaks of about 25 percent and 15 percent in real terms, respectively. Market confidence was quickly restored, and interest rates declined to below pre-crisis levels. In addition, a strong initial fiscal position and the absence of a public debt problem provided room for fiscal policies to be eased substantially as the downturn deepened and for the public sector to recapitalize the financial sector without undermining medium-term fiscal sustainability.

Exchange Rate Depreciation and Inflation Pass-Through

Large fluctuations of the exchange rate were a defining characteristic of these recent crises, which were also key to their macroeconomic effects. A common feature in the crises of the 1990s was the very sharp depreciation of the nominal exchange rate during the first year, ranging from around 50 percent in Brazil and Korea to 375 percent in Indonesia (Table 3.4). In most cases, real effective exchange rates seem to have overshot their “equilibrium” levels. One year after the crisis, real effective exchange rates generally were more depreciated than most estimates of the levels deemed consistent with a sustainable current account.

Table 3.4.

Pass-Through from Exchange Rates to Prices

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Source: IMF, World Economic Outlook database; and IMF staff estimates.

Cumulative devaluation from month prior to the crisis.

Cumulative inflation from month prior to the crisis.

Ratio of cumulative inflation to cumulative devaluation over indicated horizon.

Short-term pass-through computed at one month horizon instead of three months.

Index not meaningful since the nominal exchange rate appreciated in year 2.

The experience with subsequent inflationary pressures varied considerably among the countries that suffered financial crises. Most Asian countries experienced only a mild pickup in inflation, with the exception of Indonesia. Crisis countries in other regions (Ecuador, Mexico and Russia) recorded a significant run-up in inflation. Even in Indonesia, however, the degree of pass-through one year after the devaluation was relatively small (around 20 percent) and similar to that of the other Asian crisis countries, although the exchange rate depreciation was much larger than in the other countries. In contrast, the estimated exchange rate pass-through to consumer prices in Ecuador, Mexico, and Russia was above 40 percent at the end of 12 months, and even higher after two years. In broad terms, the low degree of pass-through in the Asian countries has been attributed not only to the sharp decline in demand and the widening of an output gap, but also to these countries’ flexible labor markets, both in terms of wages and employment. Observers have also suggested that, in the case of the Asian countries, price stability for many years before the crises helped to contain inflationary expectations.

No clear relationship emerges across countries between the size of the real depreciation and the behavior of exports (see Figure 3.1). Export volumes picked up in all cases, but the degree of the pickup does not appear correlated to the real (CPI-based) depreciation of the currency. In the majority of cases export volume growth in the years after the devaluation did not differ much from that in the years prior to the crises; and in Indonesia—the episode where the real depreciation was the largest—export volume growth was actually lower in the post-crisis period.

Figure 3.1.
Figure 3.1.

Real Effective Exchange Rate (REER) Depreciation and Pickup in Exports

Sources: International Monetary Fund, World Economic Outlook and International Financial Statistics.1Ratio of the average export volume growth in the two years after the crisis to the average export growth in the two years prior to the crisis. A ratio above 1 indicates a positive response of export volume growth.

The Tablita Episodes

The evidence from the Southern Cone countries of Latin America in the early 1980s—the so-called tablita episodes, involving crawling exchange rate pegs with preannounced devaluation path—was also relevant for ascertaining the possible fallout from the Argentina crisis. As has been amply documented, the collapse of the exchange rate pegs in Argentina, Chile, and Uruguay in 1981–82 was caused primarily by high fiscal deficits and excessive foreign borrowing6—not too different from the situation in Argentina in 2001. Moreover, since the devaluations roughly coincided with the eruption of the 1982 debt crisis, the three countries were virtually cut off from foreign financing in the period following the breakdown of the peg—another feature that Argentina was likely to share in the aftermath of the crisis.

As in the emerging market crises of the 1990s, a sharp decline in output occurred the year the tablitas were abandoned (Table 3.5). In contrast to the more recent crisis episodes, however, output continued to decline one year after the devaluation. In fact, the cumulative output declines that followed the 1982 devaluations in Chile and Uruguay are among the highest recorded among developing countries in the period 1970–98.7

Table 3.5.

GDP Growth in Tablita Episodes

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Source: IMF, IFS.

There also are differences between the pass-through coefficients of the tablita episodes and those observed in the more recent crises (Table 3.6). In particular, the short-run (three-month) pass-through in the former episodes was considerably higher than those observed in recent crises (with the exceptions of Ecuador, Mexico, and Russia). Two years after the crisis the pass-through coefficients become more similar in the two groups (a coefficient of about 0.4); however, the cumulative rates of inflation and devaluation after two years were significantly higher in the tablita episodes than in the crises of the 1990s.

Table 3.6.

Pass-Through Coefficients in Tablita Episodes

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Source: IMF, IFS.

Cumulative devaluation from month prior to the crisis.

Cumulative inflation from month prior to the crisis; CPI, consumer price index.

Ratio of cumulative inflation to cumulative devaluation over indicated horizon.

Implications for Argentina

As noted earlier, the overview of past experiences with currency and financial crises was used to assess the factors that could be important for the macroeconomic performance of the Argentine economy in 2002 and beyond. In many respects, from the very beginning the situation in Argentina was seen as more complex than that prevailing at the outset of previous financial crises. Nonetheless, an attempt was made to ascertain the factors that would have mitigated the downturn of domestic demand and output in Argentina and those that would have tended to exacerbate it, with a view to providing an overall reckoning.

Mitigating Factors

One factor that was seen as possibly dampening the downturn was that the crisis had unfolded in slow stages, thus giving the private sector plenty of opportunity to hedge its exposure to both currency and country risks. It is unclear to what extent households and firms in Argentina took advantage of this opportunity, given the enormous costs of hedging and the scarcity of hedging instruments. The 22 percent decline in bank deposits during 2001 was at least partially due to anticipatory behavior. In addition, many foreign investors are likely to have liquidated their tradable positions in Argentina over the course of 2001 (although those foreign investors with equity stakes do not appear to have fared so well). Taken together, part of the swing in the capital account that characterized most recent financial crises started in Argentina during 2001, prior to the full onset of the crisis in 2002.

Another respect in which Argentina’s currency collapse took place in slow motion is that it came on top of three years of contraction in economic activity, with a cumulative decline in GDP of some 8/2 percentage points. This factor may have somewhat limited the further decline in output in 2002: in contrast to other crises in which domestic investment and consumption started out above trend, in Argentina these were already below trend. With regard to inflation, the depressed level of domestic demand resulted in a sizable output gap that would have helped to dampen excess demand pressures on prices.

Another possible mitigating factor was the holdings of U.S. dollars that Argentine residents kept outside the domestic banking system—primarily in cash and offshore deposits.8 The positive wealth effects that a depreciation of the peso would yield to holders of those U.S. dollar assets could help arrest the decline in domestic demand. On the negative side, to the extent that the value of U.S. dollars in circulation was large, the peso demand for base money (i.e., the base of the inflation tax) could decrease to relatively low levels, which would make the inflation rate very sensitive to any monetization of fiscal imbalances.

Aggravating Factors

At the same time, a number of special features of Argentina’s situation were seen as likely to contribute to a more severe downturn than in other cases. The unilateral debt default was expected to have both favorable and unfavorable consequences. On the positive side, the default limited the volume of capital outflows and debt servicing, thus reducing the required adjustment in the trade balance in the near term. On the negative side, the default likely exacerbated the loss of access to foreign financing that is characteristic of financial crises.

With a large number of creditors affected, and the widespread breaking of contracts, Argentina was seen as likely to face difficulties in obtaining trade credits until more stable financial conditions were restored, and unlikely to regain access to voluntary market financing for a long time. Among the crisis episodes reviewed, only countries that defaulted on debt-service obligations, including Ecuador and Russia in the 1990s and the tablita episodes in the 1980s, faced similarly dim prospects for regaining access to voluntary market financing when their crises erupted. The other crisis countries were able to benefit from a relatively rapid restoration of market access, mainly because they managed to avoid a debt default.

A key negative factor, which distinguished Argentina from all the other crisis countries reviewed, was the extended period of bank closures and deposit freeze. To begin with, these actions led to several weeks of virtual economic paralysis that had lingering repercussions on economic activity and tax revenues. In addition, the extended bank holiday and deposit freeze—together with the forced conversion into pesos of U.S. dollar loans and deposits (another feature not found in any other recent crisis)—was expected to have major negative effects on the public’s confidence in the enforceability of contracts, the domestic banking system, and the government’s commitments more generally—with lasting consequences, in particular, for financial intermediation in Argentina. Before these measures, confidence in the banking system had already eroded, as evidenced by a 22 percent fall in bank deposits in 2001. Thus, it seemed reasonable to expect that even after the situation was stabilized, the level of bank deposits in Argentina was likely to be substantially lower than under the convertibility regime.

The adjustment toward the new equilibrium was seen as a function of the pace at which the deposit freeze was lifted and of the stance of macroeconomic policies. However, as has been the case in past episodes of forced conversion of U.S. dollar deposits (as shown in Table 3.7), the adjustment would inevitably entail downward pressures on the exchange rate and outflows of private capital.9 This adjustment would also likely produce a sharp depreciation and large outflows of private capital like those that were observed from the very beginning in all the other financial crises. Such outflows did not occur in the immediate aftermath of December 2001 in Argentina because of the corralito (restrictions on the withdrawal of bank deposits) and the capital and foreign exchange controls.

Table 3.7.

Forced Conversions of U.S. Dollar Deposits and Bank Intermediation

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Sources: Savastano 1996; IFS; and IMF staff estimates.

Excluding demand deposits, except in Argentina (2002).

End–2000.

End–2001.

The supply of bank credit was also seen as likely to contract more in Argentina than in other recent crises. In addition to the rise in nonperforming loans produced by the expected further decline in economic activity, Argentine banks would need to overcome the near depletion of their capital resulting from the asymmetric conversion into pesos of their assets and liabilities (asymmetric “pesification”) and would probably face a steady erosion of their deposit base. These last two factors did not exist in other recent crises episodes. Their joint presence in the case of Argentina made it difficult to envisage a scenario where real interest rates would fall and bank credit would resume, enabling credit-dependent domestic firms to finance their working capital and investment activities. Indeed, a further decline in bank credit to the private sector, similar to that observed in other episodes of forced de-dollarization of bank loans and deposits (see Table 3.7), seemed a far more likely scenario.

The scope for supportive macroeconomic policies was also seen as much more limited in Argentina than in other crisis countries. The loss of access to either debt or monetary financing was seen as severely constraining any fiscal expansion. Fiscal measures targeted at the most vulnerable groups of the population would therefore need to be financed mostly with current revenues, which could fall sharply (reflecting the collapse in confidence in policymaking). Schemes of recapitalization based on large issuances of public bonds would also be constrained. Having just defaulted on its debt, it was difficult to imagine how the government could credibly guarantee schemes to recapitalize the banks or the corporate sector with instruments backed exclusively with future tax revenues.

The scope for monetary policy was seen as particularly limited. It was recognized that a partial lifting of the corralito announced in early February would help to reduce the pent-up demand for peso liquidity (as well as bring down the high, though unobservable, real interest rate) generated during the weeks when bank transactions were brought to a virtual halt. Nonetheless, the task of ascertaining with any degree of precision the size and likely behavior of the demand for pesos was seen as particularly daunting. Any attempt to ease monetary conditions under those circumstances was seen as likely to put pressure on the exchange rate and fuel inflationary expectations and, thus, as self-defeating. Moreover, once capital controls were eased and arbitrage conditions became binding again, the high level of country risk would set a floor for domestic interest rates that was likely to be well in excess of the peaks reached in other recent crises. On the other hand, if controls were used to maintain such an interest differential over an extended period, the resulting strong incentives for circumvention would be countered only at the cost of increasing distortions.

Corporate balance sheet effects were expected to be muted in the case of Argentina because of the forced conversion of dollar bank loans into pesos (most of them at parity), which implied a substantial reduction in indebtedness in real terms, and because Argentina’s corporations tended to be less highly leveraged than those in other crisis countries (see footnote 5). To the extent that such balance sheet effects nonetheless remained important in Argentina, they were seen as contributing to push aggregate supply and demand downward.

Finally, there was little hope that a pickup in net exports would help to mitigate the fall in domestic demand in Argentina. This was because the Argentine export sector was fairly small and dependent on primary goods with relatively inelastic supply, and imports had already fallen sharply (by more than one-third) during 2001. In addition, global economic weakness was also likely to limit the scope for export expansion.

The inflation outlook was seen as more difficult to predict, since it depended on the size of the exchange rate depreciation (itself a function of the lifting of the deposit freeze) and on the future stance of monetary policy. However, the experience of other crises—including those the 1980s—suggested that substantial pass-through from the (still forthcoming) exchange rate jump was likely, notwithstanding the large output gap: large negative supply shocks such as those affecting Argentina have tended to produce both deep recessions and surges in inflation, even if macroeconomic policies were broadly adequate.

References

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1

See, for instance, Lane and others (1999).

2

The initial version of this section was prepared in January 2002. The analysis thus provides historical perspective on the IMF’s changing view of Argentina’s macroeconomic prospects as the crisis unfolded. The analysis draws heavily on Ghosh and others (2002).

3

The dates in parentheses refer to the first full year of crisis. For Argentina, the first full year of crisis is 2002.

4

Evidence on the relative importance of supply and demand shocks—the behavior of inventories and results from an econometric decomposition of real GDP growth into aggregate supply and demand shocks—provides indications that supply shocks played an important role in a number of recent crises. For details, see Ghosh and others (2002).

5

For instance, average debt-equity ratios over 1986–96 were about 350 percent in Korea, 200 percent in Thailand and Indonesia, and around 100 percent in Malaysia, the Philippines, and Brazil. In Argentina, the average debt-equity ratio in 1999 was around 70 percent.

6

See, for example, Corbo and de Melo (1987); Calvo (1986); Diaz Alejandro (1981 and 1987); Dornbusch (1983); and Edwards (1985). Note that in the case of Chile, it was the private sector, rather than the public sector, that was the main source of overborrowing, as the public sector ran a continuous surplus.

8

The role and likely size of those holdings are discussed in Kamin and Ericsson (1993) and Baliño, Bennett, and Borensztein (1999).