Argentinas Economic Crisis Essay Example for Free

Argentinas Economic Crisis Essay To divert attention from increasingly severe political and economic problems, in 1982 the junta ordered an invasion of the nearby Falkland Islands, a British territory that Argentina had long claimed. British forces counterattacked and took back the islands. A huge debt was accrued as a result of the war and at the end of the military government in 1983, the country’s industries unemployment were severely affected (Saxton, 2003). In 1983, the junta transferred power to an elected civilian president, Raul Alfonsin of the Radical Civic Union party. The new government’s plans included stabilizing the economy and introducing a new currency known as the austral. New loans were taken out and state eventually was unable to pay the interest on debt and eventually the confidence in austral collapsed. Inflation spiralled out of control, GDP shrank and wages fell by almost half. Following riots President Alfonsin stepped down six months before his term. In 1989, the Justicialist (Peronist) party’s Carlos Menem began governing and in 1991, he appointed Domingo Carvalho as the Minister of the Economy who introduced ‘Convertibility Law System’, which took effect on April 1, 1991. Saxton, 2004, p. 4). The Convertibility Law System ended the hyperinflation by establishing a pegged exchange rate with the U. S. dollar and backing the currency substantially with dollars. The aim was to ensure the acceptance of the currency after the 1989 and 1990 hyperinflation period, as people started rejecting the currency and dema nding US dollars (Hill, 2011). The exchange rate was initially 10,000 Argentine australes per dollar; on January 1, 1992 the peso replaced the austral at 1 peso = 10,000 australes = US$1. 4 (Saxton, 2003) Argentines were allowed to use dollars freely, price stability was assured and the value of the currency was preserved. The quality of life was raised for many and people could afford to travel abroad, buy imported goods and ask for loans from banks at a low interest rate. Argentina attracted extensive foreign investment, which helped modernize its utilities, ports, railroads, banks, and other sectors (Saxton, 2003). However, the fixed exchange rate made imports cheap which lead to loss of Argentina’s industrial infrastructure and increase in unemployment. In the meantime, government spending continued and public debts grew substantially as government needed to borrow to finance external debt. However, the government showed no intention of paying debt off and also delayed payment schedules, while IMF kept lending money. Eventually in 1998 Argentina entered in a four-year recession, during which its economy shrank 28 percent (Saxton, 2003). This happened as a result of the Argentina exports were harmed by devaluation of Brazilian Real and international revaluation of the dollar effectively revaluing the peso against its major trading partners Brazil and the euro area (Hornbeck, 2002). By 1999, elected President De la Rua was left with a country where unemployment had risen to a critical point and the undesirable effects of the fixed exchange rate were showing. The De la Rua government was mainly worried about the federal budget deficit, which was 2. 5 percent of GDP in 1999. That left only one option: raising tax rates. President De la Rua secured approval for three big tax increases, effective January 2000, April 2001, and August 2001. Hence, massive tax evasion and money laundering happened also led to funds evaporating to offshore banks. In 2001, the freeze on bank deposits began, in response to large withdrawals as people started losing confidence in economy. The economy turned from recession to depression as people and businesses could not make payments. Credit evaporated. Many people took to the streets in angry demonstrations which also led to supermarket looting and President De la Rua resigning (Horbeck, 2002). By late 2001, the government tax revenues plunged as the economy contracted and the Argentina government defaulted in its debt repayments, effectively ‘rendering ? 80 billion of government issued bonds worthless’ (Hill, 2011, p. 99). The debt default to IMF was the final nail in the coffin and in early 2002, the government finally allowed the peso to float freely. Hence, the peso immediately fell $1=3. 5 pesos (Hill, 2011). Q1. A fixed exchange rate is an  exchange rate  for a  currency  where the government has decided to link the  value  to another currency or to some valuable commodity like gold. For example in 1990, Argentina fixed the exchange rate of the Argentinean peso to the U. S. dollar at $1=1 peso. A government may fix its currency by holding  reserves  of the  peg  (or the  asset  to which it is fixed) in the  central bank. For example, if a country fixes its currency to the  British pound, it must hold enough pounds in reserve to account for all of its currency in  circulation. Importantly, fixed exchange rates do not change according to  market  conditions. It is also called a pegged exchange rate. For most of the period between 1975 and 1990, Argentina experienced hyperinflation (averaging 325% a year)+, poor or negative  GDP  growth, a severe lack of confidence in the  national government  and the  Central Bank, and low levels of  capital  investment. After eight currency crises since the early 1970s,  inflation  peaked in 1989, reaching 5,000% that year. GDP was 10% lower than in 1980 and per capita GDP had fallen by over 20%. Fixed investment  fell by over half and, by 1989, could not cover yearly  depreciation   particularly in the industrial sector. Social indicators deteriorated seriously: real wages collapsed to about half of their 1974 peak and income poverty rates increased from 27% in 1980 to 47% in 1989. After the 1990s when Argentina fixed its Argentinean Peso against the Dollar, the economy started to settle and actually demonstrated the benefits that fixing an exchange rate can have. By adopting a fixed exchange rate, the government reduced uncertainties for all economic agents in the country. As businesses had the perfect knowledge that prices are fixed and therefore not going to change, hence they could plan ahead in their productions. The fixed exchange rate system avoids the wild day to day fluctuations that are likely to occur under flexible rates and that discourage specialisation in production and the flow of international trade and investment. Argentina implemented its currency board in April 1991. Its main achievement was in controlling inflation, which was brought down from more than 3,000% in 1989 to 3. 4% in 1994. Another major accomplishment of the system was renewed economic growth. Enjoying the high world prices of  primary products  (Argentinas main exports), GDP grew at an annual rate of 8% between 1991 until the  Tequila Effect  of 1995. Even after the  Mexican crisis, until 1998 the annual growth rate was 6%. International trade  also increased dramatically, reflecting the growing degree of openness of the country. Imports increased from US$ 11. 6 billion in 1991 to US$ 32. billion in 2000. Likewise, exports also increased from US$ 12. 1 billion in 1991 to US$ 30. 7 billion in 2000. 2) Why was Argentina unable to maintain its fixed exchange rate regime? What does this tell you about the limitations of a fixed exchange rate regime? In the end, the fixed exchange rate regime did not last and Argentina had to abandon this policy to regain its position in the market. This was mainly because the pegged value was devalued by many countries and this caused global economic growth to decline considerably and the demand of exported Argentina commodities to decrease sharply too. This in turn made Argentinean goods more expensive in other international markets. On top of this, with Brazil devaluing their own currency against the US dollar made matters worse for Argentina as this had an influence on their Argentinean peso, pricing their goods out of the market. The decline in global prices for farm products and the global economic slowdown only added to Argentina’s problems. Even though the fixed exchange rate policy had succeeded previously in strengthening Argentina’s competitive positioning in the global market and stimulated economic growth, this would not have survived for long. The fixed exchange rate regime contains many drawbacks and would not have worked forever, as maintaining this fixed exchange rate conflicted with many other macroeconomic objectives of the country. There was also less flexibility present in a fixed exchange rate policy and caused difficulty for Argentina to respond rapidly to the shocks in the market, as pressure was added on to the currency. This affected the competitiveness of the market and also inflation rates, thus causing Argentina to alter their policy further. However, this is proven to be difficult as some countries may see this as an unfair trade advantage to them, causing some degree of disagreement between certain countries, affecting their competitiveness in the economy and making it harder for them to defend its own currency. Question 3: Do you think that the IMF was correct to insist that the Argentinian government adopt a fiscal austerity program? What other approach could the IMF have taken? The Argentine monetary crisis hit in 1999, but the IMF had been working closely with Argentine government since 1991 and had supported the Peso’s peg to the US Dollar. IEO, 2003), (Stiglitz, 2002) The IMF (2003) considers their policies in the run up to the crisis to have been lax and based on too much optimism. The organisation blames structural weaknesses in the economy; mainly high public sector debt, as well as other factors like lack of labour market flexibility and their own enforcement on these issues. While supporting Argentina through lending, the IMF called for fiscal austerity in order to boost confidence and attract much needed international investment. (MacEwan, 2002), (Stiglitz, 2002), (IMF, 2003) The fund argues that an expansionary fiscal policy was ruled out because there was no surplus from which to spend and deficit spending would have caused the debt to grow at a higher rate than the economy. Furthermore, a budget deficit could have led to higher interest rates for borrowing. (IMF, 2003) Given the fixed exchange rate, an expansionary monetary policy, i. e. increasing the money supply, was not possible. (MacEwan, 2002), (IMF, 2003) MacEwan (2002) argues that fiscal austerity had the opposite effect and reduced markets’ confidence in the country, which led to a worsening of the crisis. An alternative view is that it is normal for a country to run a moderate budget deficit in a recession and that an expansionary fiscal policy would have been more appropriate. (Stiglitz, 2002), (MacEwan, 2002) MacEwan (2002) goes further and explains that â€Å"curtailing social spending on education, health care, physical infrastructure projects cuts the legs out from under long-term economic progress. † In recent years, in spite of the financial crisis and the still-recent default, the Argentine economy has been doing well, growing by 9. 2% in 2010 and 8. 8% in 2011 and is expected to grow at least 5. % in 2012, with the growth being attributed to both fiscal and monetary stimulus. (MarketWatch, 2011), (Dow Jones Newswires, 2012), (MercoPress, 2012) The expansionary policy has led to inflation rates of 22. 75%, which seem to be causing labour disputes when wage increases fail to keep up. (MercoPress, 2012) For conclusion, something like: Even considering the high inflation rate (22. 75%) and resulting labour disputes, the situation is preferable to the massive debt and street riots of 2001. Q4 In the end the Argentinean government was forced to abandon its peg to the dollar.