In April 1991, Argentina adopted a rigid peg of the peso to the dollar and guaranteed convertibility under this arrangement. That is, the central bank stood by to convert pesos into dollars at the hard peg.
The choice was nonsensical from the outset and totally unsuited to the nation’s trade and production structure. In the same way that most of the EMU countries do not share anything like the characteristics that would suggest an optimal currency area, Argentina never looked like a member of an optimal US-dollar area.
For a start the type of external shocks its economy faced were different to those that the US had to deal with. The US predominantly traded with countries whose own currencies fluctuated in line with the US dollar. Given its relative closedness and a large non-traded goods sector, the US economy could thus benefit from nominal exchange rate swings and use them to balance the relative price of tradables and non-tradables.
Argentina was a very open economy with a small non-tradables domestic sector. So it took the brunt of terms of trade swings that made domestic policy management very difficult.
Convertibility was also the idea of the major international organisations such as the IMF as a way of disciplining domestic policy. While Argentina had suffered from high inflation in the 1980s, the correct solution was not to impose a currency board.
The currency board arrangement effectively hamstrung monetary and fiscal policy. The central bank could only issue pesos if they were backed by US dollars (with a tiny, meaningless tolerance range allowed). So dollars had to be earned through net exports which would then allow the domestic policy to expand.
After they introduced the currency board, the conservatives followed it up with widescale privatisation, cuts to social security, and deregulation of the financial sector. All the usual suspects that accompany loss of currency sovereignty and handing over the riches of the nation to foreigners.
The Mexican (Tequila) crisis of 1995 first tested the veracity of the system. Bank deposits fell by 20 per cent in a matter of weeks and the government responded with even further financial market deregulation (sale of state banks etc)
These reforms loaded more foreign-currency denominated debt onto the Argentine economy and meant it had to keep expanding net exports to pay for it. However, things started to come unstuck in the late 1990s as export markets started to decline and the peso became seriously over-valued (as the US dollar strengthened) with subsequent loss of competitiveness in the export markets.
Lumbered with so much foreign-currency sovereign debt the decline in the real exchange rate (competitiveness) was lethal.
The domestic economy by the late 1990s was mired in recession and high unemployment.
And then the “Greek scenario” unfolded. Yields on sovereign debt rose as bond markets started to panic – a vicious cycle quickly became embedded.
In 2000, the government tried to implement a fiscal austerity plan (tax increases) to appease the bond markets – imposing this on an already decimated domestic economy. The idiots believed the rhetoric from the IMF and others that this would reinvigorate capital inflow and ease the external imbalance. But for observers, such as yours truly, it was only a matter of time before the convertibility system would collapse.
Why would anyone want to invest in a place mired in recession and unlikely to be able to pay back loans in US dollars anyway?
In December 2000, an IMF bailout package was negotiated but further austerity was imposed. No capital inflow increase was observed. Duh!
The government was also pushed into announcing that it would peg against both the US dollar and the Euro once the two achieved parity – that is, they would guarantee convertibility in both currencies. This was total madness.
Economic growth continued to decline and the foreign debts piled up. The government (April 2001) forced local banks to buy bonds (they changed prudential regulation rules to allow them to use the bonds to satisfy liquidity rules). This further exposed the local banks to the foreign-debt problem.
The bank run started in late 2001 – with the oil bank deposits being the first which led to the freeze on cash withdrawals in December 2001 and the collapse of the payments system.
The riots in December 2001 brought home to the Government the folly of their strategy. In early 2002, they defaulted on government debt and trashed the currency board. US dollar-denominated financial contracts were forceably converted in into peso-denominated contracts and terms renegotiated with respect to maturities etc.
This default has been largely successful. Initially, FDI dried up completely when the default was announced. However, the Argentine government could not service the debt as its foreign currency reserves were gone and realised, to their credit, that borrowing from the International Monetary Fund (IMF) would have required an austerity package that would have precipipated revolution. As it was riots broke out as citizens struggled to feed their children.
Despite stringent criticism from the World’s financial power brokers (including the International Monetary Fund), the Argentine government refused to back down and in 2005 completed a deal whereby around 75 per cent of the defaulted bonds were swapped for others of much lower value with longer maturities.
The crisis was engendered by faulty (neo-liberal policy) in the 1990s – the currency board and convertibility. This faulty policy decision ultimately led to a social and economic crisis that could not be resolved while it maintained the currency board.
However, as soon as Argentina abandoned the currency board, it met the first conditions for gaining policy independence: its exchange rate was no longer tied to the dollar’s performance; its fiscal policy was no longer held hostage to the quantity of dollars the government could accumulate; and its domestic interest rate came under control of its central bank.
At the time of the 2001 crisis, the government realised it had to adopt a domestically-oriented growth strategy. One of the first policy initiatives taken by newly elected President Kirchner was a massive job creation program that guaranteed employment for poor heads of households. Within four months, the Plan Jefes y Jefas de Hogar (Head of Households Plan) had created jobs for 2 million participants which was around 13 per cent of the labour force. This not only helped to quell social unrest by providing income to Argentina’s poorest families, but it also put the economy on the road to recovery.
Conservative estimates of the multiplier effect of the increased spending by Jefes workers are that it added a boost of more than 2.5 per cent of GDP. In addition, the program provided needed services and new public infrastructure that encouraged additional private sector spending. Without the flexibility provided by a sovereign, floating, currency, the government would not have been able to promise such a job guarantee.
Argentina demonstrated something that the World’s financial masters didn’t want anyone to know about. That a country with huge foreign debt obligations can default successfully and enjoy renewed fortune based on domestic employment growth strategies and more inclusive welfare policies without an IMF austerity program being needed.
The clear lesson is that sovereign governments are not necessarily at the hostage of global financial markets. They can steer a strong recovery path based on domestically-orientated policies which directly benefit the population by insulating the most disadvantaged workers from the devastation that recession brings.
However, the other lesson that certain economists don’t emphasise – is that pegging a currency to another, guaranteeing convertibility and then allowing the financial sector to “dollarise” your economy (drown it in foreign currency-denominated debt) – is a sure way to force the country into financial ruin.
It has nothing to do with the volume of public debt issued in the local currency by a government which has sovereignty in that currency.