By Michael Burke, B&M Research
The Argentinean debt-swap agreement has put the situation at the top of the agenda. The consequences of a default would also be enormous and not just for the beleaguered Argentinean economy, not least because Argentina comprises about 23% of benchmark emerging market bond indices. The debt swap has the potential to reschedule up to $66 billion of an estimated $153 billion total public debt (equivalent to 57% of GDP), of which $128 billion is issued by the government.
However, the source of the crisis lies in the real economy, where output has contracted over a prolonged period. This is a function of the continued currency peg to a soaring US dollar, which has particularly taken its toll from 1998 onwards.
The US dollar has risen by 20% since the ARS was pegged to it in 1991. But for the early years of that period, the US dollar fell, and much of the subsequent rebound was simply restoring lost ground. So, by the beginning of 1997, the US dollar trade-weighted index was 1.6% below its 1991 level. Only from 1998 onwards did the dollar begin to rise significantly over its 1991 level, taking the ARS with it. The 20% gain has all arisen since 1998.
Precisely at this time, the Argentinean economy began to slow, led by a slump in the external sector. The recession began in mid-1998 and GDP has contracted by a cumulative 7.1% over that period. Manufacturing has declined by 12% over the same period. But the effect of the exchange rate regime can be seen in the external accounts, where exports have slumped by 22.2% and imports have fallen by 36% (see chart).
The fall in imports is highly revealing, and suggests that, despite currency overvaluation, the disinflationary effects of maintaining the currency peg have led to this collapse in demand. This idea is supported by the fall in prices, where the CPI has averaged -0.4% year-on-year since 1998.
Partly as a result, the real level of interest rates has been exceptionally high, averaging 10.2% since 1998. One of the supposed benefits of the peg would be the elimination of currency risk leading to a convergence with US markets. Yet US nominal rates have been an average 5.6% since 1998 compared to 9.8% for Argentina, and US real yields have been 3.2% versus the 10.2% which has hobbled both demand and investment in Argentina. In recent weeks a string of car producers have announced layoffs and/or output cuts for a number of weeks, reflecting these twin falls in demand and output. For the time being, this takes place with union support or acquiescence.
Another claimed benefit of the peg was that capital would flow into Argentina, as currency risk was eliminated for foreign investors. However the growth in foreign bank credit to Argentina since the peg’s adoption in 1991 has been 153%, compared to growth in all countries’ bank credit of a staggering 414% over the same period. Argentinean debt remains what the World Bank calls an “opportunistic asset class” for investors from the leading economies, which was graphically illustrated by a temporary withdrawal of credit in the wake of the Asian crisis. Since that time, international bank credit advanced to Argentina has risen by just 9.7%, while global bank credit provision has risen by 272%.
In order to attract or retain capital, the government itself is offering an interest rate that the private sector cannot match. Partly as a result, gross fixed capital formation has fallen by 24.2% since the end of 1997. Under the twin effects of austerity and excessively high government yields, total bank lending has been contracting since the beginning of last year, and has fallen by 4% over that period.
Under instruction from the IMF, Argentina has initiated an austerity policy with the stated aim of improving government finances. These are said to total the equivalent of $3 billion in tax increases and $850 million in spending cuts. They are part of the price to be paid for the release of $1.2 billion, of a total credit line of $13.4 billion from the Fund.
These measures will only depress economic activity further, with most private forecasts for GDP this year already pitched at 1% or below, in contrast to the government’s hope of 2.5%. As a result, they may not even work in the narrow aim of decreasing the budget deficit towards the $6.25 billion sought.
But as government supporters and IMF officials alike are fond of pointing out, Argentina maintains a primary surplus on its budget balance. The real source of the deficit is debt-servicing costs. In 2000, the deficit of the non-financial public sector was ARS4.3 billion. Debt-servicing costs comprised ARS9.7 billion of the expenditure total. This has been the real growth industry of the currency peg, as all sectors of society, government, business and individuals have been encouraged to take on debt at lower interest rates and ‘risk-free’ on the currency. Debt-servicing costs have risen by 423% between early 1994 and end-2000. It is the fear of the consequences of currency devaluation for all sectors of society that has underpinned the popularity of the currency peg.
The source of the current crisis lies in the combination of the austerity induced by the currency peg (and measures to support it), as well as the interest rate costs of the accumulated debt burden. Only measures that overcome both can reverse the economic tailspin. Until recently, it was inconceivable that Argentina would break the currency peg. But now only Senate approval stands in the way of the Cavallo plan to adopt the euro. If the authorities wait for the euro to reach parity, who knows when or if it will ever take place? Instead, any government would be likely to choose its own moment to make the currency adjustment.
But, on its own, this measure could be entirely counterproductive, leading simply to another upward twist of the debt-servicing spiral. Therefore, default of some type looks inevitable. The key question for both Argentinean borrowers and international investors, is what type of default is likely, a Russia or a Mexico?