The Roots of Argentina’s Surprise Crisis

By Martin Guzman, Senior Non-Resident Fellow, Center for a New Economy in San Juan, Puerto Rico, Research Fellow, Columbia School of Business and Joe Stiglitz, Professor of Economics, Columbia University Originally published at the Institute for New Economic Thinking website

A change in macroeconomic policies will not be sufficient to set Argentina on a path of inclusive and sustained economic development. But, as last month’s currency scare showed, abandoning the approach adopted by President Mauricio Macri’s administration at the end of 2015 is a necessary step.

The currency scare that Argentina suffered last month caught many by surprise. In fact, a set of risky bets that Argentina’s government undertook starting in December 2015 increased the country’s vulnerability. What was not clear was when Argentina’s economy would be put to the test. When the test came, Argentina failed.

Argentina had to address a number of macroeconomic imbalances when President Mauricio Macri took office at the end of 2015. Early measures included the removal of exchange-rate and capital controls and the reduction of taxes on commodity exports. Argentina also recovered access to international credit markets following a settlement with so-called vulture funds over a debt dispute that had lasted more than a decade.

The government undertook a new macroeconomic approach based on two pillars: gradual reduction of the primary fiscal deficit, and an ambitious inflation-targeting regime that was supposed to bring annual price growth down to a single-digit rate in just three years.

Markets cheered. The prevailing view, eagerly promoted by Argentina’s government, was that the country had done what was necessary to achieve sustainably faster economic growth. Presumably, foreign direct investment would flow in. But it did not.

Instead, Argentina suffered , followed by a . That led to a surge in imports that was not accompanied by a proportional increase in exports, widening the current-account deficit to 4.6% of GDP and sowing doubt about the virtues of the new approach.

Then, a few weeks ago, markets stopped cheering, expectations soured, and capital fled. The peso depreciated 19% against the US dollar in just the first three weeks of May.

Contrary to Macri’s hopes, his reforms attracted mainly short-term portfolio capital and financing in the form of bonds, both in foreign and domestic currency, rather than foreign direct investment. Argentina’s central bank bears a significant share of the responsibility; while its approach proved largely ineffective in reducing inflation to the target level (the annual rate is still at about 25%), high interest rates encouraged inflows of speculative capital, which worsened the external imbalances and heightened Argentina’s vulnerability to external shocks.

As part of their inflation-targeting approach, the central bank has been sterilizing a large share of the increases in the monetary base through the sale of central banks bonds (LEBACS). This means that the public sector has been effectively financing through short-run central bank debt issuance the largest part of the sizable primary fiscal deficit (4.2% and 3.83% of GDP in 2016 and 2017, respectively). The issuance of LEBACS has been massive, soaring by 345% since December 2015. This might have been sustainable had early expectations of Argentina’s prospects been validated.

There were obviously trade-offs. Less aggressive sterilization would have contained the growth in central bank debt that has now proven to be so risky, and it would have prevented upward pressure on the exchange rate; but it would have led to higher inflation. Nonetheless, attempting to reduce inflation and the fiscal deficit at similar speeds would have been a more prudent approach. After all, macroeconomic policy decisions should not be made on the basis of the most optimistic scenario when the cost of missed expectations is large.

The currency crisis finally revealed Argentina’s vulnerabilities. Looking ahead, the country will be exposed to several different sources of risk. First, there is still a large stock of LEBACS. And every time a significant portion of that debt falls due, Argentina will be a hostage of financial markets’ mood. This will increase the expected exchange-rate volatility, which may create opportunities for speculative financial investments, but will discourage investments in the real economy. Second, because the public sector’s foreign-currency-denominated debt is much higher than it was two years ago, the increase in exchange-rate risk will also call into question the sustainability of public-sector debt.

To assess where Argentina is heading after the crisis requires highlighting several salient elements of how the episode was managed. First, the central bank lost 10% of its total stock of foreign-exchange reserves in just a month. Second, the annual nominal interest rate on the LEBACS was raised to 40% – the highest in the world, and a move that risks creating a snowball of central-bank debt. Third, and most shocking for Argentines, Macri announced that the country would seek a stand-by agreement with the International Monetary Fund.

Thus, if Argentina’s public sector falls into a state of debt distress in the coming years, it will have to submit to the tutelage of the IMF – a creditor in itself, but also an institution that is dominated by international creditors. At that point, the conditionality that the IMF typically imposes in exchange for financing could cause severe damage.

Most worrisome is that the inflation-targeting approach that has exacerbated Argentina’s external imbalances has been reaffirmed. It would thus not be surprising if a new cycle of real exchange-rate appreciation starts in 2019. With a presidential election next year, that would be good news for Macri; but it would not bode well for Argentina’s future.

Ultimately, because Macri’s approach to putting Argentina’s economy on a sustained growth path has so far failed, and has increased the country’s dependence on international creditors, his administration still faces the challenge of avoiding a debt crisis. To protect economic activity and redress vulnerabilities, the strategy of gradually reducing the primary fiscal deficit should be maintained. But, to save Argentina from an increase in external imbalances affecting the sustainability of external public debt, monetary policy must change. That means finally recognizing that attempting to reduce inflation at a much faster rate than the fiscal deficit entails costly risks. The prudent path also requires a gradual reduction in the stock of LEBACS, recognizing that greater inflationary pressure in the short term is the price of minimizing the risk of higher external imbalances and larger exchange-rate depreciations down the road.

And it would certainly be a mistake to continue reducing the tax on soybean exports, as Macri’s administration has announced it will do. Further tax cuts would increase the deficit, while benefiting a sector that already enjoys rents.

A change in macroeconomic policies is not sufficient to set Argentina on a path of inclusive and sustained economic development; but it is necessary. At the outset of Macri’s administration, there were  that he had chosen a high-risk approach. Unfortunately, those warnings were ignored. The strategy we are recommending is not without its own risks. But we are convinced that it offers a viable and sounder path forward.

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  1. JTMcPhee

    How much of this “policy” is driven by the buddy system and corruption? (I see the bit about soybean privilege and rent-collection.) And how many “economic hit men” have been sighted sniffing in and around the incipient horror?

    1. Lorenzo

      there’s sure plenty of budding and corruption going on. That bit about the soybean export tax is something you did well to lay your eyes on. The Sociedad Rural is the single most powerful private institution in this country, as has been for over century and a half. Our minister for Agriculture and Industry is the Sociedad’s former president. Oligarquía and oligarca are terms that we very much use to talk about the most powerful men in this country and they are very much the appropriate terms to do so. Conflict of interest and corruption is firmly positioned at the top levels of our national government.

      As for economic hit men, fortunately those have largely been resigned to history. The Spanish during colonial times, relegated by the English from the 18th century and they themselves by the Yankees from early 20th were responsible for pushing, with much varying degrees of forcefulness, for an extraction-based economic model, at the obvious expense of development. Changing this approach has been largely and increasingly and internal struggle for the past 40 years at the very least.

  2. Synoia

    Early measures included the removal of exchange-rate and capital controls…

    How does a county manage what it does not control?

      1. Scott1

        Thanks for the link. I will be spending some time thinking of what Argentina would best employ as best practices from where it is.
        Would they be best off if they stopped issuing such high paying bonds? Should they pay them all off and stop with it. It does appear to me that issuing bond after bond is one of the single most dangerous things you can do.
        It would appear to me to be a superior practice to sell what you produce for the best price you can get on the open markets and dictate the value of your currency.
        I’ll have to do some more study here.
        Again, thanks for the link.

  3. Jim Haygood

    ‘attempting to reduce inflation at a much faster rate than the fiscal deficit entails costly risks’

    Let’s rewind to a seminal event that’s missing from Martin Guzman’s timeline:

    (Reuters) – Argentina changed its inflation target for 2018 to 15 percent, up from the central bank’s previous goal of 8-12 percent, Treasury Minister Nicolas Dujovne said on Thursday, raising expectations for interest rate cuts. — Dec 28, 2017

    This flagrant backsliding was what started the rocks rolling downhill to the recent crisis. It was the equivalent of a recovering alcoholic’s confident announcement that he’s reverting to a modest and manageable three or four shots a day.

    ‘it would certainly be a mistake to continue reducing the tax on soybean exports’

    The US doesn’t tax soybean exports. Argentina needs to maximize its exports to earn foreign exchange. Its fiscal deficit can be addressed through general taxation — income, VAT — rather than envy-driven attacks on farmers.

    Back in the dark days of the Kristina regime, sodbusters were actually hoarding soybeans in giant plastic buildings, refusing to be euchred by the one-two punch of 30 percent export taxes coupled with a chronically overvalued peso which haircut farmers by another third when they converted export earnings back into the local confetti.

    Kristina’s gangster regime actually paid young activists in the Peronist youth movement La Cámpora to tag La Rural — headquarters of the annual livestock show in Buenos Aires — with political graffiti. Long time NCers will recall their frantic wave of posts here in Oct 2015, as Argentina’s presidential election neared.

    1. Lorenzo

      You’re uttering the discourse of the most recalcitrant neo-liberal cum austerity-fundamentalists around.

      The US doesn’t tax soybean exports. Argentina needs to maximize its exports to earn foreign exchange.’

      it’s misleading to say the least to draw a comparison between how the US handles soybean exports and Argentina does it. They’re around a quarter of the latter’s exports, barely a hundredth of the latter’s.

      The US will never have forex issues, Argentina does have them, and they are very serious. You make it as if simply exporting commodities will fill the country’s economy with USD, while in truth those dollars will be neatly parked in tax heavens. Eliminating tax and controls over Argentina’s biggest exports -agricultural commodities- is in practice as if these commodities were produced not in this country but in some foreign territory over which only the very few who hold most of the land are sovereign. Which is what the current administration has been doing for the past two years.

      You also make it as if the current situation where the value of the peso is given over completely to whatever short-term speculators feel like doing with it whenever LEBACs are due is more desirable than the capital controls imposed by the previous government. These prevented the hurtful rapid rise we’re seeing in the exchange rate and reduced the negative consequences of the fiscal deficit thus allowing significant investment in and expansion of the real economy.

      Addressing the fiscal deficit through increased value added and income tax is something that clearly benefits the owner over the working class and depresses private consumption. I can only sarcastically wonder who would want such a thing.

      I don’t feel the need or the duty to defend the previous government, but victimization of the Sociedad Rural is something I just lack the words to condemn strongly enough

      1. ChrisAtRU

        NP. You’re welcome. See my comment below. Unfortunately, the only way to win this game is not to play (by the vulture established rules).

  4. Mickey Hickey

    Argentina is probably the most self sufficient country on earth. It has everything, fertile land that produces an abundance of wheat, barley, oats, rye, wine grapes. As well as oil, gas. uranium, silver, gold, lead, copper, zinc. Foreigners are well aware of the wealth in Argentina and are more than willing to lend to Argentinian governments and companies. This is why Cristina Kirchner refused to give in to the US vulture funds as it dissuaded foreigners from believing that reckless lending would always be rewarded. Macri ponied up, restarting the old familiar economic doom cycle. As always its the old dog for the long road and the pup for the puddle. Macri is now in a place that he chose, the puddle. As long as foreig lenders remain reckless Argentina will remain mired in the mud, well short of its potential. I was last there in 2008 when the country was booming. When I heard of Macri’s plan to pay the vulture funds I knew they were headed for disaster. This is just the beginning.

    1. JTMcPhee

      Those “foreign lenders” can’t be called “reckless.” Some, maybe most among them always seem to profit from the looting, whether by “bailouts” or “backstops” from governments like the US that for “geopolitical reasons” facilitate that lending, or by extortion after the first-round lenders (who know the risks, of course — they are big boys and girls after all) have been forestalled.

      Call them “wreckers,” maybe. Like early denizens of the Florida Keys, and other places, who set fires or put up lamps that resembled lighthouses to lure passing ships onto the sands and rocks where their cargoes and the valuables of their drowned passengers and crews could be stripped.

  5. ChrisAtRU

    Why is any of this still “surprising” to anyone?! Most countries in the world (non G7/G8) are forced to go into foreign debt in order to pursue their “development” initiatives. They are told they can export themselves out of trouble but the “free trade” (more like unfair trade!) mantra puts them at a distinct disadvantage – “unequal exchange” was the term Marx used for it. Economist Ha Joon Chang popularized the term “ladder kicking” to describe the way in which most developed countries used tariffs and trade restrictions to ascent to the top but are all for “free trade” now. Once again, so long as “Original Sin” is a reality, there is little hope. Keynes’ BANCOR was the idea to begin to fix this, but short of some other global currency initiative, we’re left to the International Finance Vultures as the primary arbiters of what’s possible.

  6. Mo Zart

    This is not a surprise crisis – its development has been fully covered and documented since day 1 of Macri’s tenure.

    Sad to see Guzmán and Stiglitz toning the whole thing down. This crisis is Macri’s plan, not just a series of unfortunate events.

  7. Synoia

    They are told they can export themselves out of trouble but the “free trade” (more like unfair trade!) mantra puts them at a distinct disadvantage

    Are there any examples where this has actually taken place?

    1. ChrisAtRU

      Well … it happens most places where there’s a country is borrowing in a foreign currency (they can’t print) … to some degree. It’s happened in Argentina. When Argentina issues debt denominated in US Dollars, how is it going to get the US Dollars to repay that debt? It has to sell stuff for US Dollars a.k.a. export to the US or to countries that will pay for Argentine goods and services in US Dollars. What developing countries choose to export is often determined by the ESI/EOI/ELI paradigm of economic growth/development that’s been foisted on the much of the “developing world”. There is an entire history of various development approaches, and the best I can do in short is refer you to my Econ textbook: The Process of Economic Development (Routledge, 2014), by James M Cypher. You can search Cypher’s text for selected sections where Export Substitution is discussed.

  8. boz

    I didn’t understand the early contrast between bond issuance and FDI (foreign direct investment). Can anyone point me to an explanation of / unpack why (how) FDI would be a better course of action?

    1. Yves Smith Post author

      Bonds are often hot money, so when that leaves, interest rates shoot up and your currency falls. The latter can produce a currency crisis.

      FDI means the money goes into physical investments, hopefully productive ones, and the invested funds can’t be withdrawn quickly. Selling businesses or mines or factories takes time.

  9. Binray

    So I went into this article hoping to understand it from a MMT point of view and came out all confused until I noticed who it was written by. Unlike MMT based writers like Bill Mitchell, its all over the place! Also it seems to be doing the fiscal deficit fear mongering. Can someone please provide a MMT based perspective on the Argentina situation?

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