Is Alan Greenspan the central banker to the world ?
or...
why a little inflation may be better than a bad recession
this, in part, can explain why...
Editorial comment:
Argentina's riches to rags tale
Domingo Cavallo's reforms may have removed exchange rate risks but economic and political instability are less susceptible
Published: March 20 2001 20:10GMT | Last Updated: April 2 2001 15:31GMT
Apart from muttering "I told you so", I intend to ignore last week's market turmoil in the north of the Americas. A couple of days spent at the opposite end of the twin continents reminded me of an equally intriguing, if less important, story. To resist the lure of inflationary sirens, Argentina tied itself to the mast of its convertibility plan. But today it risks drowning, as the economy founders on the rocks of recession.
The arguments for tight currency arrangements - such as a currency board, use of another country's currency as one's own, or membership of a currency union - are that they guarantee monetary discipline and eliminate currency risk. But these risks are merely transformed. In Argentina, inflation and currency risk have turned into credit risk.
The tragedy is that Argentina's performance improved dramatically in the 1990s. It was the world's 10th richest country in 1913. But by 1990, its income per head had fallen to 40 per cent of the western European average. Then, between 1990 and 1998, gross domestic product per head rose by 42 per cent. Over those years, the economy expanded by 60 per cent, against some 25 per cent in Mexico and Brazil.
Alas, it has not lasted. The economy is in prolonged recession. Two finance ministers have gone in a few weeks. In a desperate throw, president Fernando de la Rua plans to bring back Domingo Cavallo, architect of the initial reforms.
What has gone wrong? Adverse external events - the emerging market financial crises of 1997 and 1998, a sharp deterioration in the terms of trade, the devaluation of the Brazilian real and the strength of the US dollar - have hit the economy. Given the pegged exchange rate, these shocks delivered a big loss of competitiveness: on the basis of relative unit labour costs, the real exchange rate appreciated by about a third between early 1998 and the middle of 1999.
The link with the dollar has generated deflation. Between September 1998 and February of this year, US consumer prices rose by 8 per cent. Over the same period Argentinian prices fell by 3 per cent. Given enough time, the adjustment in relative prices will restore competitiveness. But the time has been long and hard: at the end of 2000, GDP per head was about 8 per cent lower than at its peak in the second quarter of 1998.
This long deflation is not caused by loss of competitiveness alone. Just as important are high real interest rates. Real prime interest rates, in pesos, have been running at about 10 per cent. At the long end, real interest rates in dollars have been still higher. At a spread over US treasuries of 850 basis points, the Argentinian government would be borrowing at a real rate of nearly 15 per cent against movements in the domestic price level.
Such high real interest rates are not just contractionary; they are unsustainable. Argentina's public and external debt are both just a little over 50 per cent of GDP. This would be manageable at the rates of interest paid by high income countries but not at those paid by Argentina. These high interest rates reflect perceptions of Argentina's political fragility. But that perception is, in turn, worsened by recession. Thus the system that eliminated inflation and exchange-rate risk creates a vicious downward spiral of worsening credit risk, deepening recession and back to credit risk again.
In the long run, exchange-rate and inflation risk re-emerge. Today, not only are spreads on dollar borrowing vis-a-vis US treasuries soaring but so is the gap between rates on borrowing in pesos and dollars. If the exchange rate were certain, these would be the same. But the day before yesterday, the spread on three-month inter-bank borrowing was 481 basis points, against a usual spread of about 100 points.
Argentina's currency board is solid. The government can also survive without new borrowing for a time. But if it does not come up with a credible and politically acceptable programme, the country will be driven to default, choose to devalue, or even do both.
Ricardo Lopez Murphy, the economics minister of 15 days, failed the political test. His proposed fiscal adjustment was not huge, at some 1 per cent of GDP. It would have brought the fiscal position into line with the country's agreement with the International Monetary Fund. But that would still have left a sizeable consolidated fiscal deficit - forecast by the IMF in December at 3.1 per cent of GDP for 2001 - and a modest primary fiscal surplus (surplus, before interest payments) of 1.5 per cent. That would not stabilise the debt ratio. But even this package did not gain political support and so, inevitably, failed to secure the required improvement in confidence.
Can Mr Cavallo do better? The short answer is "yes, but with difficulty". Conceptually, Argentina has just three options: to struggle on; to default; or to devalue.
Struggling on would work if a new package restored confidence to the market and growth to the economy. If there were renewed growth, confidence would revive; if there were renewed confidence, growth would improve. But given the perception that the exchange rate, albeit improving, is overvalued, and that the president, albeit trying, is weak, it would need a miracle to pull this off.
The second option is default. As I argued in a previous column (Argentina and the debt trap, November 22 2000), debt is unsustainable at current real interest rates and prospective growth rates, without implausible improvements in the fiscal and external balances. While it is perfectly reasonable to try to devise a package designed to support growth and make fiscal sustainability credible in the medium term, this may not work. An orderly debt restructuring would then be preferable to chaos.
The third option is devaluation. Most outsiders would consider a floating exchange rate preferable to this peg. But Argentina is so dollarised - and bound to become still more so if confidence weakens - that it is hard to see how it could get from here to there without wrecking much of the private sector. But if devaluation seems horribly difficult, the polar opposite - dollarisation - is simply irrelevant. The economy's chief problem is now credit risk, not currency risk. Dollarisation would do nothing about the former.
The wider lesson is that very hard exchange-rate regimes do not eliminate risks. They change them. Countries choose them to control politicians and eliminate inflation. But if politicians remain ill-disciplined and economies unstable, the risks will re-emerge somewhere else. Today, Argentina is learning this lesson. Mr Cavallo eliminated inflation with a stroke. Restoring growth to the economy and confidence to markets will be harder.
Contact: martin.wolf@ft.com
news.ft.com |
