Bold Currency Experiment and Its Det ASE Argent Argentina, once the worlds seventh-lamgest economy, has Tong been considered one of Latin ‘America’ worst basket cases. Starting with Juan Peron, who was hist elected president in 1946, and for decades afer, profligate goverment spending financed by a compliant central bank that printed money to cover the chronic budget deficits had gered a vicious eyele of inflation and devaluation. High taxes and excessive cantols compounded Argentina’ woes and led to an ‘verregulated, arthritic economy. However, in 1991, ater the country had suffered nearly 50 years of economic mismanagement, President Calas Menem and his fourth Minister of Economy. Domingo Cavallo, launched the Convertblity Act. (The first Minister of Economy, Miguel Roig took one look at the economy and died of a heart attack six days inco the job.) ‘This act made the ausral (the Argentine currency) fully convertible at a fixed rate of 10,000 sustrals ta the dolla, and by law the monetaty supply had tobe 100% backed by gold and for- ‘eign currency reserves, mostly dollars, This lnk gold and the dollar imposed astratjacket on monetary policy If for example, the central bank had to ell dollars to suppor the currency, the money supply automatically shrank. Better sill, the government could no longer print money ta finance a budget defi. In January 1992, the government knocked four zeros ofthe austal. and renamed it the peso, worth exacly $1. ‘By effectively locking Argentina into the U.S, monetary system, the Converibility Act had remarkable success in restoring confidence in the peso and providing an anchor fr infla- ton expectations. Inflation fell from more than 2,300% in 1990 to 170% in'1991 and 4% in» 1994 (ee Exhibit 2.8). By 1997, the inflation rate-was 04%among the lowest in the world. Argentine capital transferred overseas to escape Argentina’ hyperinflation began wo come home. Ik spured rapid economic grow and led toa rock-solid currency In response tothe good eco- ‘nomic news, stock prices quintupld, in dollar tems, during the fist year ofthe plan. And the, pice of Argentinas foreign debt tose from 13% of its face value in 1990 to 45% in 1992... The likelihood that the Converibilty Act marked a permanent change in Argentina and. ‘would not be revoked a later date—an important consideration for investors—was increased ‘by the other economic actions the Argentine government took to reinforce its Commitment to pice stability and economic growth: It deregulated its economy, sold off money-losingstate~ ‘owned businesses tothe private sector, cut taxes and red tape, opened its capa markets, and lowered barriers to trade. In September 1994, the Argentine government announced a sweep ing privatization plan designed to el ff all emaining state-owned encerprises—including the national ming, the postal service, nd the eountty$ rain airports Since then, however, the Argentine economy suffered from a series of external shocks and intemal problems. External shocks included falling prices fr its agricultural commodities, the Mexican peso crisis in late 1994, the Asian currency crisis of 1997, and the Russian and Brazilian financial crises of 1998-1999, The financial shocks led investors to reassess the risk of ‘emerging markets and to withdraw their capital from Argentina as well asthe countries in cri- sis The devaluation of the Brazilian rea! in early 1999—which increased the cost of ArgentineExniorr 2.8 ARGENTINA ENDS HYPERINFLATION 2 ie ates eee cree 7 i i ‘Consumer pie ination in on 25% 11% 4% 9 OK Om 1% -1% 1% -2%| ‘580 1681 Tae 1960 1858 105 196 1987 19681600 T600T601Toae T6EDT604TG05 1006 TOOT 1008 18002000 2001 ‘Sr Perio Fanless zoods in Brazil and reduced the cost of Brazilian goods to Argentines —hur. Argentina because ofthe strong trade ies between the two counties, Similarly, the strong appreciation ofthe dol- lar in the late 1990s, made Argentina’ produc less compeuve, both at home and abroad, ‘against those of its trading partners whose currencies were not tied to the dolla. Internal. problems revolved around rigid labor laws that make it coslly to lay off Argentine workers and excessive spending by the Argentine goverment. In a decade that saw GDP rise 50%, public spending rose 90%. Inially, tke growah in government spending was funded by privatization proceeds. When privatization proceeds ran out, the government turned {o tax increases and heavy borrowing. The result was massive fica deficits arising debt bur- den, high unemployment, economic stagnation, capital fights, ind a restive population. ‘On June 14, 2001, Domingo Cavallo, the treasury secretary for a new Argentine presi- dent, snnounced @ dramatic change in policy to stimulate Argentina’ slumping economy, then in ts fourth year of recession. Henceforth, the peso exchange rate for exporters and importers ‘would be an average ofa dollar and a euro, that is, Pl = $0.50 + €0,50. With the euro then ‘wading at about $0.89, exporters would now receive around 8% more pesos forthe dallas they exchanged and importers would have to pay around 8% more forthe dollars they bought, Financial markets panicked, fearing that cis change was bu a prelude to abandonment of the cyurency board. In response, Mr. Cavallo sed that his new policy just amounted to 3 subsidy for exporters and a surcharge on imports and not a attempt to devalue the peso. (Over the next sox months, Argentina bold currency experiment unraveled amid political and economic chaos brought about by the fallure of Argentine politicians to rel in spending and to reform the county$ labor lave. During the two-week period ending January 1, 2002, ‘Argentina had five different presidents and suspended payments on its $132 billion in public bt, the largest sovereign debt default in history. On Jantary 6, 2002, President Eduardo Dubalde announced that he would end Argentina’ decade-long currency board system. The collapse of the currency board had devastating consequences. Over the next week, the “Argentine peso plunged by 30% against the dollar. By year end, the peso had deprecated 70%, the government had imposed a draconian banking freeze that spatked violent rioting, and severe economic contraction tok the Argentine economy back to 1993 levels. In eflct, forced to choaee between the economic iberalizmion and fiscal discipline that was necessary to save its currency board and the failed economic policies of Peronism, Argentina ultimately chose the lauer and wound up witha disaster ‘Questions 1, What was the impetus for Argentinas currency board system? 2. How successful was Argentina’ currency board? 53. What led to the downfall of Argentina’ curency board? 4, What lessons ean we leam from the experience of Argentina’ currency board? )