Between 2001 and 2002, Argentina underwent an episode of currency devaluation and debt default that rocked international financial markets and offered fresh evidence of the varied economic trends that can lead to crises. The Argentine crisis has been the topic of wide discussion, partly because it was born of circumstances not normally regarded as fertile ground for currency crises. In the 1990s, Argentina boasted of one of Latin America’s fastest growing economies and one of its staunches devotees to the gospel of free market reform. Part of the credit for economic prosperity seemed to lie with a successful monetary reform that ended the hyperinflation of the 1980s. This monetary reform established a currency board that fixed the value of the Argentine peso at one peso to a U.S. dollar. One Argentine peso, exchangeable into dollars at any time, equaled one U.S. dollar. Argentine inflation subsided to low single-digit levels, output grew at a fast clip, and the economy seemed resilient to external shocks.
The genesis of the crisis goes back to 1998 when many of Argentina’s trading partners saw their currencies depreciate, perhaps because of fallout to the East Asian Crisis and the retreat of foreign capital. The strong demand for U.S. financial assets keep the U.S. dollar strong, which kept all currencies pegged to the dollar, including the Argentine peso, strong. The strong Argentine peso meant that Argentine exports went at higher prices in foreign markets, while Argentine imports saw falling prices. In summery, Argentina-produced goods grew costlier compared to goods produced by Argentina’s major trading partners. Cheaper imports allowed Argentina to live beyond its means, while its exports were over-priced in foreign markets. To restore balance, Argentina needed to either devalue its currency as its trading partners had done, or undergo domestic deflation. Argentina did experience some deflation, which is a characteristic that distinguishes the Argentine crises from other crises. More often these types of crises occur after government deficits, financed by monetary growth, lead to inflation.
Government’s budget deficits were modest, but were large enough to force a growing reliance on foreign debt financing. A small financial sector may share the blame for a dependence on foreign capital to finance both private sector and public sector spending. The vulnerability of the system arose from the large share of loans and mortgages denominated in dollars while the income generated to service these debts came in the form of pesos. Once deflationary forces surfaced, output shrank, unemployment spiked, government deficits rose, and the government proceeded to pile up foreign debt. In December 2001, the government of Argentina defaulted on its public debt.
After more than three years of recession, in January 2002, the Argentine government, running out of credit, devalued the peso relative to the dollar. At the time, 70 percent of all Argentine bank deposits and 79 percent of all loans were denominated in dollars (Economist, March 8, 2003). To avoid throwing many debtors into bankruptcy, the loans were redenominated into pesos at a rate of one peso per dollar, and the bank deposits were redenominated into pesos at the rate of 1.4 pesos per dollar. (Economist, March 8, 2003). The peso deposits quickly dropped in value as the peso plummeted to about four pesos per dollar. The action de-dollarized the Argentine economy.
Devaluating the peso reduced the cost of Argentine exports in the world economy, making it possible for Argentina to earn foreign exchange and recover from deep recession. Foreign exchange is necessary to repay foreign debts.
By 2005, the Argentine economy exhibited a strong expansion, helped in part by a worldwide commodity boom, and the government reported budget surpluses. The government offered the holders of defaulted bonds new bonds in a choice of four different currencies. The value of the new bonds equaled about 30 percent of the value of the defaulted bonds (Economist, January 15, 2005). Creditors fumed at the rough treatment and predicted that Argentina would meet with difficulty trying to regain the confidence of foreign investors.
See also: Currency Crises, Foreign Debt Crises
