A Deal, But No Direction

The sweltering mid-summer torpor settling over Buenos Aires feels heavier than usual these days. The streets are still busy and the traffic is as bad as ever with fumes choking the narrow streets of the microcentro financial district. But the city lacks the frenetic activity of previous years.

Some of the city’s impressive 19th century neo-classical buildings stand empty, their walls draped with peeling posters. One can make out the fading logos and names of failed banks and companies over their doorways. Beggars loiter at street corners. Stores are boarded up, waiting for new tenants that are unlikely to appear soon.

Argentina struggled to shake off its economic malaise for more than two years but its troubles only came to the full attention of the international financial system in the closing months of 2000, as markets realized that President Fernando de la Rúa would be unable to revive the economy and continue paying the country’s mounting debts. The government’s interest burden doubled in five years. Gross public-sector debt to rose to 50% of GDP this year from 30% in 1992.

Argentina has few short-term debts but markets slammed shut, making default in early 2001 by Latin America’s biggest borrower virtually inevitable. Only a $39.7 billion, three-year rescue package on easy terms that the International Monetary Fund hastily assembled in December (see chart, page 16) averted a financial market crisis whose effects would have shaken emerging markets around the world, since bond market investors hold a large portion of Argentina’s $123.7 billion debt.

The rescue has bought Argentina valuable time. The government need not scour the world’s capital markets for the time being: the IMF has said $25.4 billion of the assistance can be drawn down this year, just enough to meet $19.6 billion in maturing debt and cover next year’s expected $6.3 billion budget deficit. As José Luis Machinea, the economy minister, states: “The financial package will reduce financial vulnerability.” He adds, “We are convinced that all the measures and changes introduced over the past year, structural reforms, initiatives to foster investment and measures to improve the flexibility of the economy will generate growth [this] year.”

Daniel Marx, Argentina’s finance secretary, is back courting banks and investors to warm them up for a possible debt sale. Looking more relaxed than he has for months, Marx says, “The political situation is more aligned and there is more clarity in economic measures. The budget is more realistic. The question now is to look at how to generate and get more investment.”

Perhaps, but Argentina is in an unforgiving mood, fed up by years of economic decline. The entire country seems depressed and angry. Protesting port workers picket the Economy Ministry building and not far away, strikers outside the Buenos Aires city hall are setting off firecrackers.

Domingo Cavallo, the former economy minister and the man who rebuilt Argentina’s economy in the early 1990s, says years of recession and misguided government policies set the country up for the big scare in the financial markets. He says, “An insufficient climate for investment to end the recession and a political crisis in October accentuated [uncertainty] and a sort of financial hysteria broke out.”

De la Rúa’s botched handling of a corruption scandal last year led Vice President Carlos Chacho’ Alvarez to quit in October. Raúl Alfonsín, who as president plunged Argentina into hyperinflation in 1989, only made things worse by condemning the fixed exchange rate-now celebrating its 10th anniversary-as a “deadly trap” and urged the government to suspend debt payments. Alfonsín is not just a blast from the past: he heads the center-left Radical party, the government’s senior coalition partner.

This fracas and a stagnant economy meant the government could not float a single bond since September, and after leaning on local banks for support, it had to call in the IMF.

De la Rúa needs to make the most of the breathing space the IMF has brought him. Time is not on his side. He faces important mid-term elections in October and heavy debt repayment schedules loom in 2002 and the years ahead. The economy needs to show signs of recovery soon to avoid more problems toward the end of the year.

A renewed crisis would call the currency board further into question and prompt deeper consideration of the role private sector financial institutions should play in sovereign rescue missions. This is the third time in three years that the international financial community has had to rescue a Latin American country. In late 1998, the IMF stitched together a $41.5 billion package for Brazil, intended to prevent a devaluation of the real. In 1999, the Fund presided over Ecuador’s default. Now there is Argentina, a country that until a few years ago seemed to be doing everything right.

Been There, Done That
Fundamental reform, a rock solid peso and impressive leadership from President Carlos Menem and Cavallo made Argentina the success story of the early 1990s. And there is still reason to be optimistic about Argentina. The euro is recovering against the dollar and the European Union is an important export market for Argentina. The US Federal Reserve is easing monetary policy, which should revive confidence in the peso – linked to the dollar by law since 1991. Admittedly, a weak US economy will not help. But prices for Argentina’s commodity exports are recovering.

The banks – now almost entirely in foreign hands – are in good shape. Economy Minister Machinea has introduced reforms easing the tax burden, deregulating labor markets and freezing government spending. Brazil, Argentina’s main trade partner, is growing. Indeed, that country’s swift recovery from the real devaluation crisis in 1999 gives the world hope that Argentina too can dig itself out of its troubles. Indeed, Standard&Poor’s raised Brazil’s rating to BB- in January, two months after it downgraded Argentina, leaving both countries at the same level.

Already, banks are reporting a timid increase in credit quality and demand for loans, an encouraging indicator that confidence and demand are recovering. Sergio Grinenco, chief financial officer at Banco Galicia, Argentina’s biggest bank and the only large bank still left in local hands, forecasts that “in 2001, the economy will start growing again slowly.” Citibank expects a similar recovery and an uptick in business this year.

Growth would reduce the public sector debt and convince financial markets that Argentina can avoid a debt restructuring. Interest rates would fall, setting off a virtuous circle of growth, declining budget deficits and further rate declines. With time, Argentina’s capital markets could shoulder more of the burden of financing the deficit.

Recovery would rebuild de la Rúa’s political authority. Miguel Gutiérrez, co-head of emerging markets for JP Morgan based in Buenos Aires, says, “If the political situation gets better the markets will be in a position to provide the capital. Since the 1998 Russian crisis [investors were] underweight Argentina so now they could rebalance their portfolios to neutral.” He says the recovery would “start with flows to fixed income markets and as the risk premium falls and we get more growth by the second or third quarters, investment could start.”

This would remove the risk of yet another emerging market crisis. Collapse in Argentina would affect developing countries around the world, as investors shun emerging market paper.

Scant Political FaithThe trouble is that de la Rúa has shown scant political determination in his first year in office, an anniversary he observed in subdued style at the presidential compound of Los Olivos a week before the IMF announced details of the rescue package. Congress frequently delays or waters down de la Rúa’s reforms and a foot-dragging bureaucracy often refuses to implement changes fully. He had to withdraw reform legislation from Congress and enact it by decree instead. The gray and ascetic de la Rúa appears indecisive and bowed down with troubles. He is scornfully known as Fernando de la Duda – Fernando the Doubter.

Bill Rhodes, Citigroup vice chairman, says, “The challenge is obviously for the government to execute its program in a timely fashion in order to create confidence and lead to sustained growth. It really gets down to execution, which if done on a consistent and timely basis will create confidence, which is what the country needs.”

De la Rúa’s deal with the IMF, deregulation and tax cuts may yet do the trick. So could his pledge to freeze spending for five years to eliminate the budget deficit by 2005 (two years later than originally promised) and a limit on transfers to provincial governments. But there are let-out clauses in these agreements that could undermine progress. In January, a prominent labor confederation won a court ruling overturning a presidential decree deregulating the social security system. Former Vice President Alvarez’s center-left Frepaso party has come down against the pension reforms.

Unfortunately, a large segment of Argentine business has just about given up on the current economic team and few have much time for de la Rúa. Business and financial leaders want Cavallo back. He quit as economy minister in 1995 over corruption in the Menem government and spent the subsequent years on the margins of national politics. Since then, Menem and then de la Rúa increased spending and raised taxes, including those that penalized investment. The economy began sputtering to a halt in 1998, before the Russian crisis and Brazil’s devaluation.

The intensely ambitious Cavallo senses his time is coming. He says the government’s only hope for reviving growth is to boost investment. To do so, he says Argentina needs to “reduce the cost of investment by 20% to 30%. It is possible to do this by reducing the taxes that were imposed in the last three or four years.” These include import duties on capital goods of 14%, which should be cut to zero, and 15% tax on interest charges, which should be abolished, he says. A tax on the “presumed income” of companies should be scrapped. He dismisses Machinea’s 18-month timetable for tax cuts as too timid.

Cavallo’s policy proposals are risky and could do great damage should they fail. They could undo a year’s effort at consolidating the public finances and introduce more uncertainty just as Argentina seems to be turning the corner. Neither the Fund nor markets at home or abroad are likely to forgive failed experiments.

Confidence Needed
And not all business leaders are enthusiastic about Cavallo and his plans. The director of one of Argentina’s biggest manufacturing companies, who spoke on the condition of anonymity, says, “Cavallo was very good at reorganizing the state, making it more efficient and encouraging growth. He stopped corruption. But he could not control spending.Now that there are no privatizations left to do it is very difficult to repeat what he did.”Patricio Kelly, president and CEO of Deutsche Bank in Argentina, says bluntly, “The fact that Argentina can or cannot finance itself depends on the confidence that the market has in it.”

Confidence is a difficult commodity to measure and can be conjured out of almost nothing but can also be lost in a flash. Kelly and many other Buenos Aires financiers argue that the way to generate confidence is to reduce spending and transfer to the private sector the savings of the public sector. “The effect of this is more substantial than a devaluation,” says Kelly.

The government should underpin this by returning to its earlier declaration that it would seek an investment-grade rating, which Argentina came close to achieving in 1997. Kelly says, “Achieving investment grade should become a question of state.”

This is fine in principle, but pulling companies and consumers out of their depression will not be easy. Lack of confidence in the government is widespread. A finance director says, “Companies are liquid and they have room to increase leverage. But the problem is that with a fear of recession, that there could be a devaluation or increase in taxes, companies do not want to take on medium-or long-term dollar debt.”

Plunging Values and Profits A visit to Acindar, one of the country’s biggest steel mills, on the outskirts of Buenos Aires, helps show why the country is so depressed. Acindar’s output and profits in 2000 fell by over 10%. Return on equity collapsed to a negative 34% last year. Gustavo Pitaluga, a company spokesman, says, “Our biggest problem is that we made very large investments to accompany growth. We expected growth. [Instead] prices fell and demand remains very low.”

The company bought, but never installed, a $15 million rolling mill, but must still pay 6% tax on the “presumed income” it could earn on the machinery. The company’s stock has lost over half its value. Last November, Acindar agreed with Brazil’s Belgo Mineira, owned by Luxembourg’s Arbed steel group, in exchange for a capital injection of up to $100 million to share control.

Acindar’s difficulties are typical of countless businesses throughout Argentina. An executive at another company says, “The private sector cannot support such an inefficient state. I would not say that the taxes are so high, but that they are of the type that discourages investment. We need a tax system, rules of the game, that will not be radically altered for a decade.”

Unless industry can be convinced to continue cutting costs, invest more, increase exports and start hiring, there is a risk that the December rescue package may turn out to be just a Band-Aid for a bleeding jugular. Argentina has already used up two-thirds of an already large package (bigger than the $41.5 billion loan Brazil got in 1998, given the smaller size of Argentina’s economy). Unlike Brazil, Argentina cannot devalue its currency because the country is dollarized in all but name. There is little clamor in the streets for an end to the currency board. Nearly all liabilities are in dollars: devaluation would wreck the financial system and inflation would wipe out any competitive gain.

Voluntary Rescue
Luckily for Argentina, the IMF and the world’s capital markets have too much at stake to allow the country to drift into default. The financial community responded strongly to Argentina’s predicament. Bill Rhodes says, “Here we have the proper approach to private sector involvement: on a voluntary basis. Argentina wanted to distance itself from an involuntary, forced approach that could negatively impact its return to the capital markets.”

Ecuador’s default on more than $6 billion in Brady bonds and Eurobonds and subsequent imposition of a “haircut” – a reduction in assets as part of a debt workout – has not set a good precedent. Bondholders were “bailed-in” by sharing the pain of rescuing Ecuador and paying the price of lending to a risky credit. Ecuador is unlikely to access the world’s capital markets on a voluntary basis again for along time.

Carlos Fedrigotti, president of Citibank in Argentina says: “A haircut would be absolutely disastrous for Argentina. The private sector must play a role [in the package]. The good news is that the market will be there for this type of operations on a voluntary basis.” If all goes according to plan, the IMF’s package would allow Argentina to return to international markets on a voluntary basis soon.

Intense Arm-twisting
Anyway, the creditors subject to the most intense arm-twisting are not the foreign institutions, but local pension funds and to a lesser extent, the local banks, most of which are owned by international groups. Marx says the government is also doing its bit by accelerating pension fund and capital market reform to create a bigger pool of local capital, reducing the government’s need to borrow abroad.

But there is a price to be paid for resorting to the local markets, as Moody’s warned last November. The rating agency said this would have a “negative impact on growth prospects as it crowds out the private sector and contributes to high real interest rates in the country’s domestic markets. Strains will be particularly burdensome over the next four years given the maturity structure of the country’s debt.”

The rescue of Argentina does little to lessen moral hazard, the belief among lenders that they will be rescued in the event of a crisis, which encourages them to take greater risks than they would otherwise accept. Argentine bonds collapsed 16% during October, though they had almost fully recovered by January. Argentina is current on its service payments and should have little difficulty remaining so all this year.

Eduardo Lora, chief economist at the Inter-American Development Bank, recognizes that markets are right to see that the bigger the country, the safer it is. “The fact of the matter is that larger countries do a better job in mobilizing more resources by organizing political support,” he says.

However, the IMF has also changed its ways, accepting less strict financial targets and providing plenty of liquidity in the expectation that its money will spark a domestic economy recovery. Gone are the days of Draconian conditions for its loans.

“This is a very important shift in thinking, for the assumption in the past was not to allow for larger fiscal deficits,” says Lora. “Now the thinking is that you may allow for certain [fiscal] slippage in the short term to allow for sustainable solution in the long term.”

Forcing private sector lenders to suffer a haircut to share risk is self-defeating, he argues. The experience of the 1980s’ debt crises, when banks were forced to refinance governments, wasted time and took years for these countries to get back to the markets. The plan now is to encourage lending at reasonable interest rates.

Questions Over IMF RoleThe IMF has to strike a balance between backing Argentina with sufficient short-term financial assistance while avoiding the impression of bailing out the government on excessively generous terms. There is no clear procedure for involving private creditors in bailouts and since each crisis is different, the formula the IMF applies to countries in trouble must also differ.

However, the Fund still has some serious questions to answer over its role in Argentina. To begin with, its critics say it has failed to provide early warning of financial crises.

In a September report, the Fund gave Argentina a reasonably clean bill of health, while noting the need to rebuild confidence. The report stated, “The basic economic policy strategy of the government remains fundamentally correct and deserves the continued support of the international community.”

The IMF, perhaps for political and internal reasons, is unwilling to act as a whistle blower, alerting the world to the risk of wayward policymaking before it is too late. This is understandable. The Fund would be in the uncomfortable position of having to second-guess decisions by sovereign governments that are also its shareholders. The IMF, the IDB, and the US government have all backed Argentina throughout the 1990s with varying degrees of enthusiasm following its adoption of the currency board. Support in the first half of the decade was plainly justified, given the speed and solidity of the reform program.

They should have reduced support following Menem’s decision in 1994 to reform the constitution to ensure his reelection. His second term was marked by policy drift and deteriorating economic indicators. Menem made no effort to encourage exports. Argentina still exports very little: foreign sales peaked at $26.44 billion in 1998. Lack of an export culture is a serious weakness that leaves the country exposed to more payments crises in the future. Creating a dynamic export sector takes time, but this should be a strategic government objective.

A rise in spending in 1998 and 1999 in an abortive attempt by Menem to win support for a third term pushed Argentina further toward the brink. There were few signs of alarm from the Fund. Standard  &  Poor’s only downgraded Argentina to BB- in November, once the severity of the country’s problems were clear. Moody’s remains relatively sanguine. It last downgraded Argentina to B1 in October 1999, but changed its outlook to negative last November.

Who Holds the Bag?
However, this suggests that major financial institutions, with their regiments of highly paid analysts and networks of local offices, are unable to monitor markets by themselves. If anyone deserves protection it is the retail investors – invariably European – who wind up holding risky paper issued by Argentina and other sovereigns. Yet multilateral support for governments facing liquidity problems inevitably introduces an element of moral hazard. It distorts pricing of bonds and other assets that should act as impersonal early warning signals. In an ideal world, markets should be allowed to operate as freely as possible, with lenders assessing risk as they see fit and preparing to live with the consequences of their decisions.

Selling economic austerity is never easy or pleasant, particularly in a country where under-employment and unemployment together affect about 25% of the working population. However, if there is one thing the current generation of Latin American leaders and their advisers have learned, it is that there is simply no viable alternative to free markets and the disciplines they impose on countries to attain growth by keeping budget deficits, inflation and interest rates as low as possible.

Of course, this does not mean that Argentina is fated to return to growth. On the contrary, its history in the 20th century was one of almost uninterrupted decline, briefly arrested in the 1990s.

Fernando de la Rúa faces a challenge of historic proportions in the months ahead as he struggles to put Argentina back on the road to recovery. The jury is out, but may deliver a verdict on his presidency and the outlook for the developing world’s access to capital markets in the months ahead. LF