Argentina seems only to learn the hard way. It took a defeat in a war with Britain 20 years ago to help restore democracy. Ten years later, Argentines had to endure hyperinflation before creating a currency board that delivered the longest period of price stability in generations.
Now, with the government on the brink of defaulting on its $130 billion debt, Congress has approved a law forbidding the government from running a budget deficit ever again. This zero-deficit law and plenty of luck are all that stand between Argentina and default. Optimists believe this law will gain the same exalted status as the convertibility law of 1991 that set up the currency board.
Although Argentina’s debt burden is not particularly heavy – it is equivalent to 57% of GDP – the country is on the verge of default and devaluation because its economy stopped growing three years ago. Argentina’s problems are more profound than an economic or political crisis. The country is suffering from collective depression.
Even Domingo Cavallo, the economy minister, admits the country’s mood is bleak. Looking haggard after six months in the job, he says Argentines are sunk in “a typical depressive process that brings more recession and more depression. Foreigners see a people who have lost hope and are pessimistic.” Cavallo says this psychological ingredient was the same in the US in the 1930s and in the last decade in Japan. “This has to change and it is changing, with actions to convince people that the recession is over and that strong growth is coming. I have not lost hope,” he says (see “Argentina’s Last Defense,” page 27).
Many Argentines have become convinced that the only satisfactory solution to the crisis would be to reconstruct the deficit-ridden public sector. They hope the zero-deficit law marks a starting point in this process.
Default alone would not address the country’s problems. Rather a less Byzantine state, a more rational tax system and lower interest rates certainly would enable Argentina to grow. Improved public services would be an additional bonus. Standards at Argentina’s public schools, once outstanding, have slid. Publicly funded scientific research has dwindled. Corruption is widespread. Carlos Menem, the former president, is under house arrest pending trial on arms smuggling charges.
Hunger for Capital
Business leaders say Argentina needs to fundamentally reorder the state. Public spending in Argentina has doubled in the last 10 years and the deficit has increased six-fold, driving up debt levels and interest rates, despite privatization of nearly every state-owned enterprise during the 1990s.
Last year, public spending was $62.4 billion, and the budget deficit was $6.59 billion. A decade earlier, spending was half that and the budget deficit was $1.69 billion. Public sector wages, debt service charges and the state’s social security system consumed most of the money. The country’s bureaucracy is expensive and inefficient, especially at the provincial level. According to a study by Fundación Capital, a consultancy, a third of the increase in public spending in the last five years took place at the level of local governments. Their payroll has risen by a quarter since 1996. Staffing rose by 17% and wages rose 8%. The province of Buenos Aires, the country’s wealthiest and most populous, has started paying its staff and suppliers with bonds, known as patacones, instead of cash.
It is the public sector’s relentless hunger for capital, not the fixed exchange rate, that troubles Argentina’s corporate bosses the most. Few show much enthusiasm for Cavallo’s decision to make the currency board more flexible by using the euro as well as the dollar to back the peso. This would only happen once the euro when reaches parity with the dollar. Cavallo also introduced a more competitive exchange rate for exporters.
Taxes and interest rates are so high that it has become very difficult for businesses to function properly.
Mario Lagrosa, chief executive officer of energy group Pérez Companc, says that for a company in an emerging market country, access to capital and the cost of capital is key for its development. “Nobody knows the energy business in Latin America better than we do,” he says. “But our challenge is the cost of our capital.” Gustavo Pitaluga, an executive at Argentina’s largest steel mill, Acindar, says, “We need clear rules of the game [covering] the tax question and we need public spending that is sustainable with the taxes that are being collected.” Acindar, struggling with a weak balance sheet and heavy losses, pays about 14 different federal, provincial and municipal taxes. These include value added tax, corporate income tax, a turnover tax, a tax on “presumed income,” plus taxes on power, gas and telephone use (see “Sweet Calamity,” page 34). Acindar’s fortunes have declined so sharply that it has had to cut wages by 10%.
A Ghost Town
Deflation and unemployment have pushed Argentina into its fourth consecutive year of recession – the longest period of decline in its modern history.
Buenos Aires, a city once cursed with atrocious traffic and blessed with cafés and restaurants jammed until the early morning hours, now feels like a ghost town. Trips across town that once seemed to take forever now take 15 to 20 minutes. Nightclubs, bars, cinemas and theaters once packed with people have cut prices but rarely attract a crowd. A crime wave has spread fear across the city. The sidewalks of its broad avenues that were once filled until late are now largely abandoned at night.
Unemployment in Argentina has reached 17% and about half the population of working age lacks a regular job. Private sector wages have fallen by 40%. Militants are blocking roads throughout the country. They have mounted over 600 roadblocks since January. Labor unions have staged seven general strikes since December 1999, when the current administration of President Fernando de la Rúa was sworn in.
Argentina is paying a bitter price for not following through with reform in the 1990s. Cavallo, who served as economy minister also during that period, used the currency board to crush inflation and ushered in an economic renaissance. He rammed through Latin America’s most aggressive privatization program. He introduced a Chilean-style private pension fund system. But the boom petered out by 1998, two years after Menem fired Cavallo for denouncing corruption.
Argentina missed that opportunity to revive its flagging entrepreneurial spirits and rebuild the state, as Britain had done under Margaret Thatcher. Few new businesses were born during those boom years and fewer still have survived the bust of the last three years. The capital markets have wasted away (see “A Future or a Fall?” page 32).
For an assault on the public sector to succeed, De la Rúa, who in December reaches the midpoint of his four-year term, would need to assert his authority. Yet, with the exception of Cavallo’s Economy Ministry, the government has lost its capacity for decisive action.
Emilio Cárdenas, a director at HSBC’s Argentine bank and a former UN ambassador, says, “The despair has a lot to do with the political disarray. The country is ruled by a coalition that does not exist. The cabinet has some outstanding members, but they are being attacked from behind because the cabinet is not united.” He says managing a crisis without “leadership or authority is the worst thing you can have. We hear three or four different ideas for ending the crisis. How can you plan when you are wondering which idea will prevail?”
The priority is dealing with its debt. Cavallo and his team have trekked round the world’s financial centers rustling up loans. A $29.5 billion debt exchange in June bought barely a breathing space. In August the International Monetary Fund agreed to lend Argentina $8 billion, of which $3 billion is earmarked for a market-based debt reduction initiative. Cavallo says the remaining $5 billion will be used to bolster the central bank’s role as lender of last resort, not to finance the government. This has brought some respite. Private-sector bank deposits were up $586 million in the first week of September. But Argentines have pulled $10.58 billion from their accounts this year, fearing the banks would collapse. The spread on Argentine bonds has fallen by 20% from a peak of 1,755 basis points in August.
According to JP Morgan, the government’s financing gap for the rest of the year is likely to be only $263 million. However, come next year, the government could face a deficit of over $5 billion, in spite of heavy spending cuts. Joyce Chang, JP Morgan’s head of emerging market fixed income research, warned in a report that, “The medium-term viability of the zero-deficit concept in the context of weak economic activity and tax revenues remains precarious. The fiscal strategy will require solid political backing and sustainability will remain a challenge, especially given the evident disagreements that have prevailed within the governing Alliance.”
Argentina cannot expect to raise more loans after Moody’s Investors Service cut its rating to Caa1, the same as Cuba’s. Last year, Argentina borrowed $12.15 billion but only $1.45 billion in 2001. An IMF-sponsored debt restructuring, like the June debt exchange, could bring some immediate relief but is unlikely to be more than a palliative for a deep-seated problem. Argentina will need to convince other government and private sector lenders to support a debt reorganization. A $3 billion package would be insufficient to cut the country’s financing costs.
Default could have devastating consequences. The payments chain is already showing signs of distress. Mounting corporate defaults, rising levels of non-performing retail loans and the growing risk of a government bond restructuring have weakened a once solid banking system. Devaluation would only deepen the crisis because most loans and deposits are in dollars. Economists say dollarization, not devaluation, would be a more likely policy response to a loss of confidence in the peso.
Miguel Angel Broda, the doyen of Buenos Aires economic consultants, thinks that even without default, the country’s GDP is likely to contract by 1.8% this year but would recover with 0.6% growth in 2002. If the government were to stop servicing its debts, the economy would shrink by 2.2% this year and 5.7% in 2002, he calculates. Although much depends on how default is managed – scenarios range from an utterly chaotic process to a relatively market-friendly solution – it could still take the country many years to regain access to the world’s financial markets. It took a decade for Argentina to raise voluntary financing after it defaulted on its debt in 1982 at the outset of the Latin debt crisis.
Whatever the outcome, the country’s future still depends on straightening out the public sector. Broda says, “The government should at least use the crisis to improve the quality of public policy, reform the state, introduce a good tax-sharing law with the provinces.” Roberto Cancelliere, head of the Argentine subsidiary of US network company Diveo, says, “The cost of doing business in Argentina is so high because the state is so large. Our politicians have to understand this. There is no other way but to reduce the state. Having the zero-deficit law is not the solution. The state also needs to be efficient.”
He hopes that the result of mid-term Congressional elections on October 14th will breathe some new life into the political system, still dominated by the ruling Radical party and the opposition Peronists. Most people expect the elections to deliver De la Rúa’s government a mortal blow, but voters yearn for a political reawakening. Still, no politician has emerged to inspire Argentines with a compelling vision of their country’s future.
There are Peronists and politicians from other opposition parties who have seen the light and started reacting to public pressure. Córdoba’s Peronist governor, José Manuel de la Sota held a referendum to shut down one of the provincial legislature’s two houses. Earlier he had cut tax rates and increased revenues. Cancelliere says, “Society is discussing all this. Politicians are followers of society, they take up ideas that are already in people’s minds. They must understand they can’t go on raising taxes.”
Fiscal sanity mandated by the zero-deficit law might just revive the economy now. Cavallo says the Argentine economy is ready for revival once the country’s mood shifts. Juan Bosch, head of Compass Asset Management’s Buenos Aires office, agrees. “Years of recession mean there is considerable pent-up consumer demand. Companies have plenty of spare capacity. Many spent heavily in the 1990s to install state-of the-art technology and need not invest much now,” he says. “Falling interest rates as the state ceases to place fresh debt would bring a recovery in consumer confidence, which would lead to growth, more investment and ultimately lead to rising employment.”
However, out on the streets or in the boardrooms of corporate Argentina, the idea that De la Rúa could rebuild the hulking machinery of state sounds absurd. Opposition to further retrenchment and wage cuts is growing. Politicians such as Rodolfo Terragno, a former cabinet minister who is now campaigning for a seat in the Senate as a member of the ruling Alliance coalition, says Argentina should aim for a “negotiated restructuring of the debt.”
Rebuilding the state would mean rethinking the modus operandi of Argentine politics, yet De la Rúa lacks the political spine needed to take on the bosses of his own Radical party and the opposition Peronists (who allowed the zero deficit law to pass, but abstained from voting). Ministers in his divided cabinet are hardly likely to attack their public sector fiefdoms with much energy.
Even though the new law appears to be an impressive commitment to fiscal integrity, most of the burden of the adjustment has once again fallen on the private sector by increasing taxes and scrapping corporate tax relief. Civil servants have suffered a 13% pay cut, but private sector employees have already suffered a far more drastic drop in incomes. Furthermore, no public employee is being threatened with dismissal, even though the private sector has laid off millions of workers.
With luck, Argentina can stagger on for the rest of the De la Rúa years until the 2003 presidential elections. Cavallo and his team might yet succeed in pushing ahead with microeconomic reforms and reviving the capital markets. He aims to eliminate the country’s tangled tax rules and rely on just value added tax and income tax.
Argentina looks like a hopeless case these days, but it did so a decade ago, when prices were rising by 147% a month and cities were facing food riots. It took the emergence of the charismatic Carlos Menem as president and Cavallo as his forceful economy minister to produce an economic miracle. The fact that they failed to complete the job by rebuilding the public sector has landed the country back in crisis a decaDe later. Argentines are now wondering who will emerge to lead the country out of today’s mess.
Without firm leadership, it is easy to see Argentina defaulting on its debt and the currency board collapsing. Economic upheaval could well drive De la Rúa from office early. No Radical president has completed his term since 1930. Still, there is a growing consensus over how to solve the country’s problems. A strong, clearheaded leader may yet emerge to reverse Argentina’s decline and revive Argentines’ confidence in the future. But if nothing is done, many more years of stagnation and despair lie ahead. LF