Contagion coming?

["Ian Murray" <seamus2001@xxxxxxxx>]

If Argentina falls, we all suffer

Larry Elliott
Monday November 5, 2001
The Guardian

Here's a puzzle for you. With the world on full-scale recession alert,
the US Federal Reserve, the Bank of England and the European Central
Bank are all expected to cut interest rates next week. President
George Bush admits he is worried about the waves of job cuts and has
put Congress on notice to stop playing games and come up with a fiscal
package that will boost investment and consumer demand.

What's wrong with that, you might ask? The answer, of course, is that
there is nothing wrong with it at all. But forget for a moment about
what is happening in the developed world and take a look at what is
happening in one of the world's leading developing nations, Argentina.
There, the economy has been in recession for four years and
unemployment is 18% - as opposed to 5.4% in the US, a figure that
warrants pushing the growth accelerator hard to the floor.

So, should Argentina be cutting interest rates, should it abandon the
peso's peg to the dollar, should it give up budgetary tightening in
favour of the sort of counter-cyclical fiscal policy that is the norm
in the US or the UK? Absolutely not. The answer for Argentina, say the
experts, is more economic pain to satisfy creditors to whom it owes a
tidy $132bn (£90bn). In particular, the proposed remedies involve the
liberalisation of labour markets, presumably so that employers can
sack people twice, and budget austerity to make sure that those laid
off receive no social security benefits.

The reason for this disparity between north and south America comes
down to credibility. Alan Greenspan, who has presided over an
explosion in private debt, has credibility with the markets; Domingo
Cavallo, the hard man in charge of Argentina's economy and presiding
over a mountain of public debt, does not. Cavallo is trying to win
some by insisting to international investors that if they agree to a
restructuring of debt he will ensure that state governors impose
deflationary measures. By driving Argentina deeper into recession,
Cavallo's credibility with the markets will be enhanced, thereby
permitting him to cut interest rates. Credibility, in other words,
means giving Cavallo a ladder to escape from the pit he is digging for
himself.

Now this may seem somewhat bizarre. But the alternative to austerity
is devaluation and default. And that, you guessed it, would be a
terrible blow to Argentina's credibility.

Argentina has been something of a sideshow for the past couple of
months. There is even some suggestion that it has ceased to be the
most important patient in the IMF's intensive care ward because Turkey
is seen as a crucial US ally in the war against terrorismm. But what
happens in Argentina matters, and policymakers know it. "If Argentina
falls, Brazil could fall, too," says Carlos Zarazaga, an
Argentinian-born economist at the Dallas Federal Reserve. "If the
country does default, it will mean another lost decade not just for
Argentina but for the whole of Latin America." The fear is that
Argentina could do in 2001 what Thailand did in 1997, and set off a
chain reaction across the whole developing world.

The question is not whether a remedy should be found for Argentina's
ills but what that remedy should be. It has to be said that, even if
Cavallo secures the agreement of creditors for the debt restructuring
he is looking for, it will be nothing more than a stopgap solution.
The proposed trade-off - swap our high-interest debt for low-interest
debt so we can afford the repayments and we'll sign up for another
dose of fiscal austerity - will just postpone the inevitable. There is
a limit to the amount of economic pain that can be inflicted without
the markets becoming concerned about political fallout. When interest
rates were raised to 15% in the UK on the afternoon of Black
Wednesday, the stock market rallied because dealers knew the game was
up. Rates at that level would have devastated the economy, and were
not, and here's that word again, credible.

As we now know, Black Wednesday was great news for Britain. Lower
rates and a cheaper currency meant recovery began almost immediately
and expansion has not ceased since. None of the dire consequences
predicted for devaluation happened. This, it might be argued, is
because Britain is a first world country with a stable economic and
political framework. There is something in this - even Argentina's
staunchest supporter would admit it has plenty of form when it comes
to bad economic management. But the sky did not fall in on Mexico when
it devalued after the crisis of 1994-95, and since Russia defaulted in
1998 its economy has grown strongly, helped by higher oil prices,
admittedly. Stronger growth has made the countries more attractive to
investors in an environment where markets are now far less concerned
about fighting inflation than with policies that promote expansion.

That's the reason the US dollar continues to outperform the euro.

For these reasons, it should be a no-brainer that what Argentina needs
is a growth-based strategy. For this, there are three options.
Zarazaga says one way of proving to Argentinians that liberalisation
works would be a free trade area of the Americas that would allow
Latin American nations access to the rich markets of the north while
maintaining protective barriers for the rest of the world. The
argument in favour of this is that exports are a pitifully small part
of Argentina's economy, about 8% of output, and that a staged
liberalisation of trade would boost growth. Argentina lacks economic
dynamism and this might be a way of providing it, though it would take
time. Time is one thing Argentina doesn't have.

The second approach would be the opposite, and would involve
devaluation, default and an increased reliance on domestic savers
rather than international capital flows to finance investment. This
has a better chance of working than full-out austerity but is still
fraught with risk. Argentina is not Malaysia, which could defy the
orthodoxy and impose controls on capital because it had a stronger
manufacturing base and ample domestic savings. A go it alone policy
might lead to a controlled macro-economic expansion, but it might
equally lead to the government printing money and, eventually,
hyper-inflation.

Buenos Aires is no stranger to devaluation and default, and there is
every indication that domestic savers are just as wary of the
authorities as are international investors. For this option to work,
there would have to be a rethink of what makes for sound development
policies, coupled with a new set of rules for bankruptcy that would
give countries the same rights as corporations.

This would be sensible but looks unlikely.

The only other option is for Argentina to dollarise its economy. Now,
it has all the disadvantages of a pegged currency without any of the
benefits. Importing monetary policy from the US would mean a loss of
independence but a sharp drop in real interest rates. Such a move
requires policymakers in Washington to be fully engaged, and at this
time the US may not want to send out the message that it is running
Latin America. Nothing meaningful will happen until Argentina goes
belly-up. The way things are shaping, that may not be too far away.

larry.elliott@xxxxxxxxxxxxxx