Brazil and Argentina Hyperinflation Experience at the Beginning of the 1990s - Research Paper Example

?Introduction Hyperinflation occurs when a country faces an unstoppable and consistently increasing rate of inflation. When such situation occurs notonly the general increase in price levels rapidly occur but the currency of the country loses its real value also. The consistent increase in supply of money as well as the cost of goods often results into unnoticeable but relatively high degree of hyperinflation in the country. (McEachern,177) Brazil and Argentine both faced consistent and chronic inflation which turned into hyperinflation and sustained itself for considerable period of time. The period of relatively high level of inflation lasted for about 15 years i.e. from 1980 to 1994 and resulted into significant political, economic as well as social crisis for the country. One of the key reasons for this hyperinflation in the country was the creation of money supply to finance fiscal expenditure of the country. Government rather than using the taxes or borrowing started to created new money and hence creation of money supply. During 1990s, consumer price index ran into the factor of over 5 trillion thus indicating the overall severity of the inflation faced by the country. Argentine also faced the similar situation during 1990s however, the consistent increase in inflation lasted from 1975 to early 1990s. during that period the overall value of Argentine’s Peso went down and the country introduced massive changes and reforms in 1990s to initiate the process of recovery. This paper will look into the episodes of hyperinflation in Argentine and Brazil, what policies were adapted by these governments and what are the lasting effects of hyperinflation. Hyperinflation in Brazil Brazil was a case of chronic inflation which finally turned into hyperinflation and resulted into serious damage for the country. The key reason for this hyperinflation was the excessive creation of money to finance the expansion projects of the government. Rather than relying on the borrowing or improving tax collection, government simply resorted to printing new money thus creating excessive money supply in the country. At the start of 1990, the consumer price index in the country was to the factor of 100 Million which reached to over 5 trillion by the end of 1997. Such sharp and abnormal increase in the level of consumer price index sustained for almost a decade and proved detrimental for the overall economic future of the country. It is however, critical to note that the 1990s was the period during which the overall rate of inflation started to moderate owing to strict reforms being undertaken by the government. Since, Brazil was facing higher episodes of inflation since 1970s therefore 1990s was the period during which country started to take measures to arrest such trends. (Barbosa, Cunha and Elvia,183 ) At the start of 1990s, the rate of inflation was over 30,000% however, it gradually started to decline and reached a level of 16% in 1997. As discussed above, this was a period of relatively important reforms undertaken by the country which resulted into sharp decline in the hyperinflation and economy started to witness relatively moderate level of inflation rates. (Samuels,547) During this period, saving rates were almost negative as people continued to spend their cash due to the fact that its value was being eroded rapidly. Interest rates soared to a relatively high level in order to reduce the inflation and people who were already suffering from high inflation rates were forced to face higher interest rates also. It is however, critical to note that the real GDP during the period remained at stagnant levels due to better agriculture output as well as a consistent increase in population during the decade. A real high level of hyperinflation affected the real incomes of the households as consistent increase in inflation eroded the purchasing power of the individuals. Apart from this, the incentive to save greatly reduced as money was losing its value fast and in order to make a trade-off, individuals attempted to consume their cash rather than save it. In case of Brazil, however, the per capita income remained in a close but stagnant zone rather than decline due to hyperinflation. This may also be due to the fact that real GDP of the country during that period remained relatively high. (Bonelli, Franco and Fritsch,152) One of the key impacts of the hyperinflation on the lives of people of Brazil therefore was the high level of price appreciation they faced. The value of the savings made for years suddenly evaporated and people faced a relatively difficult trade off of increasing their consumption in order to save their currency losing its value. Hyperinflation in Argentina Hyperinflation in Argentine has a history of high levels of debts and country’s inability to honor its debt commitments. Before the start of the hyperinflation episodes starting 1989, Argentina defaulted on its commitments and when the overall situation started to go out of hand. Argentina government, in order to avoid the situation, therefore resorted to printing more money to pay off its debt obligations and resultantly attracted hyperinflation which started to affect the economy badly. During the initial years of the hyperinflation which carried over from the decade earlier, the overall inflation rate was touching almost 2600% suggesting that the bad economic policies of the Military government actually resulted into serious economic damage for the country. It is also critical to note that the cycles of inflation in Argentina along with Brazil were relatively shorter and inflation peaked at each round of the inflationary hike. (Teunissen and Akkerman,168) One of the key impacts of the hyperinflation in Argentina on the lives of ordinary citizens was the collapse of financial markets. This resulted into serious consequences for the people due to runs on the local money and fast eroding of the value of the savings of ordinary people. Due to capital flight and the heavy debt incurred by the local enterprises, the level of unemployment started to increase. Apart from this, government due to lack of revenue generation, started to levy taxes on the bank deposits thus further creating economic troubles for the ordinary Argentinian citizens. Economic Policies Adapted by Argentina’s Government Reforms and steps taken by the Argentina government during 1990s to overcome the hyperinflation were mutli-pronged in nature. Government undertook many reforms at the same level and also discontinued previous reforms which failed to achieve any credible results for the economy. Argentinian Government took following steps to overcome this situation: Tax Reforms and Trade Liberalization One of the key steps taken by the government was to remove the trade restrictions which opened the Argentina’s economy for the external world. By eliminating export taxes and removing the restrictions on the imports, government created an entry and exit portfolio. The reliance on the public sector was reduced by eliminating the subsidies for the private sector. By eliminating subsidies, government actually increased its revenues and lessened the reliance on printing money to finance its expenditure. Tax reforms included imposition of income as well as consumption taxes in order to reduce consumption. New tax laws were imposed in order to increase the powers of the government to punish tax evasion. This has allowed the government to actually accelerate the economic growth while at the same time increasing the revenue for the government. The subsidies for local industries were reduced and government also encouraged foreign firms to actually make an entry into the local markets. These changes actually resulted into a dramatic reduction and changes in the composition of prices in the local market. The overall impact of this was the creation of voluntary financing for the public debts which were rescheduled under the Brady Plan. (Maute,120) Financial Sector Reforms There have been two important pieces of financial sector reforms which were undertaken in Argentine. First the Convertibility Law 1991 and the Central Bank Charter of 1992 were two important legislations which paved the way for radical financial sector reforms in the country. The convertibility law actually pegged the value of Argentina’s currency with that of the US Dollar and also made it necessary for the Central Bank to actually back two-thirds of monetary base of the country with that of the international reserves. This law actually converted Central Bank as a currency board thus limiting the ability of the central bank to create money and hence restrict the ability of the government to finance its expenditure by creating more money. The Central Bank Charter actually made the Central Bank more independent from the powers of the executive of the country. The principal activity of the Central Bank was to maintain the value of the domestic currency without any political or other compulsions. The charter made it possible for the Central Bank to refuse lending to the provincial as well as municipal governments and as such made it possible for the Central Bank to exercise discretion while lending. (Beckerman) Banking Regulations One of the key moves made through the reforms were the strict banking regulations in place which not only expanded the base of the domestic branches in the country. Besides this, foreign banks were also allowed to enter the market thus increasing the overall competition within the industry. New capital requirements were introduced which allowed Banks to strengthen their balance sheets and become less vulnerable to external shocks. Economic Policies Adapted by Brazil’s Government The steps undertaken by the Brazil’s government to overcome hyperinflation in the economy and bring in general change within the whole economy was based upon what is called the Real Plan. The Real Plan was based upon three important components of fiscal strategy, monetary reforms as well as the opening up of the economy. (Fonseca,621). Social Emergency Fund was created and given constitutional protection to be used for the projects with greater social and economic importance. Apart from this, government also initiated a systematic program to privatize large and State owned organizations in order to provide government required funds to further expand in the future. (Gordon,210) One of the steps taken by the Brazilian Government was the indexation and freezing of the prices which could not yield the desired results for the economy. In order to overcome this, government however, introduced an artificial financial standard called Unit of Real Value (URV). All the prices in the country were actually calculated based upon this standard. URV was actually aimed at de-indexing the economy and making it more responsive to the rapid price changes. (Baer and Fleischer,335) Apart from this, Brazil also opened its economy for the international markets and took benefit of the free market economics. The overvalued currency helped increase the competition as well as kept the prices down as international players also started to directly compete with the local firms. Unintended Consequences Both the countries faced consistent episodes of hyperinflation and the policies which were aimed at reducing the impact of hyperinflation in the economy contributed towards social, political as well as economic reforms. One of the key consequences of these changes were the gradual independence of the financial and other institutions to exercise prudential economic and financial policies. By taking these institutions out of the political influence, both the countries were actually able to make their institutions more independent to pursue their own economic policies. Apart from this, the economy started to improve and as a result of this, the international firms entered into the market. By opening up of the economy, both the countries actually made efforts to increase the competition at the local level while at the same time allowing foreign entities to impart knowledge and resource base to upgrade the economy. It is also important to notice that as a part of the overall reforms, financial institutions were strengthened and as such the overall trends of saving increased. During hyperinflationary periods, people avoided to save however as the competitions improved, saving trends increased too. Higher level of savings made it relatively possible for domestic firms to borrow from a larger pool of savings at relatively attractive interest rates. Due to these reforms the reliance on the external debts reduced too and economies relied on the domestically generated revenue rather than borrowing from external agencies or printing money. By rationalizing taxes as well as privatization, both Argentina and Brazil generated domestic revenue to finance its fiscal expenditure. Last Effects of Hyperinflation One of the key impacts of hyperinflation on the monetary base of the country is that it encourages it to flee the country. Since money loses its value fast, Central Bank not only has to print the currency notes of higher denomination but also faces the consequences of money leaving the country as people prefer to save their money in other currencies. Apart from this, the real money loses its intrinsic value and gold is normally considered as store of value. In a situation where hyperinflation rapidly occurs, gold normally replaces the normal paper currency in order to minimize the impact of inflationary pressures. Monetary Policy becomes relatively ineffective because money loses its value fast and Central Bank has to print notes of higher denomination to fulfill the needs. Apart from this, hyperinflation also has significant impact on the savers and consumers as not only purchasing power fastly erodes but the overall value of investments becomes worthless too. Since money loses its value therefore investments made in paper currency provide negative returns and their value declines relatively fast. Consumers are generally forced to use currency notes of higher denomination or trade in other real assets in order to avoid the inflationary impact on their overall wealth. Consumers also tend to invest more in real assets rather than in currency during the periods of hyperinflation in order to convert their savings into real assets. Conclusion Brazil and Argentina faced hyperinflation at the same time during 1990s and both the countries successfully dealt with the situation by bringing in radical reforms. It is critical to understand that hyperinflationary episodes in both the countries continued from 1980’s and 1990s was the period during which conclusive reforms were undertaken to arrest the decline in economy caused by the hyperinflation. One of the key causes of hyperinflation in both the countries was excessive printing of money and creation of money supply. Rather than expanding the tax base of the country to finance its expenditure, both the governments relied heavily on expanding money supply in the economy by printing more currency. Excessive money supply therefore resulted into hyperinflation in both the countries affecting ordinary consumers. One of the key impacts of the hyperinflation on the consumers was the fast erosion of their purchasing power as well as their investments lost value. Due to rapidly increasing inflation, savings were reduced to none and households started to invest in real assets rather than keeping their savings and investments in cash. Both the governments took radical steps such as financial and banking sector reforms, creation of currency boards, expanding the taxation base of the country as well as decreasing reliance on external debt. Hyperinflation also has an impact on monetary policy of the country as well as the credit extension and purchasing power of the consumers. 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