Latin Economic Crisis: Relationship between Argetina and the International Monetary Fund - Term Paper Example

Emerging economies in the Latin American region were at increased risk of defaulting on their foreign debt obligations. The situation was worsened bythe banking and property crises and exchange-rate volatility in Asia Pacific in the late 1990s. Both investors and creditors became nervous and lost confidence. This led to environmental degradation, income disparities, corruption, unemployment, and social and economic uncertainty. Even after sixteen years of debt reduction and debt-service reduction schemes, seven countries of Latin America accounted for almost 89% of the regions outstanding foreign debt (Strizzi & Kindra). The higher a countrys foreign debt level, the greater are the chances of default. According to World Bank, the Latin American Countries (LAC) would need US $ 60 million annually during 1991-2000 period. This translates into higher borrowing, higher debts and debt servicing. Budget cuts were immediately felt at the international financial institutions like the Asian Development Bank (ADB), International Monetary Fund (IMF), which decreased access to officially supported credits. Global interest rates rose, which further increased foreign debts. Mexico, Brazil and Argentina could not sustain the economic growth and lurched from one financial crisis to another (Elstrodt, Lenero, and Urdapilleta). Debt has been the largest source of capital flows in the developing countries but despite that, economic development has not been successful. The causes and consequences of such debts have been the subject of debate over the years. This paper will examine the severity of Argentinas debt and the relationship between Argentina and the IMF. During the Great Depression of the 1930s, UK and France too had defaulted on the debt repayments but the problems in debt repayments in Latin American can be dated back to 1914 when Mexico suspended its payments (Dodd). Owing to a series of corrupt regimes, Argentina has experienced severe economic declines. In 1956, a group of wealthy nations met in Paris to find a solution to the looming debt problems of Argentina. In the 1970s, large amount of lending to Latin America was in the form of syndicate banks loans. Brady Bonds helped in the debt restructuring process and the Brady plan proposed exchanging the loans for bonds that would allow the debt to be traded in financial markets where it would be priced at market value. Macroeconomic management is essential if the country is to attain sustained growth. Argentina, besides pegging the peso to the US dollar at parity in 1991, it also lifted price controls (Elstrodt). Industries like mining, oil, telecommunications, transport, and utilities were privatized. Inflation was virtually eradicated and the interest rates came down. Fiscal deficits were under control and interest payments on debts became manageable. There was a growth in the country’s GPD and labour productivity. The gains were all confined to the private sector. Other sectors, which accounted for country’s 80 percent GDP achieved only slight productivity growth. “Tequila Crisis” which started in 1994 in Mexico spread to Latin America. The hyperinflation in 1989-90, led Argentina to adopt a Convertibility Plan “which stipulated a one-for-one parity between the Argentine peso and the US dollar and guaranteed the right to convert pesos at that rate, meaning that devaluation would require a new act to be passed by Congress” (Miller & Fronti). This ended the inflation and the economy grew rapidly but the dollar peg proved unsustainable with capital outflows leading to repeated bank runs. This was inevitable and the country was in economic despair. Unemployment rose to 20% and half the population was below the poverty line. The Argentine government owes $195.5 billion in bonds and loans, which is the biggest sovereign default ever in history, which occurred in late 2001. Out of this, 43.3% was Performing Debts which includes all debt owed to the international financial institutions (IFIs); BODENs, or bonds issued to compensate banks and depositors for the peso devaluation (Hornbeck). Most of this debt is held by Argentines and has been fully “pesified.” Defaulting on the IFIs would cut off Argentina from external capital. This is never allowed to happen by any country. Restructuring this debt would reignite the crisis. The non-performing debts had to take the brunt of the debt write-down. Argentina did not even honor the non-performing debt of $81.2 billion worth of bonds at nominal or face value. Interest was estimated to be $22.9 billion as of June 2004, which was expected to hit $25 billion by 2005. Maintaining liquidity during crisis is the toughest part for any bank. Domestic depositors want their money back; foreign exchange and interest-rate markets complicate liquidity management. In Argentina, cooperation between the banks and the government broke down and the banks had to face the disintegrating situation alone. The banking system nearly collapsed with freeze on the consumer deposits, loss of public confidence, currency devaluation and series of banking holidays (Barton, Newell, and Wilson). A high complex set of huge debt defaulting, pose awkward challenges on Argentina’s economic and financial sphere. Output and employment were depressed, the normal functioning of the banking system was disrupted, the Government was unable to service its debts, and substitute quasi-currencies started circulating throughout the economy. The crisis gave rise to substantial financial losses. Confidence is at low ebb, not only in the economic and financial system, but also in social and political structures more generally. This led to Argentinas economy to decline by 11.0 percent in 2002, while inflation reached 25.9 percent (Fanelli & Heymann). The government froze account holders access to checking accounts above $10,000 and savings account above $3,000 for at least one year. Activities in exchange houses reduced 50% from 7 hours working time. That measure affected about a third of all bank deposits and generated a fresh wave of violent street protests. (Munter). Argentina managed to exchange 76% of the defaulted bonds for a much lower nominal value (25–35% of the original) and at longer terms (Wikipedia). About 25% of the debt holders did not agree to these terms. During the restructuring process, IMF held a ‘privileged’ position and they did not suffer discounts. When a country becomes insolvent and defaults in its debt it has to take certain steps. It is imperative to adapt certain policy changes. When Argentina’s debt ballooned beyond sustainability, Argentina defaulted to private creditors but continued a relationship with IMF with a strong support of US, although during its boom years, 1990-94, IMF had played a minor role in Argentina’s affairs. IMF then lent during the crisis with clear understanding that reforms will be accomplished. The designed infrastructures and policies included correcting the fiscal and current deficits and structural checks in order to facilitate economic up thrust and to building of confidence of international stakeholders. In December 2001, when Argentina did not make any positive attempts to avert default, it faced restructuring problems with creditors throughout the world. The IMF proposed a Sovereign Debt Restructuring Mechanism (SDRM) modeled on Chapter 11 of the US Bankruptcy Code (which puts the courts in charge of debt restructuring). Negotiations with other creditors remained stalled in September 2003 but Argentina entered into a new controversial three-year $12.6 billion IMF stand-by arrangement (Hornbeck). This agreement provided the framework that would guide the country’s economic recovery. Argentina proposed to the IMF that it would commit to only a 3% primary fiscal surplus and only for 2004, although it would devote slightly less than that to actual debt payments. While IMF interpreted this as a “floor” on Argentina’s commitments to debt service, other creditors saw it as a long-term ceiling. It means that they should expect larger write-down of debts. The agreement at least assured that a timely and proper restructuring would take place. Argentina then turned to the bondholders to make an initial offer in September 2003. They offered to pay 25 cents on the dollar of the principal value of the debt without any consideration of the interest. According to the financial institutions, this amounted to 90% and not 75% reduction on the value of the bonds. Argentine felt this was consistent with the 3% primary surplus target. This proposal met with resistance from the creditors, the governments, and the IMF. When this proposal was rejected, IMF delayed the first quarterly IMF program review over the lack of movement on debt negotiations. This put Argentina in an awkward position, as IMF reviews are essential for any country to receive the next disbursement of funds. Even though Great Britain, Italy, and Japan refrained from voting, Argentina survived the first IMF review but the second was also problematic as the next payment of $3.1 billion was due in March 2004. Argentina continued to meet its macroeconomic targets but was charged by IMF for not making headway in microeconomic reforms. IMF pressurized Argentina to negotiate a final debt agreement acceptable to at least 80% of the bondholders by September 2004. Argentina remained undaunted by pressure from the creditor groups. It took a firm stand and refused to make the $3.1 billion IMF payment unless it was assured that the IMF would approve the second review. IMF had now $15 billion invested in Argentina at stake. With IMF intervention, Argentina finally agreed to negotiate with all creditors without any changes in its fundamental offer of the extent of debt write-down and not nor increasing its resources beyond the 3% primary budget surplus. Argentina made a final offer and anticipated issuing $43.2 billion dollars in new bonds, assuming a minimum 70% participation rate. Three options were offered in settlement. With a view to reduce the debt and debt service, it offered Discount bonds of $19.9 billion for existing bonds would be exchanged for new U.S. dollar-denominated 30-year bonds with a 63% reduction (discount) in principal value carrying varying rates of interest over 20 years. The Par bond ($15 billion) would be exchanged for new U.S. dollar-denominated 35-year bonds at face (par) value; hence there would be no reduction in principal. The Quasi-par bond ($8.3 billion) would be exchanged for new peso-denominated 42-year bonds with an undefined reduction in principal. The financial community subjected these proposals to strong criticism. In addition, Argentina requested and was granted extension by the IMF on payments amounting to $1.1 billion of some $2.5 billion due in the final quarter of 2004, which relieved it of IMF pressure. Critics have viewed the restructuring process from different angles on the economic outlook and the impact Argentina will have in the fund and in Latin America. The results of the sovereign debt restructuring could range from a reasonable high participation rate (which can be called success) or a complete breakdown in investor relations and the IMF. Unstable Argentina would imply unstable South America, which is a backlash against the United States. Financial crisis and sovereign defaults not only affect the creditors but the society as a whole. Argentina has to settle with foreign bondholders if it has to return to the debt market but it seems determined on its stand. Argentina reasons that its debt is too big to repay and there is lack of progress on structural economic reforms. Argentina has the lowest recovery rate in history and also a process which ahs stretched far beyond the guidelines of sovereign negotiations. Argentina has treated all foreign investors equally. In the April 2006 conference, Latin America has been reported as performing well (USINFO). They are implementing macroeconomic policies and reforms to sustain and strengthen economic growth. The IMF official said the region’s economies have exceeded earlier growth projections, expanding the “robust rate” of 4.25 percent growth in 2005, which is a quarter percentage point more than the IMF projected. Investments that are more efficient are needed in Latin America as a whole. Stable macroeconomic policies and structural reforms alone can remove barriers to investment and growth. Labour reforms are also essential for sustained growth. Argentina has proved that once insolvency occurs and debts are too huge to manage, there cannot be a quick solution. If Argentina fails to resolve to the mutual satisfaction of all, the internationally recognized debt restructuring system would need to be redefined. References: Barton, Dominic, Newell, Roberto and Wilson, Gregory (2004), Pursuing best practice in bank turnarounds, The McKinsey Quarterly, 31 May 2006 Dodd, Randall (2002), Soveriegn Debt Restructuring, The Financier • VOL. 9, NOS. 1-4, 2002, 31 May 2006 Elstrodt, Heinz-Peter, Ordorica, Lenero Pablo, and Urdapilleta, Eduardo (2002), Micro lessons for Argentina, The McKinsey Quarterly, 31 May 2006 Fanelli. J.M & Heymann D (2002), “Monetary Dilemmas: Argentina in Mercosur”, Santiago de Chile. Hornbeck, J F (2004), Argentina’s Sovereign Debt Restructuring, 31 May 2006 Miller, Marcus & Fronti, Javier Garcia (2005), Case study: Restructuring Argentine debt: a renegotiation game?, 31 May 2006 Munter, Paivi (2003) Argentina Disappoints. Financial Times. Strizzi N & Kindra G S (1998), Foreign debt in Asia Pacific and the Latin American and Caribbean region: is there a cause for concern?, European Business Review, Volume 98 Number 4 1998 pp. 235-244 USINFO (2006), Reports Find Strong Economic Growth in Latin America, Caribbean, 31 May 2006 Read More