Fiscal Policy The Exchange Rate example essay topic

In the sad economic history of Argentina during the last half-century, the past decade encompassed a remarkable transition. Rising from the ashes of the episode of economic chaos and hyperinflation at the end of the 1980's, orthodox policies (Carlos Me nen, Domingo Cavallo, WHICH FEATURED A HARD PEG OF THE PESO AT PARITY TO THE US $ LIMITING DOMESTIC MONEY CREATION) brought a decisive end to a decades of monetary instability and launched Argentine economy into four years of rapid and sustainable expansion. After a sharp recession in 1995 (high unemployment) Argentine economy resumed rapid growth from late 95 until the spillover effects of the Brazilian crises that hit Argentina in late 1998. At the time, many Argentina's economic policy were applauded and even suggested as a model to other emerging market countries. Two years later, Argentina's long experience with hard money and orthodox policies has ended in tragedy. The economy is well into its fourth year of recession and rapid downward.

The exchange rate peg was gone, and the peso is trading at sustainably depreciated exchange rates against the US $. Economic and financial chaos have returned together with the hyperinflation With its default on its sovereign external debt, Argentina has been transformed from the darling of emerging market finance to the world's leading deadbeat. Argentina operated under the auspices and close scrutiny of a IM Fund-supported program, thus, any failures of the Fund in the pre-crisis period were of its relatively low intensity surveillance activities. The economic issues that Arg. Needed to confront were in the area of fiscal, monetary, and exchange rate policy. The IMF DID MAKE AT LEAST 2 MISTAKES: 1- Failing to press the Arg.

Authorities much harder to have a more responsible fiscal policy, especially during the high growth years after the tequila crisis 95; 2- In extending additional financial support to Arg. In summer 2001, after it became clear that Arg. Government's effort to avoid default and maintain exchange rate peg had no chance of success. It is also clear that the collapse of the convertibility plan played a central role in the present crisis. What went wrong Several factors contributed to the transformation of Argentina from paragon economic reform and stabilization in 97-98 to the tragedy unfolding in that economy today. High unemployment rates, Fiscal deficits: Unsustainable fiscal policy was fundamental cause of the failure of the Arg.

Eco. The government has a persistent tendency to spend more then it can raise in taxes, in order to satisfy various political needs and pressures. It started to finance it excess spending with borrowing (domestically and internationally) or in inflationary money creation and / or explicit default and expropriation of creditors. High interest rate with no confidence in the part of investors in the capacity of the arg gov. to service its obligations; Strong US Dollar had downsized the competitiveness' of Arg. Vis-'a-vis its EU trading partners, contributing somewhat to negative growth and balance of payments. External shock from the collapse of the Brazilian crawling peg exchange rate policy (one of the causes for Arg.

Recession during 99-01. Much of Arg. Fiscal problems arose from inadequate fiscal discipline in the provinces for which the central Gov. had to take responsibility (Constitution). Ratio public debt / GDP increases from 29.2% to 41.4% between 93-98. Public sector debt increased even when Arg. Eco.

Was performing well, this shows the inadequate disciplined or sustained fiscal policy. Why worry If Debt / GDP ratio is over 40% in Arg. Five important reasons: 1. Argentina has had little success in raising tax revenues of more then 20% of GDP. Indeed in Argentina, provinces are perennially in deficit and, from time to time have called on central Gov. to assume responsibility for their debts. This means that the tax base that realistically might be available to pay debt service is the tax revenue of the central government, less the substantial funds that were legally required to be transferred to provinces.

2. Most of its Gov. debt denominated in foreign currency and much of its debt held externally, Argentina faced a dual challenge of persuading creditors of its capabilities to of raising fiscal revenues sufficient to service its debt and of being able to convert these revenues into foreign exchange. The ratio of Argentina's total external foreign currency debt to foreign exchange receipts from exports had risen by 98 to about 500%. This is a high debt to exports ratio for an emerging country.

So high that is often signals substantial risk of an external financing crisis that can be resolved only through a debt restructuring. 3. Not only the level of gov. debt to GDP or Tax revenue or Exports that matters, its also how the debt has been behaving. A debt to GDP ratio that rose from 29% to 41% during general good economic times was a worrying signal of incapacity to maintain reasonable fiscal discipline. 4. EM in general, and Argentina especially, was vulnerable to external eco.

Shocks. Events surrounding the collapse of Brazil's crawling exchange rate peg in early 99 had important spillovers for Argentina. Public debt rising and nominal GDP falling, the debt to GDP ratio jumped from 41% in 98 to 50% in 2000 with continuing recession deflation in 2001.5. As an EM country with substantial external debt, Argentina was clearly vulnerable to changes in financial market sentiment. Its long record of periodic financial crises and debt restructuring was not reassuring. Fiscal policy The exchange rate which was pegged at parity to the US $ in nominal terms, was becoming over valued in real terms because inflation in Argentina remained above US inflation.

As the arg. Eco. Recovered from hyperinflation, domestic expenditure rose, contributing to a growing current account deficit. The concern was that if capital flows that were financing the current account deficit began to reverse or slow down, a foreign exchange crisis would likely ensue. The policy response included a moderate tightening of fiscal policy in order to reduce the current account deficit and reassure arg, creditors.

But the deficit never came below the target. In Sum the failure of the Arg, gov. to run a prudent fiscal policy that restrain the increase of public debt when arg. Economy was performing was a key problem that contributed to the collapse of the arg. Stabilization efforts. Convertibility and bust The convertibility plan adopted in 1991 played a central role in the success of arg. Stabilization and reform effort during the past decade and in the ultimate tragic collapse.

This was accomplished by linking the value of the domestic currency at the one-to-one with the US $, WITH THE GUARANTY THAT THE PESOS COULD BE EXCHANGES FOR DOLLARS, under the mandate that it maintain dollar reserves against its domestic monetary liabilities. Government of arg. Undertook important measures to assure a sound banking system. Commercial banks were privatised and most of them were over by foreign banks (spain and US 1995) With the peso pegged to the us $, the inflation rate collapsed, the eco. Recovered however, the exchange rate appreciated and the current account moved into significant deficit. Commercial banks came under real pressure as high interest rates and a weakening eco., undermined credit quality, and deposits flowed out of the banking system because of fears of bank failure or the break in the exchange rate peg.

Down to catastrophe It is difficult to know at what point an economic catastrophe for arg. Became inevitable. the collapse of Brazil exchange rate based stabilization effort, the Real plan in early 99 was an important negative shock for arg. Interest rate spread on argentine bonds rose along with Brazilian spreads as doubts about the sustainability of the Real Plan deepened in 98-99. Measures to ensure a sound banking system clearly contributed to a massive reflation of domestic credit.

As domestic financial institutions are important holders of sovereign debts. The continued recession in the arg. Eco., (which begin in late 98) was depressing tax revenues and increasing demands for compensatory social spending. Conditions deteriorated during 2000 as the recession continued.

Because of the sovereign debt of Argentina was mainly fixed rate and medium term, it did not face the challenge of rolling over large amount of short term debt or the threat that the budgetary effect of an upward interest rate that would make the fiscal situation unsustainable. By the late 2000, arg. Sovereign debt was the largest of EM borrower on international credit markets 20% of entire asset class. Announcement of a suspension of the Fund support might provoke financial crisis that would lead to sovereign default, a collapse of the convertibility plan, and financial and eco chaos. The approaches adopted was to proceed with the fund supported program for argentina for 2001 with levels of support substantially greater than in standard Fund-supported programs.

The policies under the program would emphasis fiscal consolidation, both the deficit targets to be achieved for 2001 to insure fiscal sustanaibility in the long term.