Managing the Financial Crisis: Argentina (2002)

Managing the Financial Crisis: Argentina (2002) Mario I. Blejer Director Centre for Central Banking Studies Bank of England

Monthly Gross Domestic Product seasonally adjusted (Jan 98 = 100) 105.0 100.0 102,3 Jun 98 99,0 Dec 99 98,3 Dec 00 95.0 90.0 94,6 Jul 99 85.0 82.2 Nov 02 80.0 75.0 Source: CEA-UCEMA en base a datos del INDEC. Jan-98 Mar-98 May-98 Jul-98 Sep-98 Nov-98 Jan-99 Mar-99 May-99 Jul-99 Sep-99 Nov-99 Jan-00 Mar-00 May-00 Jul-00 Sep-00 Nov-00 Jan-01 Mar-01 May-01 Jul-01 Sep-01 Nov-01 Jan-02 Mar-02 May-02 Jul-02 Sep-02 Nov-02

Real GDP (base 1993) 15% 10% 5% var. a/a PBI real 300 290 280 0% 270-5% 260-10% 250-15% 240-20% 230 I- 98 III- 98 I- 99 III- 99 I- 00 III- 00 I- 01 III- 01 I- 02 III- 02 I- 03 III- 03 I- 04 III- 04 I- 05

Poverty and Extreme Poverty In percentage of the Population 60 50 40 Poverty 30 20 Extreme Poverty 10 0

Managing the crisis: 1. Assess the Nature and the Root Causes of the Crisis 2. Define the Tradeoffs 3. Define and Operational Strategy 4. Persevere in the Implementation 5. Learn some Lessons

1. The Nature of the Argentina Crisis The Argentine crisis was both a CURRENCY and a BANK crisis Inter-related but caused by a combination of different factors. Analytically, better to distinguish between them in an explicit manner. The third crisis, the DEBT crisis embodied in the larger sovereign DEFAULT in history is closely related to the other two.

THE CURRENCY CRISIS The Currency Crisis reached its peak with the January 2002 devaluation. It is usually analyzed in the context of the ARGENTINE CURRENCY BOARD SYSTEM, established in 1991 as an anti-inflationary devise. The question to be analyzed is: What were the weaknesses and the main causes for the demise of the convertibility regime?

THREE APPROACHES: 1. The loss of competitiveness of the Argentine economy 2. Macroeconomic policy inconsistencies 3. The Sudden Stop argument

Tradables/non tradables (WPI/CPI) 250 230 210 224 220 190 index 2001=100 170 150 148 130 110 Convertibility average 101 90 70 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 Ene-02 Mar-02 May-02 Jul-02 Sep-02 Nov-02 Ene-03

200 Real Bilateral Exchange Rate: Major T rade Partners July 95 = 100 180 160 140 120 100 80 60 40 20 Jan-98 Jul-98 Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Euro Zone Brazil USA

The Trade Account (in current prices) million of USD 20.000 15.000 10.000 5.000 0-5.000-10.000 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Fiscal Deficits Argentina 1975-2001 2 0-2 -4-6 Convertibility Period -8-10 -12-14 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001

The Use of Privatization Receipts to Reduce the Deficit 2 1 Privatization Revenue 0-1 -2-3 -4-5 Total Deficit -6-7 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996

Interest Payments/GDP 20 15 10 5 0 1993 1994 1995 1996 1997 1998 1999 2000 2001

Primary Expenditures as % of GDP (cumulative 12 months) 19,5% 19,0% 18,5% 18,0% 17,5% 17,0% Dic-97 Mar-98 Jun-98 Sep-98 Dic-98 Mar-99 Jun-99 Sep-99 Dic-99 Mar-00 Jun-00 Sep-00 Dic-00 Mar-01 Jun-01 Sep-01 Dic-01 Mar-02 Jun-02 Sep-02 Dic-02

Capital Flow s and Economic Activity (Accumulated 4 quarters - U$Sm. GDP Cyclical Component) 8% Capital Flows Private Sector 15.000 6% 10.000 4% 2% 0% -2% -4% -6% GDP Growth Russian Crisis 5.000 0-5.000-10.000-15.000-20.000-25.000-8% -30.000-10% -35.000 IV 94 IV 95 IV 96 IV 97 IV 98 IV. 99 IV. 00 IV 01

Sudden Stops in Argentina and Chile (Private Capital Flows, Percentage of GDP Argentina 4% 3% 2% 1% 0% -1% -2% 1998-I 1998-II 1998-III 1998-IV 1999-I Chile 1999-II 1999-III 1999-V 8% 7% 6% 5% Argentina 4% 3% 2000-I 2000-II 2000-III 2000-IV 2001-I 2001-II 2% 1% 0% -1% Chile

Economic Activity: GDP and Investments (1998.II=100) GDP Investment 107 105 105 103 Chile 100 95 90 Chile 101 85 99 80 97 95 Argentina 75 70 65 Argentina 93 1998.II 1998.III 1998.IV 1999.I 1999.II 1999.III 1999.IV 2000.I 2000.II 2000.III 2000.IV 2001. I 2001.II 2001.III 60 1998.II 1998.IV 1999.II 1999.IV 2000.II 2000.IV 2001.II

Financial Vulnerabilities to Capital Flows Reversals Argentina Brasil Chile Public Debt (% of GDP) Public Sector External Unhedged Exposure Private Sector External Unhedged Exposure Banking Sector Exposure To the Public Sector = High Vulnerability = Medium Vulnerability =Low Vulnerability

THE BANKING CRISIS While the problems of convertibility and the consequent exchange rate uncertainty played a role, the banking crisis was largely caused by the government abuse of the banking sector, given its inability to to adjust the budget deficit

Private Sector Deposits (in bn Arg.. Pesos) 80 75 Finance Minister Resignation Corralito 70 65 60 55 Interest rate ceilings " Devaluation 50 Sep 00 Dec 00 Mar 01 Jun 01 Ago 01 Nov 01 Feb 02 Apr 02 Jul 02

The main cause for the banking crisis was the fear was that banks would be rendered insolvent by government policy and that deposits would be confiscated. An important reason behind this fear was the fact that private sector assets were being displaced by public sector assets in bank s balance sheets.

Private Sector assets have been displaced by Public Sector assets in bank s s balance sheets 100% 80% 60% $ 76 MM 40% 20% $ 43 MM 0% Dec-99 May-00 Oct-00 Mar-01 Aug-01 Jan-02 Jun-02 Public Sector Private Sector

The increasing banking exposure to the public sector was accompanied by 1. a rapid decrease in deposits and 2. a sharp increase in country risk

220 216 110 180 100 100 151 140 90 100 104 80 80 71 60 70 dic-98 jun-99 dic-99 jun-00 dic-00 jun-01 dic-01 EMBI Indice Index EMBI Argentina Public Sector Loans / Net Worth (%) Crédito al Sector Público / Patrimonio Neto (en %) Private Deposists - Index Dec 00 = 100 (2nd axis) Depósitos Sector Privado - Base dic2000 = 100 (2º eje)

November 2001:withdrawal restrictions on bank deposits ( corralito ). December 2001: Riots the De la Rua and Cavallo government. First two weeks of January 2002: --public debt default --currency board is abandoned and the currency devalued --bank assets and liabilities are pesified asymmetrically - i.e. at different rates

The abandonment of the currency board was traumatic: -- Complete loss of confidence in the banks, the currency, and the government -- Continuous bank run -- A run on the peso that pressured strongly the exchange rate -- No money market or debt instruments for open market operations

2. The Tradeoffs and The dilemma for the central bank Having regained the LOLR function the CB could provide the liquidity needed to finance the bank run. Pesos would fly to the exchange market risk of hyperdevaluation and hyperinflation. OR

The CB could restrain the rediscount facility and let banks deal with the deposit run. May prevent hyperinflation, at the risk of the total collapse of the banking sector.

Only feasible intermediate solution: slow the pace of the bank run and, at the same time, try to avoid excessive liquidity expansion.

3. The Strategy Followed -- Provide liquidity support to banks to prevent massive bank closures. -- Develop sterilization instruments at the Central Bank --the LEBAC-- to mop up liquidity and to compete with the U$S. -- Utilize part of CB reserves to intervene in the foreign exchange market to slow the pace of depreciation and to avoid chaotic conditions.

Choice of Foreign Exchange Market Strategy: high interest rates vs. FE market intervention: substitutes or complements?

persevere to the point where greed > panic

4. Implementation

The central bank provided rediscounts to illiquid banks and financed about 1/3 of the deposit drop 25 Accumulated evolution (31-Jan-02 al 24-Jul-02) -In billion of pesos- 20 15 10 5 0 31-Ene 17-Feb 6-Mar 23-Mar 9-Abr 26-Abr 13-May 30-May 16-Jun 3-Jul 20-Jul Loans Assistance Bank Reserves fall Deposits fall

The market for Central Bank ST Bills (LEBAC) was actively developed, initially with 7 days maturities and then with 14 and 28 days, in Pesos and U$S. Interest rates reached 140% initially.

Intervention in the foreign exchange market prevented disorderly behavior but did not peg the rate, that devalued from 1 to 3.6 Pesos per Dollar. Intervention in the first five months was about U$S 2 bn.

Initially deposit withdrawals continued Private Sector Deposits - Year 2002 In million of pesos 1000 Feb Mar Abr May Jun Jul 160 0-1000 -2000-235 -340-823 -810-998 -1274-1230 -3000-2609 -4000-5000 -4335-4378 -4526 Deposits minus preventive measures Preventive measures

However, the trend reversed after four months Private Sector Deposits - Year 2002 In million of pesos 1000 Feb Mar Abr May Jun Jul 160 0-1000 -2000-235 -340-823 -810-998 -1274-1230 -3000-2609 -4000-4335 -5000-4378 -4526 Deposits minus preventive measures Preventive measures

Private Sector Deposits (in billion pesos) W ithdrawal Restrictions 80 "Corralito" Reprogramming Pesification 75 70 65 60 Devaluation 55 50 45 Recovery 40 01-Oct-01 27-Nov-01 23-Jan-02 21-Mar-02 17-May-02 13-Jul-02 18-Oct-02 04-Nov-02 31-Dec-02

The need for the provision of liquidity from the Central Bank where largely reduced

Flujos Mensuales de Asistencia del BCRA Millones de Pesos 1,500 90% 1,000 61% 52% 60% 500 29% 31% 29% 29% 30% 0 0% -500-30% Ene Feb Mar Abr May Jun Jul Ago Sep Oct Nov Asistencia Neta Mensual Asistencia/Salida de Depósitos

The demand for LEBACs grew strongly. -- LEBACs with up to one year maturities were introduced successfully. -- By October interest rate has fallen to 8-45% range, according to maturities.

Decrease of average cost and duration of LEBACs Days 140 Average duration and cost of LEBACs in pesos ANR 14d % 140 120 Average Cost 120 100 100 80 80 60 60 40 Average Duration 40 20 20 0 0 mario.blejer@bankofengland.co.uk 15-mar 14-apr 14-may Title of seminar, DATE 13-jun 13-jul 12-aug 11-sep 11-oct 10-nov Bank of England 10-dec 9-jan

The exchange rate stabilized and started to appreciate. The CB has stopped selling and is actively buying reserves to prevent a large appreciation in the exchange rate. In total the CB has regained, in a few months, all the initial stock of intervention

The stabilization of the exchange rate has also resulted in a sharp decline in level of inflation 12% 4,0 3,5 9% 3,0 2,5 6% 2,0 1,5 3% 1,0 0,5 0% 0,0 Jn Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec CPI Nominal Exchange Rate monthly average (2 axis)

International Reserves In U$S millions

Total GDP Quarterly Seasonally Adjusted 300 290 280 270 260 250 240 230 220 I98 II98 III98 IV98 I99 II99 III99 IV99 I00 II00 III00 IV00 I01 II01 III01 IV01 I02 II02 III02 IV02 I03 II03 III03 IV03 Fuente:Indec

Labor Demand 120 100 80 60 40 20 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Fuente: Universidad Di Tella

Consumers and Business CONFIDENCE 55.0 50.0 CONSUMERS 45.0 40.0 35.0 BUSINESS 30.0 25.0 Dic '99 Mar '00 Jun '00 Sep '00 Dic '00 Mar '01 Jun '01 Sep '01 Dic '01 Mar '02 Jun '02 Sep '02 Dic '02 Mar '03 Jun '03 Fuente: Universidad Di Tella

Indeed, as always, greed > panic

5. Lessons from the Crisis

1. The Potential Fragility of Financial Institutions Experience indicate that solid and solvent financial structures could deteriorate quickly. This is particularly true in the face of inadequate interventions, distorted incentives and misguided policies.

The fact is that weak financial sectors are not necessarily crisis prone. Financial crises have been generated, in many instances, by inconsistent policies and by an unstable macroeconomic environment. In this context one need to rethink the emphasis put on the enforcement of conventional standards and codes vis-à-vis inappropriate policy actions.

2. Financing the Public Sector and the Crowding Out Effect

The Financial System needs restructuring Financial statements situation - Dec2001/Dec2002 180 160 140 Loans to Private Sector 120 100 80 60 45% 17% 40 21% 54% 20 0 Dec 01 Dec 02 Loans to the Public Sector

3. The Importance of Proper Liquidity Management Availability of liquidity is a crucial element in the prevention and the management of financial crises LOLR does not guarantee stability but its absence accelerates the erosion of confidence

4. The Role of Foreign Banks -- Do they reduce financial vulnerability? -- Can they provide, implicitly, LOLR function?

5. Capital Controls Does capital account integration reduce financial vulnerability? Long run desirability vs. short run, transitional, risks Capital controls and crisis management