Meng-Ting Chen and Joseph van der Naald
November 16, 2018

Following a stunning fall in the value of its peso, a total loss of nearly 50% for 2018, and interest rates hitting 60%, Argentina’s economy appeared to be facing the strong likelihood of a crisis. While the government responded by taking a number of measures to calm the markets for the time being, the roots of Argentina’s crisis are complex. In this article, we outline the economic precursors to the Argentinian financial crisis and examine the steps being taken to address the situation. The country recently accepted a $57.1 billion bailout from the International Monetary Fund (IMF), temporarily stabilizing the situation. The administration of President Mauricio Macri has agreed to economic reforms, including spending cuts of 1.4% and revenue increases of 1.2% of GDP. The Central Bank is also keeping the nominal money supply constant with the objective of slowing inflation.

Though Argentina’s adjustments have partially restored investor confidence, the future remains uncertain. Emergency funds from the IMF signal confidence in Argentina, and yet both the Fund and Moody’s is predicting a considerable contraction in the economy in the coming year. Further, rising interest rates in the United States threaten Argentina’s situation as dollar-denominated debt becomes harder to repay. This crisis has been characterized as the potential beginnings of a “textbook” emerging-market crisis, caused by considerable short-term external debt in tandem with a budget deficit, and a current-account deficit.

The Genesis of the Crisis

Argentina’s current crisis has its roots in economic policies of crises past. During the four-year Argentine Great Depression of 1998 to 2002, the peso was pegged to the US dollar and the Argentine government imposed a set of capital controls known as “el corralito,” restricting bank account activity and prohibiting withdrawals from U.S. dollar-denominated accounts. With the official rate fixed and currency exchange restricted, these controls contributed to the emergence of twin exchange rates: one official and the other a much lower black market rate.

Economic growth in the decade that followed was weak, averaging a little less than 1.0 percent annually, although with sharp declines in the 2008 global financial crisis and again in 2012. Since 2012, annual growth rates have generally been less than 0.5%., with a sharp decline in the first quarter of 2018.

Source: Global Economic Monitor, World Bank

During the administrations of Presidents Néstor and Cristina Fernández de Kirchner (2003 – 2015), the slowing GDP growth rates coincided with a dramatic increase in public expenditure, reaching over 41% of GDP in late 2015. Government budget deficits exceeded 1.5% of GDP in eight of the past ten years. In 2002, Argentina had a trade surplus of $8.6 billion, which accounted for 16% of GDP, yet after a decade of protectionism, which threw key sectors into disarray with high tariffs suffocating agricultural exports and import restrictions putting the country at odds with global trading partners, this surplus had eroded into a deficit by 2015. Further, the Fernández de Kirchner administration imposed additional capital controls to prevent the flight of “hot money,” exacerbating the gap between the black market exchange rate, “dólar blue,” and the official exchange rate.

Efforts to Address the Crisis

As the Macri administration assumed power in 2015, Argentina faced a number of challenges. The issue of the dual exchange rates was addressed by the imposing of a flexible exchange rate. While official exchange rate initially depreciated to meet the black market rate, depreciation soon accelerated thereafter.

Source: Bank for International Settlements

Rather than engaging in money creation, the Macri administration sought deficit financing in international capital markets. This increased Argentina’s vulnerability to both currency devaluation and further external financing opportunities, and in 2017 a variety of factors from rising US Federal Reserve interest rates to a terrible drought, set the currency into a downward spiral. While a depreciated peso could help the economy through increased exports, it also has important implications for debt financing and inflation. Most of Argentina’s debts are issued in US dollars, the so-called “original sin.” As the government engages in external deficit financing with foreign currency debt, and as the value of the peso drops, these debts become harder to pay off increasing investors’ fears of default. Investors then began selling these debts fostering a further drop in the value of the peso.

Source: International Monetary Fund, World Economic Outlook Database, April 2018

Inflation, after holding steady through 2012, has been in excess of 20% in each of the past four years, in part the result of the declining peso and rising import prices. Upon taking office, Marci returned monetary independence back to the Central Bank, which began tightening monetary policy in an attempt to lower inflation. One of the ways by which the Central Bank has sought to decrease inflation is through the sale of Central Bank bonds (LEBACS). Yet, as the peso depreciates, bonds issued previously are more difficult to repay. In turn, the Central Bank increased its interest rates to attract more lenders, raising its rates to an unprecedented high of 60% in August 2018, which effectively increasing existing debts to pay old ones, creating a snowball of central bank bonds.

Source: Bank for International Settlements

The $57.1 billion credit line from the IMF is intended to reassure investor confidence; however, the credit line demands a budget deficit reduction through fiscal austerity and a narrowing of the capital-account deficit. Argentine authorities have committed to accelerating the process of fiscal convergence and plan to meet these goals in two ways. First, it is slashing operating expenses, subsidies, and infrastructure. Second, it will introduce temporary export taxes on goods and services to increase revenue. In addition to these tough fiscal steps, the Central Bank is overhauling its monetary policy, as it switches to targeting monetary aggregates as its new nominal anchor. This strong monetary contraction is likely to be effective in slowing down inflation; however, if it is too effective, it is likely to deepen the recession. The exchange rate will be allowed to float within a target zone of 33 to 44 pesos to the dollar and the Central Bank will intervene in foreign exchange markets only if the exchange rate crosses this predetermined mark.

Macroprudential Policy

In the short run, Argentine policymakers could proactively enforce capital controls to stem the risks of rapid capital outflows. Accompanied by new monetary policy and a flexible exchange rate regime, both imposing controls on inflows and outflows of capital has been proven an effective prudential policy for most of emerging market economies. Controls on outflow prevent the risk of crises, while controls on inflow can insulate Argentina from external shocks. Moreover, Argentine overborrowing due to the “original sin” exposes the economy to external shocks that can cause a “sudden stop.” Taxation of privately held foreign-currency denominated assets and/or the incomes those assets generate can preventcountries from overborrowing and reduce the probability of financial crisis.

The analysis above provides context to the needed interventions that the government should make in order to mitigate the worst aspects of the crisis’ fallout. Moreover, as the likelihood of a global emerging markets crisis increases the state must prioritize efforts to insulate the economy against further instability.

Merih Uctum and Zhuo Xi
September 22, 2018

On August 9 the Turkish currency, the Lira, hit record lows and rattled emerging markets. The travails of the Argentinian economy subsequently weakened the Lira further. In this analysis article, we examine the economic and financial reasons behind the turmoil the economy is going through and discuss the future path it may take.

Following the sound economic policies adopted in the wake of the twin crises of the early 2000s, the economy experienced solid growth, except during the 2007-8 global financial crisis. Since 2010, the economy has averaged a healthy annual growth rate of 6.85% despite a slowdown since 2017.

Source: Federal Reserve Economic Data

But the recent collapse of the currency was dramatic and does not square with the strong performance of the economy. Since 2008 the Lira depreciated by 82% against the dollar and 76% against the euro:

Source: The Central Bank of the Republic of Turkey

After hitting a historic low on August 13 of 7.0 Lira against the dollar and 7.93 against the euro, belated minor measures by the Central Bank of Turkey and a pledge of $15 billion worth of investment by Qatar in Turkey, the currency stabilized briefly before being hit again on August 18 as contagion from Argentina spread to other fragile currencies.

Public debt is usually one of the culprits in economic crises. However, in Turkey this is not the case at hand. While public finances in Western economies and in several emerging markets went into large deficits after 2008, and many are still struggling to reduce it, Turkish government debt has declined and been hovering at a modest 30% of GDP.

Source: The Central Bank of the Republic of Turkey

The story of the Turkish currency crisis, however, repeats a familiar scenario of emerging market crises. In an environment with ultra-low interest rates, strong growth in the economy is fueled by borrowed funds by the private sector, mostly from international capital markets.

During the first quarter of 2018, total external debt stock climbed to $466.67 bn, about half of GDP, with private debt making up 70% of it. Both the financial and nonfinancial (mostly corporate) sectors have been borrowing heavily since 2010. After ballooning during the financial crisis, corporate debt declined and steadied around 12% of GDP but rose steeply by 70% for the last three years. Foreign borrowing of financial institutions and banks continued and surpassed that of the corporate sector.

Source: The Central Bank of the Republic of Turkey

Although banks’ external roll over ratios (long-term external borrowing/repayments) are at a five-year low, rising interest rates in the West and a depreciating currency may generate sufficient risk to discourage lending by foreign banks.

Due to “original sin,” a term describing the fact that emerging markets economies cannot borrow in their own currency but only in foreign currency, usually US dollars, any event that triggers a depreciation of the currency and/or a rise in interest rates aggravates the foreign currency-denominated debt burden, when translated into the local currency. While various factors have been contributing to the accelerating depreciation of the Turkish Lira, it is the recent conflict with the United States that triggered the run on the currency.

Depreciation of a currency has several consequences on an economy. One beneficial impact is to stimulate exports over a certain period, but another dire and more immediate effect is to exacerbate inflation, which can undo the benefits of the first impact. In an economy dependent on oil imports and with endemic inflation, as in Turkey, the influence of depreciation on prices has been swift and painful.

August data indicate that consumer price inflation reached 17.9%, more than quadrupling since the end of the financial crisis in 2009.

Source: The Central Bank of the Republic of Turkey

The conventional response of policymakers in such a situation is to raise interest rates, reschedule the external debt and implement austerity measures. However, policymakers in Turkey had been reluctant to change rates aggressively or to start discussions with the IMF. For comparison, Argentina, which is in the throes of a financial crisis, increased rates to more than 60% and is preparing to receive guidance from the IMF. After the long-awaited increase in the one-week repo rate by 625 basis points last week to 24 %, an increase above the expectations of the markets, the currency stabilized but several dark clouds in the horizon suggest further trouble ahead.

Leading indicators point to decreased confidence among households and businesses. The Purchasing Managers’ Index in manufacturing took a plunge since the beginning of the year, falling to 46.4 and creating further jitters in markets.

Source: Istanbul Chamber of Industry and HIS Markit

Total debt service as a percentage of exports is a measure used to assess sustainability of a country’s debt burden. Turkey’s debt service ratio increased continuously since 2013 and surpassed its 2002 crisis level for the first time at the end of 2017. Tightening by the Federal Reserve Bank, which is also likely to be followed by the European Central Bank, will continue to worsen the debt burden of the country.

Source: The Central Bank of the Republic of Turkey

It took two crises (2000 and 2001) followed by serious economic reforms and austerity measures to bring down inflationary expectations in Turkey. These policies earned back the confidence of markets, with an influx of foreign direct investment and access of the country to international financial markets. The recent events might have done damage to the economic progress achieved so far.

Currently, the main concern of market participants is the contagion of the Turkish crisis to similar economies with large foreign debt levels and to international banks that lent to Turkey. During August, the Turkish Lira dragged down the currencies of several emerging economies such as Argentina, South Africa, Brazil, Russia and India against the dollar, which reached their lowest levels since May. The European Central Bank expressed concern about the impact that a plummeting Turkish currency could have on Spanish, French and Italian banks that are holding Turkish assets. Another concern is about borrowers in Turkey who might start defaulting on their debt. Both of these events could hurt European banks.

The problems discussed above necessitate concerted and committed effort by the government to contain the currency and debt crises. International financial markets are bracing for hard times ahead.