Financial markets barely noticed Argentina's long-expected Christmas Eve default on $150 billion in foreign debt. It marked the fifth time Argentina has reneged on foreign obligations since July 1827, when the City of Buenos Aires defaulted on a million-pound loan from Barring Brothers, which ultimately failed in 1890 after a subsequent Argentine default. Yet despite this history and a tough recession, sell-side analysts were actually recommending Argentine stocks and bonds until recently. But smart money knew more than a year ago that Argentina, which adopted a fixed-dollar-peg regime in 1991, would eventually falter. We reported as much last spring ("Look Out Below," Barron's, May 21, 2001).
With the resignation of President Fernando de la Rua, a former governor named Adolfo Rodriguez Saa is now leading the country, steering a populist course. The Saa government will withhold payment on all foreign obligations for the next 90 days, including the $900 million debt owed to the International Monetary Fund in January. With the price of Argentine sovereign debt at about 30 cents per dollar of face value, it's a good bet that private Argentine debtors will be forced to default on foreign obligations as well.
Brought to power after a political meltdown, Saa promises to create millions of public-sector jobs. He also claims Argentina will maintain peso parity with the dollar, but the government is rapidly increasing the money supply, issuing a new, nonconvertible currency, the argentino, to circulate alongside convertible pesos and dollars and help add liquidity to the economy. The number of pesos in circulation fell 30% in 2001 as Argentines bought dollars, compelling cities and provinces to print IOUs to pay bills and salaries.
With the Saa government trying to buy popularity, the immediate prospect for Argentina seems to be hyperinflation and more political turmoil. When the Saa government is eventually forced to let the peso float against the dollar, Argentine banks and companies will be left bankrupt, and the savings of an entire country will disappear, a fate not unlike that facing the shareholders of Enron. Deflation, it seems, respects no national borders.
Walter Molano, who was early and right on Argentina and heads research at BCP Securities in Greenwich, Connecticut, contends that the U.S. Treasury and the IMF, through inaction, precipitated the default, and this, he says, will have a chilling effect on capital flows to the developing world. "Investors once took comfort from the role of the IMF, but now investors have no incentive to choose emerging-market assets over high-yield debt," says Molano, who also worries about collateral damage as $15 billion in credit-default derivative contracts covering Argentina come due.
The Saa government views the IMF as the source of its woes by encouraging previous governments to borrow offshore to fund internal deficits, but debt is not the only reason for Argentina's economic crunch. Says Brian Wesbury of Griffin, Kubik Stephens & Thompson: "Unfortunately, the IMF forced Argentina to raise taxes in recent years, creating even more problems for the economy. Tax cuts are the answer, not devaluation." Dominated by socialist Peronistas, the Saa government is unlikely to consider tax cuts to help the economy.
For investors, the collapse in Argentina raises questions about other heavily indebted Latin giants such as Brazil and Mexico, as well as fragile states like Venezuela and Colombia. Brazil has already devalued its currency more than 50% since 1999, but Mexico's overvalued peso, remarkably stable at about 9.1 per dollar, stubbornly defies the negative economic trends that humbled Argentina. Free-market advocates were delighted as U.S. Treasury Secretary Paul O'Neill contentedly sat back and watched Argentina implode. It's uncertain, though, whether Mexico will get the same "hands-off" treatment from the Bush Administration if investors pull the plug on the Mexican peso.
The cost of Argentina's default is political as well as financial. In 1930 a similar economic crisis in Argentina led to a military coup that ended 70 years of parliamentary government and led to a forced debt restructuring. Argentina defaulted again after Mexico declared a debt moratorium in 1982.
But in 1989, after 60 years of military misrule and socialist muddle, Argentina's inflation reached more than 10,000%, a political watershed that led to the decision to peg the peso to the dollar. The failure of this courageous gamble and the resurgence of anti-foreign Peronismo, the logical reaction to the IMF's austerity prescriptions, is a defeat for supporters of free-market democracy in Argentina and may presage the start of a cycle of political instability in Latin America.
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