Managing the Financial Crisis: Argentina 2002

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Managing the Financial Crisis Argentina (2002)

• Mario I. Blejer
• Director
• Centre for Central Banking Studies
• Bank of England

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Managing the crisis

• Assess the Nature and the Root Causes of the
  Crisis
• Define the Tradeoffs
• Define and Operational Strategy
• Persevere in the Implementation
• Learn some Lessons

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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.

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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?

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

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The Trade Account (in current prices)
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The Trade Account (in current prices)
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Fiscal DeficitsArgentina 1975-2001
Convertibility Period
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The Use of Privatization Receipts to Reduce the
Deficit
Privatization Revenue
Total Deficit
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Capital Flow s and Economic Activity
(Accumulated 4 quarters - USm. GDP Cyclical
Component)
Capital Flows Private Sector
8
15.000
10.000
6
5.000
4
0
2
-5.000
0
-10.000
-2
-15.000
-4
-20.000
Russian Crisis
GDP Growth
-6
-25.000
-8
-30.000
-10
-35.000
IV 94
IV 95
IV 96
IV 98
IV 01
IV 97
IV. 99
IV. 00
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Sudden Stops in Argentina and Chile (Private
Capital Flows, Percentage of GDP
4
8
7
3
6
2
5
Argentina
4
Argentina
Chile
1
3
0
2
1
-1
Chile
0
-2
-1
1998-I
1999-I
2000-I
2001-I
1998-II
1999-II
2000-II
2001-II
1998-III
1999-III
2000-III
1999-V
1998-IV
2000-IV
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Economic Activity GDP and Investments (1998.II10
0)
GDP
Investment
105
107
100
105
95
Chile
Chile
103
90
101
85
80
99
75
97
70
Argentina
Argentina
95
65
60
93
1999.I
2000.I
1998.II
1999.II
2000.II
2001.II
1998.II
1999.II
2000.II
2001. I
2001.II
1998.IV
1999.IV
2000.IV
1998.III
1998.IV
1999.III
1999.IV
2000.III
2000.IV
2001.III
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Financial Vulnerabilities to Capital Flows
Reversals
Brasil
Chile
Argentina
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
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• 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

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Credit to Private Sector
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• 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 banks balance sheets.

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• 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
  

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EMBI Index Public Sector Loans / Net Worth ()
Private Deposists - Index Dec 00 100
(2nd axis)
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• November 2001withdrawal 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

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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

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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

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• 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.

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

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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 US.
• -- Utilize part of CB reserves to intervene in
  the foreign exchange market to slow the pace of
  depreciation and to avoid chaotic conditions.

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

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• persevere to the point where
  
• greed gt panic

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4. Implementation
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The central bank provided rediscounts to illiquid
banks and financed about 1/3 of the deposit drop
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• 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 US. Interest rates reached 140 initially.

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• 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 US 2 bn.

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Initially deposit withdrawals continued
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However, the trend reversed after four months
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• The need for the provision of liquidity from the
  Central Bank where largely reduced

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• 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.

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Decrease of average cost and duration of LEBACs
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• 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

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The stabilization of the exchange rate has also
resulted in a sharp decline in level of inflation
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Total GDPQuarterly Seasonally Adjusted
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Labor Demand
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Consumers and Business CONFIDENCE
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• Indeed, as always,
  greed gt panic

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• 5. Lessons from the Crisis

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• 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.

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• 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.

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• 2. Financing the Public Sector and the Crowding
  Out Effect

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The Financial System needs restructuring
Financial statements situation - Dec2001/Dec2002

180
160
Loans to Private Sector
140
120
100
45
17
80
60
54
21
40
20
0
Dec 01
Dec 02
Loans to
the Public Sector

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• 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

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

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• The Currency Problem
• Financial vulnerability arises from the publics
  reticence to use domestic currency as a store of
  value

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• -- Trade-off between shallow financial
  intermediation and financial dollarization and
  the risks of balance sheet mismatches
• -- The original sin is not such but just a
  corollary of the currency problem

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• If full dollarization is not an option, the
  policy question to reduce vulnerabilities is how
  to solve the currency problem
• -- Macroeconomic and Institutional credibility
  and in the transition Indexation
• -- Pesification a la Argentina

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