Stabilization of High Inflation Argentina

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Stabilization of High Inflation Argentina
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Part IWhy peg?

• Stabilize prices and discipline monetary policy
• A pegged nominal exchange rate constrains
  domestic monetary policy and prices.
• Examples
• Argentina
• Mexico

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Trend Toward Lower Inflation in 1990s
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Money and Prices

• Inflation is always and everywhere a monetary
  phenomenon.

• M a money supply, P the GDP deflator, Y
  real GDP.
• V velocity.
• Key implication Money supply increases
  ultimately generate inflation.

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Money Creation As Revenue

• Seigniorage The real output a government obtains
  by printing money.
• For example, suppose the government increases the
  nominal money supply in 2003 by

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• The amount of goods and services that can be
  purchased by the government with this new money
  is the nominal increase in money supply divided
  by the price level

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• Seigniorage as an inflation tax
• Tax base money holdings
• Tax rate Rate of money growth ? inflation rate

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The Origins of High Inflation
Purchase of bond by central bank increases money
supply
Government spends money (to please electorate)
Inability to collect tax revenue
Central bank buys government bond
Private sector unwilling to lend money
Government Deficit needs financing
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Inflation and Central Bank Independence
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Whats Wrong with Inflation?

• Menu costs (cost of changing prices)
• Tax on holding money
• Distortions in tax code
• High inflation is associated with volatile
  inflation increased uncertainty.

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Private Sector Responses to High Inflation

• Indexation
• Short-term contracts
• Foreign currency contracts
• Countries with higher inflation devote a greater
  share of their GDP to Financial Services

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Ending High Inflation

• Eliminate incentive to create money ? cut budget
  deficit. (orthodox)
• Eliminating the source may not be enough. Need to
  end propagation mechanism wage and price setting
  based on inflationary expectations. (heterodox)

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Credibility and Inflation

• A simple game between government and unions
• Unions set nominal wages in advance
• Government then sets monetary policy.
• Unions want high real wage (w/p) and high
  employment. Optimal w/p1
• Government wants high employment/output and low
  prices
• Govt Preferences aY-bP

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Outcomes

• Suppose a is very high and b is low
• Nash Equilibrium w high and M high
• Suppose a is low and b is very high
• Nash Equilibrium w low and M low
• b high is conservative or committed to price
  stability
• Non credible Disinflation w high and M low ?
  recession (US in 1979)

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Solution

• If workers move first, they need to trust the
  government.
• Establish reputation -- over time or appoint a
  known inflation hawk
• If reputation takes time inflation inertia and
  recession.
• Limit by rules such as peg or explicit
  inflation target

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The Exchange Rate As Anchor

• By pegging the exchange rate, the government
  provides an anchor on prices (given the need for
  international competitiveness).
• If the peg is credible, workers and price setters
  will adjust inflationary expectations downward,
  minimizing the negative effects of reducing
  inflation.

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Credibility Is Key

• Currency board or independent central bank.
• Monetary target hard to verify. Need publicly
  observed measure of central bank credibility.
• Inflation target also less precise may miss
  because unforeseen shock.

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Stabilization and Real Appreciation

• Stabilization often accompanied by reforms that
  attract foreign capital.
• Capital inflows may also generate inflation (if
  not sterilized, they lead to money creation).
• Additional productivity generates
  Balassa-Samuelson effect on real exchange rate.
• Often, however, real appreciation is result of
  inflationary inertia or continued money creation.

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Inflation Inertia

• Inflation inertia often a key obstacle to
  inflation stabilization.
• Credibility may only come with time.
• If wages are backward-indexed (say to last years
  CPI), then todays wages will incorporate
  yesterdays inflation even with credible program.
  
• Pegged nominal exchange rate plus inflation ?
  real appreciation in first stages of
  stabilization. Invites speculative attack.

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Part II Argentina Mission Impossible

• Argentina presents an interesting historical
  example of a country that started rich and then
  fell behind.

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1990s

• Argentina had a history of failed stabilizations
  and high inflation leading up to the 1990s.
• Monetary chaos ushered in Carlos Menems
  administration five months early in 1989.
• Inflation accelerated again in 1990.

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New Plan in 1991

• Convertibility Law established a currency board.
• The unrestricted reserves of the Central Bank of
  the Argentine Republic in gold and foreign
  currency shall always be equivalent to, at least,
  100 of the reserve money

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Central Bank Balance Sheet

• Assets
• Domestic Bonds
• Foreign Reserves

• Liabilities
• Currency
• Commercial bank reserves

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• The Convertibility Law requires (at least) 100
  reserve backing of the monetary base.
• Ensures that everyone who holds a peso can get
  one dollar.
• However, does not ensure that everyone who holds
  a peso deposit can covert that into dollars.
• The Central Bank can cover M0.
• Cannot act as a lender of last resort.

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Elements of Stabilization

• Clear nominal anchor on prices and money supply.
• No direct price controls.
• Some success on privatization, cutting public
  spending, and reducing tax evasion.
• Successfully brought down inflation (although a
  sustained real appreciation).
• First few years a tremendous success.

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Argentina The Aftermath of the Convertibility
Plan

• Price stabilization that followed was truly
  extraordinary
• The large fiscal deficits driving inflation were
  eliminated. In 1992 and 1993 Argentina had fiscal
  surpluses of 0.4 and 1.1 of GDP.
• Tax revenue rose dramatically in real terms
  through a combination of higher tax rates and a
  successful fight against evasion.
• Numerous state enterprises were privatized.
  (telecommunications, airline, power, gas and
  railway services)

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• Central Bank received official independence in
  1992, fully severing the linkage that encouraged
  funding of deficits.
• With new confidence in the stabilization,
  foreign capital flowed in at the high rates
  resulting in an increase in the Central Banks
  foreign reserves from 4.6 billion dollars at the
  end of 1990 to 14.3 billion dollars at the end of
  1994.
• In 1994, Argentina achieved the highest GDP per
  capita in Latin America, coupled with the lowest
  rate of inflation.

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The Concerns

• During the first years of the plan, inflation
  rates were higher in Argentina than in the U.S.
  which implied a rise in the Real Exchange Rate.
• The traded goods sectors were affected more
  because the price of non-traded goods rose more
  sharply than the price of traded goods. Pressure
  to devalue from this sector.
• Despite high growth, unemployment rose from 1991
  until 1995. Increasing inequality in society.

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External Pressures 1 Mexican Crisis (1994-95)

• The Mexican Peso Crisis and the Tequila Effect
  (1995) resulted in a capital flight throughout
  Latin America
• Savings rates in Argentina had been low since
  the 1980s. Investment was being largely funded
  by foreign capital. 4 billion dollars worth of
  capital were withdrawn from Argentina.
• Banks faced severe liquidity problems. (50
  financial institutions closed down)
• Severe Recession in 1995 Real GDP fell by 4.4
  and unemployment reached 17.4
• Pressure to devalue and to undertake
  expansionary fiscal spending.

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• Recovery from the Tequila Effect was quick GDP
  rose 4.6 fueled mainly by investment
• Several measures undertaken to ensure the
  liquidity and solvency of the banking sector.
• Unemployment and poverty levels were still high.
• The recession caused by the Mexican Crisis made
  austere economic policies less attractive to the
  Argentinean people.

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1993-1998 Missed Opportunities/Policy Failures
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Deficit control problems

• Main problem was spending profligacy by the
  provinces
• Provinces retained much of the initiative for
  public spending, but the responsibility for
  raising of revenue and payment of debt was passed
  off to the central government.
• Tax evasion also pervasive (still)
• During 1993-98, when Argentine economy performed
  well, the government received substantial
  non-recurring revenues (privatization), public
  sector debt to GDP rose by 12 percentage points.

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• Debt to GDP of 40 is a problem in a country like
  Argentina
• Potential to raise tax revenue is low.
• Argentina collects taxes of about 21 of GDP,
  Brazil takes 30,
• Most of its government debt denominated in
  foreign currency and held externally. Ratio of
  external foreign currency debt to export receipts
  rose to 500.
• It was not just the level of the debt to GDP but
  that it was RISING during general good economic
  times.
• Extremely sensitive to contagion.
• Extremely sensitive to changes in financial
  market sentiment.

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• Missed Opportunity to have an orderly exit from
  the convertibility plan?
• I.M.F to blame?

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External Pressures 2 Asian Crisis (1998)

• Because of the efforts to strengthen the banking
  sector the Asian Crisis did not effect
  Argentinas real economy too badly. GDP continued
  to rise.

External Pressures 3 Russian Crisis (1998) and
Brazils devaluation (1999)

• Brazils devaluation was a bigger concern

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Political Uncertainty

• Menem announced he would seek a third term
  (change the constitution)
• Peronists and Opposition (Alianza) candidates
  campaigned to reform the economic plan cut
  taxes, increase expenditures.
• This uncertainty caused investment to stop. GDP
  contracted by 5. Fiscal deficit rose from 1.4 to
  2.7 of GDP.
• Elections in 1999

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Argentina post-1995Boom, Recession, Crisis
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Province spending in the 1990s
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Argentina Second half of 1998

• Several Problems
• Economy in Recession
• High unemployment
• Rising poverty
• High income inequality
• In 2000, external funds for emerging markets
  became scarcer. Decline in the NASDAQ.

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The situation as of early 2000

• Actual 1999 fiscal deficit of 7 billion (2.4
  of GDP)
• Morgan Stanley growth forecast of 2
• 2000 deficit headed to 10 billion (higher int.
  payments, no more privatization and lower labor
  taxes)
• Proposed tax reform collecting from the
  self-employed!
• Government forecasting growth of 4

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IMF policy alternatives in Fall 2000

• Standard Fund-support program
• Likely viewed as inadequate and would probably
  foreshadow default
• Pull the plug
• Make IMF support conditional on Argentina
  reaching an agreement with its private creditors
  that would substantially reduce its financing
  requirements. (Induce default but do so when
  there are resources to help support the workout)
• Massive support (summer of 2001)
• Last chance to right the fiscal ship

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Pros and Cons of December 2000 rescue IMF
negotiated contingent loan of 40 billion dollars
for 2001

• The situation was sustainable because
• Argentina had ample international reserves
• No banks runs (a vote of confidence)
• US rates expected to fall and Argentina spread
  was still only about 750 basis points
• The situation was hopeless because
• There was no mandate for a fiscal correction
• The minute Lopez-Murphy tried support vanished

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Alvarez resigns, IMF bailout designed
Political crisis Cavallo back
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Cavallos plan in Spring 2001

• Zero Deficit Law The fed govt. must first use
  its tax revenue to pay interest on its public
  debt. Basically the idea was to eliminate
  financing of deficits through new debt issuance.
  (the convertibility plan had eliminated financing
  of deficits through money printing)
• Broad Convertibility Plan When the parity of the
  euro becomes 11 with the dollar, the Argentine
  Peso would become convertible to 0.5 Euros0.5
  dollars.

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Argentina The Aftermath of the Convertibility
Plan

• State Governments starting paying wages with
  newly created bonds. These bonds were accepted to
  pay state taxes. Basically, these states were
  issuing their own unbacked currency- huge problem
  for the convertibility plan.

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The 2002 crisis

• Debt default finally occurs
• Convertibility is broken, the peso drops like a
  rock
• Bank accounts are frozen
• Banks are subsequently forced to convert dollar
  deposits into pesos at an unfavorable rate the
  banks are bust
• Fiscal sustainability still in doubt, provincial
  spending and money creation(!) continue as
  central problems

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M3 Cash, Demand Deposits, Saving Deposits, Time
Deposits, Money Market Mutual Funds, Repurchase
Agreements.
Source Monetary Report December 2002
(http//www.bcra.gov.ar/pdfs/estadistica/bul0103.p
df)
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