Argentina and the IMF: will they benefit from hindsight?

Michele Wucker
3 September 2003

Since taking office in May 2003, Argentina’s new president, Nestor Kirchner, has launched campaigns to reduce tax evasion and to reform the notoriously corrupt and inefficient state pension system. He has shaken up the Supreme Court and the leadership of the armed forces and let it be known that he will support any international efforts to extradite human rights abusers from Argentina’s 1970s “dirty war”.

All of this signals that Kirchner is serious about moving Argentina forward and putting behind it the dark days that the country has experienced since December 2001, when President Fernando de la Rua resigned in disgrace amid a collapsing economy, currency, and bank system.

The economy grew a respectable 5.4% in the year ending 30 March 2003. The government’s budget performance is easily beating the economic targets it promised the International Monetary Fund (IMF) it would make, in return for the IMF rolling over billions of dollars that came due during the crisis. The peso has been gaining value so quickly that the central bank has had to buy dollars to hold the exchange rate steady, and Argentina’s hard-currency reserves are rising. Finally, the country has begun talking to its creditors about resuming interest payments on the more than $90 billion it owes to private investors – in exchange, of course, for investors forgiving not a small bit of the principal. (Argentina’s total foreign debt, which is owed to private investors, multilateral development banks, and foreign governments, is $172 billion and counting.)

Nestor Kirchner’s approval ratings are above 70% – quite respectable for a president who observers predicted would not get the luxury of a “honeymoon” with the public. Yet this brief honeymoon is no excuse for complacency, by Kirchner or by the international policy makers and investors who also played roles in creating the world’s largest ever default on its debts by a state.

The decisions that Argentina and its creditors make over the next several months will determine whether the country can sustain this recovery or merely stumble along until a new crisis. There is still time to address the root causes of Argentina’s crisis: an international system that made it too hard for the country and its creditors to confront its debt problem before it got out of hand.

If this does not happen, Argentina’s future once again will be sidelined by the obvious problem: the country has too much debt. What it owes is equal to roughly 113% of GDP, far too much to allow it to attract more investment. And as long as Argentina cannot attract investment, its nascent recovery will sputter out and its economy will implode again.

From poster child to pariah

Although it has been clear since long before the 2001 collapse that Argentina was falling behind on what it owed, policy makers and bankers repeatedly have avoided dealing with it head-on. Why?

First, the International Monetary Fund – as the international “policy cop” whose economic advice countries must follow if they want multilateral and private-sector loans – operated under conflicts of interest that kept it from heeding the alarm bells that signaled clearly that the economy was in trouble .

Second, there was no mechanism, like an international bankruptcy regime, that could have stopped the vicious circle under which Argentina’s worsening financial situation forced it to pay higher interest rates, which only weakened it further. As a result, warning signals went ignored for as long as three years before Argentina’s 2001 collapse, and a once-manageable problem became a disaster.

To understand why, it is important to understand the political and financial constraints on the IMF, which designs many of the economic policies that debtor countries must follow. Its approval acts as a green light that assures private investors that a country deserves its money. It often is also the biggest lender and the first one to be repaid. This creates a conflict of interest because private investors, not the IMF, are the ones who lose the most money when a country goes bust – yet private investors follow the IMF’s lead.

Argentina had only barely recovered from its 1980s debt crisis when investors in the early 1990s began to hail Argentina as an emerging-market poster child. The then president, Carlos Menem, at first followed the Washington Consensus – the broad recipe of budget cuts and high interest rates to keep inflation down, combined with liberalisation, deregulation, and privatisation – that IMF technocrats had prescribed.

Private investors took this as a Good Housekeeping seal of approval, ignoring pressing problems like the budget’s slipping out of balance, of still-inefficient public services, and above all of lack of accountability and overabundance of corruption.

Menem flagrantly used the state to benefit himself and his cronies. He travelled on a private jet with his private hairdresser. When Swiss authorities in 2001 froze $10 million in bank accounts linked to Menem over illegal arms deals, the biggest surprise was only that the sum was so small.

During the 1990s emerging-market boom, Menem’s government sold off shares in state companies and public service concessions to please foreign lenders, but it soon became an open secret on Wall Street that many of those privatisations involved rigged bidding, kickbacks and other irregularities. The lucrative postal service and airport concessions, for example, went to consortia tied to Menem crony Alfredo Yabran, the kind of figure journalists like to describe as “shadowy”.

Argentineans have one of the worst reputations in Latin America for paying taxes, but many of them simply balked at sending their hard-earned wages into the pockets of government officials.

In 1996, staggering details came out about state-owned Banco Nación, which had rigged the bidding process for a $250 million information systems contract so that IBM won. Not only did it turn out that IBM paid a $25 million bribe for the privilege, but the contract itself was estimated to have been overpriced by as much as $100 million. In 2000, IBM paid a $300,000 fine when the US Securities and Exchange Commission alleged that the company had failed to report the bribes to its own investors.

In a boom-time environment, government spending had been rising since 1995. At the same time revenues were falling: partly because of lax enforcement, partly because of the region-wide crisis that followed Mexico’s late-1994 devaluation, and partly because of a social security reform that funnelled most pension premiums into private management companies instead of the Treasury.

The government had resumed running budget deficits, which it financed by borrowing from foreigners. When the cost of such borrowing rose with the onset of the Asian economic crisis in 1997 and Russia’s default in 1998, the government kept spending anyway. This choked off credit that should have gone toward productive investments in the private sector. The economy contracted by 3.4% in 1999. Foreign debt rose steadily, surpassing 50% of GDP in 2000.

Despite the growing storm clouds, at the autumn 1999 World Bank/IMF meetings, multilateral officials showered Argentina with praise. Because the multilaterals sorely needed a success story to offset the growing criticism of their policies, they ignored the fact that the Argentine government was handling money – much of it borrowed – irresponsibly.

Argentina and its lenders hoped foolishly that when global economic uncertainty subsided and clear signs of global growth returned, things would magically improve. Like a small-time gambler indebted to a loan shark, Argentina borrowed more, at ever-higher interest rates, long after it became clear that there was no way that it could keep paying its creditors. From the government in Buenos Aires to the international technocrats in Washington to private bankers on Wall Street, policy-makers delayed acknowledging that Argentina needed to make significant changes.

When President Fernando de la Rúa took office in December 1999, he moved to balance the budget and make it easier for businesses to hire temporary workers. To reward him, the IMF in early 2000 increased the country’s standby credit, to $7.6 billion – if Argentina followed policies including poorly-designed tax increases that actually dampened the economy.

By the end of 2000, Argentina’s outlook had deteriorated so sharply that the IMF and United States cobbled together nearly $40 billion in emergency support funds. Yet there was practically no discussion of how it must change its policies. A year later, Argentina was in default. From 1999 and 2001, Argentina had gone from poster child to pariah, yet with little discernible change in its policies, or clear urging to change direction, until it collapsed.

Policies of evasion

If it had been easier for Argentina to admit much earlier that it could no longer afford its debt, the problem would not have reached such epic proportions. But there is no system for deciding when a country is doomed, nor for how to help it and fairly divide the pain among its creditors. Why not? Politicians and many private-sector bankers fear that a formal international bankruptcy regime would make it “too easy” for countries to default. In Argentina’s case, it was too hard to acknowledge that the country could no longer keep up with its obligations.

Why was it so difficult to admit the obvious?

A big part of the problem is that creditors still have not resolved satisfactorily who gets what after a country collapses. The IMF and other multilaterals expect full repayment (eventually) from creditor nations, while routinely insisting that private investors forgive substantial amounts of what they are owed when countries get into trouble. To add insult to injury, when a financial crisis occurs, the IMF often accuses bondholders of having invested irresponsibly – even though the Fund itself had deemed the country in question creditworthy, not to mention prescribing and approving its economic policies.

In November 2001, with Argentina’s default imminent, IMF deputy managing director Anne Krueger sagely proposed the creation of a much-needed international bankruptcy regime. But the Fund’s controversial role in crises made it the wrong institution to spearhead such an institution. Private-sector bankers rightly bristled at the idea that the IMF could even mention the possibility of overseeing an international bankruptcy tribunal. The IMF’s senior creditor status means that it expects that countries will repay in full what they owe it. Thus, it was always in the IMF’s interest for investors to forgive debt, because that would make it easier for a country to pay what it owed Number One.

In April 2002, Krueger responded to private sector concerns by proposing a framework that would give “bankrupt” nations protection from legal action after the suspension of payments and during negotiations with creditors; assurances that creditors’ interests were being protected during the stay; and a guarantee that the borrower would not request forgiveness on any fresh financing from private creditors after the stay. The problem is how to put these into effect.

Bondholders have been understandably wary of allowing the Fund to cement the status quo – under which private investors usually have to forgive as much as 45% of the principal they have lent (in the Argentine case, they likely will be asked to write off 60-80%). They prefer that private-sector lenders employ collective-action clauses; that is, enhanced contracts between countries and their creditors that would allow a super-majority of creditors to force minority lenders to follow the terms of a restructuring instead of suing to try to claim their own portion. Yet these clauses are not widely being used.

A stronger legal framework most likely will be needed to prevent investors in countries with sympathetic legal systems from squeezing more than their share from bankrupt nations. It is unlikely, however, that investors would accept the IMF as arbiter, even if the fund were to back away from bailouts and its insistence that it be repaid first and in full. Thus, the idea of an international Chapter 11 remains stalemated.

In late 2002, Argentina failed to make a $753 million payment to the World Bank. Who could blame Wall Street bankers for enjoying – despite their own losses – a moment of schadenfreude at the misfortune of an institution whose “senior” creditor status has been a major sticking-point in the relationship between the multilaterals and Wall Street?

That failure to make payments to the World Bank and IMF became one more warning to international economic policy-makers. Even before it fell behind, the Argentine government had made it clear that it could only afford to pay if the IMF could agree to resume funding. In early February 2003, the IMF approved an “interim” programme that allowed Argentina to catch up with its payments. This saved face for both sides but did nothing significant for reform of the IMF or Argentina.

Preparing for the fire next time

In 2001, the IMF created the Office for Independent Evaluation, a supervisory body which is now reviewing the IMF’s role in the Argentina debacle. Its conclusions – and the IMF’s reaction to them – will be instructive not only about the crisis, but also about how open the IMF is to learning from its mistakes.

If the evaluation is honest, it will analyse how the IMF contributed to Argentina’s failure by continuing to lend without pushing the government to rein in its boom-time borrowing and spending, improve its tax collection record, or credibly attack corruption, and by pushing policies that were deeply unpopular and often counterproductive (like tax increases during a recession).

To prevent similar mistakes in the future, the Fund could establish a review procedure that would be triggered by warning signals (like rising debt-to-GDP ratios, sharp changes in the balance of payments) and carried out by teams of examiners independent of the IMF and including a range of outside perspectives from diverse sectors of lender and borrower nations. These could include representatives of the public and private sectors, business and labour, lender and non-lender governments.

The IMF should also consider ways to make it less expensive for private investors to lend to debtor nations during times of crisis, when private sources of capital become prohibitively expensive. The IMF has dealt with this by providing large bailouts, which typically only help lenders get their money out of failing countries. Investors are especially reluctant to leave their investments in place because they know that when total collapse comes, the IMF will be at the front of the line asking to be repaid.

The IMF needs crisis practices beyond the emergency solution it used in Argentina. It could still require countries to pay obligations coming due, but channel that money into, say, guarantees for loans to the private sector to keep trade credit lines active or to stimulate investment. The Fund could tie interest rates and repayment schedules to economic performance in debtor countries; if the country grew fast, the IMF would get more, and vice versa. (Private investors are already likely to follow this road; the Argentine government has said that when it issues new bonds to cover the debt on which it defaulted in 2001, it will link payouts to economic growth.) This sort of solution could be the key to a feasible longer-term arrangement between the IMF and not only Argentina, but similar accords for other debtor nations too.

For its part, Argentina has lots of work to do on rebuilding its economy and its government – as do other countries in similar straits. Within the next few months, it is likely to normalise its relationship with its international creditors. But its default is still only a symptom of more difficult problems, whose origin is deep in the relationship between Argentines and their leaders.

Because the Argentine public does not trust the government, one administration after another has sustained itself by handing out political jobs and favours, creating a permanently bloated government bureaucracy that is all but incapable of spending within its means. Argentina must end this vicious circle if its government is to lower the relative cost of servicing its debt, free up credit for private businesses, and earn citizens’ support for the difficult choices it will have to make in the future.

The Kirchner administration’s early efforts to bring order to the social security administration and the courts have been promising. Yet it could do much more to hold itself accountable, both in the economic policies it chooses and in its day-to-day workings.

One good example to follow is Mexico’s recently signed Transparency Law – a sort of Freedom of Information Act – which gives the citizens the right to see how government officials are spending citizens’ money. Another way to attack the country’s endemic corruption would be to create a Truth and Reconciliation Commission dedicated to financial crimes. Like similar commissions that gave human-rights violators a chance at amnesty only if they admitted their crimes and showed remorse, such a body could help the country come clean about past corruption.

This could build citizens’ trust in government. In turn, this would help efforts to combat tax evasion, since many would-be taxpayers have no qualms about not paying a government that they expect will simply steal their money. It would also bring transparency to business transactions involving the government, and thus help attract needed investment.

Argentina has taught us that the international financial community needs ways to respond faster when countries are on the verge of insolvency; a combination of warning signals and an international bankruptcy mechanism could halt the accumulation of mountains of debt and limit the damage when countries default.

The IMF must be less dogmatic and more pragmatic in the policy menus it offers, and assume responsibility – moral and financial – when those policies fail. It has also showed the costs of pushing through policies based on dogma instead of pragmatism, and on refusing to admit that those policies have failed. Borrower governments and international lenders must learn to listen to public opinion when developing economic policy, build consensus support for the difficult choices they make, and hold accountable all parties who are responsible when things go awry.

These are the important lessons from Argentina’s crisis . If they go unlearned, the seeds of promise they contain will go to waste when the next crisis breaks.


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