Cavallo’s high-stakes confidence game

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Domingo Cavallo
When Argentina cancelled a domestic bond auction last month - its government refused to pay the interest rates the market demanded - fears about the country's ability to meet its debts were revived. The government, mired in recession for almost three years, has debt of at least $125 billion. Argentina would need to cut imports in half or boost exports by half to service that overhang.

"Everything coming out of the country right now is aimed at avoiding the double-D, by which I mean default and devaluation," says Morris Goldstein of the Institute for International Economics in Washington. "I hope they make it, but so far it doesn't look as if they will. They're not putting forward enough to do the job."

Few expect contagion on the scale that knocked out Long-Term Capital Management almost three years ago. "We're not likely to see any balance-sheet-based fire selling," predicts Michael Gavin, head of Latin American research for UBS Warburg. "If anything, most leveraged investors are short Argentina and likely to benefit from a collapse."

Still, there would be plenty of pain to go around. Many private clients are exposed to Argentina and virtually all institutional bond investors own some Argentine paper. But borrowing countries would probably take the main hit. "The contagion would be grounded in a reassessment of the rules of the game about the official sector's willingness to countenance or even encourage default," Gavin warns.

Gavin expects that if Argentina defaults it will be out of the market for three to five years and pretty much a ward of the official community. Borrowing costs would go up for other countries that rely on these markets and they would run into some pretty big problems as a result.

"But there's nothing in the numbers that makes a crisis inevitable," points out Ricardo Hausmann, a professor at Harvard and chief economist at the Inter-American Development Bank until last year. "There is what economists like to call either self-fulfilling prophesies or multiple equilibria."

Hausmann sees one equilibrium resulting from lower interest rates. Reaching it is like playing a confidence game. "The nature of the Argentinian problem is a fiscal problem," says Hausmann. "If the market believes that there is no fiscal problem, interest rates will fall and the economy can grow. The tax base will expand and Argentina can pay its debts."

But interest rates will stay high if the market believes that the country can't pay, raising the spectre of collapse. "I don't think that's the most likely outcome at this point," says Gavin. "I think Argentina wants to pay its debts and I personally think that Argentina has the capacity to pay its debts.

Argentina's problem is more of a political one and, to some extent, an exchange rate problem vis-à-vis Brazil where default is really not a solution."

Argentina has a current account deficit of less than 3.5% of GDP. It's true that it has large external debt interest payments. But it also has substantial external debt income, something that the "devaluation claque" tends not to know or conveniently forgets, as Gavin sees it. "The net external interest burden is actually quite modest," he says. "External debt payments were $12.5 billion in 2000 or about 4% of GDP. But Argentines earned an estimated $6.4 billion in interest, bringing net external interest payments down to $6.1 billion, or just over 2% of GDP. For that, the country should pay the price of default?"

So Gavin thinks that the most likely outcome is that Argentina will stagger through a difficult couple of months before the economy will start to recover weakly, but enough to give locals a hint of light at the end of the tunnel. "If there's a modest recovery," he believes, "this story hangs together very well."

That could be a big if. Argentina's economy shrank by 3% in 1999, there was no growth last year and this year also looks anaemic. "If they don't get out of the recession, they can't maintain the current situation," Goldstein warns. The country's currency board and an overvalued exchange rate lie at the root of the problem. "People look at Brazil and Mexico and they say that those fellows used to suffer from a lot of inflation, but they now have managed floating with inflation targeting and they're doing very well on economic growth."

Argentina's currency board - designed to put the country in an economic straitjacket - purged hyperinflation from the economy in the early 1990s. The arrangement performed reasonably well in the early years but it's been mighty uncomfortable lately. "Their monetary policy is completely dictated by the Fed," Goldstein complains. "The Fed was raising rates for much of the period when Argentina was in trouble. And they kept tightening fiscal policy to get out of a recession. That didn't work any better there than it did in Japan."

Ricardo Hausmann
Argentina can't move to floating exchange rates as long as the financial system is dollarized to such a great extent. "If there's one thing that makes me nervous," says Gavin, "it's for Cavallo to be playing with the convertibility regime in the way he has been doing." Economy minister Domingo Cavallo - the original architect of Argentina's currency board - last month proposed a switch from US dollar convertibility to a basket made up of the euro and the dollar.

Gavin sees this move not so much as an attempt to bring in the euro as the beginning of a campaign to reintroduce the peso as Argentina's dominant currency. "Near term, I don't look for a major change in the currency board," he reckons. "But it's not hard to imagine that Argentina could move to a floating exchange rate regime if they succeed in reintroducing the peso - something that's three to five years off at least."

There's added pressure coming from next door to see that Argentina finds a way out of its conundrum in 2001. Brazil also has a big debt position and a presidential election coming up next year. "We don't want to have an exposed, risky situation in Brazil during an election year and a write-down of Argentine debt at the same time," warns Charles Calomiris, a professor at Columbia University's business school in New York.

Calomiris is proposing a write-down of the order of 25% to 30% of the face value of Argentina's official debt. And he thinks that the reverberations would be muted. Argentine sovereign bonds have slumped by almost that amount during the past several months and investors already see them as very risky.

Others take a more cautious approach. "The day after is not going to be particularly rosy," says Hausmann. "A write-down will reduce the probability of recovery, create uncertainty about the solvency of Argentina's banking system and throw a new set of problems in the way of Argentine pension funds that bought this debt."

If the government defaults, Hausmann worries about a greater likelihood that Peru will follow suit under Alan García or that Chavez will follow suit in Venezuela. "The lack of US leadership is likely to loom large in the economic stability of the world," he warns. "The ideas that are being floated are not compatible with this atmosphere. People take for granted that we are in the post-Cold War era and that everybody sees eye to eye on the fundamental economic issues. The last time there was a swing between Democrats and Republicans was in 1981. Soon after, a Latin American debt crisis ensued that took 10 years to overcome. I do not know if the new Republican administration wants to be so sanguine about playing with default."

The US Treasury clearly has the power to keep Argentina from defaulting this year and next. But whether or not the Bush administration should use that power has become the subject of heated debate. The plan was for the official sector to take a little bit more money out of Argentina next year than it was going to put in. Gavin, for one, argues that it's too early for that. "The IMF and other official lenders should make net disbursements of $2 billion to $4 billion next year," he says. "Argentina is a country that's trying to play by the liberal capitalist rules. It's more important to prevent them from backsliding on those rules than it is to deal with the moral hazard bogeyman."