IMF

Mexican & Argentine Crisis

The Mexican & Argentine Crisis

Submitted To Professor D.N.PandeyMSC IBM - FORE School Management

Submitted By

Puja Sharma

32

Shivani Aggarwal

45

Smita Swarup Kapur

51

Shradha Prakash

70

ACKNOWLEDGEMENT

This report on the The Mexican and Argntine Crisis has been prepared with the support provided by Professor D.N. Pandey, International Financial Markets and Instruments. We are thankful to him for providing us his guidance without which this report would not have been possible.

CONTENTS

1) Objective

2) Research Methodology

3) Mexican Crisis

Background

Causes

Effects

Lessons

Mexican Crisis and the International Monetary Fund

Current Scenario of the Mexican Economy

4)Argentine Crisis

Background

Causes

Effects

Lessons

Argentina and International Fund

Analysis

5)Bibliography

OBJECTIVES

The main objectives of this project are as follows:-

1) To study the causes and effects of Mexican and Argentine currency crisis in detail.

2) To highlight the lessons that can be learnt by other developing nations from these crises.

3) To study the role of the International Monetary Fund in these crisis.

RESEARCH METHODOLOGY

All the data gathered for the purpose of this project is secondary data.

The Secondary Data has been gathered from websites, books and magazines. The magazines used were The Economist, The Business Week.

No primary research has been done.

Mexican Crisis

BACKGROUND OF THE MEXICAN CRISIS

Mexican crisis has been described as the first crisis of the 21st century, meaning the first major financial crisis to hit an emerging market economy in the new world of globalized financial markets. Mexico has witnessed two major currency crisis the first one in 1982 and the more recent one in 1994-95. A currency crisis essentially means that international investors "lose confidence" in the value of a currency. This loss of confidence causes them to refuse to lend more to the country. The reasons highlighting a currency crisis are difficult to pin point. But most of the countries that have faced a currency crisis till now have had pegged exchange rates to a foreign currency. The Mexican Crisis had such a large impact globally because it was a period of global recession and many other countries were running large debts and financially vulnerable. The Mexican experience weakened banks and investor confidence overall and decreased the amount of funds available to many middle-income countries who were at the time in desperate need of capital. The crisis highlighted the weaknesses of the international financial system.In 1976, massive reserves of oil were discovered and oil quickly became Mexicos top export. In 1979 and 1980, there was an oil hike and Mexico earned huge revenues. Now, the Mexicans assumed that the increase in oil prices were permanent and embarked on ambitious development projects. Government spending rose rapidly and this increased their fiscal deficit to 14.1% of GDP in 1981. There was an increase in aggregate demand due to the rapidly rising government spending, which in turn was fueled by rising oil exports, and this drove Mexican inflation up. Given the fixed nominal exchange rate, the Mexican real exchange rate appreciated, increasing the relative price of Mexican goods and services. The real price of the peso was about 15 percent higher in 1982 compared to 1980. The trade and current account deficits increased. The rise in the current account deficit resulted in need for borrowing from international capital market. The banks in Europe and US had funds mainly invested from Middle East countries and were willing to lend. Many of these banks viewed oil rich Mexico as a particularly good lending risk, and they believed that the high export revenues Mexico earned from oil assures their future repayment. Thus, the Mexican government and the state owned enterprises in Mexico had no trouble borrowing on international capital markets.

By mid-1981, oil prices were falling, reducing Mexican export revenues. For a while the Mexican government was able to continue financing its burgeoning current account deficit with increasingly short-term bank loans (full repayment in less than one year). But the dithering by Mexican policymakers and the continued need for borrowing began to concern developed country banks and other investors. The investors and banks were mainly concerned because if there is too much accumulation of foreign debt and Mexico is unable to repay, then the Mexican government would have to devalue its currency. In August of 1982, the Mexican government announced a 90-day suspension of payments of principle on its loans from foreign banks, as Mexicos Foreign Exchange reserves had begun to run out.

In quick succession governments in Brazil, Argentina, and several other countries announced they could not repay loans from U.S. and European banks. Developed country governments, like the U.S., feared that some of the debtor countries would default on the debts they owed the banks, which could have made several large U.S. and European banks insolvent and endangered the world financial system. To avert disaster and help the debtor countries, the developed country governments, the commercial banks, and the international lending agencies (principally the IMF and the World Bank) put together packages of relief. These packages included debt rescheduling (delaying principle repayments) and new lending. In return, the debtor countries like Mexico had to revamp their economic policies to reduce their government and current account deficits. These usually involved some combination of higher taxes, lower government spending, tight monetary policy, and devaluation of the domestic currency.

Mexico, like other debtor countries experienced six years of slow growth, low employment and occasional bursts of high inflation because it had to pursue policies and reforms as recommended by international creditors, as it needed Foreign exchange reserves.

In late 1987, after inflation had again accelerated, the Mexican government and formal representatives of labor, agricultural producers, and the business sector agreed to cooperate to reduce inflation and stabilize the economy. The government fixed the exchange value of peso in terms of dollars so that it would be forced to pursue a tight monetary policy to bring inflation down. They also were privatizing many government-owned enterprises, lifting the restrictions on businesses, moving toward free international trade, and allowing more foreign direct investment. Three months after nationalization of banks, people had become upset, jobs were disappearing, shops were closing, people were restive. The next years were very difficult indeed for ordinary people in Mexico, as indexed by the fact that their wages were reduced by an average 50 percent in six years, according to the report of the President. In 1988,economist reported that Mexico's financial deficit had reached 18.5 percent of GDP, surpassing 1982's record 17.2 percent, inflation had reached 150 percent and GNP growth had only managed 1 percent , even though Mexican labor had suffered a pay cut in five years of the last six.

In a climate of uncertainty, potential new lenders were reluctant to provide new financing for fear that it would end up in old creditors pockets. Mexico, along with other Latin American countries lost access to international capital markets. In 1988, Nicholas Brady, former secretary of the U.S., brought together the main creditors, governments of the countries of the major banks involved, and debtors. After negotiations, it was agreed that the old debt would be exchanged for new long-term debt with lower nominal value. Multilateral Institutions and industrial countries guaranteed the new bonds with $30bn. The main points of the Brady Plan were the following: -

Partial write off and recognition. Creditors agreed to write-off a percentage of the nominal value of the loans according to the value of the outstanding debt in the secondary market.

Commitment by debtor countries to improve macroeconomic policies and engage in serious reform policies. The main purpose was to permit countries engaged in macroeconomic reforms to achieve long term economic growth and also to allow them to borrow again in the international capital markets and relieve them from the extremely high interest payments. At the same time, special prov)sions were included in the debt reduction packages to allow these countries to borrow in the transition period while the stabilization efforts took place.

Securitization of existing debt the outstanding debt was already trading in informal secondary markets but they were illiquid.

In 1989, the new reform program was pushed by president Salinas and had four basic components:

1. Opening up of the economy

2. Privatization

3. Stabilization program centered on a predetermined nominal exchange rate and supported by restrictive fiscal and monetary policies

4. A broad social and economic agreement between private and government sector and labour unions called Pacto.

In 1989, the exchange rate system changed to a system based on a preannounced rate of devaluation- where the rate of devaluation was set below the (actual and expected) rate of inflation, but later in 1991 it further changed to a (narrow) exchange rate band with a sliding ceiling. The rate of inflation fell drastically in the first eighteen months of the program, but from then, the pace of disinflation became slow. At this point of time, many observers felt that this trend would become unsustainable because the country lacked Foreign exchange reserves to finance the rapidly growing current a/c deficit.

In 1990, the government authorities again accelerated the pace of their reforms and foreigners started reinvesting in Mexico. These capital inflows allowed Mexico to finance current a/c deficits and real exchange rate continued to appreciate and output growth remained subdued. Even though there were oppositions from economists, the government felt that capital inflows were largely private and fiscal a/cs were in surplus, it was not a matter of concern. Government also argued that, the increasing productivity and the narrowing of current a/c were about to take place and stressed that exchange rate bands and freely determined exchange rates gave enough flexibility to the monetary policy to deal with eventual disruption in the flow of capital. But it can be very rightly said that the rate at which the capital was flowing into Mexico was not sustainable in long run and indicated that flows of this kind will eventually tend to decline and real exchange rate will also decline. Hence, over indulgence in credit, a frenzy of spending, a substantial short-term debt and fixed exchange rate set the stage for the economic crisis.

At first, the rising risk premium did not affect the value of the peso, for Mexico was operating with a fixed exchange rate mechanism. But political instability and the assassination of the presidential candidate Luis Colosio and investors did not take much time to change their decision. The investors now started placing a larger risk premium on Mexican assets. Bondholders decided not to roll over debt. Other investors decided not to finance Mexico and that led to a liquidity crisis and need of external assistance. Yet, Mexicos reserves of foreign currency were too small to maintain its fixed exchange rate. When Mexico ran out of dollars at the end of 1994, the government, (even though it repeatedly promised that it would not devalue) announced a devaluation of the peso. The Mexican devaluation came as a surprise to many market participants. Despite the initial enthusiasm by market participants and policy makers, there was disappointing news in three main fronts.

Hard currency policies only brought down prices gradually, bringing a real exchange rate appreciation. Real output, and particularly real per capita output, grew at a much slower pace than the capital flows.

The benefits of the sluggish growth were not widely distributed. Unemployment raised and the poor were getting poorer.

Investors now became more distrustful and feared further devaluations. The country risk premium rose once again, adding to the upward pressure on interest rates and downward pressure on the peso. The investors were now unwilling to buy new debt and default appeared to be the governments only option. Mexico, which recently was considered a promising economy, now was on the verge of bankruptcy.

Then the US intervened and its government had mainly three motives:

To help its neighbour to the south.

To prevent the massive illegal immigration that might follow government default and economic collapse

To prevent investor pessimism regarding Mexico from spreading to other developing countries.

The US together with the IMF led an international effort to bail out the Mexican government. US provide loan guarantees for Mexican government debt, which allowed the Mexican government to re-finance the debt that was coming due. These loan guarantees helped restore confidence in the Mexican economy, thereby reducing to some extent the country risk premium.

Although the US loan guarantees stopped a bad situation from getting worse, they did not prevent the Mexican meltdown of 1994 from being painful experience for the Mexicans.

CAUSES OF THE MEXICAN CRISIS.

Domestic Inflation > Foreign Inflation

The peso was pegged to the U.S. dollar. Mexican inflation exceeded U.S. inflation, and, given the virtually fixed nominal exchange rate, the real Mexican exchange rate had increased. This appreciation of the peso in real terms meant that the average price of Mexican goods and services increased relative to the U.S. goods and services. The result was a decrease in Mexican exports of goods and services, an increase in Mexican imports, and a widening current account deficit.

Increase In Current Account Deficits.

In 1994, the current a/c deficit had become too large, nearly 8% of GDP or US $ 31 billion. The capital flows which had flowed into Mexico started to flee and reserves dropped from US $ 26 billion to US $ 10 billion. The Mexican government thought it was temporary and it will be able to manage to reduce it as they had support of NAFTA and increase in productivity.

Political Causes

The main political events in the year 1994 were:

Uprising in Chiapas.

Assassination of Luis Donaldo Colosio, presidential candidate of ruling party.

Resignation of assistant Attorney general, Mario Ruiz, who had been charged of the assassination of his brother.

These events scared investors away and the currency risk increased sharply. Each of the negative political events translated into major declined in the stock of international reserves held by the central bank. Under normal circumstances, interest rates should have gone up or/and the currency depreciated. But 1994 was an election year, and authorities decided to maintain the exchange rate band and minimize the rise in domestic interest rates.

Fixed Exchange Rates

Under a fixed exchange rate, the central bank agrees to trade the domestic currency (pesos) for a foreign currency (dollars) at a predetermined rate. Thus, when an increase in country risk premium put downward pressure on the value of peso, the central Mexican bank had to accept pesos and payout dollars. This automatic exchange market intervention contracted the Mexican money supply, when the currency might otherwise have depreciated.

Too Fast In Liberalizing Its Capital A/C

One of the main culprits of the crisis were the excessive reliance on short term portfolio flows, and speculators that did not hesitate to sell their investments once the situation turned sour.

EFFECTS OF THE MEXICAN CURRENCY CRISIS OF 1994-1995

As a result of the recession, debt problems, cuts in public investment, import substitution, currency devaluations and high inflation there was a great loss in the living standards of the Mexican people.

The application of switching policies, like devaluation, is supposed to increase output of tradeables and reduce its consumption. Expenditure reduction policies, like public spending cuts, are supposed to reduce consumption of both tradeable and non-tradeables. Both the mechanisms have contractionary effects and affect the real income and the distribution between wages and profits. Moreover, when fiscal cutbacks are achieved by a reduction of non-transfers expenditures such as social spending, it hurts the population through a reduction in social and earned wages. These are some of the factors that provoked in Mexico a huge fall in the living standards in terms of real wages, poverty, income inequality and social spending.

The steep rise in interest rates due to the highly contractionary monetary policy wreaked havoc on the Mexican economy. There was a large decrease in Mexican spending, leading to decline in production and employment. The devaluation of the Mexican peso against the dollar raised the price in Mexico of imported goods. Because Mexican consumers and producers could not immediately reduce their purchases of imported goods, they had to reduce their purchases of Mexican-made products. This reinforced rising interest rates in pushing down Mexican aggregate demand. Further, the rise in prices prompted Mexican workers to ask for wage increases. Many Mexican producers complied, which raised costs of production. This produced high inflation and reinforced falling production.

As time passed, the devaluation resulted in a real depreciation of the peso. The prices of Mexican products relative to those of the U.S. fell. This increased Mexican exports and decreased Mexican imports, raising aggregate demand once again. However, this latter effect took many months to play out.

When the Mexican crisis blew out of proportion and the peso began to depreciate, both the international investors and the local population were very affected. First, because the devaluation took the investors by surprise, and they lost 30,000 billions dollars, according to estimates. This undermined the investors confidence, increasing the rate of capital outflow from Mexico.

But the ones who suffered more severely were the people of Mexico. The reason for the crisis affecting the local Mexicans more severely were mainly the measures that the Mexican government choose to face the balance of payments crisis. The policies followed by the government were contractionary. These measures were part of the International Monetary Fund prescription. In order to reduce the aggregate demand the IMF suggested the tightening of the fiscal and monetary policy and a market driven exchange rates. During the first three months of 1995, the Mexican government prepared and put in practice a hard shock economic program sponsored by the IMF. It included a free exchange rate, increases in interest rates, an increase in the value-added tax from 10 percent to 15 percent and a rise between 20 and 35 percent in prices of public goods and services. Further, the programmable public spending was cut by more than 12 percent in real terms with respects to 1994. These policies were part of an agreement among all economic sectors in Mexico aimed to avoid the inflationary effects of devaluations, to reestablish the confidence, to reduce the cost of the adjustment and to get back to sustained economic growth.

The cost of the crisis and adjustment were large, mainly in the short term. One the most harmful policies was the credit restraint. The monetary base declined by 23 percent in real terms. The interest rates of credit cards, public debt bonds and car, and house financing reached more than 90 percent in March 1995. As result of this many small and medium sized firms could not keep working because the debt service was too high.

Among the middle class, a social movement arose called El Barzon whose motto was cant pay, wont pay. The devaluation of the peso and the public goods and services prices increase, caused a fall in total aggregated demand. In 1995, the private consumption and investment declined 14.3 and 27.40 percent, respectively. The real GDP fell 6.5 percent. Retail and industrial sales declined 40 and 50 percent, respectively, only in the first semester.

As everybody had expected, the economic contraction caused a great employment loss.

During 1995, Mexico lost one million jobs in the formal sector and the number of working hours for other 8 millions workers of the country decreased to approximately 15 hours. The open unemployment rate increased from 3.7 percent in 1994 to 6.3 percent in 1995. People working in the informal sector increased 36 percent in this year. The problem was even worse as Mexico did not have any employment insurance or unemployment benefits. The purchasing power of workers was the most affected because of the inflationary effects of devaluations of the peso.

The value of the Mexican currency decreased more than 100 percent in a year. It raised the prices of the imported commodities. Furthermore, the prices for public goods and services increased between 35 and 50 percent, especially gasoline, diesel and propane gas. It caused the inflation rate to hike from 7.1 in 1994 to 52 percent in 1995. For April 1995, the cost of the food basic basket had already erased the minimum wage increase. The minimum, manufacturing and construction wage rates, in real terms, fell 14, 16 and 13 percent in 1995, and 8, 12 and 9 percent in 1996. The non-wage income fell significantly too, affecting also rural sectors.

The social spending was reduced by 12 percent in 1995, since debt service grew as consequence of the crisis and the government had to shrink the public spending. A significant part of this reduction happened mostly due the government as it allowed the real wages of people working in the social sector to be dropped.

However, in spite of the socioeconomic cost that the adjustment program brought on, the Economic recession bottomed quickly. After the slump of 9.2 percent in real GDP during the second semester of 1995, the contraction began to slacken, and the economy got back to grow by 5.1 percent in 1996 and 7.0 percent in 1997. The open unemployment rate began to decline after the third quarter of 1995, and for the last quarter of 1997 it was at the same level of 1994. The rate of inflation decreased rapidly to 27.7 percent in 1996 and 15.7 percent in 1997. In addition, social spending began to increase immediately after the crisis through the creation of new social programs to fight poverty.

This recovery has been the fastest ever in the economic history of Mexico. The reasons for the fast recovery of the Mexican Economy are as follows:

1) Mexico entered to an economic crisis for the first time, with a balanced public sector and it helped to minimize the damage to the operation margin of the government, to apply the right measures to resolve the crisis.

2) The financial aid of 51 billions dollars had no precedents. These resources allowed the government to face the short-term debt and to support the bank to accomplish with its external liabilities. It reduced the pressures over the financial and exchange market.

3) The importance that Mexico acquired the United States as a commercial partner and one of the most important emerging market, led government to contemplate some more realistic goals and to apply the measures with more consistency and responsibility.

The Contagion Effect Of The Mexican Crisis

A crisis in one country can cause a crisis in another country; that is, the channel(s) by which contagion spreads. These channels are as follows: -

Trade - Strong trade links are one explanation of contagion.

Macroeconomic Similarity and the Demonstration Effect - Similarity in macroeconomic (including political) conditions and economic policies also lead to the contagion effect. The "demonstration effect" is related to this theory. The effect is that the crisis in one country demonstrates to investors that there could be cause for concern about countries of a similar macroeconomic nature.

The Tequila Effect was the name given to the contagion effect caused by the Mexican crisis. This was transmitted by a rational demonstration effect based on shared macroeconomic fundamentals. Although the demonstration effect was largely rational in its discrimination between "weak" and "strong" countries, it did, however, contain an element of irrationality; nervous investors withdrew their funds in the expectation that other investors would do likewise. "Therefore, the possibility of panic, which had existed before December 1994, became the fact of a panic after December 1994".

The contagion of the Mexican crisis impacted the countries mentioned below more adversely.

1) Argentina

Between December 1994 and March 1995, Argentina suffered badly from the Tequila Effect. Bank liquidity tightened, interest rates surged and 15% of deposits were withdrawn from the banking system. International reserves decreased substantially, while the stock market fell by 35%. The authorities reacted by obtaining international aid and establishing lender of last resort facilities, which eventually led to a restoration of confidence and an economic recovery.

2) The Philippines

The Philippines was the Asian country most deeply affected by the Tequila Effect. The duration of speculative pressure on the peso was longer and the drop in stock prices greater by April 1995, the stock indexed measured in dollars stood 16.7% i.e. at its previous November level - than for any other country in Asia. The capital outflow by small investors equaled to US$1 billion in the first quarter and a US$500 million outflow of residents portfolio investment

3) Thailand

In early 1995, the Thai baht was attacked, despite Thailands strong reserve position and high economic growth rate. The speculative attack was not sustained as the authorities intervened to ensure that the fixed exchange rate was maintained with reserve losses being restricted to only $374 million.

LESSONS FROM THE MEXICAN CRISIS

Large external current a/c deficits are dangerous, especially when they are being used to support domestic consumption and are being financed by short term capital inflows. They are dangerous because they are not likely to be sustainable. In Mexico, the fiscal position is strong and the external deficit largely reflects weak private sector saving. With the benefit of hindsight, Mexicos fiscal position should have been even stronger, to contain the countrys dependence on easily reversible capital inflows.

Mexicos devaluation in December shows that it is inherently difficult to adjust a pegged exchange rate even when such a change is called for , but also that sound and credible accompanying macroeconomic measures are essential to provide a firm basis for market expectations.

Mexico used too much of its foreign borrowing for private consumption and not enough for investment. Due to the real exchange appreciation, and the change in relative prices, exports growth slowed and imports surged, and therefore, most of Mexico's foreign borrowing had to be spent on foreign imports, instead of domestic goods or in investments in capital equipment and infrastructure. Productivity growth had been insufficient to offset the loss of external competitiveness implied by the peso appreciation.

Impose taxes in foreign exchange transactions: This tax would prevent speculators from shifting money in and out of a currency in response to small interest rate changes.

Mexico relied too heavily on short-term and foreign currency indexed debt in 1994: Mexican authorities engaged in a large scale substitution of peso denominated debt -Cetes-, by short-term dollar indexed securities with lower yields - Tesobonos-, and therefore assumed fully the risk of a devaluation that previously had been carried by creditors. In an effort to avoid rising peso interest rates, the Mexican authorities decided to adopt a very risky strategy. This increased drastically the Mexican government's outstanding debt relative to its foreign reserves. Increasing the cost of devaluation was seen at first as a measure of credibility, but as the already short maturity of the debt became shorter, the risk taken by the Mexican government was enormous.

No Dependence on inflows: If developing nations depend too heavily on the inflows, they will be subject to a considerable risk, as external conditions may reverse, and an inflow today may become an outflow tomorrow. The inflows into developing nations are not only because of the attractiveness of the domestic factors of a country but also because of external factors such as global liquidity, conditions and the level of interest rates.

Mexicos crisis illustrates the costs of failure to publish regulary and in good time information about the key economic variables. The crisis arose in the way it did partly because the scale of the problem only became apparent at the time of devaluation, and took the financial markets by surprise. If information about international reserves and other key variables had been published more frequently and with a shorter time lag, the efficiency of market discipline and the chances of a smoother adjustment would clearly have been enhanced.MEXICOS REFORMS AND THE

INTERNATIONAL MONETARY FUND (IMF)

The Mexican government in close collaboration with the IMF designed a stringent adjustment program, and a large-scale international financial rescue package was drawn up in support of that program. This package had three elements. The IMF approved on February 1st an 18-month stand-by credit of $17.8 billion in support of Mexico's program for 1995-96, of which $7.8 billion was made available immediately. The other two elements were both dependent on Mexico's arrangement and policy understandings with the IMF were, $20 billion in swaps and guarantees from the U.S. Exchange Stabilization Fund, and $10 billion of short-term support from the G-10 central banks through the BIS (Bank for International Settlements). To achieve these goals, the program was centered on a further tightening of the fiscal position and a strong monetary policy. The program also pursued the strategy of privatization and liberalization of activities previously reserved for the public sector, and included a number of measures to protect the poorest from the short-term adverse effects of the adjustment process.

Following the currency crisis of Mexico, the authorities announced a comprehensive economic program that was aimed at stabilizing the economy, restoring financial market confidence and deepening the process of major structural reform. The principal goals of the program were to contain inflation and the reduction of the external current account deficit by about 4 percentage points of GDP to a level that could be financed by the government on a sustainable basis. The program received the support of Mexican business and labor sectors within the context of the Agreement to Overcome the Economic Emergency. The program was centered on a further strengthening of the public finances, a restrictive monetary policy and wage restraint. The programmed fiscal improvement was to be achieved through cuts of current expenditure and a temporary reduction in capital expenditure. The program was supported by a wage policy that strengthened the public finances and ensured the maintenance of a strong international competitive position. The government also announced the expansion of their wide-ranging privatization program to promote faster economic growth and social development. In particular, railroad operations, which are a major source of structural inefficiency, were opened for private investment; Mexican financial markets were opened for greater foreign participation; and the reforms telecommunications industry was accelerated. To ensure orderly conditions in foreign exchange markets under the floating exchange rate regime, an Exchange Stabilization Fund of US$18 billion was established, with contributions under the North American Financial Agreement, and from the monetary authorities of other major countries and from private commercial banks.The IMF approved the economic policies mentioned above. They supported these reforms and believed that these reforms would result in low inflation, renewed economic growth, and a significant strengthening of the balance of payments.

The 1995-1996 Program

The program formulated by the Mexican authorities, and supported by the stand-by credit was developed keeping the background of Mexico's favorable economic fundamentals and its past record of macroeconomic and structural reforms in mind. The program comprised of a two-pronged approach, which aimed at consolidating the progress made in the past several years after the debt crisis and addressed the liquidity problem of dealing with substantial short-term obligations falling due. To ease the investors immediate concerns about the situation in Mexico, and reverse the overshooting of the depreciation of the currency that has occurred, resources were made available for the authorities in the form of external financing to support the conversion of short-term government debt into medium- and long-term debt and to help domestic commercial banks to meet their short-term external obligations

The program's specific objectives for 1995 were: -

(i) The reduction in the external current account deficit from 8 percent of GDP in 1994 to 4 percent of GDP in 1995, and to 3-3 1/2 percent of GDP in 1996; and

(ii) A lowering of the annualized rate of inflation to around 9 percent in the fourth quarter of 1995, from more than 30 percent in the first quarter of that year. Economic activity was expected to decline in the first half of the year, as the effects of the change in relative prices and the financial adjustment worked through the economy. However, it the economy was expected to recover in the second half of 1995 as the financial conditions stabilized. Real GDP was expected to grow by around 1.5 percent for 1995 as a whole.

To achieve these goals, the program was centered on a policy of wage, price, and credit restraint supported by an improvement in the fiscal position. The revised 1995 budget for the non-financial public sector provided for a fiscal surplus of 0.5 percent of GDP (compared with a balanced position in 1994), and a primary surplus (the overall balance excluding interest obligations) of 3.4 percent for the year as a whole, compared with a primary surplus of 2.6 percent of GDP in 1994. The contribution of the public sector to the adjustment process was expected to be particularly large in the first half of 1995.

The fiscal tightening was aimed at achieving an early stabilization of financial and exchange markets, and the measures could boost savings and result in a substantial reduction in imports. In addition, acceleration in exports growth was expected to result from the real depreciation of the currency.

The policy on wages and prices that was formulated within the context of the Agreement of Unity to Overcome the Economic Emergency signed between the Government, the Bank of Mexico, and the labor and business sectors, set the path for the evolution of wages and public sector price rises during 1995. This agreement resulted in a significant reduction of the real wages on average and represented a major contribution on the part of the labor to set the basis for a resumption of growth. Wage policy under the agreement provided for an increase of seven percent in the minimum wage and the public sector wage and an additional three percent through an income tax credit for workers that had incomes of up to twice the minimum wage. Contractual wage negotiations adhered to these guidelines and, in addition, they included productivity bonuses freely negotiated between the labor and businessmen. The pact also limited the increase in public sector tariffs during 1995 to about ten percent, or about two thirds of the expected average rate of inflation. The price strategy resulted in a revenue loss for the public sector (of about 0.6 percent of GDP), which was compensated by other fiscal measures. The authorities also dealt with the price distortions that resulted from these measures.

Credit policy was expected to play a critical role in achieving the objectives of the program. The monetary program established a limit on the growth of net domestic assets of the Bank of Mexico of MexN $10 billion in 1995, compared with MexN $60 billion in 1994. Under this limit, credit expansion by the Bank of Mexico was set at 17 percent of the monetary base at the end of 1994, a rate that was less than that of the projected nominal GDP and was consistent with the inflation target of 19 percent for 1995 as a whole. The Bank of Mexico tightened the credit conditions further to counter unforeseen pressures in the exchange market.

The development banks and trust funds continued to provide net financing to priority sectors, including exports and agriculture even though the credit expansion of these banks was reduced.

The substantial depreciation of the exchange rate that had taken place was expected to contribute to a significant improvement in the current account of the balance of payments. Merchandise exports were projected to grow by close to 25 percent in 1995 helped by the devaluation. In addition, the effect of the peso depreciation, the policy of credit restraint, and the expected fall in real incomes was expected to decrease the imports of seven percent in U.S. dollar terms.

The Bank of Mexico was supporting the floating exchange rate regime through limited intervention in the foreign exchange market. The authorities envisaged that the strength of their economic program, together with external financial support would help to stabilize financial markets and result in a significant correction of the overshooting of the exchange rate.

For 1996, the authorities indicated that they would follow policies to lower inflation to single digits and further reduce the external current account deficit to 3-3 1/2 percent of GDP. With the return of financial and exchange market stability, investment was expected to recover which, together with continued export expansion, would contribute to a rebound in real GDP growth to around 4 percent.

The authorities were committed to review tax policies to at least maintain the surplus position of the public sector and improve the equity of the tax system.

Structural Reform Policies

Mexico had made substantial progress in the area of structural reform since the 1982 debt crisis. The program consolidated and extended the progress in important ways. It provided a reinforcement of the Government's strategy for privatization and the granting of concessions to the private sector in areas previously reserved for the public sector. In the past, the privatization efforts had focused mainly on commercial enterprises (although some concessions have been granted for the operation of highways). Beginning in 1995 privatization also involved basic infrastructure like rail, ports, airports, electricity generation, and radio and telecommunications. The implementation of the strategy required some constitutional changes as well as reforms in the regulatory environment, which were already under way.

The authorities expected revenues from privatization and concession operations to be about US$6 billion in 1995 and an additional US$6-8 billion in 1996-97. The privatization proceeds were to be used largely for the cancellation of the public external debt.

Social Costs

During the late 1980s and early 1990s there was a significant reduction in the number of families living in extreme poverty, reflecting the strong economic growth and increases in real wages in that period, complemented by a program of targeted social expenditures. The authorities recognized, however, that the peso crisis and the adjustment measures that it had to entail could complicate efforts to sustain the steady improvement in the well being of the poorest sectors in the short term. A number of policy measures were being implemented to protect the poor from the adverse effects of the adjustment process. While overall lending by the development banks was being scaled back sharply, financing of agriculture through specialized agencies was the main concern that would lend to small farmers. To limit the real wage adjustment for the lowest wage earners, employers were to be allowed to supplement wages of those earning up to twice the minimum wage and to claim a corresponding tax credit.

CURRENT SCENARIO OF THE MEXICAN ECONOMY

The world as a whole has been characterized by complexities recently. The slowdown of the global economy, the terrorist attacks on the United States of America, the Iraq war, the problem of transparency of the large corporate, weaknesses of the international financial system and crisis of the Latin America countries have been the highlights of the world over the last couple of years. The global growth during 2002 was patchy and weak. The global output grew by just three percent in 2002. The three economic blocks of the world experienced slowdown in 2001. The graph below shows the growth rate of the Euro Zone, U.S.A and Japan from 1996 to 2002.

Real GDP Economic Growth 1996-2002 (%)

Despite the adverse external environment the macroeconomic stability in Mexico was preserved. (Economic Intelligence Unit, The World in 2003, The Economist). The Gross Domestic product grew at 3.4% amounting to US $ 641 billion in 2002. (Economic Intelligence Unit, The World in 2003, The Economist). The GDP per head of Mexico in 2002 equaled. US$ 6,210 (Economic Intelligence Unit, The World in 2003, The Economist). The exports of Mexico as a percentage of GDP equaled 30.1% in 2002. (Economic Intelligence Unit, The World in 2003, The Economist).

Inflation (annual % change)Nominal Interest Rates

(cetes 28 days%)

The Mexican authorities have stabilized the inflation rate and in 2002 it was 5.1%. The graph above on the left shows the inflation rate of Mexico. The inflation has been declining since January 1999.

The graph above on the right shows the nominal interest rates of the cetes. The cetes are a form of Mexican peso denominated debt.

Current Account Deficit and Foreign Direct Investment (Billion Dollars)

The graph on the previous page shows the current account deficit and the foreign direct investment of Mexico. During the crisis in 1994 the current account deficit of Mexico shot up to 29.7 billion dollars. In 2001 the foreign direct investment was the highest since 1994 equaling 25.2 billion dollars.

Capital Flows To Mexico (As % Of Total Flows To Latin America)

The capital flows into Mexico have had an increasing trend since 1999. 60.6% of the total flows into Latin America are for Mexico. There has been a very huge jump of the capital inflows from 2000 to 2001. the capital inflows have risen from 16.5% to 60.6%.

Public Sector Borrowing Requirement (PSBR)

The PSBR were lower than originally projected by the Mexican Authorities. The graph on the previous page shows that the projection level was set at 3.22% of GDP but the actual requirement was 2.68% of GDP.

The fate of the Mexican economy depends a lot on the world economy and especially on the economy of The United States of America, which takes 85% of the Mexican exports. If the American economy falters the exports of Mexico which are forecasted to grow by eight percent will go in the reverse direction. A double dip recession north of the border could choke the Mexicos incipient recovery before it gathers pace. And a slow world growth implies no recovery in prices for the commodity exports on which Mexico is still dependent. The growth of the Mexican economy is expected to be 3.5% in 2003.

Argentine Crisis

BACKGROUND TO THE ARGENTINE CRISIS

For most of the 20th century, Argentina was considered one of the most developed countries in South America. However, poor economic decisions, political instability and endemic corruption have contributed to Argentinas decline from the tenth richest country in the world in 1913 to the thirty-sixth in 1998.Argentina now finds itself bankrupt with an external debt of US$ 155 billion in January 2002. This constitutes one-seventh of all the debt of developing countries.

Argentina has a long history of unstable policies. It has a record of defaults, rocking the London Exchange on occasions. Inflation raged for years. Argentina suffered from high inflation rates in 1975, from 1982 to 1985 and from 1987 to 1990. In 1989, the consumer price change was 3079.4% and in 1990 it was 2314%. Carlos Menem who was elected President in May 1989, was determined to end inflation. Therefore, his economy minister, Domingo Cavallo introduced the Convertibility Law in March 1991 establishing the convertibility of the currency and a currency board charged with regulating the countrys currency. The currency board had to maintain the pegged exchange rate by keeping dollar reserves. Argentinas currency, then the austral, was made fully convertible into US dollars at a fixed exchange rate of 10,000 austra,s/US$, changeable only by an act of the Argentine Congress. In January 1992, the currency austral was reformed, with one new Argentine peso replacing every 10,000 australs. Thus, the peso was pegged to the US$ at a one-to-one ratio.

To maintain the pegged exchange rate, the currency board maintained dollar reserves, and could not expand the supply of pesos without an equivalent increase in the dollars that it held. The Convertibility Law required that the monetary base be backed entirely by gold or foreign currency, so it sharply curtailed the central banks ability to finance government deficits through continuing money creation. Currency board measures were tagged onto other reforms like reduction in government spending, tax reforms, elimination of budget deficits, liberalization of foreign trade (import tariffs were slashed), removal of restrictions on direct foreign investment, removal of permission needed for capital flows including portfolio investment, deregulation of banking industry and privatization of major state companies (including the national airline).

Cavellos plan had a dramatic effect on inflation, which dropped from 800% in 1990 to under 5% in 1995. Growth also picked up. The growth rate went up from an average annual rate of minus 1% between 1980 and 1990 to an average annual rate of 8% from mid 1990 to mid 1994.

However, continuing inflation in the first year of the convertibility plan, despite a fixed exchange rate, implied a steep real appreciation of the peso. From 1990 to 1995 the currency appreciated in real terms by about 30%. The pesos real appreciation lead to unemployment and a growing current account deficit (as Argentinas exports became uncompetitive). Also, the US Federal Reserve hiked up interest rates in February 1994 and over the next year doubled the short-term rates from 3% to 6%. Argentina was hit immediately because of the uncertainty created over emerging markets : Argentinas borrowing rate increased. The devaluation of the Mexican peso in December 1994 partly triggered by the hike in US interest rates that attracted billions of dollars away from Mexican bonds to the US exacerbated the situation in Argentina. After the Mexican financial crisis that erupted at the turn of 1994-95, speculators attacked Argentinas currency and the banking system lost 18% of its deposits within weeks. The domestic interest rates rose sharply. Unexpectedly higher borrowing costs placed Argentinas banks under severe pressure. The central bank could do little to help because the Convertibility Law made it hard to print pesos and lend them to the banking system as a lender of the last resort. Instead, the government arranged for credits from official foreign agencies such as the World Bank. Nonetheless output slumped and unemployment jumped. In 1996, Menem fired Cavallo.

The economy went into a steep recession. Scarred by hyperinflation, Argentines continued to support their new monetary system. The pesos real appreciation process ended and Argentinas government strengthened the banking system to reduce the weakness that had been revealed in the 1995 crisis. By 1997, the economy was growing rapidly again.

After the eruption of the East Asian crisis in July 1997, there was a temporary relief to Argentina. Foreign deposits with Argentine banks increased by about 40%. The convertibility act had independently encouraged a disproportionate increase in the operation of foreign banks in dollars in Argentina. Loans and interest payments were denominated in dollars. Total debt liability was around $155 billion and more than 90% of it was in dollars and estimated at 50% of its GDP. The situation was unsustainable. The Argentine risk premium and cost of borrowing went up again. The dollar became overvalued and as the peso was pegged to the dollar, the peso also became overvalued. Also, 28% of Argentinas exports were confined to Brazil, and these became uncompetitive when the Brazilian Real was devalued. Due to this, Argentinas current account deficit increased. The spread of the Asian crisis to Russia and then Brazil made things worse, and the Argentine economy went into recession in the second half of 1998. Efforts to restore confidence in the overvalued peso through spending cuts and IMF loans (including a $40 billion package in December 2000) could not reverse the downward spiral.

During 2001, the Argentine recession grew rapidly deeper. Argentinas debt to the international financial institutions increased from $15 billion to $33 billion, and throughout the IMF insisted that more fiscal tightening was the key to recovery, even though it was quite clear that no amount of budget-cutting or tax increase could have saved Argentina from default and devaluation. Fearing a crisis, Argentineans started withdrawing money from their bank accounts. To stop the bank run, the government imposed restrictions to put limits on the amount of money Argentineans could withdraw from their accounts. The government also imposed caps on offshore transfers.

The Argentine government took draconian economic measures on the advice of the IMF. To reduce the budget deficit, the government introduced spending cuts of nearly 20% in the 2002 budget. There was a 13% cut in public service salaries and pensioners were told that there was no money to pay their pensions. These measures lead to massive social unrest and the country erupted into violence on 19th December 2001. Argentineans took to the streets to protest against the worsening situation and to raid supermarkets to feed their hungry families. Argentina officially defaulted on its debt repayment and on 20th December 2001 a state of siege was declared. The four-year recession had lead to a crisis.

CAUSES OF THE ARGENTINE CRISIS

The crisis in Argentina was caused by the failure of policies that were set and encouraged by the IMF. IMFs policies of tightening government fiscal and monetary policy, privatization of state enterprises and liberalization of foreign trade and investment, worsened Argentinas situation instead of improving it.

The root causes of the crisis were the weak fiscal policy, large amount of public debt and most importantly the exchange rate regime.

Weak Fiscal Policy

The total fiscal balance of Argentina over the period 1993-2000 shows a significant loosening of fiscal policy, with the budget moving from a surplus of $2.7 billion or 1.2% of the GDP in 1993 to a deficit of $6.8 billion or 2.4% of the GDP in 2000.

However, this shift from surplus to deficit does not accurately represent government fiscal policy. The primary balance of the government (government spending other the interest payments, subtracted from government revenue) moved from a surplus of $5.6 billion or 2.4% of GDP in in1993 to $2.9 billion or about 1% of GDP in 2000. Even this movement did not occur on the expenditure side. Government spending minus interest payments was essentially flat over the period 19.1% of GDP in 1993 and 18.9% of GDP in 2000 despite the serious recession. All the deterioration was on the revenue side, as tax collections fell off during the recession. Tax collections and other revenues net of privatization income peaked in 1994 (at 24.3% of GDP) and declined during the next five years despite various hikes in tax rates (example in the VAT from 18% to 21%), base broadening measures, enforcement initiatives and much tinkering with the tax structure. One reason is the pension reform implemented in mid 1994, which allowed for the deviation of employee contributions to privately run pension funds. The transition costs of this pension reform were on the order of 1% of GDP per annum. The fiscal implications of the reform were also quite predictable and likewise should have been offset for the sake of fiscal prudence. The other reason for the shortfall in revenues is that cost cutting pressures in the private sector became intense, especially after the Argentine economy lost international competitiveness in the late 1990s. (this happened due to the dollars appreciation and the Brazilian Reals sharp devaluation. Since the peso was pegged to the dollar, it appreciated and this lead to an increase in the price of Argentine exports. Exports to Brazil also became uncompetitive when the Real devalued. Due to this, Argentinas current account deficit worsened) Thus, tax evasion and avoidance grew out of control. Companies started to view tax payments as another cost of doing business that had to be minimized in the face of a grossly overvalued peso, and individuals sought to reduce their tax burden to maximize their disposable income as living standard started to fall. The structural changes that took place in Argentina during the 1990s meant that tax-paying jobs in the formal economy were destroyed (example in state-owned companies that were privatized) and that most new jobs were created only in the underground economy. After 1998, as the employment situation worsened, most Argentines increasingly felt that they had to choose between paying taxes and paying the rent and there is no question that more and more opted to do the latter.

There was a significant increase in non-primary government spending relative to GDP. This was due to two reasons. Firstly, the government had issued Brady type bonds that had initial coupon payments that were low but were scheduled to increase (namely, step up) during the 1990s, and then there were other government bonds that had a grace period on interest payments during which said payments were capitalized. As time passed, these had heavy budgetary implications. Secondly, the government budget moved from surplus to deficit also because of the interest payments, which rose from $2.5 billion in 1991 to $9.5 billion in 2000 or from 1.2% to 3.4% of GDP. This was due to the continued growth of the stock of public debt during the 1990s (from less than 35% of GDP prior to 1995 to 50% of GDP by 2000). Since more than 90% of the debt was in dollars, most of the interest payments had to be made in dollars. This was a significant drain on the economy.

The effect of rising interest rates, in the context of the fixed exchange rate, was damaging. The budget deficit increased uncertainty in the financial markets about the viability of the exchange-rate regime, and the uncertainty drove interest rates even higher.

Efforts to meet the deficit by cutting primary government spending even further during a period of recession made things worse: it directly cut demand and, by causing political instability and uncertainty, fed the fears of devaluation and/or default. The collapse of the economy occurred without any new borrowing by the government to finance its primary spending.

To reduce the budget deficit , on the advice of the IMF, the government implemented 13% cut in public service salaries, and reduced pension payments. Pensioners were told that there was no money to pay their pensions. As the worsening situation of Argentina raised fears that the peso would be devalued, the government moved to prevent people from trading their pesos for dollars by imposing limits on cash withdrawals from banks. This caused distrust among investors who stopped putting their money in banks, and with foreign debt mounting, Argentina was thrust into deep economic crisis.

On 19th December, 2001, the country erupted into violence as Argentineans took to the streets to protest against the worsening situation and raid supermarkets to feed their hungry families. The riots left 30 people dead and thousands injured and lead to the resignation of President Fernando de la Rua. On December 20th, everything was out of control and Argentina went into crisis. The government defaulted on $155 billion of Argentinas foreign debt, the largest debt default in history.

Public Debt

Argentina had a large amount of foreign debt. Because the exchange rate was pegged at too high a level, Argentina exported too little and imported too much. This trade imbalance made it impossible for the country to earn the foreign exchange it needed to pay the interest on its foreign debt. Instead, Argentina had to borrow to meet those interest payments, causing the debt to grow ever larger. The country's foreign debt, most of which was owed by the central and provincial governments, eventually reached 50 percent of GDP by late 2001 and included $30 billion due in 2002. Once it finally became clear that Argentina could no longer borrow to roll over those debts and pay the interest, Buenos Aires was forced to default and to devalue the peso.

The Pegged Exchange Rate Regime and The Convertibility Law

The pegged exchange rate (locked at one peso per dollar since 1991) was an important cause of the Argentine crisis. The one-to-one regime encouraged the government (and also the private sector) to take on mostly foreign-currency-denominated debt. Indeed, by late 2001, only 3% of the public debt was denominated in Argentine Pesos. This represented a huge potential liability, because when one peso was equal to one dollar, the public debt was equivalent to some 50% of GDP, but if ever one peso no longer purchased one dollar then the countrys debt ratios would instantly grow out of control. At an exchange rate of 2 pesos/US$, the mostly foreign currency denominated debt would jump to the equivalent of about 100% of GDP, and at 3 pesos/US$ it would jump further to 150% of GDP. Thus a government that collected tax revenues only in pesos, had long ago sold all of its assets that could attract dollars, and was legally prevented even from printing pesos - the autonomous central bank was authorized to issue pesos only in exchange for dollars - could not afford to have only 3% of its liabilities denominated in pesos.

A pegged exchange rate and a high foreign debt denominated in dollars ensured that if ever there was a change in the currency regime involving a devaluation, the public sector would be rendered insolvent. Although the pegged exchange rate regime virtually eliminated inflation, it also eliminated the flexibility in the monetary policy. When the current recession began to develop, the government could not expand the money supply as a means of stimulating economic activity. Worse yet, as the economy continued downward, the inflow of dollars slowed, restricting the country's money supply even further (by the one-to-one rule). And still worse, in the late 1990s, the U.S. dollar appreciated against other currencies, which meant (again, the one-to-one rule) that the peso also appreciated; the result was a further weakening in world demand for Argentine exports. Thus, due to the pegged exchange rate regime the government could not increase the money supply to fight the recession, and prevent the economy from going into a crisis.

Thus, though the fiscal policy of Argentina during the 1990s was not as prudent as it should have been, the maximum damage to Argentina was caused by the artificial one-peso-equals-one-dollar exchange rate regime. An inexplicable number of leading economists in policy making and academic roles have remained enamoured of exchange rate based stabilizations, despite mounting evidence that they work for a while but prove catastrophic later. Even in 1991, when Domingo Cavallo came up with the one-to-one Convertibility Plan for Argentina, there was ample evidence from nearby Bolivia and Peru, who were able to halt hyperinflation in its tracks without relying on a fixed exchange rate regime. If government spending or the public debt had been chosen as the means to stabilize Argentina, then today it would have been celebrating rather than lamenting its destiny.

EFFECTS OF ARGENTINE CRISIS

After the crisis on December 20th 2001, Argentina was growing poorer by the day and its political class had lost all credibility. The decline was brutal, coming after a four-year-long recession that spared some sectors. The downfall of President Fernando De La Rua, showed many signs that indicated that Argentina, once a great power, was in economic mourning.

The tragedy had struck hardest, however, among the middle class, the urban poor and the dirt farmers. Their parts of this once-proud society appeared to have collapsed.

Fall in GDP

Argentina's gross domestic product (GDP) fell by 13.5% between June 2001 and June 2002, with a record drop of 16.3% during the latter six months. This drastically affected employment and incomes and caused a dramatic rise in poverty. The United Nation's economic commission for Latin America and the Caribbean has predicted a 13.5% drop in GDP for Argentina for the year 2003. The country has a population of 35m, of whom 19m were classified poor, with earnings of less than $190 a month; 8.4m were destitute, with monthly incomes below $83.

Wages Fall, Prices Rise

Food manufacturers and grocery stores are raising prices even as earning power has taken a historic tumble. A large factor in both the prices rises and the slump in real wages is a 70 percent devaluation of the peso over the last six months. But the price of flour has soared 166 percent, canned tomatoes 118 percent -- even though both are local products that have had little real increases in production costs.

Severe hunger and malnutrition have emerged in the rural interior -- something almost never seen in a country famous for great slabs of beef and undulating fields of wheat. In search of someone to blame, Argentines have attacked the homes of local politicians and foreign banks. Many of the banks have installed steel walls and armed guards around branch offices, and replaced glass windows decorated with ads portraying happy clients from another era.

Poverty And Unemployment

Before 1999, when this country of 36 million inhabitants slipped into recession, Argentina's per capita income was $8,909 -- double Mexico's and three times that of Poland. Today, per capita income has sunk to $2,500, roughly on a par with Jamaica and Belarus.

The economy is projected to shrink by 15 percent in 2003, putting the decline at 21 percent since 1999. In the Great Depression years of 1930-33, the Argentine economy shrank by 14 percent.

What had been a snowball of poverty and unemployment has turned into an avalanche since January's default and devaluation. A record number of Argentines, more than half, live below the official poverty line. More than one in five no longer have jobs. Health

Young people have been showing visible malnutrition for two years and the situation has worsened in recent months in secondary and primary schools. Hungry children are fainting; absenteeism at school is down since primary school children do not want to skip the food offered at school, which is often their only meal of the day . Sometimes mothers appear at schools with empty plates, demanding food for sick children at home. Earlier this year this was happening only in the most impoverished province of Tucumn; now it happens nationwide, including in Buenos Aires province, where for the first time 100 schools kept their cafeterias open over the winter holidays.

The Suffering Middle Class

Argentina long had the largest middle class, proportionally, in Latin America, and one of the continent's most equitable distributions of wealth. Much of that changed over the last decade as millions of middle managers, salaried factory workers and state employees lost their jobs during the sell-off of state-run industries and the collapse of local companies flooded by cheap imports.

Most banks here are subsidiaries of major U.S. and European financial giants that arrived with promises of providing stability and safety to the local banking system. But many Argentines who did not get their money out in time -- more than 7 million, mostly middle-class depositors, faced a bitter reality: Their life savings in those institutions, despite names such as Citibank and Bank Boston, were practically wiped out. Virtually all had kept their savings in U.S. dollar-denominated accounts. But when the government devalued the peso, it gave troubled banks the right to convert those dollar deposits into pesos.

Reality of Rural Hunger

For some rural families, the crisis has gone further. It has generated something rarely seen in Argentina: hunger. In the province of Tucuman, an agricultural zone of 1.3 million people, health workers say cases of malnutrition have risen 20 percent to 30 percent over the previous year.

Wealthy Argentines

Wealthy Argentines are selling their large cars to avoid being conspicuous targets for criminals who abduct. Kidnappers strike in rich and poor neighbourhoods, and hold their victims to ransom, demanding anything from $240 to $4,800 for their release. Business is booming for firms that specialize in security systems, self-defence courses, guards, and armoured vehicles Loss Of Faith In Political Leadership

Left bankrupt by their government, their bankers and the International Monetary Fund, Argentines have lost faith in their political leadership. Those from Buenos Aires province resorted to marches, blockades and demonstrations. Spurred on by the piqueteros, a large group of jobless and hungry people set up blockades in the south of the capital on 26 June 2002. The police arrested 160 people, two piqueteros were killed and 90 people were injured. Since 19 December2002, when the government declared a state of siege, 35 Argentines have been killed in street demonstrations. So far the only response to these anti-government protests has been repression.

Social Inequality

In terms of social inequality worldwide, Argentina ranks fifteenth from the bottom. Whereas in the 1970s the top 20 percent earned roughly 8 times the income of the bottom 20 percent, the multiple is now 14 times. The bulk of the change took place during the 1990s. Currently Argentinas income inequality is more extreme than in Mexico, Costa Rica, Malaysia, Spain and most of Eastern Europe. While in Spain the top 20 percent earn roughly the same as in Argentina, the bottom 20 percent earn four times as much. Until the 1980s Argentina had one of the most equitable distributions of income in Latin America.

Breakdown Of The Banking Sector

The government had halted all banking and foreign exchange transactions, to stem the growing tide of money being withdrawn from the crippled banking system. The move sparked more riots among Argentineans already frustrated at the growing unemployment and poverty. The government imposed a control on the interest rate paid on deposits accelerating the run on the banking system.

Following the imposition of controls on the deposit interest rate, the government opted to freeze deposits in the banking system, and impose tight controls on cash withdrawals, a system known as the "corralito". Despite these restrictions, however, funds were allowed to be transferred across banks at the controlled interest rate, as well as from time deposits into transactional accounts.

Banks were forced to convert dollar-denominated loans into pesos at the pre-devaluation 1 to 1 exchange rate. At the same time, dollar-denominated time deposits were converted into pesos as the rate of 1.4 pesos per dollar. This action alone wiped out the entire capital of the banking system, and introduced a significant foreign exchange exposure into banks balance sheets as foreign obligations and lines of credit remained denominated in their original currency.

Devaluation Of Currency

The authorities in Argentina introduced a dual exchange rate: a fixed exchange rate of 1.4 peso per dollar for official transaction, mainly for exports and imports and debt service and floating exchange rate for other transactions. The dual exchange rate was abandoned and the authorities allowed the currency to float. By early June 2002, it fell below 3.6 peso per dollar loosing more than two third of its value.

Goods not in high demand, such as new clothing, have not gone up significantly in price, but staples that families need for daily subsistence have doubled or tripled. The last time inflation hit Argentina -- in the late 1980s, when it rose to a high of 5,000 percent -- the unemployment rate was half the current 21.5 percent and most salaries were indexed to inflation. Today, there are no such safety nets.

Contagion Effect

As most economies and financial markets in Latin America saw downturns owing to the economic crisis in Argentina, more and more local and international investors had lost their confidence in the region, which was one of the main reasons for the financial turmoil throughout the region. Investors were worried that some unhealthy economies in the area, troubled by the crisis in Argentina, would also go down. Therefore, in order to safeguard their own interests, investors had tried all means to recover their investments and transfer the capital abroad, further aggravating the already grave economic situation in the area.

1) Uruguay

The banking system of Uruguay had been greatly shaken by the economic predicament of neighboring Argentina. Hit by the most severe financial crisis in the past seven decades, some banks in Uruguay were on the brink of bankruptcy due to massive withdrawals by depositors who took as much as possible their savings from automatic teller machines.

The Uruguayan government had to suspend the banking activities after drastic fall of capital in many banks, with the aim of curbing the flow of capital.

2) BrazilUnder the strain of the crisis in Argentina, Brazil, the region's largest economy, also got mired in financial turmoil. The real, Brazils currency, lost its value against the US dollar.

The government debt, about half of it in dollar liabilities, had risen to ratio to GDP that's nearly 20% higher than Argentina's on the eve of its default. The Brazilian government had been relying on IMF-approved medicine--raising interest rates and cutting primary spending--but has nevertheless fallen into a debt trap dynamic comparable to Argentina's.

Exchange rate depreciation and rising risk premiums keep increasing both the government's and the corporate sector's dollar-denominated debt loads, while higher interest rates for real-denominated bonds add to their domestic currency payment burdens. High interest rates and a credit crunch are depressing industrial output and real wages, with unemployment approaching double digits.

Besides Uruguay and Brazil, other countries in the region such as Bolivia and Chile have also been affected by Argentina's economic crisis. Even some countries with better economies faced the same problem. In Chile, a large amount of foreign capital was taken out from the security market causing a 38 percent fall in the trade volume. At the same time, the influx of capital into Latin America had dropped sharply.

The developments had proved that investors had lost confidence in the region after they saw Uruguay mired in a financial meltdown following the collapse of the Argentine financial markets.ARGENTINAS CURRENCY CRISIS:- LESSONS FOR DEVELOPING NATIONS

The popularity of fixed exchange rate arrangements has risen over recent years, especially among observers of the European Monetary Union (EMU). However, the collapse of the Argentinean currency board regime, previously perceived as a strong and credible arrangement, has stalled the momentum for the adoption of formal currency

The Argentinean board pursued policies associated with standard central banking regimes, thus classifying it as a fixed exchange rate regime with a hard dollar peg. In addition, one clear difficulty faced by Argentinas board was overvaluation.

The collapse of the Argentinean currency board has had a devastating impact on the country's "real economy," serving as a reminder to advocates of such schemes elsewhere. It observes, in addition, that even "good pegs" are likely to be less than perfectly credible. Thus, while there are good arguments favoring pegging exchange rates, developing nations must consider this option carefully.

Lesson 1:- The Peg's The Thing

One lesson from Argentinas failed currency board is that an improper exchange rate peg is doomed to failure, no matter how rigorously one attempts to impose credibility. This is an important lesson for the Asian nations because a basket peg is likely to serve them best as their trade patterns are diversified across the United States, Europe and Japan.

Lesson 2: - Exchange Rate Arrangements Are No Cure For Improper Macro Policies Despite the relatively strong set of rules governing the conduct of Argentinas currency board, the regime collapsed quickly when domestic and foreign investors determined that the policies pursued by the Argentine government were unsustainable. Argentinas public debts at the time of its devaluation exceeded $155 billion.

One important implication for prospective Asian currency arrangements is that the degree of disparity in development levels across these countries is likely to prove difficult. The Asian nations as a group, particularly if Japan is included, represent a more heterogeneous set of nations than the EMU members. As such, the predilection of these nations to fall into the pursuit of poor macroeconomic policies is likely to be higher.

Lesson 3: - Rigidity Vs. Credibility

Another lesson from the Argentine experience is the relative ease with which the currency board regime collapsed once the government fiscal situation was perceived as unsustainable. Much of the literature on the relative desirability of pegged exchange rate regimes discusses a tradeoff between rigidity, which can hinder a nation's ability to adjust to external shocks, and the credibility of the regime itself. It is generally understood that a nation can buy credibility (at the cost of reduced flexibility) by adopting formal rules designed to increase the cost of abandoning the announced peg.

In the case of Argentina, this cost was clearly very high. In response to the relatively rigid mandate to the currency board, contracts were written in both dollars and pesos interchangeably. As a result, the terms of the devaluation will have crucial distributional implications and result in numerous bankruptcies.

Nevertheless, one of the main lessons of the collapse of the Argentinean regime was the ease with which the rules of its currency board were circumvented once the government lost its interest in maintaining the currency board regime. The introduction of dual exchange rate system and the freezing of bank accounts were readily available policies despite currency board rules to the contrary.

Lesson 4: - Dollarization?

Under dollarization, Argentina would have experienced the same exchange rate appreciation and therefore the same loss of competitiveness vis--vis its primary trading partners. It follows that the government would have likely ended up in a similar unsustainable fiscal situation.

Lesson 5: - Vindication of floating?

Many argue that the ultimate lesson from the Argentine currency crisis is that no fixed exchange rate regime, even one as institutionally strong as Argentinas, is completely sound. As a result, it will sooner or later lose its credibility. Moreover, since financial contracts will have been written in the domestic currency, this loss of credibility will have real effects and will likely precipitate a financial crisis, or at least a severe disruption to the real side of the economy. As such, the main lesson from the Argentine currency crisis is that floating is a superior policy over the long run, despite the fact that it may exhibit more volatility in limited episodes.

However, there are important difficulties with floating exchange rate regimes for developing countries. First, because many of these countries are relatively open, external shocks can do more damage to them than most developed nations. Second, because developing countries lack the ability to issue debt in their own currency, depreciations immediately correspond to increases in indebtedness in domestic currency. As a result, floating regimes may exacerbate the potential for financial crises stemming from widespread bankruptcies.

Finally, floating regimes place responsibility for maintaining price stability back squarely in the hands of the national central bank. Because developing country institutions are often less established, it may be difficult for a developing nation central bank to resist, for example, monetizing the deficit of its treasury. As a result, price stability may not be attainable when left in the hands of the national government. Instead, nations may look to exchange rate pegs as mechanisms for "institutions substitution by which they can import developed nation monetary policies that are unattainable given their own level of institutional development.

The collapse of Argentinas currency board has had a devastating impact on that nation. It serves as reminder to those advocating such arrangements in Asia and elsewhere of a number of lessons. Perhaps the most important of these lessons are that an exchange rate regime is only as good as its peg. No set of rules surrounding the regime, regardless of their strength, can force a nation to remain attached to a peg that has outlived its usefulness. As a result, even "good" pegs are likely to be less than perfectly credible. Despite its drawbacks, the alternative of pure floating therefore must be seriously considered.

Other Lessons For Developing Nations

The developing countries should adopt strategies that would support a democratic, egalitarian form of economic development. Such strategies would promote structural adjustment in low-income countries. Firstly, a democratic development strategy could begin with a focus on the expansion of social programs, a greater investment in schooling, health care, and other public services that would establish a social foundation for long-run economic expansion.

Secondly, a democratic strategy should not ignore macroeconomic stability, but instead of seeking that stability in government cutbacks, it should pursue expanding the government revenues (raising taxes) as a means to provide fiscal balance.

Thirdly, a democratic strategy should not ignore the private sector, but it should recognize the problems of allowing the private sector to be guided simply by private profits in an unregulated market. It should push the private sector towards high-technology activities instead of production based on low wages, and it should seek to provide support for local farmers to maintain their livelihoods and community stability.

Fourthly, if people in low-income countries are to move in an alternative direction, they must find ways to deal with the oppressive burden of foreign debt. Not only is the debt itself a problem, creating a growing drain on countries' resources, but also the need to continually seek new debt in order to repay old debt forces governments to accept the IMF conditions that perpetuate the problem.

Fifthly, those forces that want change can take a lesson from the high-income countries. As the governments of high-income countries work together in pursuing their economic relations with the low-income countries, low-income debtor countries have a common set of interests that could provide the foundation for common action. Working as a bloc, they would have a greater chance of gaining better terms, greater leeway in the conditions that come with foreign finance, and the freedom to pursue the meaningful structural adjustment of a democratic strategy. Ultimately, the power of such a bloc would depend on the willingness of member countries to repudiate their foreign debts. Such repudiation would have legitimacy because of the coercive practices that have given rise to this debt, and repudiation would have wide popular support. The power that the high-income countries have in the threat to cut off new loans would be matched by the power that low-income countries would have from their threat to cut off the flow of repayments.

IMFS POLICIES AND THEIR ROLE IN THE

ARGENTINE CRISIS

Many developing nations are in debt and poverty partly due to the policies of institutions such as the International Monetary Fund (IMF) and the World Bank. Their programs have been heavily criticized for many years for resulting in an increased poverty and dependency of the developing countries upon the richer nations. This is despite the IMF and World Bank's claim that they will reduce poverty.

The IMF imposes Structural Adjustment Policies (SAPs) to ensure debt repayment in such a way that social spending and development must be cut back and debt repayment must be made the priority. In effect, the IMF and World Bank demand that these poor nations lower the standard of living of their people.

In theory, the IMF supports democratic institutions in the nations it assists. In practice, it undermines the democratic process by imposing policies. Officially, of course, the IMF doesn't "impose" anything. It "negotiates" the conditions for receiving aid. But all the power in the negotiations is on one side - the IMF's - and the fund rarely allows sufficient time for broad consensus-building or even widespread consultations with either parliaments or civil society. Sometimes the IMF dispenses with the pretense of openness altogether and negotiates secret covenants.

The IMF encourages the aggressive opening up of countries for trade, but this is coupled with too much privatization and too much deregulation with fewer safety nets able to be put in place by the governments (which would be there for the benefit of the people of that nation). That some of the poor nations may not be as aggressive as the IMF would like, in privatization and other conditionalities, is also one of the reasons in the continual delay of debt relief. This inevitably means that the poor suffer, while the rich get richer.According to the IMF, its structural adjustment policies are tailored to the needs of the respective nations. However, in practice, after each nation's economy is analyzed, the World Bank "hands every minister the same programme". The finance minister is handed a "restructuring agreement" pre-drafted for "voluntary" signature".

The IMF has prescribed the same medicine for troubled third world economies for over two decades:

Monetary Austerity : Tighten up the money supply to increase internal interest rates to whatever heights needed to stabilize the value of the local currency.

Fiscal Austerity : Increase tax collections and reduce government spending dramatically.

Privatization : Sell off public enterprises to the private sector.

Financial Liberalization : Remove restrictions on the inflow and outflow of international capital as well as restrictions on what foreign businesses and banks are allowed to buy, own, and operate. However, disastrous capital flows can ruin economies when the outflow of capital happens. In such a condition, to seduce speculators into returning a nation's own capital funds, the IMF demands these nations raise interest rates to 30%, 50% and 80%."

Free Trade : Removing barriers to trade. Through the IMF, Europeans and Americans today are kicking down barriers to sales in Asia, Latin American and Africa while barricading their own markets against the Third World's agriculture. PRIVATEThe U.S. uses its dominant role in the global economy and in the International Financial Institutions to impose SAPs on developing countries and open up their markets to competition from U.S. companies.

Only when governments sign this "structural adjustment agreement" does the IMF agree to:-

Lend enough itself to prevent default on international loans that are about to come due and otherwise would be unpayable.

Arrange a restructuring of the country's debt among private international lenders that includes a pledge of new loans.

Thus, there are two problems with the IMF/World Bank plans. Firstly, the plans are devised in "secrecy and driven by an absolutist ideology", that "undermine democracy". The same Structural Adjustment Policies are imposed upon all the third world countries without any consultation with the respective countrys finance minister and without taking into the account the countrys problems. And, second, SAPs are based on a narrow economic model that perpetuates poverty, inequality, and environmental degradation. The IMF structural 'assistance' led to Africa's income dropping by 23%.

Failure Of Argentina Under The Direction Of The IMF

Argentina is an example of the failure of IMF policies to establish the bases for long-term economic growth in low-income countries. Numerous other countries such as - much of sub-Saharan Africa, Mexico, and several other countries in Latin America, Thailand, and other parts of East Asia, and Turkey, demonstrate the failure of IMF policies.

IMF policies do often succeed in curtailing inflation; sharp cuts in government spending and restrictions of the money supply will usually yield reduced price increases. Also, IMF programs can provide large influxes of foreign loans - from the Fund itself and the World Bank, from the U.S. government and the governments of other high-income countries, and, once the approval of the IMF has been attained, from internationally operating banks. But nowhere has the IMF policy package led to stable, sustained economic expansion. Also, as in Argentina, it often generates growing inequality. The policies that the Argentine government has followed in recent years, have delivered substantial benefits to local elites. Those policies have allowed them to strengthen their positions in their own economies and secure their roles as junior partners with U.S.-based and other internationally operating firms. The IMF officially laments the fact that these policies have a severe negative impact on low-income groups (because they both generate high rates of unemployment and eviscerate social programs).

Argentinas economic policies during the 1990s were developed under the direction of the IMF. From the late 1980s onward, a series of loans gave IMF the leverage to guide Argentine policymakers, and they increasingly adopted the Fund's conservative economic agenda. Under the prescription of IMF, the Argentine government privatized state enterprises, liberalized foreign trade and investment, and tightened government fiscal and monetary policy. As the country entered into the lasting downturn of the current period, the IMF continued, unwavering, in its support. The IMF provided Argentina with "small" loans, such as the $3 billion made available in early 1998, when the country's economic difficulties began to appear. As the Argentine crisis deepened, the IMF increased its support, supplying a loan of $13.7 billion and arranging $26 billion more from other sources at the end of 2000. As things worsened still further in 2001, the IMF pledged another $8 billion.

The IMF coupled its loan with the condition that the Argentine government maintains its severe monetary policy and continues to tighten its fiscal policy. According to the IMF, deficit reducti