Lessons from Argentina and Brazil

Abstract

What have we learned from the sovereign debt crises in Argentina and Brazil, and what can the United States and the International Monetary Fund do, if anything, to repair the damage, and to avoid similar problems elsewhere? Policy Lessons I would emphasize five policy lessons: * First, in emerging market countries (EMs), monetary policy--or, what amounts to the same thing, exchange rate policy--is often constrained by the need to finance government spending, which underlies the eventual collapse of the exchange rate. * Second, even well-regulated banking systems are highly vulnerable to the risks of fiscal imbalance. * Third, the IMF needs to stop intervening to prevent sovereign defaults when they are necessary. * Fourth, EM debt capacity cannot be captured adequately by the ratio of sovereign debt to GDP. Export growth, and hence the need to follow through on trade reform, is just as important a fundamental determinant of debt repayment as discipline over government spending. * Fifth, contagion among sovereign debtors is selective. Fiscal Imbalance and Monetary Collapse Unlike the United States or the European Union, where an independent central bank determines monetary policy, in most EMs, the policies of central banks are often determined by arithmetic--the arithmetic that requires debts to be monetized, because that is the only way that they can be repaid. When government debt grows too fast, the government is unable to repay debt service with future taxes, and the government forces debt monetization to occur. That problem is at the core of every exchange rate collapse of the recent and distant past. Typically, exchange rate depreciation precedes debt monetization because the markets anticipate the inevitable monetization that will occur. Sometimes, fiscal imbalance does not show itself in government accounts. That was true of Brazil in the 1970s, which used off-balance sheet spending to disguise its fiscal imbalance (Brazil often ran an official fiscal surplus 'alongside high inflation in the 1960s and 1970s). Anticipated banking bailouts (which have been costing upward of 20 percent of GDP in the twin-crises countries of the past two decades) are the most frequent source of fiscal imbalance in recent crises. But Brazil and Argentina reached their current fiscal difficulties and weak currencies largely in the old-fashioned way--by failing to rein in measured government spending programs. In Argentina, government spending grew substantially in the final years of the Menem administration, despite the crescendo of criticism of the debt run-up and the visible need to reform the infamous coparticipation system that hampered fiscal reform. And that debt was almost entirely denominated in hard currency, despite the lack of adequate growth in exports. The fiscal side of the liberalization cycle in these and other countries seems to follow a familiar path: liberalization and privatization result in new revenues for government and ebullient expectations about future growth in GDP, government revenues, and exports; market confidence in reform lowers the cost of accessing foreign capital for both the private sector and the public sector; EM governments cannot resist running deficits, but the fiscal imbalance grows and eventually catches up with them. Initially, the response to this fact is denial, with assistance from multilateral lenders (and not only at the IMF--Ricardo Hausman was described by Walter Molano, a prominent market analyst of Latin American debt markets, as the lead salesman for Argentine government debt in the mid-to-late 1990s, when Hausman was chief economist at the Inter-American Development Bank (IDB). Then, the IMF programs grow in size, along with the anti-growth tax hikes that the IMF insists upon in return for providing stability. At this point, debt yields rise and market analysts become largely political forecasters: Will this debt swap provide a short-run profit for me? …