Public sector "debt distress" in Argentina, 1988-89

Policy Research WORKING PAPERS Country Operations Country Department IV Latin America and the Caribbean Region The World Bank May 1992 WPS 902 Public Sector "Debt Distress" in Argentina, 1988-89 Paul Beckerman Efforts to control Argentina's inflation in 1988 and 1989 failed, generating episodes of hyperinflation, largely because the stabi- lization programs drove the public sector into debt "distress." Policy Research Working Papers disseminate the findings of work in progress and encourage the exchange of ideas among Bark staff and all others interesed in developmentissues.Thesepapers, distributed by theResearch Advisory Staff, carry the names oftheauthors, reflect only theirviews, and should beused and cited accordingly.The findings, intepretations, and conclusions awthe authors'own. Theyshould not be auributed to the Wotld Bank. its Board of Directors, its management, or any of its member countries.  Policy Research Country Operations WPS 902 Copies of this paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Alexandra Blackhurst, room 16-018, extension 37897 (May 1992, 53 pages). An earlier version of this paper -a product of the Country Operations Division, Country Department IV, Latin America and the Caribbean Region- was published as the Region's Internal Discussion Paper 66, "Public Sector 'Debt Distress' in Argentina's Recent Stabilization Efforts." Under the August 1988 "Primavera" Plan and The Central Bank played a focal role in these the July 1989 "Bunge y Bom" Plan stabilization processes. It issued interest-bearing debt in the programs, the Argentine authorities sought to forms of remunerated bank reserves, "inacces- anchor the price level through an appreciated sible deposits," and Central Bank bills, to absorb real exchange rate, which they sustained through money. The interest bill on these liabilities policies that maintained high domestic interest generated mounting "quasi-fiscal" borrowing rates. The public sector's domestic debt was requirements, which the Central Bank financed substantial, however, and the high interest rates through additional debt issues. This debt was drove the public sector's interest bill consider- held mainly by commercial banks who financed ably above its non-inte""st surplus. The public themselves through high-yielding short-term sector could therefore cover its interest bill only deposits. Hyperinflationary pressure developed by taking on additional debt. Because the interest when depositors, perceiving that the Central bill was so large, domestic debt grew rapidly. Bank"s debt accumulation was becoming Hyperinflation resulted when the outstanding excessive, withdrew and moved rapidly into debt became larger than domestic financial foreign exchange, engendering heavy devalua- markets could be persuaded to hold. tion pressure. ThePolicy Research Working Paper Series disseminates the fimdings of work under way in the Bank. An objective of the series is to get these findings out quickly, even if presentations are less than fully polished. The findings, interpretations, and conclusions in these papers do not necessarily represent official Bank policy. Produced by the Policy Research Dissemination Center  Public Sector "Debt Distress" in Argentina, 1988-89 by Paul Beckerman* 1 Introduction 1 2. Argentine inflation in the 1970s and 1980s 5 3. The role of Argentina's Central Bank 11 4. The Primavera Plan 17 5. The BB Plan 19 6. Common characteristics of the Primavera and BB Plans 22 7. Stabilization measures of December 1989 and January 1990 24 8. Concluding observations 25 9. Appendix: Some technical issues regarding Central Bank losses and borrowing requirements 27 References 35 Tables 37 Graphs 48 * World Bank. The author gratefully acknowledges comments by Werner Baer, Suman Bery, Donald Coes, Roque Fernandez, Dale Gray, James Hanson, Ricardo Lago, Millard Long, William Mayville, Paul Meo, Richard Newfarmer, Martha Preece, Peter Scherer, Eduardo Somensatto, William Tyler, and John Welch on earlier drafts. The writer is particularly indebted to Ricardo Lago for discussions of the game-theory approach briefly discussed in section 6.  1. Introduction. 1.1. On July 9, 1989, the day after Carlos Menem succeeded Raul Alfonsin as Argentina's Presiden>, thle new authorities announced a program intended to stop the hyperinflation that had run since February 1989, when the previous stabilization program, the August 1988 "Primavera Plan," collapsed. The Menem Government was assuming office five months before the constitutional date, because the outgoing Government of Raul Alfonsin had plainly lost the capacity to manage the economy. Although elected as a Peronist on a populist pl.ttform, the new President had drawn his economy team from the executive ranks of the Argentine multina- tional firm Bunge y Born. The program reflected the firm's macroeconomic analysis, and the Buenos Aires press therefore called it the :'BB Plan." Its initial measures were a devalua- tion of the official exchange rate well beyond what was then the parallel exchange rate, from 303 to 655 aulales per dollar; massive increases in such puilic-service prices as fuel charges, electricity rates, transport fares, and telephone rates; and an agreement by the largest industrial enterprises to freeze output prices as long as the exchange rate and public-service prices remained unchanged. The devaluation was intended to persuade exporters to surrender foreign exchange, and -- no less impor- tant -- pay export taxes, toward the overall objective of reduc- ing the public sector's overall deficit. 1.2. The Government's strategy was then to run tight mone- tary policy to hold the parallel and official exchange rates equal and fixed, thus to buy time by establishing a kind of ar- tificial stability and so fostering a degree of financial market confidence. The authorities submitted three pieces of legisla- tion to the Congress. (i) The Economic Emergency Law would em- power the authorities to suspend or cut subsidies and expendi- ture programs. (ii) The Public Sector Reform Law would provide the legal basis for reorganizing, closing, and privatizing public enterprises -- notably the national telecommunications monopoly (ENTel), the railways, and the national airline. Fin- ally, (iii) a new tax reform was intended to close important tax loopho'es and extend the base of the value-added tax. The Con- gress passed the first two of these measures by September, and completed the tax-reform txw by December. 1.3. Like other recent heterodox stabilization plans in Ar- gentina and Brazil, the BB Plan worked at first. Inflation eased to single-digit monthly rates. For about four months the parallel and fixed official exchange rates remained unchanged and equal. The Central Bank's depleted international reserves recovered rapidly. Interest rates on seven- and fourteen-day commercial-bank time deposits -- to which the rates on most of the public-sector debt were linked -- fell gradually from 15 per cent per month at the outset of the program to about 4 per cent in early October. In September 1989, domestic macroeconomic  -2- conditions were sufficiently favorable to enable the Government to negotiate a stand-by program with the International Monetary Fund: the IMF wade an initial US$233-million di3bursement in No- vember following its Board's approval. 1.4. In mid-October, however, the parallel exchange-rate premium began to drift upward. Expectations of further devalua- tion induced bank-deposit withdrawals. Interest rates rebounded as banks struggled to retain time deposits. Financial-market turbulence deepened through November. The Central Bank sold foreign exchange, but could not reverse the gathering tide against the exchange rate. By early December, with the parallel premium ranging between 35 and 50 per cent and monthly interest rates back up to 15 per cent, the program had clearly become un- tenable. On December 10 the authorities admitted defeat: they devalued the official rate from AS655 to A$1010 per dollar, raised public-service prices an average of 65 per cent, raised export taxes, and raised public-sector wages. When financial markets reopened after a day's holiday, however, interest rates remained high, and the same percentage parallel exchange-rate gap reemerged. The Bunge y Born economic team accordingly re- signed. 1.5. A new economic team took office on December 18. It im- mediately floated the exchange rate, removed all price controls, and rescinded the export-tax increases. These measures failed again to secure stability, however. Interest rates continued to rise and the austral continued to sink. The price level roughly doubled over December; over New Year's weekend the austral de- preciated almost fifty per cent against the U.S. dollar. 1.6. On New Year's Day, 1990 Argentina's Economy Minister announced dramatic measures to halt the developing hyperinfla- tion. The principal action was the forced conversion of commer- cial-bank time deposits into ten-year dollar-denominated Nation- al Treasury "External Bonds" ("BONEX"). Approximately US$500 of each deposit account were exempted from conversion and were to be made available in cash. Because the BONEX traded in domestic financial markets at a heavy discount, this "BONEX Plan" consti- tuted A substantial confiscation of private asset holdings. Compulsory and voluntary holdings of Central Bank and National Treasury obligations, yielding interest at rates closely linked to the deposit rates, made up an unusually large proportion of the commercial banks' assets. The Treasury purchased these ob- ligations with BONEX, and the commercial banks then used the BONEX to make the conversion. The point of the measure was not merely to erase liquidity, but, more important, to end the mas- sive public-sector borrowing requirement deriving from the in- terest on the Central Bank and Treasury obligations to the bank- ing system. The conversion was the authorities' response to their perception that the public sector had slipped into acute "debt distress."  -3- 1.7. The reasons why the BB Plan failed -- and indeed why Argentine stabilization efforts foundered during the 1980s -- remain highly controversial. Observers attribute varying c- grees of importance to persisting non-financial public sector deficits, to wage pressure, to Central B?vnk policies, to devalu- ation and the consequent external trade surpluses, and to sudden crises of confidence in the markets where interest rates and ex- change rates are determined. These factors all contributed to reviving inflationary pressure during the latter part of 1989. Nevertheless, to understand why the BB Plan collapsed, it is more helpful to consider them as events linked in a dynamic in- flationary process, rather than as independent contributing fac- tors. This essay argues that the dynamic process was inherent in the framework of the BB Plan, and that it was also inherent in the Alfonsin Government's August 1988 "Primavera (Spring) Plan." 1.8. The essential argument is as follows. Like the Prima- vera Plan -- and like other recent heterodox stabilization pro- grams, such as Argentina's June 1985 Austral Plan, Brazil's June 1987 Bresser Plan, and Brazil's January 1989 Summer Plan ("Plano do Verao") -- the BB Plan began with a substantial, pre- sumably corrective, devaluation. The idea was then to use the fixed exchange rate temporarily as a price-lovel "anchor," to set a context of price stabi.lty within which to carry out pro- found public-sector reforms and so set a basis for lasting price stability. In the short term, exchange-rate stability was to ensure price stability by (i) "anchoring" prime cost, not only by setting the price of importable inputs but by setting a ref- erent for wages and financial rates of return; (ii) reducing competitive pressure on tradeables prices generally; and (iii) reducing devaluation expectations, thereby strengthening people's willingness to hold assets denominated in australes rather than U.S. dollars. 1.9. The problem with this approach was that, in combina- tion, (i) the public sector's continuing credit demand, (ii) persisting exchange-rate uncertainty, and (iii) financial markets' perception of Argentina as ricky implied that domestic interest rates would have to remain exorbitantly high to sustain the fixed exchange rate. High interest rates placed economic policy in a no-win situation, however. Even after the Febru- ary-July 1989 hyperinflation, the domestic debt stock of the combined public sector -- essentially, the Treasury and the Cen- tral Bank -- remained substantial. High interest rates on a large debt stock implied a high public sector interest bill: the debt was almost entirely at floating interest rates with terms of one to two weeks. 1.10. Moreover, to keep interest rates high, the monetary au- thority itself had to place interest-bearing debt in domestic financial markets -- that is, to sterilize money created through (i) purchase of the trade-surplus foreign-exchange proceeds at the. (devalued) exchange rate and (ii) the monetary authority's  -4- financing of its own interest payments. The interest bill sub- stantially exceeded the public sector's primary (nzn-interest) surplus. This meant the public sector could pay the interest only by capitalizing it into its domestic obligations -- that is, into the austral-denominated assets. The austral-denominat- ed asset stock grew rapidly through such interest capitaliza- tion. As austral-denominated assets became increasingly abun- dant relative to dollar-denominated assets, the austral came under pressure to depreciate in the parallel market. In sum, the public sector could not afford the interest rates required to maintain a high austral value. It tried, nevertheless, to pay them by borrowing; but this failed once private-sector port- folios became saturated with ustral-denominated debt. 1.11. The only way to forestall the growth of public debt would have been for the public sector actually to pay the inter- est on its debt in cash rather than by borrowing through capi- talization. This would have required the public sector either (i) to issue money or (ii) to run a non-interest cash surplus sufficient to cover the interest bill. The incoming authorities understood the problem in these terms. The initial public-ser- vice price increases were intended to increase the non-interest budget surplus. Part of the point of the price-freeze agree- ment, and the resulting decline in the inflation rate, was to produce a favorable Olivera-Ta-zi effect, raising tax receipts as a proportion of GDP. Indeed, aC the sharp devaluation en- couraged exporters to surrender export proceeds, it not only helped rebuild international reserves but also restored the export-tax base. These reasures reduced the public sector's non-interest deficit, and with several further measures, the Treasury secured a non-interest surplus by September 1989. The surplus remained insufficient, however, to cover the interest bill, particularly after interest rates rebounded in October. By that point the authorities were in a losing race, struggling to increase the non-interest surplus to overtake the surging in- terevt bill. Once the financial markets concluded that the public sector was in distress, the exchange rate surged, and the program failed. 1.12. The two following sections describe the historical and institutional background of the 1989 hyperinflation episodes. Section 2 summarizes the reasons why inflationary pressure mounted through the 1980s despite stabilization efforts, and Section 3 focuses on the unusual intermediation role that the Central Bank of the Argentine Republic (BCRA) had come to play in the macroeconomy. Section 4 reviews the August 1988 Prima- vera Plan and macroeconomic events in late 1988 and early 1989. Section 5 describes the BB Plan and macroeconomic events between July 9 and December 28 in somewhat more detail. Section 6 briefly discusses some of the similarities of the Primavera and BB Plans. Section 7 briefly discusses the measures taken in the early part of 1990, including the BONEX conversion. Section 8 offers some concluding observations.  -5- 2. argentina infiation in the 1970s and 1980s. 2.1. The macroeconomic mechanisms that powered the 1989 hyperinflation episodes developed with the chronic inflation that has plagued Argentina for decades. Some of these mecha- nisms -- notably, dollarization and the various money-creation mechanisms described in the section following -- were means that public and private institutions developed to cope with and defend themselves from inflation. In addition, chronic infla- tion, with the concomitant price-level uncertainty and price-system disarray, debilitated the real economy. From 1980 through 1989, real GDP fell at an annual average rate of 0.9 per cent; annual industrial output fell at an annual average rate of 1.5 per cent (although annual industrial growth rates varied sharply). Real per-capita GDP fell at an average annual rate of 2.4 per cent and overall per-capita real consu;aption diminished at an average annual rate of 2.2 per cent. Cap.tal formation followed a clear downward trend as a proportion of real GDP, from 24.6 per cent in 1980 to 13 per cent in 1988 and 9.4 per cent in 1989. Inadequate capital formation has contributed to declining productivity, inevitably affecting Argentina's inter- national competitiveness. 2.2. Argentina had a brush with hyperinflation in the mid-1970s: consumer prices quintupled between March 1975 and March 1976 (see Table 5), partly as a result of a massive deval- uation in August 1975. The armed forces took power from a weak- ening Peronist regime in March 1976. Through the remainder of the 1970s, the military governments allowed external debt to grow. Both the private &nd public sectors were able to secure credit from international financial markets at what were then low real interest rates. Since the military regime intended to promote economic liberalization and private-sector growth, it had no qualms about permitting the private sector to borrow overseas. 2.3. The public-sector borrowing requirement remained high because the authorities found it easier to borrow than to raise taxes or open the political conflicts a thorough public-sector reform would have entailed. The armed forces, who were engaged in a violent struggle against their political opposition, proved unwilling or unable to design nor carry out profound economic reforms. Their economic policy consisted of simple liberal- ization of domestic and external financial activitiy. Th2y made few efforts to improve public-sector efficiency. Their lais I 4-faize approach to economic policy included fairly permissive financial-sector supervision. The 1977 Financial Entities Law allowed barks full freedom to set interest rates, although it reinstitutsd a system of Cer.tral Bank deposit insurance. A de- liberate policy of maintaining a high real effective exchange rate in the late 1970s (see Table 6) -- the pre-announced "tabjjit" (schedule) -- set an incentive for a substantial re- source transfer: in 1979, 1980 and 1981 non-factor imports less  -6 exports were 0.5, 6.9 and 4.8 per cent of GDP. By this means the build-up of private and public external debt was transferred as real goods and services into the economy: from 1978 to 1981, disbursements less repayments were, respectively, US$1.4, US$2.2, US$2.8 and TS$6.4 billion. This permitted capital for- mation rates of 22, 22.8, and 20.1 percent in 1979, 1980 and 1981. 2.4. Heavy external borrowing left the economy vulnerable when international credit markets tightened and interest rates surged in the early 1980s. As the interest bill on term debt soared from US$1.3 billion in 1980 to US$2 billion in 1981 and US$2.4 billion in 1982, and Argentina lost access to "voluntary" external financing, the authorities devalued heavily to increase the trade surplus and so effect the negative resource transfer, which reached 3.3, 4.8, 4, and 7.6 per cent of GDP in the years 1982-1985. Devaluation also increased the domestic-currency equivalent of the public and private sectors' external interest bill, however. Devaluation also gave a powerful impetus to in- flation. Precisely because of the higher external interest bill, devaluation worsened the public-sector deficit, and worked against the authorities' attempts to offset the inflationary ef- fects of the devaluation with better control of public finances. Although the external accounts surpluses rose dramatically, this did not translate into improvement of the public sector ac- counts, since Argentina's public sector (like Brazil, unlike Chile or Mexico) had no significant source of foreign exchange earnings. As a result, the public sector's demand for external and domestic financing continued to grow. 2.5. These problems were intensified by a banking-sector crisis brought on by high interest rates, excessive overseas borrowing, rapid lending growth and inadequate bank supervision. (See Balino 1987.) The crisis began in March 1980 with the failure of a large, overextended bank, and continued over the next two years with the failure of 70 other private financial institutions. This crisis also had inflationary consequences. Judicial and administrative delays stretched the liquidation processes over years; since the monetary authority guaranteed bank deposits and could not rapidly liquidate the banks, it had to create money to pay depositors. The macroeconomy slipped out of control through 1982 in a spiral of devaluation, inflation, mounting external debt, and corporate debt distress. Capital flight, encouraged by expectations of devaluation, high world interest rates, and diminished domestic prospects, became a sig- nificant problem in the early 1980s. The conflict with Great Britain that began in April 1982, which forced a sharp increase in public expenditure, and the eruption of the international debt crisis in August 1982 aggravated the crisis. 2.6. During 1982 the BCRA effectively assumed the private sector's external debt service by agreeing to "insure" against further devaluation. At the same time the authorities addressed the growing domestic corporate-distress problem :'y requiring  -7- commercial banks to reschedule outstanding debt for terms of 60 months at a monthly interest rate of 4 per cent, well below the expected inflation rate. To forestall coum'ercial-bank decapitalization the authorities imposed controls on deposit rates for the first time since 1977. These measures, together with further doses of devaluation and inflation, diluted the debt stocks and relieved the private sector's distress problem, but at the cost of diminishing the financial system. 2.7. After the defeat in the conflict, a transitional mili- tary regime took power in mid-1982 to prepare elections. In De- cember 1983 Raul Alfonsin took office at the head of an elected cohstitutional government, inheriting an unprecedented combina- tion of external indebtedness, inflation, and economic stagna- tion. Inflation worsened over 1983, 1984 and the first half of 1985 as the authorities struggled simultaneously to revive real growth and to recover policy control. At the same time they had a series of confrontatior.s with Argentina's commercial-bank creditors: on two occasions they made interest payments only at the last possible moment before triggering the U.S. regulators' non-accrual rules, and then only on the basis of funds advanced by other Latin American nations and the U.S. Treasury. Toward the end of 1984, however, Argentina secured a concerted new-money and rescheduling agreement with foreign commercial banks, after agreeing to an IMF program. The round of devalua- tions and negative per-capita GDP growth in 1982 and 1983 turned the trade balance from negative to positive and even reduced the current-account deficit, in spite of the higher interest bill (see Table 2). The diminished current-account deficit relieved external-debt growth, but the negative resource transfer reduced domestic capital formation and deepened inflationary pressure. 2.8. Over the first half of the 1980s, public-sector saving fell and borrowing requirements soared as declining tax revenues and rising interest expenditures overwhelmed expenditure cuts. Tax revenues fell because the economy stagnated and because tax administration deteriorated. Subsidies, principally the costly regional "industrial-promotion" program, increased. With exter- nal finance reduced, domestic debt increased and the public do- mestic interest bill rose. Meanwhile, state-owned non-financial enterprises, which operated such basic industries as interna- tional air transport, rail transport, petroleum production, and telecommunications, developed heavy operating losses over ex- tended time periods, through the combined consequences of poli- cies regarding output prices, employment and investable-fund- allocation. 2.9. Argentina's state-owned term-financing institutions -- the housing bank and the development bank -- ran losses, partly because of excessive operating costs and over-ambitious lending programs, but also because macroeconomic instability made term financial operations inherently unprofitable. In the financial system generally, price-level and exchange-rate uncertainty shrank deposit terms to weeks and even days; moreover, financial  -8. institutions had to pay high real interest rates to compensace savera for 92a