Managing the Financial Crisis: Argentina 2002 Mario I. Blejer

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Managing the Financial Crisis Argentina (2002)
Mario I. Blejer
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Managing the crisis

• Assess the Nature and the Root Causes of the
  Crisis
• Define the Tradeoffs
• Define and Operational Strategy
• Persevere in the Implementation
• Learn some Lessons

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The Nature of the Argentina Crisis

• The Argentine crisis is both a CURRENCY and a
  BANK crisis Inter-related but caused by a
  number and combination of different factors
• Analytically, better to distinguish between them
  in an explicit manner

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THE CURRENCY CRISIS

• The Currency Crisis reached its peak with the
  January 2002 devaluation. It is usually analyzed
  in the context of the ARGENTINE CURRENCY BOARD
  SYSTEM, established in 1991 as an
  anti-inflationary devise.
• The question to be analyzed is
  What were the
  weaknesses and the main causes for the demise of
  the convertibility regime?

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• THREE APPROACHES
• 1. The loss of competitiveness of the Argentine
  economy
• 2. Macroeconomic policy inconsistencies
• 3. The Sudden Stop argument

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Fiscal misalignement turned the burden of the
debt unsusutainable
-1,0
-2,0
-3,0
-4,0
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Fiscal misalignement turned the burden of the
debt unsusutainable
Public Debt
-1,0
-2,0
-3,0
-4,0
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Fiscal misalignement turned the burden of the
debt unsusutainable
-1,0
-2,0
Country Risk
-3,0
-4,0
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Capital Flow s and Economic Activity
(Accumulated 4 quarters - USm. GDP Cyclical
Component)
Capital Flows Private Sector
8
15.000
10.000
6
5.000
4
0
2
-5.000
0
-10.000
-2
-15.000
-4
-20.000
Russian Crisis
GDP Growth
-6
-25.000
-8
-30.000
-10
-35.000
IV 94
IV 95
IV 96
IV 98
IV 01
IV 97
IV. 99
IV. 00
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Sudden Stops in Argentina and Chile (Private
Capital Flows, Percentage of GDP
4
8
7
3
6
2
5
Argentina
4
Argentina
Chile
1
3
0
2
1
-1
Chile
0
-2
-1
1998-I
1999-I
2000-I
2001-I
1998-II
1999-II
2000-II
2001-II
1998-III
1999-III
2000-III
1999-V
1998-IV
2000-IV
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• THE BANKING CRISIS
• While the problems of convertibility and the
  consequent exchange rate uncertainty played a
  role, the banking crisis was largely caused by
  the government abuse of the banking sector,
  given its inability to to adjust the budget
  deficit

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Credit to Private Sector
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• The main cause for the banking crisis was the
  fear was that banks would be rendered insolvent
  by government policy and that deposits would be
  confiscated.
• An important reason behind this fear was the fact
  that private sector assets were being displaced
  by public sector assets in banks balance sheets.

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• The increasing banking exposure to the public
  sector was accompanied by
  
• 1. a rapid decrease in deposits and
  
• 2. a sharp increase in country risk
  

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EMBI Index Public Sector Loans / Net Worth ()
Private Deposists - Index Dec 00 100
(2nd axis)
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• November 2001withdrawal restrictions on bank
  deposits (corralito).
• December 2001 Riots the De la Rua and Cavallo
  government.
• First two weeks of January 2002
  --public debt default
  --currency board is abandoned and the
  currency devalued
  --bank assets and liabilities are
  pesified asymmetrically - i.e. at different rates

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The abandonment of the currency board was
traumatic

• -- Complete loss of confidence in the banks, the
  currency, and the government
• -- Continuous bank run
• -- A run on the peso that pressured strongly the
  exchange rate
• -- No money market or debt instruments for open
  market operations

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The Tradeoffs and The dilemma for the central bank

• Having regained the LOLR function the CB could
  provide the liquidity needed to finance the bank
  run. Pesos would fly to the exchange market
  risk of hyperdevaluation and hyperinflation.
• OR

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• The CB could restrain the rediscount facility and
  let banks deal with the deposit run. May prevent
  hyperinflation, at the risk of the total collapse
  of the banking sector.

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• Only feasible intermediate solution
• slow the pace of the bank run
  
• and, at the same time, try to avoid excessive
  liquidity expansion.
  

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The Strategy Followed

• -- Provide liquidity support to banks to prevent
  massive bank closures.
• -- Develop sterilization instruments at the
  Central Bank --the LEBAC-- to mop up liquidity
  and to compete with the US.
• -- Utilize part of CB reserves to intervene in
  the foreign exchange market to slow the pace of
  depreciation and to avoid chaotic conditions.

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• Choice of Foreign Exchange Market Strategy
• high interest rates
• vs.
• FE market intervention
  
• substitutes or complements?

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• persevere to the point where
  
• greed gt panic

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The central bank provided rediscounts to illiquid
banks and financed about 1/3 of the deposit drop
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• The market for Central Bank ST Bills (LEBAC) was
  actively developed, initially with 7 days
  maturities and then with 14 and 28 days, in Pesos
  and US. Interest rates reached 140 initially.

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• Intervention in the foreign exchange market
  prevented disorderly behavior but did not peg the
  rate, that devalued from 1 to 3.6 Pesos per
  Dollar. Intervention in the first five months was
  about US 2 bn.

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Initially deposit withdrawals continued
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However, the trend reversed after four months
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• The need for the provision of liquidity from the
  Central Bank where largely reduced

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• The demand for LEBACs grew strongly.
• -- LEBACs with up to one year maturities were
  introduced successfully.
• -- By October interest rate has fallen to 8-45
  range, according to maturities.

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Decrease of average cost and duration of LEBACs
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• The exchange rate stabilized and started to
  appreciate. The CB has stopped selling and is
  actively buying reserves to prevent a large
  appreciation in the exchange rate.
• In total the CB has regained more than the
  initial stock of intervention

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The stabilization of the exchange rate has also
resulted in a sharp decline in level of inflation
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• Indeed, as always,
  greed gt panic

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The Financial System needs restructuring
Financial statements situation - Dec2001/Dec2002

180
160
Loans to Private Sector
140
120
100
45
17
80
60
54
21
40
20
0
Dec 01
Dec 02
Loans to
the Public Sector

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• LESSONS
• 1. The Potential Fragility of Financial
  Institutions
• Solid and solvent financial structures could
  deteriorate quickly in the face of inadequate
  interventions and policies.
• The fact is that weak financial sectors are not
  necessarily crisis prone. Crises are generated by
  inconsistent policies and an unstable
  macroeconomic environment

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• 2. Financing the Public Sector and the Crowding
  Out Effect

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• 3. The Importance of Proper Liquidity Management
• Availability of liquidity is a crucial element in
  the prevention and the management of financial
  crises
• LOLR does not guarantee stability but its
  absence accelerates the erosion of confidence

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• 4. The Role of Foreign Banks
• -- Do they reduce financial vulnerability?
• -- Can they provide, implicitly, LOLR function?

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• 5. Capital Controls
• Does capital account integration reduce financial
  vulnerability?
• Long run desirability vs. short run,
  transitional, risks
• Capital controls and crisis management