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December 23, 2001

The Argentinean Collapse - Another IMF Triumph
by William Thomson

As predicted here, the Argentinean economic policy collapsed last week in an orgy of anger in the streets where almost 20 percent of the population is unemployed and the rest are threatened by financial ruin. They took their anger out on the Finance Ministry, the erstwhile home of Domingo Cavallo, the architect of the policy of pegging the currency to the US dollar on a one-to-one ratio under what is known as a currency board. In delicious, if futile, revenge they torched the dreaded ministry.

The elected President resigned to be replaced by a temporary fill-in of a provincial governor whilst new elections are planned in the next 60 days. In the meantime, there is no effective economic policy but the local currency, the peso, is trading at about 1.5 to the USD on the streets and the futures market expects it to be a two to one within a year.

Argentina's USD 150 billion of foreign debt is trading at between 25 and 30 cents on the dollar reflecting the reality that it is will inevitably go into formal default within days.

Such a tragedy, so long in the making, has several fathers, although like any illegitimate child they have all rushed for cover. The DNA tests will however identify the IMF's as a prime suspect. With the enthusiastic support of the US treasury, they were the proponents of the concept of a currency board to cure Argentina's endemic hyperinflation - which in the 1980s and early 1990s paralleled that of the 1930s Weimar Republic. It was supposed to cure hyperinflation, eliminate all chance of devaluation by maintaining at all times enough dollars in the central bank to cover the Argentine pesos in circulation and, thereby, encourage investment in the country and keep Argentine money in Argentine banks, rather than those of Miami, Madrid and Milan.

Coupled with a policy of privatisation that brought in much needed foreign investment from the US and Spain, the Argentineans engaged in an orgy of borrowing, most of it denominated in US dollars. The problem was that the country saved only 17 percent of GDP but invested (or consumed 23-25 percent). This compared with most Asian countries that save between 30 and 40 percent of GDP. But the geniuses who run large international banks and international organisations did not see that as a problem for many years. We recall a conversation with the President of one of the largest US banks in 1995, claiming that Argentina would wipe the floor long time with Asia (including China). He seemed oblivious to arguments about savings rates, education levels or work ethic. We heartily disagreed and concluded that he was either completely incompetent, been seduced by a Latin lovely or had spent too long at too high an altitude in his executive jet with the controlled substances of the Pampas.

Now we face the nightmare that most middle class Argentines have their home mortgages in dollars so if the peso is devalued they will be unable to service their mortgages and lose their homes.

We expect that a multiple policy will eventually be introduced where the peso is allowed to float (downwards to a new level); the foreign debt will be renegotiated after a period in default and a portion wiped out; existing dollar deposits and loan converted to peso obligations at a new lower exchange rate. Savers will have some of their savings confiscated but their will eventually be a chance of recovery after a generation has been wiped out.

Who will gain? Politicians and others who held their funds abroad in non-Argentine banks and the vulture investors, whether in defaulted bonds or repossessed real properties. For vultures, it could be a great time in the next couple of years to buy an apartment or villa in Buenos Aires. The cost of living in dollar terms should plummet.

Contagion elsewhere
What should be watch out for? One is contagion to Brazil and other emerging market economies. So far the omens are favourable but the situation bears close watching. South Africa is suffering right now although we believe the situation is different: at least, South Africa has gold and other metals that people want to buy. Argentina only has beef.

Asia, in general, is in relatively good shape to avoid fall-out from Argentina. The concern for Asia will be continued deterioration in Japan's economy that could affect their currencies in the coming months.

The one remaining important currency board arrangement in the world is Hong Kong. That arrangement is still as sound as a dollar - for the time being. Hong Kong has massive currency reserves and no government debt. Prices and wages have tended to be more flexible in a downward direction than elsewhere. But the economy is sluggish and the important property industry would like to see increasing property prices and an end to negative equity in middle class properties. There are therefore increasing sotto voce voices there for a more flexible exchange rate policy. Eventually the peg in Hong Kong will likely undergo change but not in the immediate future.

IMF policy
With the exit of Stanley Fischer from the IMF look for dropping of the 'two corner solution' to exchange rate policy of either pure floating - as for the Euro, the Canadian dollar etc. - or a currency board as in Argentina. The currency board arrangement is likely to be kept to the refined form of 'dollarization' and restricted to small economies such as those in the Pacific Islands that cannot justify the expense of having their own currency and therefore adopt another's currency. Micronesia and the Marshall Islands use the US dollar and many other islands use the Australian dollar.

It seems that the IMF and the US Treasury have decided to allow Argentina to be the first major country to go broke rather than be bailed out with more tax payer funds. Withdrawal of an automatic future bailouts for the profligate may, in fact, introduce greater caution into future lending to emerging markets. Greater responsibility on the part of both investors and borrowers is clearly to be welcomed, if scenes such as those in Buenos Aires are to become less frequent in future.

William R. Thomson
Chairman of Private Capital Ltd.

William Thomson, Chairman of Private Capital Ltd., an advisory company in Hong Kong. He is also a senior adviser to Franklin Templeton in Hong Kong and Axiom Alternative Funds in London.

Mr. Thomson is not a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While he believes his statements to be true, they always depend on the reliability of his own credible sources. Of course, we recommend that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.