Lessons from Argentina and Brazil.

• Author: Calomiris, Charles W.

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? Will the IMF give us an exit in the not-too-distant future, and is the current yield high enough to bet on that exit?" Economists who refer to long-run arithmetic are dismissed. Investment banks' "research" departments cooperate with the masquerade because not doing so means that they will be cut off from millions in underwriting revenue from the new debt offerings or debt swaps. When the collapse comes, the IMF shakes its head about how unstable markets are, how irrational investors are--all the more reason, of course, to increase IMF footings.

Economic "emergence"--the combination of industry privatization, trade liberalization, price stabilization, and financial deregulation--would work much better if sovereigns did not see market optimism about their private-sector prospects as an opportunity to ramp up their expenditures. Imagine how much better off the people of Brazil and Argentina would be today if their governments had not been able to borrow in the international bond market during the 1990s.

What were government officials thinking? Wouldn't even a self-serving politician or bureaucrat do better in the long run by waiting until after growth had succeeded before increasing government expenditures? The problem is twofold. First, politicians do not have long-time horizons. That failure ultimately must be seen as a political failure of democracy in EMs. Second, local bureaucratic interests can be impervious to change even when politicians try to cut spending. That was particularly true in Argentina and Brazil, where spending was often decided at the local level but paid for at the national level.

Vulnerability of Banks in Emerging Markets

Argentina was one of the boldest and most successful reformers of bank regulation during the 1990s. By the late 1990s, the banking system had achieved (1) substantial foreign entry by European and North American banks, (2) substantial privatization of loss-generating provincial banks, and (3) real reform of deposit insurance, capital regulation, liquidity regulation, and other prudential regulation and supervision, which resulted in bank solvency, stability, and private market discipline over bank risk taking. These reforms were impressive, and were the result of years of hard work by Roque Fernandez, Pedro Pou, and their staffs at the Banco Central (Calomiris and Powell 2001).

But that very success produced a plum (in the form of banking system liquidity and net worth) that was ripe for government picking. Domingo Cavallo opined at a conference in 2001 that the regulatory system in Argentina was too good, that banks were forced to maintain too much liquidity and capital. He "fixed" that "problem" by forcing changes in the Banco Central's personnel and rules to reduce banks' liquidity, and more important, he used those freed-up banking system resources to absorb ever more government debts by forcing banks to "participate" in new government financing schemes. Ultimately, we learned in Argentina that when sovereigns are at the end of their rope, they'll...