Argentine Financial Crisis

1. Argentine Financial Crisis Can Aydinoglu Andres Perez Jennifer Koyce Vic Chidgopkar Erik Deneergaard

2. Introduction Argentina 2001-2002 • One-fourth of all third world debt ($132b) • 18% official unemployment • 30 People dead during riots • Devaluation cut national wealth by 30% • Huge costs socially and financially • Were these avoidable? • What should have been done by the government? • What are the strategic implications for businesses?

3. Agenda: • Theoretical Background • Case of Argentina • Case of East Asia • Comparisons and takeaways • Prevention policies • Business implications

4. What is a Financial Crisis? • A financial crisis is a disruption to financial markets • Extreme adverse selection and moral hazard problems • Financial markets become unable to efficiently channel funds to productive investment opportunities.

5. Stages of a Financial Crisis Increasing Vulnerability Currency Crisis Full fledged Financial Crisis

6. Stages of a Financial Crisis Increasing Vulnerability Currency Crisis Full fledged Financial Crisis Financial Liberalization Period Non performing loans skyrocket • Heavy Lending • International Capital Inflows • Higher yields in Ems • Government Safety Net • Currency Peg Substantial loan losses Shortening of loan terms High illiquidity • Rapid Expansion • Excessive risk taking due to • Lack of trained loan officers • Insufficient bank supervisors • Weak government regulations • Moral hazard due to safety net Deterioration of Bank B/S Vulnerability to shocks • High leveraging of corporate sector

7. Stages of a Financial Crisis Increasing Vulnerability Currency Crisis Full fledged Financial Crisis Deterioration of financial and non-financial B/S Central Bank cannot protect currency by raising rates Speculators start attacks on currency Central Bank’s Reserves melt down Collapse of Currency

8. Stages of a Financial Crisis Increasing Vulnerability Currency Crisis Full fledged Financial Crisis • Three mechanisms are triggered • Direct effect of devaluation on B/Ss • NPLs skyrocket leading to further deterioration • Depositors panic and bank runs occur • Depositors panic and bank runs occur • Inflation shoots up due to higher import prices • Nominal interest rates increase • Huge increases in interest payments • Sharp deterioration and collapse of financial and non-financial B/S • Contraction in lending and severe economic turndown

9. Case of Argentina Increasing Vulnerability: • Fiscal deficit was resolved by privatizations • Unions have a lot of power. There is no possibility to reduce salaries • 1996-2000 Net FDI ($48.9B) covered nearly 90% of the accumulated current-account deficit over the same period • When all the public companies were sold, Argentina borrowed money from international markets • Fixed exchange rate resolved a huge problem: the inflation • Prices fell in Argentina through a painful period of deflation • (1.8% in 1999, 0.7% in 2000 and 1.5% in 2001)

10. Case of Argentina Currency Crisis: • Results from 1990 to 2000 • Exports more than doubled (US$12.4b to US$26.4b) • Imports rose by nearly seven times (US$3.7b to US$25.2b) • Inflation was almost zero • Trigger of ARS currency crisis: • The devaluation in Brazil (its largest trading partner) made the country increasingly uncompetitive and deepened the recession

11. Case of Argentina Full Fledged Financial Crisis: • Fiscal Deficit Snowballs • Government Too Reactionary to pull out of crisis • Tax revenue declined due to recession and avoidance • Unwilling to devalue because it would multiply government debt • Government unable to reduce expenditures due to social instability • Bottom Line: Huge fiscal deficit and the weakness of the economy triggered the default

12. Argentina’sdebt: US$150b

13. Case of East Asia Background: • The Five Asian-Crisis Countries: Indonesia Philippines Thailand South Korea Malaysia • Before the Crisis: • Average Annual GDP 7% - 8% • Significant per captia income level increase over the last 30 years • Attracted nearly half of all capital inflows to developing countries • Bottom Line: Outstanding economic performance first step to financial liberalization

14. Case of East Asia Increasing Vulnerability: Chain of Events in 1997 Feb Jun Jul Aug Sep Oct Nov Dec • 2nd attack • on baht • Speculation • on baht • Thailand • floats the • baht • Malaysia • floats the ringgit • Korea • floats • won & • obtains • IMF • assistance • KRW • falls 1000 • to USD • Indonesia • obtains IMF • package of • $35Billion • KRW • depreicates10% • Indonesia • floats the • rupiah • Kia seeks • Korean court • protection • from creditors

15. Case of East Asia Currency Crisis: • Asian-crisis countries experienced nominal currency deprecations of more than 50% from July 1997 to 1998 • Reaction: Asian-crisis countries institute currency controls to avoid speculation • Example: Sept 1998 Malaysia restricted Foreign Direct Investors from repatriating their MYR. • Feb 1999 Foreign Direct Investors able to repatriate their MYR • However Proceeds now subject to a graduated exit levy scheme on Principal and Capital Gains

16. Case of East Asia Full Fledged Financial Crisis: Non-Performing Loans as a % of GDP

17. Case of East Asia The Recovery: • Rates of economic growth have rebounded in 1999-2000 • Failure of investment ratios to rebound significantly • Real stock market prices failed to return to pre-crisis level • Bottom Line: Crisis had long-term adverse effect

18. Comparisons and Takeaways • Government Stability • ARS: Financial Crisis transferred into Political Turmoil (I.e. 5 Presidents in 2 weeks) • Fiscal Deficit • ARS incurred 10 years of Fiscal Deficit • Banking System: • Non-performing loans & Bank Runs diluted the assets • i.e. Bank customers did not have necessary USD to repay their USD loans • Devaluation adversely effected the liabilities since Gov’t mandated Banks absorb the devaluation & not the bank customers

19. Financial Policies to Prevent Financial Crises • Adherence and supervision of banks • maintain balance sheets • provide safety net yet prevent moral hazard • Accounting and disclosure requirements • measure risk through quality of information • Legal and judicial systems • property rights • allowable collateral • bankruptcy policies • Market-based discipline • credit ratings • issue subordinated debt

20. Financial Policies to Prevent Financial Crises • Entry of foreign banks • Diversify and insulate • strengthen foreign confidence • Less like likely to be bailed out – market discipline • Capital controls • ouflows  devaluation • inflows  debt • effectiveness? • Reduction of role of state-owned financial institutions • not efficient and won’t manage risk if no profit motive • Restrictions on foreign-denominated debt • prevents monetary responses

21. Financial Policies to Prevent Financial Crises • Elimination of “too-big-to-fail” firms • no implied rescue – market discipline • Sequencing financial liberalization • lending boom precedes information • gradually remove restrictions • well-functioning regulatory structures limit risk, lending boom precedes information • Monetary policy and price stability • domestic vs foreign denominated debt • Exchange rate regimes and foreign exchange reserves • fixed rate • crawling peg • capital flows • low reserves

22. Is Peso Overvalued? Or Legalized Theft! • Government repealed convertibility and confessticated $18 B belonging to peso holders • Goal to boost exports and GDP • Prior to devaluation: Exports (10% of GDP); Rest of the GDP • 50% devaluation of peso will result- Export 5%; GDP 0.5% • Central Banks instead of devaluation should sell assets - & Dollarize • Not a currency problem, but a banking problem, political, legal, & corruption problem…….

23. Managerial Implications: Micro • Uncertain Monetary and Fiscal Policy • Banking and Political Stability • Tax Structure and Tariffs on Import or Exports • Corruption at all Levels • Parallel Economy (cash transactions) • Legal System - Delays & Cost • Unreliable Police Protection • Bureaucratic and Expensive Public Workforce • Provincial legislators’ salary - $300,000/year

24. Managerial Implications: Macro • Tax Structure - VAT etc. • Tariffs on Import and Exports • Stability of Local Vendors and Customers • Fluctuating Exchange Rate - minimize inventory & cash collection cycle • Reliability of local banks • Use Financial Models to Minimize Risk • debt.

25. Managerial Implications: Macro • Government approvals - Corruption • Litigation is Time Consuming and Costly • Illegal Tactics used by Local Competition • Safety of Local Employees • Unreliable Political and Banking System • Use Local Resources and Minimize Dependence

27. Factors Leading to Crises Deterioration in Bank’s B/S • Contraction of Lending • Interest Rates Up • Uncertainty Up • Collapse of an institution • Sustained Recession • Political Instability More Adverse Selection Dilution of Credit Quality Capital Outflows Stock Market Crash • Deterioration of Non-Financial B/S • Collateral values down • Net worth of companies down • Devaluation • Value of $ up • $ denom. debt up • Borrowing short, lending long (liabilities up, assets down) • Less ability to monitor credit quality • Moral hazard and adverse selection further up • Bank runs • Collapse of Banks