When the Argentine President Fernando de la Rúa was forced out of office in late 2001, Argentina was already deep in what would become the most severe economic, social and political crisis of its history. Since the late 1990s, most fundamental indicators had painted a gloomy outlook. Incomes were falling and unemployment rising. The Argentine government, meanwhile, continued to add to its enormous international debts, leaving the economy increasingly vulnerable to economic shocks.

The breaking point came on 30^th November 2001. With Argentines worried about a peso devaluation and a deposit freeze, overnight interest rates rose sharply. In addition, spreads between US treasury bonds and Argentine bonds increased to 5,000 basis points. A run on the banks was now the inevitable outcome.

The making of a crisis

Argentina’s debt crisis had its roots in market reforms adopted a decade earlier by the government of Carlos Menem. In the early 1990s, the incoming Menem administration had committed itself to tackling malignant hyperinflation. After an earlier inflation stabilisation plan had ended in abject failure – a substantial devaluation and a 58% fall in foreign exchange reserves, to be precise – a currency board arrangement was adopted in a last ditch attempt to rescue the economy. Under the ‘convertibility law’, the Argentine peso was tied with the US dollar at par. In other words, one Argentine peso was to be equal to one US dollar.

It was a gamble but one which appeared, at least initially, to have paid off. Inflation quickly returned to more manageable levels and, fuelled by a torrent of IMF-backed privatisations and deregulation, the economy entered a decade-long boom. In the context of the resulting surge of optimism in the Argentine financial markets, the country received large volumes of foreign capital in a very short period of time. In turn, this increase in foreign capital inflows helped to foster confidence in the convertibility plan, which increased both banks’ propensity to make dollar denominated loans and the willingness of debtors to borrow in dollars. The result was an extensive and, as it would turn out, ominous dollarisation of both liabilities and assets in the Argentine banking sector.

There was one other major drawback to the policy. Exports shot up in price and foreign imports suddenly became very cheap. Many goods, formerly produced domestically, now began to be imported from abroad. To begin with, this trend was mitigated by the fact that Brazil, Argentina’s main trading partner, also pegged its currency the real against the dollar. But when the Brazilian government was forced to devalue in 1999, an Argentine balance of payments crisis could only be delayed temporarily through greater international borrowing. By late 2001, the country’s foreign debt, largely owed by central and provincial governments, accounted for 50% of GDP. Approximately $30 billion of that sum was due to mature in 2002. It was clearly an unsustainable situation.

That Argentina’s leaders found themselves in a self-imposed fiscal and monetary strait-jacket did not help matters either. With the convertibility plan in place, the central bank was unable to adjust interest rates or devalue the peso to help restore industrial competitiveness. The only recourse, therefore, was to control public spending in an attempt to trigger a process that economists call ‘internal deflation’. However, in a country where federal government held little influence over state and municipal spending, such attempts at budgetary discipline were all but futile.

Unsurprisingly, concerns about the sustainability of the currency peg began to mount. Meanwhile, the cheap market finance that helped to drive the boom of the 1990s began to dry up and capital inflows began to reverse. Businesses and citizens, guessing the government’s next move, looked to store more of their wealth in dollar accounts at their banks. The logic, of course, was that if the country’s political leaders did decide to do what everyone expected and devalue the peso then at least their savings would be safe denominated in dollars. For many Argentines, it was an assumption that proved to be very costly indeed.

El Corralito

Fearing an all-out run on the banks, the Argentine government froze all accounts on 1^st December 2001. Argentine citizens were allowed to withdraw a small amount of cash – initially 250 pesos – on a weekly basis from their accounts but, crucially, this was limited only to peso accounts. If one wanted to withdraw savings from a dollar account the sum had to first be converted into pesos which, given the ongoing crisis, very few rational people were willing to do. The situation came to be known as “El Corralito”, or “the little corral”. Argentine depositors – much like the cattle the country has long been famed for farming – were trapped in a small pen with no means of escape.

The following month, just weeks after defaulting on a record $95 billion worth of sovereign debt, the government succumbed to the inevitable and proceeded with a devaluation of the peso. Dollar accounts, however, were not spared. All accounts denominated in dollars were subsequently converted into pesos – but at the old exchange rate. It effectively amounted to an appropriation of three-quarters of people’s savings. A citizen with savings totalling $10,000 the month before now had a mere $2,500.

The economic impact of Argentina’s crisis was unprecedented in the country’s history. Although GDP growth had been on a negative slope since the late 1990s, it declined by a colossal 11% in the year following the crisis. Unemployment soon accounted for more than a quarter of the total workforce and inflation, the country’s longstanding nemesis, inevitably worsened.

“Imagine what your reaction would be going into a bank today and the teller informing you that you cannot access your money anymore,” says Fernando Aguirre, who recently authored a book detailing what life was really like in Argentina during the crisis period.

Aguirre explains that during the Corralito, citizens were only permitted to withdraw very small amounts of money from their accounts each week – a sum which he approximates would be equal to £100 in the UK today. There were absolutely no concessions or exceptions to this rule and, distressingly, there were even some cases in which people who had saved up money to fund life-saving operations were denied access to their cash at the critical time. “People knew they were being robbed and they were furious.”

In the weeks that followed the bank freeze, social unrest very nearly brought the country to its knees. It began with protestors taking to the streets of Buenos Aires, banging pots and pans and chanting defiant slogans against the government. But by the time of the peso’s devaluation, those protests had escalated into full scale rioting and looting. In ugly scenes, which will appear depressingly familiar to anyone who has followed the Greek sovereign debt crisis, police deployed water cannons, rubber bullets and executed cavalry charges in a desperate attempt to break up the crowds and restore peace. Four weeks and four presidential resignations after the first bank runs began, the country was in a state of total disarray. “That was when the unrest was at its worst across the country,” adds Aguirre. “When you went outside, you really feared for your personal safety.”

Life after default

The economic impact of Argentina’s crisis was unprecedented in the country’s history. Although GDP growth had been on a negative slope since the late 1990s, it declined by a colossal 11% in the year following the crisis. Unemployment soon accounted for more than a quarter of the total workforce and inflation, the country’s longstanding nemesis, inevitably worsened – although not by as much as some economists expected. By the end of 2002, the exchange rate had reached nearly four pesos on the dollar and the rate of accumulated inflation totalled 80% according to data from Trading Economics. Falling incomes and rising prices meant that before the year was out, nearly two-thirds of the Argentine population would be living on incomes below the national poverty line, a quarter of which were considered destitute.

Devaluations are often messy, painful affairs. Argentina’s recovery, however, was remarkably quick given the scale of the initial downturn. By August, the exchange rate had stabilised and even began to slowly appreciate soon after. Exports immediately became more robust and imports waned following the devaluation providing immediate relief to the current account. By the end of 2002, the country was once again reporting positive GDP growth figures (see Chart 1).

Source: World Bank

What factors explain the Argentine recovery? Typically, analysts refer to three key factors although there is often disagreement about which one should receive most emphasis. Some analysts argue that most of the credit should be attributed to the default on the debt. There is one shortcoming to this explanation, however. In 2001, Argentina’s debt-to-GDP ratio was 55% – although because much of this figure was denominated in dollars it did increase substantially after devaluation of the peso. But if one takes that 55% and compares it to ratios recorded in the UK and France in 2013 of 88.7% and 90.2% respectively, it quickly becomes clear that Argentina was not facing a solvency problem in the run up to the crisis, but a liquidity problem. Although defaulting would certainly have helped to alleviate some of the burden of this liquidity problem, there is little evidence to suggest it was a decisive factor in Argentina’s return to growth.

The decision of the Argentine government to devalue the peso appears to have more explanatory power. Leaving the peg to the dollar was not only advantageous to Argentina’s exporters; it also helped to weaken the real value of wages and public sector expenditures, something which was critical in reducing government expenditures in real terms and allowing the government to run substantial fiscal surpluses. Moreover, the downside of devaluation – rapid inflation – was also less severe than many expected, largely due to the immediate recession and accompanying high rates of unemployment.

Leaving the peg to the dollar was not only advantageous to Argentina’s exporters; it also helped to weaken the real value of wages and public sector expenditures, something which was critical in reducing government expenditures in real terms and allowing the government to run substantial fiscal surpluses.

Finally, changes in the global economic environment couldn’t have been more favourable for Argentina. With Brazil recovering from its slump and China beginning what would become a decade of stratospheric economic expansion, demand for Argentine goods soon looked a lot healthier. Then there was the boom in the commodities cycle. Global demand for Argentine exports such as soybeans, corn, wheat, petroleum and gas was not only growing, but the prices being paid by importers for these goods were increasing too.

Vultures circling

It took four years of negotiations before Argentina agreed a deal with their creditors to restructure the terms of Argentina’s outstanding debts. On 1^st March 2005, the late Néstor Kirchner, Argentina’s President – and husband to current President Christina Kirchner – declared the deal, in which a majority of investors (75%) surrendered their claims in exchange for new bonds worth roughly 35 cents on the dollar, to be a triumph.

Not every bond holder accepted defeat that easily, however. Holdouts retained a total of $4 billion of debt, of which so-called ‘vulture funds’ – funds which buy securities in distressed investments – held $1.3 billion. The vulture funds refused, outright, to negotiate with the Argentine government, opting instead to enter into a long litigation battle to be repaid at 100% face value.

The case is still making its way through the US court system today. In 2010, the Argentine government reopened the debt exchange deal for the bondholders who had rejected the previous offer. A large majority of the holdouts opted to accept the swap this time around, raising the total amount of sovereign debt restructured to 92.6%. But two hedge funds, NML Capital and Aurelius, held on for 100% repayment of their $1.3 billion lent to the country. Despite an influential US appeals court ordering them to repay all the holdouts, Argentina maintains that these creditors will not be paid at all, and have stated their plan to challenge the ruling by bringing their case to the US Supreme Court.

Lessons for the Troika?

In some respects Argentina’s crisis resembles the situation in the Eurozone today. Just as Greece joined the euro to import German monetary credibility, Argentina tied itself to the dollar allowing it to piggyback on US monetary credibility. Greece, like Argentina, has also found itself in a recession which it is unable to combat through monetary and exchange rate policy, with membership to the euro restricting these options in the same way that the convertibility plan did for the Argentine government.

There are important differences, however. Firstly, when it was hit by the crisis Argentina still had its own currency. Dropping the peg to the dollar was a difficult step but, for Greece, leaving the euro would be a mammoth feat to accomplish without causing yet more turmoil both in Greece itself, and the wider Eurozone. Secondly, Greece, as a member of the Eurozone, has been able to call on the European Central Bank (ECB) and, by extension, other Eurozone countries, for assistance. Argentina, meanwhile, had no lender to turn to, not even the IMF, after the situation began to deteriorate in late 2001. Lastly, Greece’s debt today is far larger than Argentina’s was when it defaulted, meaning that the adjustments which will need to be made, subsequent to default, will be much more severe than was the case with Argentina.

Nevertheless, Europe should be able to draw some general lessons from Argentina’s crisis. Debt defaults can be messy and, as the ongoing litigation demonstrates, sometimes extremely protracted. But it is not impossible and, even if defaulting is not enough to restore growth in itself, it can work to restore fiscal health. In Argentina’s case, however, the recovery hinged on two main factors – the real depreciation of the currency, and the luck of a positive global economic environment stimulating export demand. Ominously for Europe, neither of those factors appear conceivable in Greece’s case.

Blue dollar crisis (reprised)

Sadly, recent events suggest that Argentina’s leaders are still haunted by their past mistakes. Although Argentina has defied expectations since the default, embarking on its strongest run of growth since the 1940s, recent declines in commodity prices have once again put the economy under pressure.

Analysts have been warning for some time now that the country has allowed inflation to spiral out of control. Rather than introduce measures to tackle inflation, however, the Argentine government reportedly opted instead to manipulate the figures. Staff at the central statistical authority, the Nacional de Estadista, were replaced with political appointees and the rate of inflation was henceforth decided almost entirely by edict. Meanwhile, although the dollar peg was abandoned in 2002, the peso continued to be heavily managed through central bank intervention in the foreign exchange market.

In mid-January 2014, the Argentine central bank finally gave up the ghost and stopped acting to prop up the currency amid intensifying capital outflows and dwindling foreign exchange reserves. The Argentine peso promptly fell by 11%, its sharpest decline since the last crisis.

Whether or not Argentina’s authority figures have the resolve to avert a full-blown crisis of the type we saw at the beginning of the millennium remains to be seen. By repealing foreign exchange controls, the central bank might help to restore some confidence and the economy’s competitiveness in international markets. But that will merely buy the country some time, say analysts. For the situation to improve, Argentina will have to make tough decisions to tackle the perennial problem of inflation. If that fails to happen, the combination of falling currency reserves and rising prices could put the economy on the brink once again.