WORKING PAPER N.9/03 Public Disclosure Authorized Restoring Economic Public Disclosure Authorized Growth in Argentina William R. Cline** Center for Global Development and Institute for International Economics Public Disclosure Authorized June 2003 This study was prepared under the auspices of Economics International, Inc. The author is grateful for financial support from General Motors Corpor ation, the Japan Bank for International Cooperation, and the World Bank. For helpful discussions during the preparation of the manuscript, he thanks Daniel Artana, Juan Luis Bour, Emilio Cardenas, Javier Finkman, Miguel Kiguel, Minister of Economy Roberto Lavagna, Daniel Marx, Guillermo Mondino, former Central Bank president Pedro Pou, Central Bank president Alfonso Prat-Gay, Andrew Powell, and Public Disclosure Authorized Federico Sturzenegger. For comments on a previous draft, he thanks Emilio Cardenas, Mario Gutierrez, Javier Finkman, Daniel Marx, Atsushi Masuda, Guillermo Perry, Andrew Powell, Luis Serven, Mario Teijeiro, Edwin M. Truman, and John Williamson. None of these individuals is responsible for any shortcomings remaining in this study. ** Joint Senior Fellow. Dr. Cline has previously been Deputy Managing Director and Chief Economist for the Institute of International Finance (1996-2001), and Senior Fellow, Institute for International Economics (1982-1995) and Brookings Institution (1973-1981). World Bank Office for Argentina, Chile, Paraguay y Uruguay – Working Paper N.9/03 TABLE OF CONTENTS SUMMARY..........................................................................................................................................................................................1 1. INTRODUCTION..............................................................................................................................................................................7 2. ORIGINS OF THE CRISIS ...............................................................................................................................................................10 A. Principal diagnoses.................................................................................................................................................................... 10 B. Fiscal imbalance and debt sustainability.................................................................................................................................... 13 C. The currency board and overvaluation....................................................................................................................................... 19 D. External shocks.......................................................................................................................................................................... 28 E. Political shocks .......................................................................................................................................................................... 32 F. Role of the IMF.......................................................................................................................................................................... 36 3. A YEAR IN PERDITION: 2002........................................................................................................................................................42 A. Overview ................................................................................................................................................................................... 42 B. Output and inflation................................................................................................................................................................... 43 C. The external sector..................................................................................................................................................................... 46 D. The deposit freeze and pesification............................................................................................................................................ 47 E. Fiscal performance..................................................................................................................................................................... 49 F. Monetary policy ......................................................................................................................................................................... 50 4. IMMEDIATE CHALLENGES...........................................................................................................................................................53 A. Avoiding high inflation.............................................................................................................................................................. 53 B. Refurbishing the financial sector ............................................................................................................................................... 56 C. Restructuring government debt.................................................................................................................................................. 63 D. Maintaining the social safety net ............................................................................................................................................... 69 5. STRATEGIES FOR THE LONGER TERM.........................................................................................................................................72 A. Baseline prospects for growth and principal challenges ............................................................................................................ 72 B. Fiscal reform.............................................................................................................................................................................. 74 B. Reforming provincial revenue sharing....................................................................................................................................... 84 D. Exchange rate regime ................................................................................................................................................................ 86 E. Trade policy ............................................................................................................................................................................... 94 F. Rules of the game for foreign direct investment......................................................................................................................... 98 G. Labor market reform.................................................................................................................................................................100 H. Political institutions ..................................................................................................................................................................102 VI.CONCLUSION............................................................................................................................................................................106 ANNEX A. CONDITIONS FOR FISCAL SUSTAINABILITY.................................................................................................................108 ANNEX B. THE ANALYTICS OF RESTRUCTURING GOVERNMENT DEBT.......................................................................................110 ANNEX C. EVALUATING THE 2001 MEGASWAP ...........................................................................................................................112 REFERENCES .................................................................................................................................................................................114 “Restoring Growth in Argentina”. By William R. Cline World Bank Office for Argentina, Chile, Paraguay y Uruguay – Working Paper N.9/03 SUMMARY Economic potential – Despite its economic collapse in 2001-02, the Argentine economy has elements of fundamental strength that should enable it to return to growth. Argentina’s growth performance was strong in most of the 1990s after privatization, deregulation, and other market-oriented reforms. It is a relatively advanced economy in terms of standard of living, with purchasing-power parity income per capita and levels of education and health that exceed those of most emerging market economies. The 3D economic collapse – The default and devaluation at the end of 2001 and depression of 2002 with an 11 percent decline of GDP comprised Argentina’s worst economic collapse on record. The one ray of light was that Argentina avoided hyperinflation, which many had feared would follow the plunge of the peso’s value from parity to the dollar to as low as 3.8 per dollar. The severe depression in domestic demand, the bank deposit freeze, and an incomes policy averting wage increases in response to the devaluation (in contrast to historical experience) all helped avoid hyperinflation, but the outcome was also consistent with the international pattern in recent years whereby domestic price increases in emerging market economies following severe devaluations have been surprisingly modest. Principal causes – The initial section of this study surveys the leading interpretations of the causes of the collapse. Some authors emphasize fiscal weakness. Although the rise in non-interest (primary)