A Wrong Turn in Argentina?

The country's crisis may get much worse

It was painful to watch even for those with no money at risk. On Jan. 6, Argentina finally let go of its decade-long embrace of the U.S. dollar and devalued the peso, ending one of the world's boldest experiments in economic reengineering. Overnight, the country went from being the world's 16th-largest economy to No. 23, and even before the peso was floated several days later, money-changers were paying up to 1.55 pesos for greenbacks. "We are bankrupt," admitted Economy Minister Jorge Remes Lenicov when he announced that the peg was dead. The new government also confirmed that Argentina can't go on servicing its $141 billion public debt.

Devaluation and default: Economists have been predicting both for months. But some of the emergency measures that President Eduardo Duhalde and Remes Lenicov are implementing have stunned Argentines and foreign investors alike. What's alarming is that a dramatic reversal in economic policy is under way that could plunge the country's economy into an even deeper crisis and erode political support for free-market reforms throughout Latin America. "We hope the biggest casualty of Argentina will not be the march of democratic capitalism in Latin America over the past 20 years," says Peter Geraghty, managing director at Darby Overseas Investments, Ltd. in Washington.

But some of what the Duhalde team is doing looks all too much like a throwback to the failed stratagems of the 1970s and '80s. The government is reinserting itself into numerous areas of economic life via the introduction of a dual exchange rate, capital controls, extraordinary taxes on oil exports, and unilateral changes to the contracts of privatized utilities. These measures, along with the halt in debt payments, risk turning Argentina into a pariah in global investment circles. "After a decade of thinking Argentina was the golden child of emerging markets, investors are waking up to the fact that it was the black hole," says Christian Stracke, chief Latin America strategist for Commerzbank Securities.

Both Wall Street and Argentine business leaders are skeptical that the Duhalde administration can even pull off a controlled devaluation. Mexico attempted such a feat in 1994 only to see its currency plunge. Brazil tried it four years later with similar results. Already, the International Monetary Fund has warned that Duhalde's plan to debut a two-tier exchange rate--with an official rate of 1.4 pesos per dollar for import-export and a floating rate for most other transactions--won't work. If history is any guide, the two rates will diverge widely as demand for dollars soars, forcing the government to dig deep into its dwindling stock of foreign reserves to ensure the survival of the scheme. Indeed, J.P. Morgan is predicting that the free-floating peso will be worth a mere 37 cents by yearend.

Duhalde is also courting controversy with his treatment of the nation's banks, most of which are foreign-owned. The administration intends to convert around one-third of the $50 billion in dollar-denominated loans held by the banks into peso loans at the old 1-to-1 exchange rate. Consumer and small business loans of up to $100,000 will be eligible. The scheme is designed to pacify Argentina's middle class, which has been hit hardest by a partial freeze on bank withdrawals imposed in December. Yet critics point out that with consumers paying off debts in devalued pesos, the scheme will blow a big hole in the balance sheets of local subsidiaries of Citibank, BankBoston, and Spain's Banco Santander Central Hispano and Banco Bilbao Vizcaya Argentaria. A post-devaluation report by J.P. Morgan warned that Argentina's "bank sector is effectively bankrupt."

Other targets of convenience for Duhalde & Co. are the foreign owners of the telephone, water, and electric utilities that were privatized in the 1990s. Authorities say the companies must bill their clients in pesos, not dollars--a dictate that will slam revenues. The list of casualties includes Spain's Telefónica, which operates the largest telephone company; power provider Endesa; and water utility Aguas de Barcelona. They, along with other Spanish investors, have plowed upwards of $40 billion into Argentina over the past 15 years. Spanish oil company Repsol, which paid $15 billion in 1999 for former Argentine oil monopoly YPF, is bracing for a proposed 20% tax on oil exports that could eat up more than $900 million in revenues over five years.

"They are defrauding and hurting investors, sticking their hand in the pockets of many who came to the country to invest in good faith when nobody else wanted to," says Argentine lawyer Jorge Pérez Alati. His firm represents many foreign investors, including the recently formed Argentina Bondholders' Committee, which includes creditors with holdings of $50 million or more in bonds. Duhalde spokesman Eduardo Amadeo insists the government isn't singling out foreign investors. "We don't want to expel these companies or hurt them," he says, "but this is the reality we face."

Because the crisis had been percolating for more than a year, the biggest emerging-market debt default in history has resulted in little financial contagion so far. The same week Argentina devalued, Brazil and Mexico together sold $2.75 billion in government bonds--proof that the appetite for even Latin American debt has not evaporated.

Nonetheless, analysts warn that the longer-term effects could be serious. Populist politicians such as Venezuelan President Hugo Chávez point to Argentina as an example of how the neoliberal policies touted by Washington and the IMF only serve to further impoverish Latins. Even in Brazil, where President Fernando Cardoso has been a strong proponent of the free-market model, the population is not entirely sold. Otherwise, why would left-leaning former labor leader and globalization foe Luis "Lula" Inácio da Silva lead opinion polls in the runup to presidential elections in October?

Another victim of the meltdown might be the Bush Administration's plan to push for a Free Trade Area of the Americas by 2005. "With Argentina's collapse, Latin America looks like a less attractive trade partner to many in the U.S.," says Peter Hakim, president of Washington think tank Inter-American Dialogue. While it's clear that its financial woes are largely of its own making, the debacle will inspire debate over how best to prevent financial brushfires from becoming conflagrations.

There's an outside chance that Duhalde can yet repair some of the damage. One encouraging sign would be a balanced budget for 2002, proof that Argentina finally intends to live within its means. "We have lost substantial credibility," concedes Martín Redrado, the Foreign Ministry's secretary for international economic affairs. "We need to show that the country is serious." Unfortunately, given its shaky start, it may be months, even years, before Argentina achieves that elusive goal.

By Geri Smith, with Joshua Goodman in Buenos Aires, Cristina Lindblad in New York, and Andy Robinson in Madrid

    Before it's here, it's on the Bloomberg Terminal.