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Debt and Doubt in Argentina
Subject Inflation, Deficits and Debt
Topic International Finance, Employment, Unemployment, and Inflation
Key Words Budget Deficit, Government Debt, Inflation, Default, Devaluation
News Story

The International Monetary Fund (IMF) has just arranged an emergency loan package to prevent Argentina from defaulting on its debt. Argentina is in the midst of an economic crisis due in part to economic choices that the government has made, but also as a result of international credit markets demanding higher interest rates. For example, Argentina was recently paid 16 percent interest on a debt refinancing. The IMF may have avoided a crisis with their bailout, but high interest rates may be a signal that more turbulence lies ahead.

In an effort to control inflation and attract international capital, Argentina fixed the value of the peso, Argentina's national currency, permanently to the dollar. This policy was beneficial to Argentina until Brazil, Argentina's neighbor and competitor, devalued its currency. The fall in the value of the euro coupled with Brazil's devaluation meant that Argentina's exports were relatively more expensive. The fall in exports depressed the economy. Budget deficits materialized and the government responded by cutting spending and raising taxes. Unemployment increased, as did social unrest. Argentina's economic difficulties deterred foreign investment.

Argentina's level of indebtedness is lower than Japan's and not out of line with other countries. Yet, Argentina and other third-world borrowers are facing interest rates that have risen substantially -- 1.5 percentage points since September. While the U.S. Treasury pays approximately 6 percent to borrow funds, Argentina recently paid 16 percent. Investors appear to be less willing to buy bonds that they consider risky and this attitude is also apparent in the market for risky corporate bonds. While economic forecasts for the next few years are both positive and growing, the bond market apparently views the world differently. The added premiums for risk suggest potential problems ahead. To the extent that increased interest rates push a country to default, the bond-market view may be a self-fulfilling prophecy.

(Updated January 1, 2001)

Questions
1. Why is it appropriate when comparing the debt or government deficits between countries to use the ratio of the debt or deficit to the country's GDP?
2. What is the relationship between a country's government deficit and its debt?
3. What is the impact of higher interest payments on a country's government deficit?
4. How can a government maintain a balanced budget in the face of increased interest payments on its debt?
Source Paul Krugman, "The Shadow of Debt," The New York Times, November 22, 2000.

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