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Fear of Diving
Subject Economic Growth
Topic International Finance
Key Words Economic Growth, Debt, Default, Devaluation
News Story

Argentina's economy has been in recession for the past 3 years. With a $132 billion debt, high unemployment and rising poverty, many feared that devaluation was imminent. In August, the International Monetary Fund transferred $8.0 billion to rescue the Argentine currency and stave off a financial crisis that could potentially affect the entire region. However, the September 11 terrorist attacks combined with the upcoming congressional elections and Brazil's devaluation has intensified the recession and produced investor panic and soaring interest rates. Argentina's President Fernando de la Rua tried to calm investor fears, stating that neither a devaluation nor default is planned. As the U.S. and other Latin American economies slow, hopes for a quick Argentine recovery diminish.

Fear that a collapse of Argentina's economy could spread throughout Latin America and even beyond, was responsible for the IMF developing its rescue package in August. The inflow of dollars, it was thought, would restore confidence, stabilize the Argentine currency and allow the government to pursue policies to generate an economic recovery. The IMF bailout appeared to be working until the government reported tax receipts for September that are 14 percent below last year's. Argentina had implemented a zero deficit plan and last month, in order to meet its goal, the government cut government salaries and pensions. These moves caused a wave of protests. Revenue shortfalls for this month will likely cause even deeper cuts in government expenditures and even more protests.

Argentina's monetary system is based upon a "convertibility plan" which regulates the supply of pesos to the amount of dollars held in reserve at a one-to-one exchange rate. This system was created 11years ago to stabilize the peso and control inflation. Under this system, about 85 percent of private and corporate debt is denominated in dollars. In the event of a run of the banking system, the government might resort to dollarization of the currency, doing away with the peso and replacing it with the U.S. dollar. Although this measure might prevent devaluation of the peso, it might throw the economy into deeper crisis as bankruptcies result from firms not being able to repay their debts.

(Updated November 1, 2001)

Questions
1. As the news that government revenues had fallen short of expectations was received, investors started to withdraw their funds from banks. Why would investors want to withdraw their pesos? What other assets would they likely apply their funds to? How would a run on Argentine banks affect the country's money supply? What would happen to Argentine interest rates?
2. In light of the revenue shortfall, what measures could the government adopt to achieve its goal of a government deficit equal to zero? What is the likely impact of these policies on unemployment?
3. All of this concern is directed towards avoiding devaluation. What is devaluation? How would it affect the Argentine economy? Is it something that should be avoided at all costs?
Source Anthony Faiola, "Argentina Economy Dives, Setting Off Investor Panic," The Washington Post, October 6, 2001.

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