Emergencies in emerging markets

The crisis in Argentina highlights not just how insecure emerging markets are, but also how dubious and fleeting the advantages are of obeying the dictates of international capital.

FOR months, it has teetered on the brink. And in the second week of July, the Argentine economy finally appeared to have succumbed to pressure and fallen into full-fledged financial crisis. The present problems are the result of investors' fears that the Argentine government may be forced to default on its debt and devalue the peso by abandoning the currency board arrangement which has effectively linked it to the U.S. dollar.

Such fears had been responsible for financial markets putting pressure on the Argentine peso on several occasions over the past year. Each time, such pressure was seen to be the effect of "contagion" from other emerging markets. But this contagion has been only tenuously connected with geographical proximity.

It is certainly true that Brazil is a neighbour and so the impact of its financial crisis last year on Argentina is relatively easy to explain. But the same cannot be said for Turkey, Russia, South Africa or, most recently, the countries of East Asia, all of which have seen their own problems reflected or even magnified by financial markets in Argentina.

The current crisis in Argentina highlights once again not just how insecure all emerging markets are, but also how dubious and fleeting are the advantages of being obedient to all the whimsical dictates of international capital. For Argentina has indeed been the quintessential "good boy" when it comes to following the prescriptions of the International Monetary Fund or those proposed by private foreign investors.

Until recently it was also commonly cited as an example for other developing countries to emulate. It has meekly and even willingly followed the most stringent conditionalities, which have entailed large fiscal cutbacks, massive privatisation and allowed deregulation and recession to multiply company closures and bankruptcies and increase unemployment, all in search of the Holy Grail of a supposedly more competitive economy.

The currency board arrangement means that the money supply in Argentina is actually linked to the prevailing dollar reserves. This effectively destroys any chance of being able to pursue an independent monetary policy and puts very severe limits on fiscal policy in the country. The arrangement has been a hugely costly exercise for Argentine citizens, forcing upon them highly deflationary policies and making the government more anxious to placate and interest international investors than to serve the needs of its own people.

But even this most draconian of fixed exchange rate systems is not quite the same as a unified currency, and so there can always be expectations of a change if there is sufficient pressure. That is why speculators have been swarming around like bees, and joining in attacks on the currency, anticipating a devaluation which their own expectations can eventually make self-fulfilling.

Of course, the situation has not been eased by the U.S. economic slowdown which has affected Argentina's exports (as, in fact, it has affected all major exporters in the world) and the fixed exchange rate which has made its exports more expensive than those of competitors like Brazil with depreciating currencies. But the prime cause of the domestic contraction is not external policy so much as internal, reflecting the very tight macroeconomic regime which has not allowed any expansionary activity by the government.

At the moment, the argument being made by market analysts is that the levels of public debt in Argentina are unsustainable at current rates of interest. But Argentina does not face any big external debt repayment until next year, so there is no immediate problem. And rates of interest are high because they have been raised over the year to prevent capital flight in the wake of contagion. The real problem may well be that the recent collapse of IT (Information Technology) stocks in the U.S. and elsewhere has reduced the financial markets' appetite for risk, and therefore they are attacking the Argentine currency now simply because there is a general move towards "safer havens" such as U.S. government securities.

This is more than just another round of bad news for Argentina; it is a calamity which calls into question the entire macroeconomic strategy of the recent past. In a desperate measure to restore market confidence, President Fernando de la Rua brought in last year Domingo Cavallo as Economy Minister with special powers. Cavallo is greatly beloved of international finance because in his previous stint as Finance Minister he had steered the economy out of financial crisis by imposing very severe cuts on wages and employment, swiftly privatising almost all the public assets and providing large concessions of various sorts to international capital.

That certainly did provide a temporary reprieve, but it also laid the ground for greater vulnerability and deeper crises in future, and that is precisely the situation the Argentine economy has now reached. The irony for Cavallo - and the tragedy for Argentina - is that this time round there is nothing left to sell.

So, the only solution the current government could propose for this crisis is to promise (once again) to pay up all the public debt and announce a fiscal strategy that would bring the government budget into balance through massive cuts in salaries and pensions. There has beenpublic anger; apart from that, the idea has been rejected by the financial markets as well, which has shown that they are not impressed by measures that cause stock markets and Argentine bonds to fall even further, pushing up risk premia on public debt. At the time of writing, it appears almost inevitable that Argentina will, sooner or later, be forced to devalue its currency and slide into an even more severe economic contraction that will cut drastically into the real incomes of most citizens.

BUT that is not the only fallout of the situation. The troubles in Argentina are casting their shadows on emerging markets across the world. Brazil, which infected Argentina last year, has been infected in return, and the Brazilian real fell over a week to a level some 30 per cent below that at which it started the year. The Mexican peso, which had seemed relatively immune, was also affected and depreciated. The troubled Turkish economy faced even more upheaval: the Turkish lira fell almost 5 per cent to reach TL 1,380,000 to the dollar, while Turkish bonds fell 4.5 per cent.

Perhaps more significantly, the economies of East Asia also faced nervous and volatile behaviour in their stock and financial asset markets, rendering their currencies vulnerable once again to a spate of speculative attacks. This will only compound the broader economic difficulties in this region, which was experiencing a partial recovery based on an expansionary fiscal stance and high exports to the booming U.S. economy. Neither the large fiscal deficits nor the U.S. boom could be sustained over time, and the current year has been a story of decelerating growth and sluggish investment.

The fall in export growth has been the proximate factor in the downward revision of growth expectations in the East Asian region. Most economies have experienced low or negative growth in the first quarter of this year, and the outlook is anything but promising. But the real cause of the deceleration lies in the fact that the conditions which enabled the recovery in some East Asian countries were themselves not sustainable over time. In fact, many economies such as Thailand did not really recover from the crisis in terms of reaching the levels of output and employment achieved earlier, while those such as South Korea and Malaysia, whose recovery was the most impressive, relied heavily on large fiscal deficits.

Of course, this time around the financial volatility in East Asia will not have such a severe impact on the real economies, not only because there are more currency swap and reserve-sharing agreements in place but also because all of these countries now have fairly large current account surpluses which they are using to repay debt. But the insecurity and currency fluctuation does mean that investment, employment and economic activity in these countries will be negatively affected.

To an outside observer, the astounding thing about all these cases appears to be the inability or unwillingness of policy-makers in these countries to learn either from their own history or from others' experiences. It is now established beyond question that financial liberalisation renders economies more vulnerable, even in situations where the macroeconomic "fundamentals" are supposedly quite sound. It is also abundantly evident that measures such as large-scale privatisation of utilities and handing them over to multinational companies, independent of their possible adverse effects on workers and consumers, create further problems of balance of payments fragility because of the large foreign exchange outflows such measures entail.

Most of the "structural reforms" which are advocated by the mainstream, which involve allowing more bank and company closures and labour market deregulation, would actually contribute to economic contraction, especially in the current atmosphere of recession. Yet, despite all this clear evidence, governments across the world continue to follow the same medicine prescribed by financial markets, during and after each crisis.

It almost seems like the suicidal march of lemmings to the sea, except that presumably there are some agents in individual countries and in the world economy who end up benefiting from this process. The false argument that is given, of "current pain for future gain", surely cannot be believed by so many people. Or is it that the turn of this century is being marked by an extraordinary collective masochism, with people as a whole choosing to inflict more material suffering upon themselves?