Reference no: EM132136870

Argentina and Ecuador: Understanding the Currency Crisis

While fiscal policy is never far from the mind of your average Argentine, who remembers the tough times and hyperinflation of the 1980s, the events of 2001 and 2002 have brought fiscal policy back to the forefront of public concern. Though the early 1990s may have been characterized by financial optimism, Argentina has been in a recession since Brazil's 1998 monetary crisis sent shockwaves across the regional and global markets.

In early 2002, Argentina defaulted on its US$132 billion in debt. Outraged over the limits imposed on bank withdrawals, 'and fed up with four years of recession, Argentines took to the streets, calling for general strikes. The popularity of President Fernando de fa Rua, who took office in December 1999, plummeted until he was forced to step down.

Travel north to Ecuador and you'll encounter a very different financial perspective. In March 2000,.Ecuador underwent dollarization, the process of making the US Dollar its currency. This policy move is credited with bringing the country's current stability and growth.

In this segment, we'll cover the factors surrounding the economic situations in both countries: the different foreign exchange paths and policies the countries took to address the economic challenges, and what they mean for global businesses operating in each country.

Crisis in Argentina

First we'll look at Argentina. To completely understand the crisis that rocked this nation, we need to look at Argentina's economic history and culture. The land of gauchos, the tango, and Eva Peron, Argentina is considered by many to be the most Europeanized of all the countries in Latin American. The clean, orderly, cafe-lined streets of Buenos Aires and the mannerisms of the people are indicative of a country that takes great pride in its modernity as well as its Spanish and Italian heritage.

With a population of almost 38, million in 2002, Argentina is the third-largest country in Latin America. After its independence from Spain in 1816, more than 4 million Europeans immigrated to Argentina. Others poured in from the Middle East, notably from Syria, Lebanon, and Armenia.. Koreans, Peruvians, Bolivians, and Paraguayans are also prominent. Italian and German are second languages for many Argentines, though the country's distinctive Spanish is the principle tongue. Today, only 15 percent of Argentina's population is mestizo. Unlike other Latin American countries, Argentina has virtually no indigenous people or customs.

These immigrants came to Argentina in search of opportunity. As their successful offspring can attest, many found it. Despite the economic tumult of the late '90s, Argentina boasts Latin America's largest middle class and the highest per capita GDP in Latin America. However, since 1997, the country has been in a steep recession that .has sent many middle-class Argentines back into the ranks of the poor.

Boosting Exports

Through the early '90s, Argentina was the sweetheart of Latin American economies. The economic situation looked good in the early 1990s, largely due to the reforms of the government of President Carlos Menem, who managed to pull his country through the extreme economic hardships and hyperinflation of the '80s. State enterprises were privatized, and Argentina modernized, rebuilding its social and transportation infrastructure, its water and sewer systems, and cooperating with formerly state-owned corporations in the fields of electricity, oil, gas, and telecommunications. Foreign direct investment in Argentina flourished.

Argentina pegged its currency to the dollar in 1991, curbing hyperinflation and creating an economic boon. Presidente Menem was credited with implementing free-market reforms, opening the borders to more trade and restructuring monetary and economic policies. Better trade policies capitalized on Argentina's natural resources, which include an agriculturally based export sector focusing on wheat, meat, corn, oilseed, manufactured goods, and oil. As the economy flourished, national and provincial government spending skyrocketed. Many believe that government spending contributed to the economic crisis.

Unfortunately, the strong rules governing the currency board under which the Argentine government maintained its fixed peso-dollar exchange rate eventually subjected the country to fluctuations in the U.S. currency, as well as fluctuations in US fiscal policy. The government of Argentina could no longer control its own monetary policy, and subsequently it had no control over the price of its exports.

The negative effects of one-to-one parity with the U.S. dollar became apparent in 1995 when the Mexican peso devalued, and again in 1999, when Brazil's currency devalued as a result of the Asian meltdown. Suddenly, Argentina's exports, priced virtually in dollars, were overpriced and no longer competitive. Argentina, like its neighbors, relies heavily on the export of its goods for revenue. With Argentine products no longer competitive, revenue from exports plummeted and unemployment soared.

The policies and practices of the then-President Fernando de la Rua, which included strong- arming the banks into buying government bonds, triggered a widespread bank-run, and Argentines withdrew over $15 billion between July and November 2001. The country's default on public debt in December 2001 combined with unpopular policies led to De La Rua's resignation. Over the next four months, the country went through five presidents, culminating in Eduardo Duhalde's election. .

Duhalde imposed new restrictions on the foreign exchange markets that were unsuccessful. Further, the IMF frowned on the way provinces were being allowed to issue their own parallel currencies to make government payrolls. After months of discussion, during which the central bank promised, yet failed, to take control of the economy, the IMF and Argentine officials began to negotiate a bailout package. Eventually, the peso was devalued against the U.S. dol1ar, falling to nearly 3 pesos per dollar in mid-2003.

Some economists have argued in favor of a system of managed floating to give the government flexibility within a set of targets. Others believe that dollarizing the Argentine Peso at' a discount would bring back stability. For a country that prized itself on its cultural similarities to Europe, facing large spending cuts in return for continued financial assistance from the IMF is a bitter pill to swallow. However, with an unemployment level of 25 percent and a poverty level of 60 percent by mid-2003, Argentina may have little choice.

In May 2003; Nestor Kirchner became the default president, after the two-time former president Carlos Menem, fearing defeat, withdrew from the race. Kirchner vowed to put Argentineans first while taking a hard line with extremely unpopular foreign creditors. Kirchner faces some tough economic issues, including finishing a new accord with the International Monetary Fund, reforming a weakened banking system and renegotiating a large part of Argentina's $144 billion foreign debt. Many are concerned that the lack of popular mandate may make it difficult for him to garner critical political and public support.

Ecuador

Although smaller in size, Ecuador is a picture of diversity. The Andes run through the country north to south, bringing a spectacular variety of climatic conditions. Ecuador's people and culture are equally diverse, with nearly as many Indians as mestizos and nearly as many blacks as whites. The largest cities are sophisticated, while dozens of rural communities struggle for survival without the basic necessities. Presiding over all of this is a fragile government run by the sixth president since 1996, searching for solutions to the country's economic problems - large and small.

With a population of around 13 million, Ecuador is the eighth most populous country in Latin America. It has just a million more inhabitants than Guatemala and 2 million fewer than Chile. Sixty percent of Ecuadorians live in urban areas, all of which are located in the coastal lowlands and the central highlands. Some 2.7 million live in Ecuador's commercial center, the steamy southern port city of Guayaquil, and 1.8 million live in the capital city, Quito, high in the Andes.

Most of Ecuador's rural dwellers are indigenous people. It's difficult to break down the population into ethnic groups, partly because the last official census was in 1990. Some estimates put the mestizo population at 55 percent and the indigenous at 25 percent, while others place the two groups equally at 40 percent each. About 15 percent of Ecuadorians are white, and around 5 percent are black, although some figures put the black population at about 10 percent of the total. There are also a small number of people of Asian descent.

Ecuador has never been a wealthy country, and the political instability of recent years has exacerbated the massive inequality that has characterized the society since colonial times. Most of the wealth is in the hands of white elite, who live sophisticated lives in the large cities, eating in fancy restaurants and flying off to Miami for shopping trips. Indeed, Quito looks much like any other modern industrialized city, complete with cinemas, fast-food restaurants, Internet cafes, and shopping malls.

But while the rich enjoy an enviable lifestyle, the vast majority of the country's large indigenous population lives in extreme poverty. Eight out of ten rural households live below the poverty line, and four out of 10 are unable to meet basic nutritional requirements. Running water and sewage systems reach a paltry 40 percent of households, and only half of Ecuador's teenagers go to school. Although official unemployment figures show a small drop in the jobless rate in recent years, more than half the population is underemployed.

The disparity in wealth distribution and the lack of viable jobs have caused more people, particularly children, to join the "informal economy." Hundreds of itinerant peddlers pepper the streets of the country's cities, selling chewing gum, candy, cigarettes, and flowers, hoping to scrape together enough money for something to eat.  

Various international aid programs attempt to alleviate the poverty blighting so many Ecuadorians, but a lot depends on the country's government. Corruption is endemic in the political system, which is run largely by the white elite, so progress is forecast to be slow.

Like many Latin American nations, Ecuador is struggling economically despite abundant natural resources. Its economy has traditionally been agrarian, and banana exports drove its economy through the second half of the last century. Petroleum took over as the country's biggest export in the 1970s and by the early 1980s oil accounted for more than half of Ecuador's export earnings.

The fall in oil prices in the1980s hit Ecuador hard, compounding the damage caused by floods in 1982 and 1983 and the severe disruption in the country's agricultural production and exports, particularly bananas and coffee. The devastating earthquake of 1987 wiped out much of the Ecuador's only oil pipeline, pushing the economy into full-scale meltdown.

While the country still relies on oil and is the world's biggest exporter of bananas, other major exports, like shrimp, have dropped in recent years and inflation is on the rampage. In 1999, Ecuador's inflation was the worst in Latin America, at 60 percent.

Dollarization

In March 2000, in what many predict could be one of the key moves to help the economy in the long run, the dollar was implemented as Ecuador's currency, replacing the sucre. Many considered the move to full dollarization a structural reform to end the unstable dual-currency system that had resulted from an earlier move to semi-dollarization.

When President Jamil Mahuad first broached the idea of dollarization in 1999, it was extremely unpopular. Indeed, opposition to the idea helped motivate the indigenous people who triggered the January 2000 coup that cost Mahuad his term in office. They realized that, as the country's poorest people, they had the most to lose from the dollarization process, the price of seed, fertilizer, and insecticide would be sure to rise, while their incomes would not.

Despite the resistance to Mahuad’s plans to change the currency, his successor, President Gustavo Noboa, followed through on them, and, although it's still too early to assess the full impact of dollarization, the results so far have been positive. Inflation and unemployment rates are both improving, although the transition process has proven a little difficult for the large number of people living below the poverty line. Unemployment now fluctuates between 10 and 15 percent and half the population is estimated to be underemployed.

Inflation has been tamed, and the civil unrest that led to the January 2000 coup seems to have died down.tn20Q1, Ecuador was the fastest growing economy in Latin America, with GDP expanding by 5 percent.

Despite the stabilizing effects first felt after dollarization, a number of concerns persist. Some pundits have suggested that the impressive results are just a flash in the pan and that sustainable growth will be much harder to achieve. They point to the economic meltdown in Argentina as a prime example of what can go wrong in a dollarized system. Analysts say that for dollarization to work long-term in Ecuador, the government needs to strengthen public finances, but various plans to do 80 (including increasing the value-added tax and privatizing the electricity companies) have been slow in progressing. .

There is also a certain amount of unease over the effects of dollarization on the country's many poor people. The higher cost of basic necessities is causing problems in rural indigenous communities, where people live an agrarian life and stilt buy and sell their produce in.Sucres. Development activists say they would like to see more government money spent on antipoverty programs in the wake of dollarization. Global businesses operating in these countries will find that the economies remain fragile. Argentina, once considered a model country for regional economic success, is being forced to reinvent its financial policies. Ecuador, currently in a stat~ of steady progress, must hope to elude the problems of Argentina's economic crisis. The long-term effectiveness of dollarization, and the future of these two countries, remains to be seen.

Questions:

Your response to each question must be a minimum of 500 words.  

Each case must have an executive summary of the issues discussed in the case.

1. Identify two core factors that caused the Argentine economic crisis. Did Dollarization help Ecuador in overcoming its economic crisis and in improving its economic conditions?

2. Compare and contrast the two different approaches of Argentina and Ecuador to their currency crisis.  

3. Do you think dollarization is the best response to fix currency problems? Why or why not?

4. What would you do differently in the case of Argentina and Ecuador to prevent the crisis occurring again?

5. Do you think each country should have its own currency? Provide arguments for and against this.