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TheArgentinebankingcrisesof1995and2001:Anexplorationinto

theroleofmacro-prudentialregulations.

PabloGuidotti

UniversidadTorcuatoDiTella

and

JuanPabloNicolini

FederalReserveBankofMinneapolis

Firstdraft,May20th,2016

Abstract

ThispaperdealswithtwobankingcrisesthattookplaceinArgentinain1995andin2001,whentheeconomywasfunctioningunderafixed-exchangerateregimecalledConvertibility.Thetwocrisistookplaceinadecadeofsignificantreformsinthemacro-prudentialframework.Theexperiencewascontrasting.Whilethe1995bankingcrisiswasvirulentbutwassuccessfullycontainedbythepolicyresponse,thebankingsystemcouldnotescapetheeffectsofthe2001macroeconomiccrisis,eventuallyleadingtodefaultandtheabandonmentofConvertibility.Wefocusonthemacro-prudentialregulationsputinplace,onthecrisisresponsebythecentralbank,andonsomeimportantinstitutionalreformsdesignedtoresolvemoreefficientlybankingproblems.Weanalyzethedynamicsofcrisesand,inparticular,thebehaviorofdepositors,aswellastheeffectsthatthecrisesandtheregulatoryframeworkhadontheevolutionoftheArgentinebankingsystem.Finally,wedwellonwhatadditionalreformsandprudentialregulationscouldhavepreventedthe2001outcome.

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Introduction

Foralongtime,Argentinahasbeenacasestudyforeconomists.Fordecadesitseconomywascharacterizedbystagnation,volatility,fiscalindisciplineandhighinflation,oftengroundedinchronicpoliticalinstability.Asaresult,acountryrichinnaturalresourcesandwidelyperceivedwiththepotentialofprovidingitscitizenswithahighlivingstandardfellbehindexpectations.

In1991,withtheimplementationofConvertibility,historyappearedtochangeasArgentinaembarkedinanambitiousreformprogramwhiletacklinginflationheadonanchoredonaquasicurrencyboardsystem.Optimismalsocoincidedwiththeadventofglobalizationandasurgeofcapitalflowstoemergingmarketeconomies.

Argentina’seconomicperformanceduringmostofthe1990swasindeedimpressiveonanumberoffronts.Inparticular,theConvertibilityregimewasabletowithstandsuccessfullyaseverebankingcrisisthatoccurredatthebeginningof1995,followingtheMexicandevaluationofDecember1994.AsanexampleofthehighregardArgentina’sreformsweregeneratingintheinternationalcapitalmarketaswellasintheinternationalofficialcommunity,ontheoccasionoftheAnnualMeetingsoftheIMFinOctober1998,theIMF’sManagingDirectorMichelCamdessusdescribed“theexperienceofArgentinainrecentyears”as“exemplary”andstated“Argentinahasastorytotelltheworld:astorywhichisabouttheimportanceoffiscaldiscipline,ofstructuralchange,andofmonetarypolicyrigorouslymaintained.”1

However,asisbynowwell-known,thestoryhadasourending;Argentinamanagedtobacktrackoncemoreandfellintoaseverecrisisattheendof2001andthebeginningof2002.Thatcrisiswascharacterizedbyatrilogy:defaultonthepublicdebt,currencydevaluation,andmandatoryconversionofforeign-currencycontractsintopesos(“pesification”).Thetrilogyslashedthenewlyacquiredcredibilityandseriouslydisruptedtheruleoflaw.

Inthispaper,wefocusmainlyononeaspectofthereformprocesscarriesoutin1990s,thatofbankingandmacro-prudentialregulation.Althoughtheevolutionofthebankingsystemcannotbeentirelydisentangledfromtherestofthemacroeconomy,thereareimportantlessonsthatcanbelearnedfromthereformsundertakenaswellasfromthosethatwerenotputinplace.Inreviewingthefactsaroundthe1995and2001bankingcrises,weanalyzetheinteractionbetweentheprudentialregulationputinplace,thebehaviorofdepositors,thestructureofthebankingsector,andthemacroeconomicpolicyresponse,withparticularemphasisontheroleofthecentralbank.

Thepaperisorganizedasfollows.Insection1wesetouttheinitialconditionsthattheConvertibilityplanof1991encountered.Insection2,wediscusstheregulatoryandsupervisoryreformsadoptedintheearly1990s,aswellastheevolutionoftheArgentinefinancialsystemuntiltheendof1994whenthesuddendevaluationoftheMexicanPesowouldsetinmotionthefirstepisodeoffinancialcontagionthatwouldmarkemergingmarketsinthesecondhalfofthe1990s.Section3analyzesthe1995bankingcrisis,anddiscussestheroleoftheregulatoryframeworkin

1 Seethe“ReportontheEvaluationoftheRoleoftheIMFinArgentina,1991-2001”,issuedbytheIMF’sIndependentEvaluationOfficeonJuly2004.

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place,andthepolicyresponsethatmadeitpossibletosuccessfullyovercomeavirulentbankingrunwithlittlefiscalcosts.Thesectiondiscussesthebehaviorofdepositors.Theevidencesuggeststhatthe1995crisisreflectedmainlyinternalweaknessesofthefinancialsystemanditwasovercomebyanefficientpolicyresponsethatdidnotendangeredmacroeconomicstability.Insection4wefocusonthelessonsofthe1995crisisandontheregulatorychangesthatwereputinplaceasaresult.Weshowthatthe1995crisis,combinedwiththechangesinmacroprudentialregulations,hadasignificantimpactonthestructureoftheArgentinebankingsystem.Thefinancialsystembecamemoreresilient,bothintermsofcapitalizationandliquidity.However,assection5discusses,thatgainedstrengthwouldbeseriouslytestedin2001.The2001crisisexemplifiesthat,nomatterhowstrongabankingsystemis,iteventuallycannotsurviveafull-blownmacroeconomiccrisis.Thedifferencesbetweenthebehaviorofdepositorsin2001ascomparedto1995arestriking.

Insections6and7,wedealwiththequestionofwhatmacroprudentialregulationswouldhavehelpedtomitigatethe2001/2002crisisoutcome.Inparticular,withthebenefitofhindsight,wetrytoanswerthedifficultquestionofwhetherthe2001/2002crisiscouldhavebeenavoidedwithadditionalordifferentmacro-prudentialregulations,anddiscussalternativecoursesofactionthatwereavailabletothegovernmentinordertoavoidormitigatethecrisis.Section8concludes.

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1. Background.Fromhyperinflationtopricestability:theConvertibilityplanof1991.

EversincepermanentlyabandoningthegoldstandardaftertheGreatDepression,theArgentineeconomyexhibitedchronicallyhighinflationrelativetotheUSorEurope.ButextremelyhighinflationbecameadailyexperienceforArgentineansstartingin1975.Indeed,whiletheaverageyearlyinflationratefrom1960to1974wasaround30%andneverexceeded50%,itwas,onaverage315%from1975to1991anditreachedamaximumofalmost5000%in1989.

Thetechnicalexplanationofthis,asafirstapproximation,isrelativelysimple.Duringthatdecadeandahalf,thegovernmenthadrunsustainedandchronicdeficitsthatweremostlyfinancedbymoneycreationfromthecentralbank.ThedeficitoverGDPwasonaveragearound7%,withaminimumof2%andamaximumof12%.Inaddition,startingintheearly80´s,thegovernmentdefaultedonitsdebtanddidnotsettledonanagreementtilltheearly90´s,sotherewasnoaccesstothecreditmarkettofinancethedeficits.Moneyfinancingwastheonlyavailablealternative.ThereasonwhyArgentinacouldnotmakeafiscalreformandavoidinflationisadeeperquestion,beyondthescopeofthispaper.

Asaconsequence,atthebeginningofthe90´sitwasclearwhichbulletwasatthetopoftheagenda:endinginflation.Itmayevenbemoreaccuratetosaythattheagendahadonlythatonebullet.Foravarietyofreasons,themonetaryregimethatwaschosentoendinflationatthetimeinvolvedacurrencyboardthatpeggedthepeso-thelocalcurrency-totheU$dollaratarateofone.ThismonetarystrategywasapprovedbyCongresswhopassedthe“Convertibility”law.Thenameofthelaweventuallybecamethebrandnametheeconomicprogramwasgiven.

Thecurrencyboardimplied,uptosomelimitedexceptionswewillmentionbelow,thatthecentralbankcouldprintlocalcurrencyonlytoaccumulatereserves,soitwasmakingmoneyfinancingofthedeficitillegal.Thefinancialrelationshipbetweenthetreasuryandthecentralbankwerelimitedstrictlytothepurchaseofbonds,markedtomarket,withatightlimit—setinnominalterms—tothegrowthofgovernmentbondsholdingsbythecentralbank.Asabyproduct,thecentralbankwasbannedfromissuingitsowndebt.

Themainshort-runchallengeforeconomicpolicywasonthefiscalfront:Sinceborrowingwasnotanalternativethenewregimewasonlyconsistentwithaneliminationofthefiscaldeficit.Thiswaseffectivelywhathappened,with1992and1993witnessingfiscalsurpluses.Then,aBradyplanwasagreedupon,sothegovernmentcouldthenstartfloatingbondsininternationalmarketsandfinancedthepositivebutsmalldeficitsthatensuedstartingin1994.

Theprogramwasremarkablysuccessful:In1992theyearlyinflationratewas17%,andby1994ithadconvergedfrom1993to2001itwasalwaysbelow3%.ItisreasonabletoconjecturethattheinflexibilityoftheConvertibilityplanwasanimportantcomponenttofostercredibilityonthecurrencypegitselfandonthefiscaladjustmentrequiredtomakeitsustainable.

Buttheinflexibilitycamewithacost:Byremovingtheabilitytodiscretionallylendtothebankingsectoritrestrictedseverelythelender-of-last-resortcapabilitiesoftheArgentineancentralbankmakingitsfinancialsectorpotentiallymorevulnerabletobankruns.

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Intheory,onecouldimaginethatrestrictionnottobeveryimportant,sincethefiscalauthoritycouldeventuallyborrow(say,inUSdollars)andusethoseresourcestolendtothecentralbank.ButitisimportanttorememberthattheGovernmentlaunchedtheprogramwhilestillbeingindefaultininternationalmarketsandcomingoutoftwodecadesofchronicdeficits.Thus,neithermonetarynorfiscalmeasureswereavailabletoactasalenderoflastresort.ThiswasacriticalandwellacknowledgedpotentialshortcomingtheConvertibilityplanhadsinceitsinception.ItexplainsmanyofthefeaturesofthebankinglegislationputintoplacerightaftertheConvertibilitylaw.

Thelongperiodofveryhighandunstableinflationduringthe80´shadperverseeffectsonthefunctioningofthefinancialsector.Withveryhighandextremelyvolatileinflationrates,thebankingsectorcouldbarelyfunctionasanintermediarybetweensavings,thatwerelow,andinvestment,thatwasevenlower.Itmostlyofferedtransactionalservices.Asaconsequence,totalliabilitiesofthebankingsectorwereverylow.InFigure1,wepresenttheevolutionoftotal

Figure1:TotalLiabilitiesoftheBankingSector

liabilities(inmillionsof1982USdollars)since1982.Asitcanbeseen,thenumbersareverysmalluntil1991,theyearinwhichaperiodofspectaculargrowthstarts.Inaddition,duringthe80´s,thereserverequirementontotaldepositswasveryhigh,gettingtoover90%insomeyears.Thesereservespaidinterestrates.Thismechanismwasyetanotherdistortioncreatedbythefiscalvoracityofthegovernmentthatneededfinancingandthereforeusedthebankingsystemasanintermediarybetweendepositorsandthegovernment.

Tosummarize,then,duringthe80´s,thebankingsectorwasverysmall,issuingdepositsthatmostlyservedtransactionalpurposes(thematurityofthemajorityofthesedepositswasjustaweekduringmanyyears)andusingthosedepositsmostlytofinancethegovernmentthroughmandatoryremuneratedreserves.

Thesearetheinitialconditionsofthebankingsectorthatweanalyzeinthispaper.Thisbankingsectorgrewinasystemwithalimitedlenderoflastresortandwasthereforemoreexposedtobankingpanicsthanmostbankingsectoroftheworldatthetime.Twobankingcrisisensued,as

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wewillexplainandanalyzeindetailbelow,onein1995theotherin2001.ThosecaneasilybeidentifiedinFigure1.

2. Thebankingreformsoftheearly90’sandtheevolutionofthebankingsectortill1994.

TheveryrapidsuccesstheConvertibilityplanhadinreducinginflationtoUSlevelsandtheensuingreductioninnominaluncertaintychangedthebusinessmodelforbanks.NewsavinginstrumentswerecreatedandcredittothedomesticmarketstartedtodevelopasFigure1clearlyshows.Atthesametime,thesigningoftheBradyPlanin1993endedtheexternaldebtcrisisthatstartedin1982andopenedfortheArgentineeconomytheopportunitytoinitiateaprocessofintegrationtothe international capital market, and carry on major economic reforms that would produce asignificanttransformationinthefunctioningofthebankingsystemanditsregulatoryframework.

From a macroeconomic perspective, the sharp reduction—and eventually the elimination—ofinflation,alargeincreaseincapitalinflowsandforeigndirectinvestment,andthestrengtheningof fiscal policies represent significant achievements for emergingmarket economies in the firsthalfofthe90s.2

AsFigure1intheprevioussectionmakesclearthefinancialsystemwasextremelysmallatthebeginningofthe1990sinArgentinaand,followingthemacroeconomicstabilization,itexperiencedastrongexpansion.Betweenend-1991andend-1994,depositsincreasedby173%andmorethandoubledaspercentageofGDP.Suchexpansionwouldcontinueatsimilarpaceinthesecondhalfofthe90s.

Aswementionedabove,amajorpolicyrestrictionfacedbythefinancialsectorwastheverylimitedabilityoftheCentralBanktooperateasalenderoflastresort.Butthereweretwoadditionalconcernsthatwererelevantinthiscase.

First,asinothercountriesoftheregion,oneofthesalientfeaturesoftheArgentinebankingsystemwasitshighlevelofdollarization,onbothsidesofthebalancesheet.3Theshareofdollar-denominateddepositsandcreditincreasedsystematicallysincethebeginningofthe1990s.Bytheendof1994,theshareofdepositsandcreditthatwasdollar-denominatedstoodabove55%andabove60%,respectively.AscanbeseeninFigure2,dollarizationcontinuedtoincreaseduringtheentiredecade.Itmustbenotedthat,whiledollarizationseemedanaturalresultoftheConvertibilityregimethatencouragedtheperceptionthatapesohadbecomeequivalenttoaUSdollar,dollarizationposedasignificantbankingrisk.Suchriskderivedfromthefactthatalargeportionofcredit,althoughdenominatedinUSdollars,wasowedbyfirmsandconsumerswhoseincomewasdenominatedinpesos,hencegeneratingapotentiallydangerousmismatchintheeventofalargedevaluation.Aswewillseethiswasacrucialprobleminthemidstofthe2001-2002crisis.

2 See,forinstance,Guidotti(2007). 3 Guidotti and Rodríguez (1992) and Calvo and Végh (1992) analyze the phenomenon of dollarization in developingcountries.

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Figure2.DollarizationoftheFinancialSystem(in%)

Source:CentralBankofArgentina

Second,theArgentinebankingsectorhadinheritedanumberandsizedistributionofinstitutionsthatgrewoutofthebankingcrisisof1982.Attheendofthe1970s,Argentinahadexperiencedashortperiodoffinancialderegulation,albeitwithweakbankingsupervision,inwhichthenumberofbankshadexploded(therewere469institutionsin1980,ofwhich255werenon-banks).Afterthebankingcrisisof1982(seeFigure1)mostofthenon-banksdisappeared,andasmallerbankingsystemevolvedduringtheyearsofhighestinflationrates,mostlyprovidingservicestodefendagainsttheerosioninthevalueofmeansofpayments.

Thetransformationhadbeensubstantialby1991(therewere212institutionsthen,ofwhichonly45werenon-banks).However,itwasverynaturaltoexpectthat,inspiteofthedramaticgrowthofthesector,amajortransformationinthenumberandsizedistributionofinstitutionswouldtakeplace.Indeed,thisinitialcompositionwouldsufferdramaticchangesduringthe1990s,asthenewregulatoryenvironmentputinplacestartingin1993,andthe1995bankingcrisiswewillanalyzeinthenextsection,inducedasignificantfurtherconsolidationoftheArgentinefinancialsystem:Byend-2000,therewere90banksinthesystem,andonly19non-banks.

Thiswasthescenariofacedbypolicyandregulatoryinstitutionsintheearlyquartersofwhatseemed,atthetime,theperiodinwhichArgentinawouldpermanentlyleavebehinddecadesofinstabilityandstagnation.

Followingthe1992passingbyCongressofanewcentralbankcharter,Argentinainitiatedawide-rangingreformofbankingregulationandsupervision,adaptingtointernationalstandardsbutalsorecognizingtheparticularconstraintsimposedbyConvertibilityandthenewmacroeconomicrisksderivingfromthecountry’sincreasingintegrationtoavolatileinternationalcapitalmarket.Thenewcentralbankchartercontainedsomeimportantlimitations:1)itdidnotprovidefordeposit

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insurance,althoughdepositswerelegallyrecognizedasseniorclaimsonassets,and2)thelender-of-lastresortfunctionofthecentralbankwasverylimited,initiallysettoamaximumof20%ofthemonetarybase—latertoincreaseto33%.Furthermore,thecentralbankwasprohibitedfromissuingdebt,payinginterestonbankreserves,andwasseverelylimitedinitscapacityofprovidingfinancingtotheArgentinetreasury.

Inlightofitsnewcharter,theArgentinecentralbankintroducedimportantchangestothebankregulatoryandsupervisorysystembetween1993and1994.4Thefirststepwastodismantleatightapparatusofforeignexchangeandcapitalcontrolsthathadbeeninplaceduringthe1980s.Suchapparatushaddivertedthesupervisoryresourcesofthecentralbankawayfromtheassessmentandpreventionofbankingandsystemicriskstowardscontrollingthatindividuals,firms,andfinancialinstitutionsfullycompliedwiththevagariesofacomplexadministrativesystemofcapitalandexchangerestrictions.Therefore,thecentralbankhadtocarryoutanoverhaulingofitsbankingsupervision,hirenewandprofessionallycompetentstaff,andtrainittoadequatelymeetthechallengesstemmingfromtheadoptionofinternationalstandardsinbankingregulation.SuchprocesswascarriedoutwithaspecialassistanceprogramthatthecentralbanksetupwiththeUSOfficeoftheComptrolleroftheCurrency(OCC)andtheFederalReserveBankofNewYork(FRBNY)toprovidetrainingforseniorsupervisorystaffandassistintheadoptionoftheCAMELratingsystemforfinancialinstitutions.5

Asregardsregulation,Argentinaadoptedthemaininternationalprudentialstandards,summarizedinthefollowingfivepillars:1)consolidatedbankingsupervision;2)capitalrequirementsemergingfromthe1988BaselAccord;3)regulationsregardingassessmentofcreditriskandprovisioning;4)limitsonriskconcentration;and5)standardsregardingtransactionsandrelationswithrelatedorconnectedparties.

Althoughbasedoninternationalstandards,theregulatoryframeworkhadtobeadaptedtothelimitationsimposedbytheabovementionedinitialconditionsoftheArgentineeconomy.Inparticular,acapitalrequirementof11.5%ofrisk-basedassetswasadopted,avalueabovetheBaselparametersofthetime.Moreover,relativelyhigh(non-remunerated)reserverequirementswereimposedonbanksinrecognitionofthefactthatthecentralbank’slimitedabilitytoactasalenderoflastresortneededtobecomplementedbynon-encumberedliquidityatbanks.Areserverequirementof43%wasimposedonovernightdeposits—i.e.,depositsatcheckingandsavingsaccounts—whilesignificantlyloweranddeclining-according-to-maturityrequirementswereimposedontimedeposits.Therationaleforsuchstructurereflectedaninterestonthepartofthecentralbanktocreateincentivestolengthenthematurityoftimedeposits,whichwasthenlargelyconcentratedat7days.

Thefactofthematteristhattheincentivesimbeddedintheabovementionedstructureofreserverequirementsdidnotwork,andthematurityoftimedepositsdidnotlengthen.Asaresult,the

4 See Dujovne y Guidotti (2001) for a detailed analysis of the prudential regulation put in place in the 90s. VariousaspectsofbankingregulationandsupervisionarealsodiscussedinGuidotti(1996). 5 CAMELisanacronymthatstandsforCapital,Assetquality,Management,Earnings,andLiquidity,asfiveessentialareasofevaluationofbankingrisk.

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centralbankadoptedin1994arelativelyunorthodoxmeasuretoreduceliquidityrisk:itimposedaminimum30-daysmaturityontimedeposits,theonlyinterest-bearingdeposits.Therationaleforsuchrestrictionreflectedacoordinationproblem.Nobank,orforthatmatternodepositor,feltconfortableinchoosingalongermaturityfortheirdepositsaslongaseverybodyelsestayedatashortermaturity.Simply,theydidn’twanttobelastinlineintheeventofabankrun.Hence,thecentralbankactionhadtheeffectofreducingsystemicliquidityriskwithoutaffectingtheindividualliquidityriskperception.Infact,depositinterestratesremainedunchangedaftertheadoptionofsuchmeasure,indicatingthatnoadditionalliquiditypremiumhadtobepaidasresultofthemandatorymaturityextension.Lengtheningmanumilitarythematurityoftimedepositsfromeffectively7daysto30daysprovedenormouslyusefulincontainingtheliquidityeffectsofthe1995bankingcrisis,asitslowedbyfourtimesthepaceofthedepositsdrainage.

Amongothercomplementaryactionstaken, it isworthmentioningthatalldifferentialtreatmentas regards banking regulations between foreign and domestic banks were removed, and thecentral bank initiated with the OCC a program of joint inspections of branches of US banks inArgentina.

Theabove-mentionedreforms,althoughquiterevolutionaryforLatinAmericaatthetime,werestilllargelyatanearlystageofimplementationwhentheso-calledTequilacrisiserupted,followingtheDecember1994devaluationoftheMexicanPeso.Asthenextsectiondiscusses,the1995TequilacrisistestedConvertibilityandallthereformsthatweretakingplaceattheprudentialregulatoryandsupervisorylevel.

3. Thecrisisof1995andthechangesinregulationduringthecrisis.Keyelementsthatexplainthequickresolutionofthecrisis.

FollowingtheMexicandevaluationoccurredattheendofDecember1994,theArgentinebankingsystemexperiencedaprofound,buteventuallyrelativelyshort-livedbankingcrisis.Althoughwewillprovidesomeempiricalevidencethathelpsdisentanglingtheextenttowhichthebankingcrisisreflectedgeneralmacroeconomicfactorsorreflectedinternalfactorstothefinancialsystem,itsmostimmediatemanifestationwasthesuddenappearanceofrumorsinthesystemthatafewwholesale(investment)bankswerehighlyexposedtogovernmentbonds—whosepriceswererapidlydecliningbecauseofcontagion—andthatheavylosseswerebeenhiddeninconnectedoffshorecompanies.6Theseoffshorecompanieswereunknowntothecentralbankinspiteoftheconsolidatedsupervisionprinciplethatwasbeingadoptedinthenewregulation,simplybecauseittooksometimetohaveallfinancialinstitutionstocomplywithit.

Forthemost,wholesalebanksweresmallinstitutionshardlyassociatedwithsystemicrisk.Butsoonenough,interestratesintheinterbankmarket,whichhadincreasedsignificantlyjustaftertheMexicandevaluation,collapsed.Themosttypicalindicatorofsystemicliquidityriskhadstoppedtransmittingtherelevantinformation,asitbecameevidentthattheamountoftransactionsinthatmarkethadcollapsed—thelendingvolumeintheinterbankmarketfellbyover6 Attheendof1994therewere34wholesalebanksinthesystem,outofatotalof135privatebanks.Wholesalebankshad very few branches in comparison with retail banks and, hence, represented a small proportion of total bankdeposits.

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50%--indicatingthatthemarkethadfrozeninresponsetoasharpincreaseincounterpartyrisk.Wholesalebankswerebeingrationedoutoftheinterbankmarketandhadnoaccesstoliquidity.

Soonafter,stillinearlyJanuary,thefirstindicationsofheavydepositlossesstartedtobecomeevident.Depositsfleeingwholesalebankswerenotfromsmallinvestorsbut,rather,fromlargeandmoreinformedinvestors,aswellasotherfromfinancialinstitutionsthathadfundedtheoperationsofwholesalebanks.AsshowninFigure3,atthebeginningofthecrisis,wholesalebanksstartedfacingseverelosseswhiletherestofthebankingsystemappearedlargelyunaffected.

Inwasonlyamatteroftimeforpanictostartspreadingfromwholesalebankstoothersmallandmedium-sizebanksofdomesticcapital.AsshowninFigure3,depositorsclearlydifferentiatedacrossbanks,asforeignbanks—andtolesserextentpublicbanks—werequicklyperceivedassafeheavens.Duringtheentireperiod,depositsatforeignbanksandfederalpublicbanks(e.g.,BancodelaNaciónArgentina)increased,whiledepositsatprivate-domesticandpublic-provincialbanksfell,albeitatamuchslowerpacethanatthewholesalebanksandexhibitingsignificantdifferencesacrossthem.Largedomestic-privatebankssufferedsignificantlylessdepositlossesthansmallerbanksand,especially,thancooperativebanks,whichhadamuchlesstransparentcorporategovernanceandmanagementstructure.Duringthefirstthreemonthsof1995,totaldepositsoftheArgentinebankingsystemfellbyanimpressive18%.

Figure3.Tequilacrisis–Evolutionofdeposits

Source:CentralBankofArgentina

The banking crisis required central-bank action on several fronts. On the one hand, therewascrisis management. On the other hand, new changes had to be introduced in the prudentialregulatoryandsupervisoryframeworktoaccountforthelessonslearnedfromthecrisis.Thenextsectiondealswiththelattersubject.

Intermsofcrisismanagement,thefirstchallengefacedbythecentralbankwashowtomanagesystemic liquidity. The Argentine central bank resorted initially to a lowering of reserve

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requirements, but its effect was short lived. In the way they were structured, reserverequirements injected liquidity mostly into large retail banks that held a large proportion ofovernight deposits subject to high reserve requirements. But the injection of liquidity did notarrivesignificantlytowholesalebanks.Thesebankswereexperiencingtheheaviestdepositlossesandheldliabilitiesthatmostlywereeithernotsubjecttoreserverequirementsorhadlowreserverequirements.Moreimportantly,wholesalebankswerecutoutoftheinterbankmarket.

This situationcalled for thecentralbank toactasa lender-of last-resortandextendemergencyliquidity to affected banks. However, the crisis unveiled the typical shortcomings that centralbanksfaceundersystemiccrises,aswellassomeshortcomingsmorespecifictotheConvertibilityregimeanditsmonetaryinstitutions. Thefirstwell-knownproblemisthe“stigma”effectofthelender-of-last- resort function. Especially in a situation where banks face different degrees ofdeposit losses,banks thatneed liquidity themostcannotget it in the interbankmarketandarereluctant to go to the central bank because they fear sending a clear signal that they are introuble. On the contrary, the only banks thatwould potentially accept liquidity offered by thecentralbankarethehealthybanksthatdon’tneedit.

Toresolvetheproblemsofunequaldistributionofliquidityandthestigmaassociatedwithcentral-bank emergency lending, a “safety net”was established at the federal public bank Banco de laNaciónArgentina.ThissafetynetwasfundedwithanincreaseintheoverallreserverequirementthatwasdepositedatBancodelaNaciónArgentina,whichinturnmadelendingavailabletothebanksthatrequiredliquidityassistancethroughtheinterbankmarket.Inanyevent,astherunondeposits intensified and spread to a larger number of medium banks, the central bank’semergencyliquidityprovisionalsoexpanded(Figure4).

Figure4.Emergencycentral-bankliquidityassistance

Source:CentralBankofArgentina

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Theemergencyliquidityassistancesituatedthecentralbankveryclosetoreachingeventuallythelegal limit imposed by the 1992 central-bank charter. As Figure 5 shows, the backing of themonetarybasewithbonds,reached18.5%,almostatthe20%legallimit.

Figure5.TheTequilaEffect(rightscaleinUSDmillion,leftscalein%)

Source:CentralBankofArgentina

As the crisis deepened, the central bankmonitored the liquidity position of all institutions thatrequiredemergencyliquidityassistanceonadailybasisinordertoestimatehowtobestusethelimited lender-of-last-resort function legally allowed. Notwithstanding, the central bank relaxedboth thematurity, aswell as the collateral requirements, of the emergency liquidity assistanceprovided.Inaddition,relyingontheprincipleofsupervisiononaconsolidatedbasis,thecentralbankcrackeddownonconnectedoffshorecompaniesintheArgentinebankingsystemtoimprovetransparencyandassessthetruesolvencysituationofasignificantnumberofinstitutions.

Buttheabove-mentionedcrisismanagementactionsalonedidnotreversethedepositrun.Soonenough it became clear that the liquidation of some banks was unavoidable and, hence, aprofoundpolicydiscussionstartedinrelationtothespeedoftheprocess.AtoneextremeliedtheIMF, recommending a once-and-for-all clean up of the financial system by liquidating about 40banksinonemove.Butthecentralbank,thoughacknowledgingtheneedtorestructureseveralbanks, favored and pushed for significant institutional changes to correct the shortcomingsstemmingfromConvertibility.

At theworst of the crisis a numberof significant reforms to thedomestic financial architecturewereputinplacewiththerapidanddecisivesupportfromCongress.InFebruary1995,thecentralbank revised the position imbedded in its 1992 charter, and formally reintroduced a privately-funded and limited deposit-insurance scheme to inspire confidence in the banking system andcontain the drainage of deposits 7 However, by being privately funded by contributions from

7Depositinsurancewouldbeprovidedbyanewinstitution,SEDESASA,thatwouldadministerthefundspaidbyallbanks,onamonthlybasis,ataraterangingbetween0.015%and0.06%oftheirdeposits,dependingontheCAMELratingoftheinstitution—i.e.,theriskiertheinstitutionthehigherwasitsdepositinsurancepremium.Inthenewscheme,depositorswereinsureduptoUSD30.000perperson,providedthattheinterestpaidondepositswaslower

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withinthebankingsystem,theeffectivenessofnewdeposit insurancewas limitedatthetime itwas introduced. Nevertheless, it represented a realistic institutional reform thatwouldplay animportantroleinthefollowingyears.

The most important reform introduced in the midst of the 1995 crisis was the creation of amechanism for resolving troubled financial institutions. Such reformwas introduced through anew article in the Law of Financial Entities—known as art. 35bis—which gave the central banklegal power to extract from certain assets and liabilities from the balance sheet of a bank thatenters the process of liquidation. In particular, on the liability side, senior liabilities—deposits,laborobligations,andcentralbankemergencyliquidityloans—couldbeextracted,alongwiththebest quality assets up to an amount equivalent to the extracted liabilities. The residual bankwould then be liquidated through normal bankruptcy proceedings in the justice system. Thepackage of extracted assets and liabilities, along with the bank’s employees, could then beauctionedtointerestedbuyersinthefinancialsystem.Asthisrestructuringwasoccurringinthemidstofabankingcrisis,thegovernmentsetupaFiduciaryFundforBankCapitalization,fundedbyan initialUSD500million loan fromtheWorldBank, toprovide thebuyerbank the requiredregulatory capital—in the form of subordinated or convertible loans—as well as liquidityassistanceifneeded.

Therationaleforthisinnovativemechanismwastwofold.Firstly,giventhefiscalconstraintsfacedbyArgentina,thebailoutoftroubledfinancialinstitutionscouldresultinahighfiscalcostthatthecapital market could regard as unsustainable and, hence, could weaken the credibility of theConvertibility regime. Secondly, it iswell known that as soon as a bank enters liquidation, thevalue of assets tends to deteriorate rapidly as debtors stop servicing their obligations and thefailedbankhasnoresourcestomonitorthedebtors’compliance.Therefore,art.35bisprovidedanefficientmechanismtorestructurea failingbankthatwouldprotect thevalueofbankassetsand the repayment of senior liabilities with the bank’s existing resources, thus minimizing thefiscalcostofbankclosuresaswellastheirdisruptiveeffectsoncreditandonemployment.8

The results from the applicationof theArt. 35 bismechanismwere impressive. Itwas used toresolve 19 private financial institutions between 1995 and 1999. About 97%of the deposits atliquidatedbankswereabsorbedbytheacquiringbank,orbanksyndicateinfewcases.Contrarytothe international experience,where the fiscal costs associatedwithbanking crisesoftenexceed15%ofGDP,thesuccessfulresolutionoftheArgentine1995bankingcrisisrequiredasmallfiscalcost,estimatedatjust0.1%ofGDP.9

In parallel to the resolution of private banks through Art. 35 bis, the government activelypromoted theprivatizationof severalprovincialpublicbanks. Asa result, thenumberofpublicbanksfellfrom33institutionsattheendof1994to15institutionsbytheendof1999.

thanarateestablishedbythecentralbank.Thelatterfeaturewasmeanttodiscouragethephenomenonknownas“gamblingforresurrection”bywhichatroubledbanktriestokeepitsdepositbasebyofferinghigherandhigherinterestrates.8 SeeDeLaTorre(2000)andDujovneandGuidotti(2001)foramoredetaileddescription. 9 SeeGuidotti(1996)andIMF(1998).

14

ArgentinawasclearlythecountrymostaffectedbycontagionfromtheMexicandevaluation,andtheConvertibilityregimewasputtoatestbyforeigninvestorsaswellasdepositors.Asaresult,economicactivitycontracted,asevidencedbya2.8%fall inGDPin1995.Moreover,theleadingstock market index (Merval) fell by 50% and bond prices fell by 45% reaching their trough onMarch 8th of 1995. The spreadon government bondsover comparableUS Treasuries averagedover1400basispointsduringthefirstquarterof1995.

In addition to the measures taken by the central bank to cope with the banking crisis, thegovernmenttookdecisiveactiononthefiscalfront,andsped-uptheprivatizationofseveralstate-ownedprovincialbanks.10Moreover,inordertoreassureinvestorsaboutthegovernment’sabilitytomeet its financing needs, inmid-March of 1995, the government signed a programwith theInternationalMonetaryFund(IMF)thatincludeddisbursementsfromthatinstitutionforUSD2.4billionandloansfromtheWorldBank(WB)andtheInter-AmericanDevelopmentBank(IADB)foranadditionalUSD2.3billion.Tocomplementtheofficialeffort,anumberofcompaniesandbankssubscribedtheissueoftheArgentinaBond(alsocalledthe“PatrioticBond”)byanadditionalUSD2billion.

The combination of official financing and clear and decisive policy actions by the governmentproducedthedesiredresult:thebankrunceasedandfinancialactivityreturnedtonormallevelsinthesecondhalfof1995.

Thebehaviorofdepositors:Acloserlook

Oneimportantaspectofthe1995crisisrelatestothebehaviorofdepositorsduringthecrisisandthenatureofrisksthatbroughtitabout.Ifisoftenverydifficulttodisentanglebankingcrisesformmacroeconomiccrises,asnomatterwhichonestartsfirsttheareoftenseenasinseparabletwins.InthecaseofArgentina,withalonghistoryofeconomicandfinancialinstability,afixedexchange-rateregimesuchasConvertibilitycouldeasilybeperceivedasanaturalcandidatetocomeundermarketpressureand,inthatcase,thebankingsystemisanaturalweaklink.Inthisview,thebankingcrisiswouldresultfromalossofconfidenceinthegeneralmacroeconomicframeworkandnotviceversa.

However,adifferenthypothesiscouldbeconstructed.Itcouldbearguedthatthe1995crisisreflected,toalargeextent,weaknessesthatwereinternaltotheArgentinefinancialsystem,asystemexperiencingrapidgrowth,inacontextwhereprudentialregulationwasstillatitsinitialstagesofdevelopmentandimplementation.

EmpiricalanalysiscarriedoutbyGuidotti(2008)shedslightonthesecompetinghypotheses.Hiscross-sectionempiricalanalysis(attheindividualbanklevel)focusesonwhatfactorsexplainthedepositrun—occurredbetweenDecember1994andApril1995—and,inparticular,whyitwasdifferentacrossthevariousfinancialinstitutionsinthesystem.

10 Inadditiontoanumberofexpenditurecuts,includingareductioninpublicsectorwages,thegovernmentincreasedthe value-added-tax (VAT) rate from 18% to 21%, increased temporarily import tariffs, partially reversed a previousreductioninemployers’laborcontributions,andwidenedthetaxbasefortheVATandincometaxes.

15

Totakeintoaccountthevarioushypothesis,theindependentvariablesincludedtoexplainthedepositlossoccurredbetweenDecember1994andApril1995(i.e.,thedependentvariable)were:1)theinterestpaidbybanksondepositsbeforethecrisis(atNovember1994);2)theoriginofbankcapital(domesticorforeign);3)themarketshareofthefinancialinstitution(atNovember1994);and4)theexposureofbankstothepublicsector(atNovember1994).

Theempiricalresultsarequiteilluminating.Thecoefficientsoffirstthreeexplanatoryvariablesarestatistically highly significant and possess the expected sign.11 Results show that those financialinstitutions that were paying the highest interest rates on their deposits suffered the heaviestdeposits losses. This result is consistentwith thehypothesis thatdepositorswereawareof thepositive association between interest rates paid and the risk profile of the financial institution.Thus,assoonassystemicriskincreased,depositorsfledwiththehighestintensityfromthebankstheyperceivedasmorerisky.

Asregardstheoriginofcapital,resultsalsosuggestthatinternalfactorstothebankingsystemplayedthemostsignificantroleinexplainingthebehaviorofdepositors.Bybeingforeign-ownedabankwasperceivedasalessriskybank,becauseofthepotentialsupportofheadofficesaswellasbettergovernance.Hence,resultsshowthat—giventheothervariables—depositorstookintoaccounttheoriginofcapitalintheirbehavior,andrunfromdomesticbanksbutnotfromforeignbanks(seeFigure3).

Inasimilarvein,resultsshowthatthesizeofthebankmatteredintheeyesofdepositors.Giventheotherexplanatoryvariables,largerbankssufferedlessdepositlossesthansmallerbanks,asmeasuredbytheirmarketsharebeforethecrisis.Onepossibleinterpretationofthisresultrelatestothewellknowntoo-big-to-failproblem.Largebankswereperceivedashavingsystemicimplicationsand,therefore,wereexpectedtobebailedoutbythecentralbankwithhigherprobabilitythatthatofsmallbanks.Inthisinterpretation,depositorswouldnotbeconcernedaboutthefiscalcapacityofthegovernmentintheeventabailoutwouldbecomenecessary.Hence,ifthetoo-big-to-failconceptwaspresentintheperceptionofdepositors,thisresultwouldsupportthehypothesisthatthe1995crisisreflected,toalargerextent,factorsinternaltothebankingsystemratherthanuncertaintyabouttheArgentinemacroeconomy.

Theaboveviewisalsoconsistentwiththelastresult:thattheexposureofbankstothepublicsectorturnedoutnotstatisticallysignificantinexplainingthebehaviorofdepositors.Hence,thisresultsupportsthehypothesisthatdepositorsdidnotperceivethefiscalsituation,orapotentialdefaultonthepublicdebt,tobeasignificantriskindecidingtheirdepositwithdrawals.

Insummary,the1995bankingcrisisexhibitedthecharacteristicsofaneventgeneratedlargelybyinternalweaknessesofthefinancialsystematatimeofrapidcreditgrowthandachangingregulatoryandsupervisoryenvironment.Inthiscontext,thesuccessfulmanagementofthecrisisreflectedtheroleofthereformsputinplace,whichmadethecrisisresolutionconsistentwithmacroeconomicandfiscalsustainability.Thescenariowillbeverydifferentwhen,lateron,wewillanalyzethebankingcrisisof2001.

11Overall, theregressionhasanR2of51.3%.

16

4. Changesinregulationpost-crisisandtheevolutionofthebankingsectorfrom1995to2000.

Despite the intensity of the 1995 Tequila crisis, the flexibility shown by the economy and thegovernment’ssuccessinweatheringtheexternalshockwithoutalteringtheConvertibilityregimeboostedsignificantlytheinternationalanddomesticconfidenceintheArgentineeconomy.Suchconfidence translated, for instance, into a significant increase in the inflows of foreign directinvestment.ForeigndirectinvestmentthathadtotaledUSD3.6billionin1994almostdoubledin1996, reaching USD 7 billion. As the Argentine economy recovered, the spread paid bygovernmentbondsoverUSTreasuriesfellmarkedly. Thespreadongovernmentbondsthathadaveraged740basispointsduring1994(i.e.,beforetheTequilacrisis)felltoanaverageof450basispointsin1997.

Fromthelastquarterof1995tothesecondquarterof1998,Argentina’seconomygrewatafastpace.Duringthoseelevenquarters,GDPgrowthaveraged1.8%aquarter,equivalenttoanannualgrowthrateof7.4%.Asaresult,yearlyGDPgrowthreached5.5%in1996,8.1%in1997,and3.9%in1998.

Thefastrecoveryoftheeconomyprovidedtheopportunitytodrawfreshlessonsfromthe1995financialcrisisandstrengthentheprudentialregulationandsupervisionofthebankingsystem.Atthesametime,theregulatorychangesandthecrisisitselfproducedasignificantconsolidationoftheArgentinebankingsystem.

Asregardsprudentialregulationsthemainchangesintroducedbythecentralbankfollowingthecrisisimpingedonthetwocentralfeaturesofbanking-riskmanagement:capitalandliquidity.Onceagain,thechangesinprudentialregulationfollowedtheevolvingnatureofinternationalstandards,butalsoreflectedthelessonslearnedfromtherecentexperienceinactualcrisismanagement.

Bankcapitalrequirementswereincreasedfurtheronaccountof,ontheonehand,theintroductionofaRiskIndicatorinthedeterminationoftherequiredcapitaland,ontheotherhand,theadoptionofcapitalsurchargesreflectingmarketriskandinterest-raterisk,derivedfromBaselupgradedrecommendations.

TheintroductionofaRiskIndicatorwasinstrumentalinraisingthecapitalrequirementtoaneffectivelevelof13%to15%ofrisk-basedassets,measuredaccordingtotheBaselmethodology.TheRiskIndicatorwascomputedasafunctionoftheinterestratechargedbybanksontheirloanportfolio.Thus,thehighertheinterestratecharged,thehigherwastheRiskIndicator.TheRiskIndicatorwasthenmultipliedtothebasic11.5%capitalrequirement.12Inaddition,thecentral

12 Although theobjectiveof theRisk Indicatorwasprudential—soas to require riskierbanks toholdmorecapital, asmeasured by a market measure such as the interest rate on loans—some observers interpreted this feature as amechanismtoinduceareductionininterestrateschargedbybanksontheirloans.

17

bankintroducedtheCAMELSratingsinthecomputationofcapitaladequacy,thusrequiringmorecapitaltoinstitutionswithlowerratingsfrombankingsupervisors.13

Besidesincreasingthebankcapitalrequirement,theRiskIndicatorintroducedapro-cyclicalelementintoit.14Inpractice,possiblyduetothepro-cyclicalnatureofthecapitalrequirement,Argentinebanksexhibitedsignificantexcesscapitalization,rangingfromamaximumof39%in1996toa32%in2000.Theexcesscapitalizationexhibitedbybanksreflectedaprecautionarymotive,asbankersknewthattherequiredcapitalwouldincreaseiftherewereageneralincreaseininterestrates.Interestingly,suchprecautionarybehavioronthepartofbanksendedupcompensatingthepro-cyclicalfeatureofthecapitalrequirement.

InadditiontotheRiskIndicator,andfollowingtheevolvinginternationaldiscussionleadingtoBaselII,capitaladequacyrequirementsweremodifiedtoincorporatesurchargesforinterest-raterisk,andmarketrisk.Themostimportantelementinthesemodificationswasthatgovernmentbonds,althoughremainedwithazeroweightintherequirementforcreditrisk,nowbecamesubjecttothesurchargeformarketandinterest-raterisk.Giventhatexposuretogovernmentbondshadbeenimportantdeterminantsinthelossofconfidenceexperiencedbywholesalebanksinthe1995crisis,thecentralbankdecidedtodepartfromBaselrecommendationsandsubjectgovernmentbondstoacapitalrequirement.Inparticular,governmentbondshadacapitalsurchargethatfluctuatedbetween1%and5%,dependingontheirmodifiedduration.

Recognizingtheimportanceofbankliquiditywhenthecentralbank’sabilitytoactasasystemiclenderoflastresortislimited,theadoptionofMinimumLiquidityRequirements(MLR)constitutedthesecondpillarofthepost-1995ofthemacro-prudentialframework.

Duringthe1995bankingcrisis,thepolicyofloweringreserverequirementshadplayedanimportantroleincomplementingtheemergencyliquidityextendedbythecentralbank.However,thatexperienceshowedimportantshortcomingofhowthereserverequirementsweredesigned.Inparticular,thefactthatreserverequirementswerehighoncheckingandovernightsavingsaccounts,butmuchlowerontimedeposits,generatedanunequaldistributionofliquidityinthesystem.Moreover,timedepositsshowedamuchhigherpropensitytofleethanovernightaccountsthatwheremostlytransactionalinnature.Hence,liquiditywasparkedinthewrongplaceand,asarguedearlier,theinterbankmarketprovedtobeapoorchanneloftransmissionofliquidityacrossinstitutionsinasystemiccrisis.

Twoadditionalshortcomingswerealsoworthconsidering.Firstly,asmandatedbythecentralbankcharter,reserverequirementswerenon-remunerated.Hence,increasingliquidityrequirementsonfinancialinstitutionsincreasedthecostoffunding.15Secondly,bybeing

13 CAMELSisthesecond-generationofCAMEL,andaddsasixthcomponenttotheoriginalratingtoassessthebank’ssensitivitytomarketandinterest-raterisk.ThemultiplicativefactorenteringthecomputationofthecapitalrequirementthatwasassociatedwiththeCAMELSratingsvariedfrom0.97foraninstitutionrated1(thehighestrating)upto1.15foraninstitutionrated5(theworstrating).14 TheRiskIndicatorwasnottheonlypro-cyclicalfactor inthecapitalrequirement.Alsothesurchargeformarketriskplayedasimilarrole. 15 See Fernandez and Guidotti (1999), and Guidotti (2003) for an analysis of the effects of capital and liquidityrequirementsonthebankingsystem,andonlendinganddepositinterestrates.

18

depositedatthecentralbank,reserverequirementswherenotregardedasentirelyrisk-freebythecapitalmarket.

Therefore,attheendof1995,reserverequirementswerereplacedbythenewlycreatedMLR.MLRcouldbemetthroughthreemaincomponents:1)reposongovernmentbondswiththecentralbank;2)holdingsofforeigngovernmentbondswithacreditratingnotbelowAandotherselectedforeignassetsofsimilarcharacteristics;and3)stand-byone-yearlettersofcreditwithforeignfinancialinstitutionsratedAAorhigher,upto20%oftheMLR.InordertoensurethatMLRconstitutedunencumberedliquidityand,inparticular,toavoidback-to-backloans,DeutscheBank(NewYorkbranch)waschosenasthemandatorycustodian,withacontractthatcouldbemonitoredbytheArgentinecentralbank.

Tocomplementsystemicliquidity,thecentralbanksetupacontingentrepolinewithanumberoflargeinternationalbanks,usingitsgovernmentbondholdings.AsshowninFigure6,systemicliquidityincreasedwiththevariousmeasuresdescribedabovetoover28%oftotaldepositsoftheArgentinefinancialsystem.TheadoptionofMLRandthecontingentrepolineconstitutedacentralfeatureonthecentralbank’sstrategyinstrengtheningthefinancialsystem’sresiliencetofacevolatility.16

Figure6.SystemicLiquidity(as%oftotaldeposits)

Source:CentralBankofArgentina

The financial system’s internal weaknesses exposed by the 1995 banking crisis, and the vastreform of macro-prudential regulations, were critical factors in explaining the extensiverestructuring and consolidation that occurs in the Argentine banking system after 1995. Suchrestructuringandconsolidationmodernizedthebankingsystemandstrengtheneditssolvencyandliquidity.

16 SeeGuidotti(2003)foradiscussionofhowtobuildaliquidity-managementstrategyinemergingmarketeconomies.

0

7

14

21

28

35

1994 1995 1996 1997 1998 1999 2000

RepoProgram

Liquiditybills

Repos

Depositsabroad

DepositsatCentralBank

19

TwomainfactsillustratetheextentoftheconsolidationthattookplaceintheArgentinefinancialsystemafter1995bankingcrisis.Firstly,thetotalnumberoffinancialinstitutionsfellsharply,from212 in 1992 to 109 by end-2000. Secondly, reflecting the significant process of privatization atprovincialpublicbanks,thetotalnumberofpublicbanksfallsfrom33atend-1994to14atend-2000.Table1illustratesthemainfeaturesoftheconsolidationprocessthattookplaceafter1995.

Table1.Depositsshare(in%)

Source:CentralBankofArgentina

Theshareofthetenlargestbanksintotaldepositsincreasedfrom35%in1995to51%in2001.Moreover,theshareofforeignbanksintotaldepositsexpandedasaresultofanumberofacquisitionsoccurredbetween1996and1998,inparticulartheacquisitionoftwolargedomesticbanks,BancoRioandBancodeCréditoArgentino,bythetwolargestSpanishbanks,BancoSantanderandBancoBBVA,respectively.Between1995and2001,theshareofforeignbanksinprivatedepositsincreasedfrom25%to56%,andfrom21%to48%intotaldeposits.

Theincreaseinmarketshareexperiencedbyforeignbankshadanimportantimplicationforsystemicrisk.Undertheassumptionthattheirhomeofficeswouldsupportforeignbanks,systemicliquidityavailabletodealwitheventualdepositlosseswasperceivedtobelargerthanthecoverageratiooftheMLR.AsshowninTable2,notonlysystemicliquidityincreasedbytheadoptionofMLR,itincreasedtoover55%oftotaldepositsoncedepositsatforeignbankswereexcludedfromthecomputation.17

Table2.Foreignbanksandsystemicliquidity

Source:CentralBankofArgentina.

17 In thesuccessful resolutionof its2001crisis, theUruguayangovernmentadoptedthecriterionofplacingonhomeofficesofforeignbankstheresponsibilityofprovidingliquidityassistancetotheiroperationsinUruguay.

20

Aspreviouslymentioned,thestrongrecoveryexperiencedbytheArgentineeconomyafterthe1995TequilacrisisboostedsignificantlytheinternationalanddomesticconfidenceintheConvertibilityregime.However,the1996-1998periodofstrongeconomicgrowthwasagaininterruptedbythefalloutfromtheRussiandefaultinAugust1998.AsRussiadeclaredadefaultonitspublicdebt,ArgentinatogetherwithseveralotheremergingmarketeconomieswasaffectedseverelybythecontagioneffectsstemmingfromtheRussiancrisis.Asaresult,riskspreadsincreasedagainandeconomicgrowthhalted.TheeffectsoftheRussiandefaultcompoundedasaresultoftheBraziliandevaluationinMarch1999.

Duringtheeight-monthperiodmarkedbytheRussianandBraziliancrises—fromAugust1998toMarch 1999—the risk spread onArgentine bonds averaged 800 basis points reaching a peak of1100basispointsinSeptember1998.AsillustratedinTable3,theincreaseinriskspreadswasageneralized phenomenon among a large number of emerging market economies and affectedArgentina relatively less thanBrazil,Mexico, and the groupof countries included in JPMorgan’sEmergingMarketsBondIndex+(EMBI+)index.

Table3.TheEmergingMarketsBondIndex-PeriodAverage

Source:J.P.Morgan.

Note:LatinAmerica,Argentina,Brazil,MexicoandRussiarefertotherespectivecomponentsintheGlobalEMBI+index,expressedinbasispoints.

Notwithstanding the increase in risk spreads, bank deposits—unlikewhat had happened in the1995crisis—continuedrising,asdidbankcredit to theprivatesector. Thiswasreflectiveof theinvestors’ confidence in Argentina’s convertibility system, which had successfully managed theTequilaeffect.

Beyondthevolatilityofriskspreadsonthepublicdebt,confidenceintheArgentineeconomyalsowasreflectedinthefactthatforeigndirectinvestmentcontinuedtoincreaseduringthatperiod.Foreign direct investment amounted to USD 7.3 billion in 1998 and USD 24 billion in 1999,equivalent to 2.4% and 8.5% of GDP, respectively. These foreign direct investment figurescomparefavorablywithanannualaverageofUSD6.3billionintheperiod1994-1997.In1999,thecurrent account of the balance of payments displayed a deficit of USD 12 billion, equivalent to4.2%ofGDP.GiventhatduringthatyearinternationalreservesattheCentralBankincreasedbyUSD1.5billion,thepresenceofacurrentaccountdeficitwasaclearindicationofthewillingnessof foreign residents to increase their holdings of Argentine assets (as well as of the country’sabilitytoattractforeigncapital).

Inthesecondhalfof1999,theArgentineeconomywasalreadyrecovering.Industrialproductionincreasedmarkedly by 10% in seasonally-adjusted terms—equivalent to an annualized rate ofincrease of 20%— between June and December 1999, while the year as a whole exhibited an

Period EMBI+ Latin Argentina Brazil Mexico Russia

Jan ´98 - Jul ´98 535 489 447 542 413 782

Aug ´98 - Mar ´99 1,210 996 799 1,223 772 5,084

Apr ´99 - Dec ´99 1,069 806 706 943 573 3,527

21

increase in industrial production of 6.6% (measured as the change from December 1998 toDecember1999). The favorableperspectives that theArgentineeconomywasdisplaying in thesecondhalfof1999alsotranslatedintoa lowerspreadthatthegovernmenthadtopayoverUSTreasuries compared to the risk spread applying to Brazil (283 basis points higher inDecember1999), toRussia (2350basispointshigher),andto theaverageofLatinAmerica (60basispointshigher inDecember1999). The reduction in spreads tookplacenotwithstandingArgentinawasfacingpresidentialelectionsaftertwoconsecutiveterms inofficebythenPresidentMenem. Bytheendof1999,theriskspreadongovernmentbonds—measuredbytheArgentinecomponentoftheEMBI+index—hadfallento586basispointsoverUSTreasuries.

InOctober1999,acoalition(theAlianza)composedbytwoparties,UniónCívicaRadical(UCR)andFrente País Solidario (Frepaso), beat the traditional Peronist party in the general presidentialelections. OnDecember10,1999PresidentFernandoDe laRúawas sworn intoofficeandwasmetwith a very favorable sentiment prevailing among international investors as Argentinawasseen as leaving behind the effects of the Russian and Brazilian crises. As a result, in the firstquarter of 2000, government’s access to the international capital market was very ample as itissuednewbondsintheamountofUSD4.1billion.Moreover,riskspreadsongovernmentdebtcontinuedtodeclinetoanaverage levelof538basispoints inMarch2000,asmeasuredbytheArgentinecomponentoftheEMBI+index.

An important reason behind the market’s optimism was related to the perception that theArgentine economyhad strong fundamentals andhaddisplayed in its recent past a remarkablecommitmentandabilitytoovercomecrises.Inparticular,thesizesofthepublicdebtandoftheinterestbillmeasuredasaproportionofGDPwereperceivedasmanageable,andwerelowerthanthelevelsexhibitedbyotheremergingmarketeconomies.18Argentinainitiatedyear2000witharatioofpublicdebttoGDPof43%;theaverageinterestratepaidonthepublicdebtwasrelativelylow,anannualrateof7.3%.Innominalterms,grosspublicdebtamountedtoUSD121.9billion,andtheinterestbillhadamountedin1999toUSD8.2billion,equivalenttolessthan3%ofGDP.In fact, most analysts at the time considered that Argentina needed only a moderate andattainablefiscaladjustmenttoensuredebtsustainability.AccordingtoanalystsatJPMorgan,forinstance, therequiredadjustmentwas in theorderof1.6%ofGDPwhileaccording toDeutscheBankitwas2.1%.1920Asthesereportswereissued,Argentinawasundertakingafiscaladjustmentofthatorderofmagnitude.

However,asArgentina’sdomesticcapitalmarketwassmall,thegovernmentdependedsignificantlyontheinternationalcapitalmarketforthenecessaryrolloverofitsdebt.Hence,theeconomywasvulnerabletoshiftsinexternalinvestors’sentimentandinparticulartosuddenstopsincapitalinflows.21

18 For instance, Brazil exhibited during year 2000 a ratio of public debt to GDP of approximately 74%, andnotwithstandingaprimaryfiscalsurplusof3.5%ofGDP,theinterestbillamountedtoover7%ofGDP.19 SeeSekiguchiD.,Argentina’sdebtdynamics:Muchadoaboutnotsomuch.September6,2000. 20 SeeGhezzi,P.andL.Leiderman,DebtsustainabilityinLatinAmerica,December20,2000. 21 There isbynowavastacademic literatureonwhatGuillermoCalvocalled“suddenstops”.See, for instance,Calvo(1998),Mendoza(2001),Guidotti,Sturzenegger,andVillar(2004).

22

Inastablemacroeconomiccontextandwithagrowingfinancialsystem,thenewregulatoryframeworkposedanimportantchallengeforthebankingbusiness:toexpandthedepositbaseaswellascreditprovisionwouldrequiremorecapital.Iftheadditionalrequiredcapitalwouldnotcomefromnewcapitalinjections,thenitwouldhavetocomefromthereinvestmentofprofits.Infact,afterthe1995crisis,newcapitalinjectionswereimprobablefordomesticbanks(unlikeforeignbanks),sothatprofitabilitywouldneedtoplayacentralroleinthegrowthofthefinancialindustry.Table4showsthemainchangesinthebalancesheetoftheArgentinefinancialsystemafter1995.

Table4.SimplifiedBalanceSheetoftheFinancialSystem

Source:CentralBankofArgentina

Thefollowingtrendsareworthmentioning.Ontheliabilitiesside,thesystemexperiencedasignificantgrowthofdepositsbetween1995and2001.Thedepositsgrowthreflectedincreasedconfidenceinthebankingsystemafterthesuccessfulmanagementofthe1995crisis.Inparticular,thelowcostexperiencedbydepositors,aswellasbythestate,inthecrisisresolutioncontributedtoboostpublicconfidenceinthepost-1995period.

Ontheassetside,twomaintrendsappearclearly.Firstly,liquidityandthebanks’exposuretothepublicsectorincreasedtheirshareintotalbankassets,reflectinginparttheeffectsofthenewregulatoryenvironment—i.e.,theintroductionofMLRandtherelativelyfavorabletreatmentofgovernmentbondsinthecapitalrequirement.Thebanks’exposuretothepublicsectorincreasedfrom15%ofassetsin1995to18%ofassetsin2001.Duringthesameperiod,theshareofbankliquidityintotalassetsincreasedfrom13%to25%,whiletheshareofcredittotheprivatesectordeclinedfrom49%to35%.

23

BehindthesetrendsliedthefactthattheArgentinefinancialsystemdidnothavehighprofitability.Formostofthepost-1995period,thereturn-on-equity(ROE)wasverylow,rangingbetween0.6%and6.2%.AlthoughthetenlargestbanksmanagedtoreachROEsbetween8%and13%,thatprofitabilitycouldnotbesustained,reflectinglargelyhighoperatingcostsandrelativelyhighlossesfromnon-performingloans.Partoftheproblemwasthat,byinternationalstandards,theArgentinefinancialsystemwassmall.

In summary, the new regulatory environment introduced in the 1990s had made the bankingsystemmoreresilienttoacrisisoriginatedfrominternalfactors—suchasthe1995crisis—duetoitshighcapitaland liquidity requirements. However,highdollarization—notdiscouragedby theregulatoryframework—impliedapotentiallyhighriskexposuretochanges intheexchangerate,andhighexposuretothepublicsectorimpliedahighriskintheeventofamacroeconomiccrisisthatwasexternaltothesystem.Inaddition,thesystem’slowprofitabilitysheddoubtsaboutthebanks’ ability to generate a dynamic credit growth to the private sector. In these conditionsArgentinebankingsystemwouldfacethedifficulteventsof2001,asubjecttowhichwenowturn.

5. The2001bankingcrisis.

Uncertainty about the evolution of the Argentine economy, as well as the political dynamicsgeneratedwithin the newly governing coalition that had succeeded theMenem administrationafterwinning thepresidential electionof end-1999, testedagain the resilienceof theArgentinebanking system at the beginning of 2001. In particular, starting in October 2000, the newgovernmentfacedasequenceofunsettlingpoliticalevents,summarizedintheresignationofvice-presidentAlvarez(headofoneoftwomainpartiesconformingthecoalition),andsubsequentandtraumaticcabinetreshufflesinOctober2000andMarch2001.Partofthepoliticalcrisisstemmedfromaccusation—within the coalition—of a corruption schemedesigned topass a labor reformthroughCongress.

TheapparentpoliticalweaknessofthenPresidentDeLaRúawasnotwhatArgentinaneededatatimewhenemergingmarketswerestillunderpressure—acrisisinTurkeyhadtakenplaceattheendof2000—andwhentheConvertibilityregimeseemedparticularlyvulnerabletointernationalcapital volatility. After the cabinet crisis of March 2001, which led to the replacement of theEconomyminister just after 15daysof being inoffice, prompted the first episodeof significantdeposits loss in the banking system. Total deposits, which had increased to a level of USD 90billionattheendofFebruary2001,fellby6.7%inlessthanamonth,andbymid-Maythelosshadreached 7.6%. Although Argentina had secured a USD 40 billion IMF-led emergency assistancepackageinDecember2000—so-calledthe“Armor”—thelossofbankdepositsreflecteddwindlingconfidencebythepublicintheeconomyandinthepoliticalenvironment.

RiskspreadsonArgentinegovernmentbonds—asmeasuredbytheEMBI+--increasedby200basispointsintheperiodApril-JunerelativetothevalueofFebruary2001.Nevertheless,riskspreadsremainedbelowthemaximumlevelsreachedduringthe1995TequilacrisisuntilNovember2001.

During the first half of 2001, deposits fluctuated. After the initial fall, they increased by 2.6%betweenmid-May andend-June, to fall again in July. Between July andAugust, deposits fell by

24

11%.AlthoughinSeptemberdepositsrecoveredby3.3%inresponsetoafurtheraugmentationoftheIMFprogram,thedepositlossresumedsoonafter.

AsshowninFigure7,thebehaviorofbankdepositsduring2001showedsignificantdifferencesincontrastwiththatobservedduringthe1995crisis.Firstly,thedepositrunin1995hadbeenmorevirulent,asittookeightmonthsin2001toreachthe18%depositlossthatin1995hadtakenplaceoverathree-monthperiod.22

Figure7.The2001crisis–Evolutionofdeposits

Source:CentralBankofArgentina

Secondly, in contrast to1995,deposits fell sharplyatpublicbanks in2001, indicating that fiscalworrieswere starting to play a significant role in depositors’minds. In fact, almost half of thedeposit lossexperiencedby the systembetweenMarchandOctober isexplainedby the runondepositsatthetwolargestpublicbanks,BancodelaNaciónArgentinaandBancodelaProvinciadeBuenosAires.

Thirdly, while foreign banks had increased their deposits during the 1995 crisis, this time theywerenolongerconsideredsafeheavensbythepublic.While,bymid-2001,48%oftotaldepositswere placed at branches and subsidiaries of foreign banks, these banks also faced significantdepositlosses,albeitatarelativelyslowerpacethandomesticbanks.

Althoughthecentralbankprovided lessemergency liquidityassistancetobanksthan in1995, inviewofthesubstantiallyhigherbankliquidity,theperceptionofdepositorsfocusedontherapidlydeterioratingpolitical situationandon the increasingprobabilityofa full-blownmacroeconomiccrisisinArgentina.

In such an event—if Argentina would default on the public debt and devalue its currency—allbanks,domesticor foreign,privateorpublic could face serious solvency issues.As illustrated in

22 Byend-Septemberthecumulativedepositlossstoodat12.9%.

60

65

70

75

80

85

90

95

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105

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Figure7, the last twomonthsbefore the impositionof restrictionsondepositwithdrawals—so-calledcorralito—thedepositrunacceleratedespeciallyatprivatedomesticbanks.

Someactions takenbythegovernment in the finaldaysofConvertibilitycontributedto fuel thedeposit run. Inparticular,a ceilingon the interest ratebankscouldoffer todepositorshad thecounterproductive effect of increasing the run on domestic banks vis-á-vis foreign banks.Moreover, the introduction of quasi-currencies in several provinces, with the approval of thefederal government, rapidly increased the loss of public confidence in the viability of the fixedexchangeratethatwasthecornerstoneoftheConvertibility.

6. Lessonsfromtheexperience:Whichadditionalprudential-regulationmeasurescouldhavehelpedinpreventingthe2001crisis?

Asarguedintheprevioussections,duringthe1990sArgentinahadstrengthenedsignificantlytheprudentialregulatoryframeworkofitsfinancialsystem.Asaresult,thebankingsystemwashighlycapitalizedandheldsignificantliquidityinforeignassets.Hence,itshowedremarkableresilienceevenunderthestressingconditionsthatledtothemacroeconomiccrisisof2001.

However,eventhoughafterthe1995crisisthegovernmentbecameawareofthesystemicrisksderivingfromtheconnectionbetweensovereigndebtandbankingrisks—andthereforeimposedcapitalrequirementsonbank’sgovernmentbondholdings—itwasnotfullyawareofthebalance-sheetrisksthatextensivedollarizationposedforthebankingsystemintheeventofadevaluation.Atleast,prudentialregulationsdidnotrecognizethisriskexplicitly.

PartoftheproblemwasthatConvertibilitywasdesignedtobeapermanentmonetaryregime.Andinthatcontextdollarizationwasperceivedtoplayausefulroleinaligninggovernmentincentivesand,therefore,wasperceivedtocontributingtostrengtheningthecredibilityofconvertibility.23

Withthebenefitofhindsightitisclearthattheinadequateattentionpaidbyregulatorstoexchangeraterisksconstitutedthesinglemostimportantweaknessofthebankingregulatoryframework.Inparticular,therecourseofbankstodollar-denominatedfundingshouldhavebeeninourviewlimitedtoabank’scapacitytolendtofirmswhoseincomewasgenuinelyearnedinforeigncurrency(e.g.,exporters).

Thisispreciselywhathappenedafterthe2001/2002crisis,whenbankcreditdenominatedinforeigncurrencywaslimitedmostlytofundtradefinancing,anddollar-denominateddepositsweresubjecttoveryhighreserverequirements—i.e.,depositedatthecentralbankandinvestedininternationalreserves—and,thus,paidextremelylowinterestrates.

Adoptionofsuchregulationinthe1990swouldhavehadprosandcons.Theclearsystemicadvantageisthereductionintheperceivedexposureofthebankingsystemtoexchangeraterisk,whichwouldhaveplayedasignificantusefulrolein2001.Thedisadvantageliesinthefactthatpeso-denominatedcreditanddepositscarriedhigherinterestratesandlowermaturity.Hence,

23 SeeCalvo(1988)andCalvoandGuidotti(1990)ontheroleofdollarizationinenhancingcredibilityinpricestability.

26

forinstance,thedevelopmentofamortgagecreditmarketwouldhavebeenmuchslowerandmoredifficultthanwhatitwasbyrelyingonforeign-currencydenominatedcontracts.

Amuchmorerevolutionaryreformwouldhavebeenonethatrequiredamodificationinthecorporatestructureofbanksinordertorecognizethelimitsthatcentralbanksinemerging-marketeconomieshaveinactingaslenderoflastresort.Acriticalobjectiveofcentralbanksduringsystemiccrisesistoprotectthepaymentssystem.Hence,apossiblewaytoshieldthepaymentssysteminasystemicbankingcrisis,asproposedbyGuidotti(2003),istoadoptaspecificcorporatestructurethatfacilitatesresolutionwhileisolatingthebank’stransactionalrolefromthecredit/intermediationrolethatentersliquidation.24

Accordingtothisproposal,financialinstitutionswouldbeorganizedaccordingtothefollowingcorporatestructure.ABankHoldingCompanywouldown,ataminimum,twoseparatesubsidiaries:aPaymentBankandaFinancialSubsidiary.Typically,toimproveexternaldiscipline,BankHoldingCompanieswouldberequiredtoissueatleastbetween20%and30%ofitscapitalinanorganizedexchangemarket.

Liabilitiesof thePaymentBankwouldbecomposedofcheckingaccounts, savingsaccounts,andtime deposits up to a maximum per depositors. The maximum amount of time deposits perdepositor would be consistent with the amounts covered by the deposit insurance. Thus, theliabilitiesofthePaymentsBankshouldbeconsideredeitherasdirectedrelatedtothepaymentssystem,orconnectedtotheobjectiveofprotectingsmalldepositors.

On its asset side, thePaymentBankwouldonlybeallowed toholdprimequality (liquid) assetsand,except foroverdraftoncheckingaccounts, itwouldalsohold the fixedassets relatedto itstransactionalrole.1 Primequalityassetswouldinclude:1)foreignassets(publicandprivatewithhigh credit-risk rating), 2) domestic government bonds, and 3) private domestic assets ratedinvestmentgradeinternationally.

TheFinancialSubsidiarywouldcontainallremainingbankingassetandliabilities. Therefore,theFinancial Subsidiary would be similar to a normal bank with the exception of the assets andliabilities directly linked to the payments system that are now located at the Payments Bank.Figure8showsthecorporatestructureofatypicalBankHoldingCompany.

24Guidotti’ s (2003) proposal is a direct precedent of the concept of “livingwills”, created in response to the recentglobalfinancialcrisis.

1 Emphasisisplacedhereontransparencyinthevaluationofassets.Ofcourse,liquidassetsareprime-qualityassetsbydefinition.

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Figure8:TheBankHoldingCompany

Intermsofprudentialregulations,thecapitalrequirementwouldapplytotheBankHoldingCompany,andapositivecapitalwouldberequiredatthelevelofthePaymentBank,withassetsmarkedtomarket.TheBankHoldingCompanyandtheFinancialSubsidiarywouldbesubjecttotheprudentialregulatoryframeworkthatwouldapplynormallytofinancialinstitutions.

As regards management, the above-mentioned corporate structure allows for a jointadministration of the Payments Bank and the Financial Subsidiary, in order to avoid costlyoverlappingandduplicationoffunctions. However,acriticalelementoftheproposal isthattheBankHoldingCompanywouldberequiredtoidentify,exanteandatalltimes,andimplementingcontractsaccordingly,aself-containedmanagementstructureforthePaymentsBankincasetheFinancial Subsidiary would be liquidated or sold. Hence, for instance, although the branchnetworkcouldbeoperatedjointly,itwouldneedtoholdseparateaccountingrecords.

The above-mentioned state-contingent corporate structure is a natural extension of theinstruments—suchasArt.35bis—giventothecentralbanktoresolvebankingproblems.Themainadvantagesofsuchcorporatestructureisthatitmaketheprocessofresolutionefficient,withouthavingtoresorttoexpostemergencymeasures,andwouldenormouslyfacilitatetheprocessofdividingassetsandliabilities.

Consider thenhowtheactualmechanicsofa liquidationor resolutionwouldwork. In theeventthe financial institution faces illiquidity problems that exceed the central bank’s emergencyassistancecapability,suchilliquidityislikelytoappearattheleveloftheFinancialSubsidiary.3Insuchanevent,thecentralbankwouldforcetheFinancialSubsidiaryinto“suspension”,whilethePayments Bank would continue to operate. During the “suspension” period, when assets arevaluedat liquidationlevels,andequityandsubordinateddebtmaybemarkeddowntozeroandremainingseniorliabilitieswouldbeconvertedintosharesintheFinancialSubsidiary’sassets,thecentralbankwouldbeabletoapplyArt.35bisontheFinancialSubsidiaryandauction,eitherpartor itsentirety, to interestedbuyers. Any residualofassetsand liabilitieswouldbe sent to finalliquidation.

3 Thishappensbecauseoftworeasons:1)becausethePaymentsBankholdsthemostliquidassets;and2)because

empirical evidence suggests that transactional deposits tend to bemore stable during bank runs in relation to otherbankliabilities.

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Theresolutionprocessdescribedabovehastheadvantageofisolatingthepaymentssystemfrombank failures,whilemakingefficient theprocessof transferringassetsand liabilities tohealthierfinancial institutions. Asmost of bank capital is lost in the process, it would be reasonable toexpectthatthePaymentsBank,thoughoperative,wouldalsobeauctionedtoprospectivebuyersatthesametime.Inthiscontext,therewouldbecleareconomiesofscaleforabuyertopurchasetheremainsoftheFinancialSubsidiarytogetherwiththePaymentsBank.

7. Wasthe2001/2002crisisavoidable?Twopossiblealternativecoursesofaction.

Acriticalquestionthatariseswhenevaluatingthecourseofeventsleadingtothe2001/2002crisisis to what extent default could have been avoided and what policy options were open to thegovernmentatvariouspointsintime.Twopossiblecoursesofactionareexploredinwhatfollows.

Lettheexchangeratefloat,paythedebt.

In our view, even well into 2001 Argentina could have avoided default by adopting adequateeconomicpolicymeasures. The key to the first argumentweexplore lies in the relativeprioritythat should have been given tomaintaining the convertibility regime on the one hand, and toavoiding default at all costs on the other hand. All of the alternatives considered by thegovernmentaswellasbytheIMFtookforgrantedthatConvertibilitywasgoingtobemaintained.Noalternativepolicyoptionswereseriouslyconsidered. Forall thatmatterstheauthoritiesandthe internationalofficial community treatedConvertibilityasa tabooand in theend,pushedbypolitical disarray, default led to the repeal of Convertibility materializing the (avoidable) worstpossible scenario. In this sectionwewill argueandexplainwhy, even in2001,Argentina couldhaveavoideddefaultbyexitingConvertibility.

Inordertoelaboratetheaboveargumentwewillstartbyaddressingthreeissuesthattoppedthelist of concerns of investors and analysts as Argentina was entering 2001. The first issue waswhetherpublicdebtdynamicsweresustainable.ThesecondissuewaswhetherConvertibilitywasmakingArgentinauncompetitiveand,hence,neededalargecorrectionintherealexchangerate.Thethird issuewaswhetherArgentinawasabletoobtaintherequiredfinancing in internationalcapital markets to meet its obligations while facing considerable skepticism on the part ofinvestors.

Let’sstartwithdebtdynamicsandthestanceoffiscalpolicy.AsArgentinaenteredyear2000,theratioofpublicdebttoGDPwasabout40%carryinganaverageinterestrateoflessthat7.5%perannum. Hence, by conventional standards, the size of the public debt and of the interest billmeasuredasproportionofGDPwereperceivedasmanageableand,indeed,theywerelowerthanthe levels exhibited by other emerging market economies. In fact, most analysts at the timeconsideredthatArgentinaneededamodestfiscaladjustmenttoensuredebtsustainability.

Theusualcomputationsperformedbyanalysts inthecapitalmarkettogaugedebtsustainabilitywere favorable and certainly were distant from describing an economy affected by grave orirresolubleproblems.Reportswrittenbyleadinginternationalplayersinthecapitalmarketcanbecited as examples of what actions—in their view—were needed in order to stabilize over timeArgentina’s ratio of debt toGDP. These analyses placed the necessary fiscal adjustment in the

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primaryfiscalbalanceintherangeof1%to2%ofGDPrelativetotheobservedlevelinyear2000.WhenexaminingArgentina’sfiscalsituation,JPMorgan25statedthat:

“A primary surplus of 3.1% of GDP, up from the current 1.5%would be sufficient tostabilize public debt-to-GDP, even assuming that growth remains at the currentdepressed levels…Alternatively 4.4% nominal GDP growth would stabilize thegovernment’s debt ratio…. It is expensive for Argentina to cover its current financingneeds,buttheaverageinterestrateisstill lowat7.9%,andits increaseisgradual(pp1).”

AsimilarviewcanbefoundinaresearchpiecepublishedbyDeutscheBank,26wheretheauthorsstatethat:

“The results indicate that a structural primary surplus of 2.9% of GDP is needed toachievesustainability.Thustheadjustmentthatisrequiredinordertostabilizethedebtisan increase in2.1%ofGDP in the structuralprimary surplusbeyond its level in year2000(pp.4).”

Of course, all these analysiswerebasedon assumptions, and a particularly critical onewas therateofeconomicgrowth.InthecaseofJPMorgan,theanalysiswasbasedonanimprovementintheprimarysurplusof0.9%tobecarriedoutgraduallybetween2000and2003,assumingarateofgrowthof1.8%in2000and3%thereon.UnderthoseassumptionsJPMorganwasprojectingaslightdeclineintheratioofdebttoGDP.

In the caseofDeutscheBank theprojected rateof growthwas similar to JPMorgan’s—2.5% in2000and3%thereon—buttherequiredfiscaladjustmentwaslargerbecauseDeutsche’sanalysiswas based on a higher initial debt stock—50 percent of GDP—on account of implicit debts notincludedintheofficialstatistics.

Theconclusionsreachedbyacademicswhostudiedex-postArgentina’simplosionarenotdistantfromtheviewsofcapitalmarketparticipants inyear2000. In theiranalysisofArgentina’scrisisHausmannandVelasco27alsodismissthefiscalcausebyarguingthat:

“…In spite of the strong temptation to blame everything on the politician and theirirresponsibility,thesimplefiscalexplanationisalsoinadequate.Thereisnoevidenceofaspendingboom:asashareofGDP,primaryGovernmentexpenditureremainedroughlyconstant in 1993-2001. True, public debt grew rapidly. But this paper shows theaccumulation of debt was driven mainly by the transition costs of the Social Securitysystem, recession, and recognition of preexisting debts, not by a lack of adjustmentefforts…”28

25 SeeSekiguchi,David.Argentina’sdebtdynamics:Muchadoaboutnotsomuch,September6,2000. 26 SeeGhezzi,P.andL.Leiderman.DebtsustainabilityinLatinAmerica,December20,2000. 27 “Hard money´s soft underbelly: Understanding the Argentine crisis”. Kennedy School of Government. HarvardUniversity.2002. 28 AlsoGuidotti(2006)documentsthesignificantimpacttheSocialSecurityreformonArgentina’sfiscaldynamics.

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Hence,despiterelativelyminorvariations,theprevailingviewwasthatArgentina’sdebtwasnotclearlyunsustainableprovided the country could resume its economic growth. 29 On this issue,however, there was less agreement. The main question was whether Argentina could shortlyresumegrowthwhilemaintainingafixed-exchangerateregimeatamomentwhencapitalmarketswereunsettled, theUSdollarhad strengthenedagainstothermajor currencies, and commoditypricesweredepressed.Inthisvein,Calvo,IzquierdoandTalvi(2003)concludedthatadevaluationwas inevitable given the size of the external shocks hittingArgentina, and that the governmentwouldhavehad toacquireadditionaldebtsbecauseof thebalance-sheeteffectson theprivatesector,requiringanadditionalfiscaladjustmentof0.6%ofGDPassuminga50%devaluation.

In sum, the concerns regarding fiscal sustainability were not necessarily pointing at fiscalirresponsibility,butwerefocusedonwhethergrowthcouldberesumedunderConvertibility,andonwhetherapossibleexitfromthefixed-exchange-rateregimewasmanageable. Andacriticalquestion here was to evaluate how large a devaluation would have occurred in the caseConvertibilitywasabandoned.Theassessmentofhowundervaluedwasthepesowascentraltobothconcerns,anissuetowhichwenowturn.

To this effect, we start by examining whether export performance had been weak duringConvertibility.AscanbeobservedinTable4,themonetarysystemimplementedbyArgentinainApril 1991 coexisted with a strong growth in exports, while the real effective exchange rate30(weightedbyusingtheexportsbasket)appreciatedonlymoderatelycomparedtoothersuccessfuleconomiesintheregion—despitethefactthatmostofthemhadflexibleexchangerates.

Table4.RealEffectiveExchangeRateandExportsChangebetween2000/1991

*January2001/Average1991(+)meansREERappreciation,(-)depreciation

Source:RealEffectiveExchangeRate–J.P.MorganREERIndex,Exports–IMF.InternationalFinancialStatistics.

Between 1991 (the beginning of the Convertibility regime) and January 2001, the real effectiveexchangerateforArgentinasufferedanappreciationofonly8%.31Thestrongexportperformancedisplayed byArgentina during Convertibility suggests that the real exchange rate, ifmoderatelyappreciated, was not making Argentina uncompetitive in international trade. The growth ofexports in theperiod1991-2001 reflectedmostly the increase inexportedvolumes, rather thanpricechanges. Inparticular,exportsincreasedfromUSD12billionin1991toUSD26.6billionin

29ItisimportanttostressthattherewasnoconsensusontheroleoffiscalpolicyinArgentina’scrisis.Mussa(2002),forinstance,arguesthatfiscalpolicyhadbeentooexpansionaryoncyclicallyadjustedtermsandthatitleadtoanexcessivebuild-upofpublicdebt.30 TherealeffectiveexchangeratesfiguresarepublishedinBloombergundertheTickerJBXR. 31 Considering thatduring thatdecadeproductivity improved significantly, suchmoderateappreciationdidnotaffectArgentina’sexternalcompetitiveness,asshownbyitsexportperformance.

Selected countries Argentina Brazil Chile Colombia Ecuador Mexico Peru Venezuela Average

Real Exchange Rate * 35% 6% 10% 22% 3% 17% -8% 89% 20%

Real Effective Exchange Rate * 8% 13% 22% -2% 58% 18% 1% 86% 28%

Exports 121% 74% 115% 83% 77% 289% 104% 125% 124%

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2001,atanaverageannualgrowth rateof7.8%. Thisgrowth rate canbeattributedentirely toexport volumes, as the annual change in export prices averaged -0.1%during the period underconsideration.

However,theevolutionofexportsunderConvertibilitywasnotuniform.Exportperformancewasparticularly strong in the period 1994-1998, growing at an average annual rate of 15.1%, incomparison with a much weaker performance both in the initial and the latter years ofConvertibility.TheperformanceofArgentina’sexportsalsocomparesfavorablytotheevolutionofworld trade flows. Inparticular, the shareofArgentina’s exports inworldexports increasedby26%between1991and2001,increasingfrom0.34%in1991to0.43%in2001.

IndependentassessmentsundertakenbytheinvestmentbankGoldmanSachsinMarch2000areconsistentwiththeabovefindings.TheyshowthatArgentina’srealexchangeratewasovervaluedby just 7.6% compared to the equilibrium level that obtained from their ownmodel, comparedwitha22.7%overvaluationoftheMexicanpesoandoneof9.7%oftheChileanpeso.WiththatinmindGoldmanSachsrecommendedtheirinvestorstotakepositionsintheArgentinepeso.32

The issuewhether theArgentinepesowasundervaluedandbyhowmuchhasbeenextensivelyanalyzedintheaftermathofthe2001/2002crisis.Forinstance,Calvo,IzquierdoandTalvi(2003)examined in a simple model the relation between the real exchange rate, the balance ofpayments,andthedegreeoftradeopenness.Inthatcontextandforasampleofemergingmarketeconomies, they estimated the adjustment in the real exchange rate required to eliminate acurrentaccountdeficitintheeventofasuddenstopincapitalflowssimilartothatoccurredafterthe 1998 Russian crisis. In the case of Argentina, the authors estimated that a 46% realdepreciation would have been required to eliminate the current account deficit, a figure thatcomparestoa52.5%realdepreciationrequiredinthecaseofBrazil,anda43%anda32.4%realdevaluationsrequiredinthecasesofColombiaandChile,respectively.33

Anotherstudythatfocusedontheovervaluationofthepesoasacauseforthe2001/2002crisiswascarriedoutbytheIMF’sIndependentEvaluationOffice(IEO)in2004.34Interestingly,theIEOfinds that while today there appears to be a consensus that the peso was undervalued, suchconsensusdidnotexistfromthestandpointofyear2000:

“…In the spring of 2000, before the further worsening of economic and financialconditionsinArgentinaandbeforethefurtherweakeningoftheeurorelativetotheU:S dollar, there were equally divided views of the peso´s overvaluation. Forexample, theovervaluationwasestimatedtobe7%byGoldmanSachs,13%by JPMorganand17%byDeutscheBank.”

32SeeGoldmanSachs,March2000.33 TheCalvo,IzquierdoandTalvi(2003)exercisemaybeconsideredanupperbound,asthecomputedadjustmentwasconsistentwithreducingthecurrentaccountdeficittozero.Inlightofwhathappened,privatecapitalflowstoemergingmarketsfellby55%in1998comparedtothe1997peak,butdidnodisappear.Intheperiod1998-2002privatecapitalflowstoemergingmarketswereonaverage46%smallerincomparisonto1997,andincreasedsharplyagainsince2003to reach in 2005 a level 75% higher that prior to the Russian crisis. Moreover, considering the depressed levels ofcommodity prices, using 1998 as the base for the experiment may overestimate the required change in the realexchangerate. 34 “TheIMFandArgentina1991-2001”.IndependentEvaluationOffice,IMF,2004.

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Finally, Hausmann and Velasco (2002) even without estimating the size of the overvaluationconcludethatthefixed-exchangerateregimehadamajorroletoplayintheArgentinecrisis:

“There is an unmistakable sense then that Argentina did have an exchange rateproblem. What is much less clear, however, is whether it had an exchange ratesolutionavailable to it. Itwas thecombinationof relativepricemisalignmentwithincreasinglyscarce financingthatmadethesituationvulnerable.And,witha largeaccumulated dollar debt, both private and public, the competitiveness gains of apotential devaluation had to be weighted against the balance sheet damage itwouldinflict,andtheadditionalmarketaccessthiswouldbring….”

Insummary,theArgentineeconomyunderConvertibilitycouldhavebenefitedfromexchangerateflexibilitybut it canhardlybecharacterizedasaneconomy inneedofa largedevaluation.Withthispremiseinmind,wenowturntothepolicyactionsthatwereavailabletothegovernmentinorder toavoiddefault,andwhichwereanchored inproviding flexibility to theexchangeratebyexiting Convertibility. The crucial point here is to establish how Argentina would have had tomanage the exit from Convertibility in a context of significant stress in international capitalmarkets.Inourview,aswillbediscussedbelow,thegovernmentcouldhaveexitedconvertibilityinanorderlyfashion.

AccordingtotheConvertibilityLawthemonetarybasehadtobebackeda100%inliquidforeignassets, limiting the centralbank’s ability toact as a lenderof last resort to thebanking system.However, if the authorities had decided to abandon convertibility when the country still had asignificant amount of international reserves at the Central Bank, then it would have had asignificant amount of funds that—added to those obtained from multilaterals—would haveallowedArgentina tocoverallof thedebtpaymentobligationscomingdueovermore thanoneyearwithouthavingtoissueasingleUSdollarofnewdebtinthecapitalmarket. Thatperiodoftimewouldhavelikelybeenenoughtorestoreconfidenceinlocaldepositorsaswellasinforeigninvestors.

TheConvertibilityLawpreventedthecentralbankfromassistingthefinancialsystemuptoalimitestablished in the law. However, once convertibility was abandoned, the ratio of US dollarreservestothemonetarybasecouldhavebeenreduced,for instance,upto50%. Moreover,totheextentthattheauthoritieswouldhaveconsideredadoptingasolutionálaUruguayaccordingto which banks who chose to do so could reprogram the maturity of their time deposits, theliquidityavailabletothecentralbankcouldhavebeendirectedat,for instance,coveringuptoa30%runontransactionaldepositswhileusingtheremainingportiontocoverTreasuryobligations.

It is relevant to examine the amount of funds available to the central bank, including thoseavailablefromtheContingentRepoFacilitythatthecentralbankhadcontractedwithagroupofinternationalbanksafter theTequilacrisis.35 Bymid2001, theamountof fundsavailableundersuchfacilityamountedtoUSD1.2billion.

35 Theterm“repo”standsforrepurchaseagreement.

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In addition to the funds thatwould have been freed by abandoning convertibility and to thoseavailable from the repo facility, the government could have had access to the remainingdisbursementsavailableundertheexistingIMFprogram.TakingintoaccounttheamountoffundsdisbursedfromtheIMFbetweenJanuary2000andSeptember2001(SDR4.8billion),theavailablecredit to Argentina at the time when the last IMF agreement was signed in January 2001amountedtoSDR12.1billion,equivalenttoUSD15.2billion. Ofthisamount,theIMFdisbursedonly SDR 4.9 billion during 2001, remaining available at the year-end about SDR 7.2 billion,equivalenttoapproximatelyUSD9billion.

Basedonthesefiguresonecanestimatethetotalamountoffundsavailabletothegovernment—with the already committed IMF support— in order to assure the capital market that it couldservice itsdebt for thesignificantperiodof timewithout resorting tonewbond issues. Table5shows the results of computing the available funds at various relevant dates during 2001.Availablefundsaredefinedastheexcessfundsoverthoserequiredtokeepa50%backingofthemonetarybase and toprovide the central bankwith the additional capacity toprovide liquidityassistancetothebankingsystemforanamountequivalentto30%ofalltransactionaldeposits.

Table5.AvailableFunds

Source:OwncalculationsbasedondatafromCentralBankofArgentinaandtheEconomyMinistry

ForthecomputationstwodifferentexchangeratebetweenthePesoandtheUSdollarwereused:theone-to-oneexchangerateprevailingunderconvertibility,andanalternativescenarioofa100%devaluation.36

The analysis shows that, if the exchange rate had devalued by a 100% had convertibility beenabandoned, the governmentwould have had available in June 2001 excess funds for USD 30.4billion, compared with the USD 18 billion it had under the Convertibility Law. Of course, theamountof excess funds is larger theearlier theexit fromConvertibilitywouldhavebeen taken

36 ThePesoultimatelydevaluedbya100%betweenJanuaryandFebruaryof2002,underquitechaoticcircumstancesofdefault,depositfreezing,and“asymmetric”pesification.

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during 2001. For instance, if Argentina had exited Convertibility in March 2001, excess fundsavailableundertheassumptionof100%devaluationwereUSD35.6billion.

Thesefiguresneedtobecontrastedwiththegovernment’sfinancingrequirementsatthetime.Inthisrespect,theArgentinegovernmenthadexplicitlyadoptedafter1995astrategyoflengtheningthematurityofitspublicdebttoreduceliquidityrisk.By2001,theaveragematurityofthepublicdebtexceeded8yearsandthesizeoftheyearlygovernment’sfinancingrequirementhadreachedUSD12billionandwouldbebetweenUSD13and14billioninthefollowingtwoyears.37Hence,theamountofexcessfundsavailabletothegovernmentwaslargeenoughtocoverthefinancingneeds of the following year and a half (without issuing new debt), even after allowing for asignificantlender-of-lastresortcapabilityinhardcurrency.

Withafloatingexchangerateandthefinancingneedscoveredforasignificantperiodoftimeinadvance, interest rateswould likely have fallen and the economywould have resumed growth.Hence, it canbeconcludedthat thegovernmenthadalternativepolicyoptions toavoiddefault,devaluationandpesification.Attheendofthethirdquarterof2001theCentralBankofArgentinahadastockofinternationalreservesofUSD21.5billionandthebankingsystemheldforeignliquidassetsforanadditionalUSD3.3billion.Moreover,theIMFprograminplacehadstilltodisburseadditional funds to the government by USD 9.3 billion. Even in late 2001, such amount ofresourcesprovided thegovernmentwith significantcapacity tomanageanorderly resolutionofthe economic crisis without having to resort to unprecedented and arbitrarymeasures such asasymmetricpesification.

Anotherimportantquestionthatwouldhaveariseninthisscenariowasthatofthepotentiallossesthatadevaluationwouldhavehadonthebankingsystemandwhatwouldhavebeentheamountofcapitalthegovernmentcouldhavebeenrequiredtoinjectintothesystem.Inthisrespect,onepossibleroutecouldhavebeentoallowfinancialinstitutionsvoluntarilytorestructureforeigncurrencyloansofthoseclientswhoserevenuesderivedmostlyfromthenon-tradablesector(i.e.services)and,hence,weresubjecttoasignificant(buttemporary)adverserelativepriceshock,andprovidegovernmentfundstorecapitalizethoseinstitutionsthatdidnothavethecapitaltoabsorbtheresultinglosses.Asignificantdistinctionmayhavebedrawnherebetweendomesticandforeignbanks,asthelattergroupwouldhavethecapacitytoabsorblossesprovidedtheruleoflawwasnotbroken.

As shown in Table 6, the stock of bank loans to the private sector denominated in US dollarsamountedtoUSD34.7billiononDecember31st,2001whilethestockofforeign-currencydepositstotaled USD 37 billion. On that date, foreign-currency loans provided by foreign banks andforeign-ownedsubsidiariesamountedtoUSD20.6billionwhileforeign-currencyloansprovidedbydomesticbanksamountedtoUSD14.1billion.

37 Guidotti(2006)documentsthesignificantlengtheningofdebtmaturityoccurredintheperiod1994-2000.

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Table6.Dollar-denominatedloansintheArgentinebankingsystemin2001

Source:OwncalculationsbasedondatafromCentralBankofArgentina

Moreover,outofthetotalstockofforeign-currencyloanstotheprivatesector,about17.6%wasallocatedtothetradablesector.Toreachthisfigure,averyrestrictivedefinitionoftradablesectorisused,asitcontainsonlyloanstotheprimarysector(holdingashareof8.7%oftheloans)andmanufacturingindustry(holdingashareof9%oftheloans).Assumingthattheproportionofloansdistributedbetweenthetradableandnon-tradablesectorissimilaracrossforeignanddomesticbanks,weobtainthatthestockofforeign-currencyloansprovidedbydomesticbankstothenon-tradablesectorandhouseholdsamountedtoapproximatelyUSD11.6billion.

Hence,toobtainanestimateoftherecapitalizationthatwouldhavebeenrequiredbythefinancialsystemunder theabove-mentionedscenario,wecomputed the impact that threedifferent loanrestructuringoptionsonbankcapitalandassumedthat the loss facedbydomesticbankswouldhaverequiredrecapitalizationinfull(it is importanttokeepinmindthatsuchrecapitalizationofdomesticbanksreflectedthelackofadditionalcapitalofdomesticshareholdersandwouldmostlikelyhavebeen required independently if banks themselveswouldhave changedownershipornot).

AfirstoptionconsideredisoneinwhichtherestructuringoftheUSD11.6billion in loanstothenon-tradablesectorwouldhavelikelyentailedanextensionofmaturityofexistingdollarloansto5years(withbulletamortization)andareductionofinterestto5%peryear,withagraceperiodof2yearsinwhichtheinterestcapitalizes.Usingadiscountrateof10%peryear,thereliefreceivedbyadebtoramountsto32.7%innetpresentvalue,yieldingabankcapitallossofUSD3.1billion.38

Asecondoptionconsideredisonewhereinterest isreducedto4%peryear,andthematurity isextendedto10years,witha2-yeargraceperiodandamortizationsdividedinequal installmentsof12.5%inyears3to10.39 Inthisoption,therecapitalizationrequiredwouldhaveamountedtoUSD3.3billion.

38 Avariationofthisoptionisonewheretheloanrestructuringentailsareductionoftheinterestrateto3%peryear,anextension of maturity to 5 years but with amortization in three installments in years 3, 4, and 5. Using the samediscountrate,thisoptionwouldhaveimpliedarecapitalizationofUSD2.6billion.39 Thisstructurereplicatesthatofthedollar-denominatedbondsthatwereissuedin2002(i.e.,theBoden2012)topaydepositorswhosedepositshadbeenfrozenbythegovernment.

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Ascanbeseen,thepotentialbankinglossesthatcouldhaveemergedfromadevaluation,andtherequiredcapitalization,weremanageableundertheassumptionthattheruleoflawwouldbemaintained.

DollarizewithanagreementwiththeFed?

WhilethealternativeofexitingConvertibilitywasneverseriouslyconsideredbyArgentinepolicymakers,afterthe1998Russiandefault,thegovernment—specifically,theeconomyministryandthecentralbank—initiateddiscussionswithUSauthoritiesonaverydifferentexitstrategy:thedesignandimplementationofanArgentine-USMonetaryAgreementthatwouldserveasthelegalframeworkforArgentinatofullyadopttheUSdollarasitsowncurrency.40

ThedollarizationdebateinArgentinareflectedtwocontrastingfactors.Ontheonehand,therewasageneralperceptionthatConvertibilityhadcontributedtosubstantiallyimprovemacroeconomicperformanceandhadfacilitatedtheadoptionofanumberofstructuralreformsinconnectionwiththegovernment’sobjectiveofincreasingtheeconomy’sintegrationtointernationaltradeandfinance.Ontheotherhand,despitethesuccessfulweatheringofthe1995Tequilacrisis—whichhadstrengthenedsignificantlydomesticandinternationalcredibilityinConvertibility—therewasanincreasingperceptionthatArgentinaremainedvulnerabletofinancialcontagion.Hence,thevulnerabilityassociatedwithastillincompletecredibilityintheConvertibilityregimetranslatedintoasignificantriskpremiumthathadtobepaidongovernmentandprivatedebts.

Moreover,by1998,theinternationalconsensushadclearlyshiftedinfavoroftheadoptionofflexibleexchangeratebyemergingmarketeconomies.Tobesure,theso-called“bipolar”viewofexchange-rateregimes—thatrecommendedeitherflexibleexchangeratesorveryhardpegswasmostlyadiplomaticefforttoaccountforHongKong‘currencyboardandArgentina’sConvertibility.41

Inthisvein,in1998,theArgentinegovernmentstartedexploringwiththeUSTreasuryandFederalReservetheimplementationofamonetaryagreementbetweenthetwocountries.4243InadditiontotheadoptionoftheUSdollarasitsowncurrency,thediscussioncontainedanimportantfeature:therebateofseigniorage.Themostinnovativeaspectoftheseignioragediscussionwasitsuse.TheArgentinegovernmentenvisagedthattherebateofseignioragefromtheUSTreasurywouldimplyarevenuethatArgentina—thedollarizingcountry—wouldreceivearevenueflowofUSdollarsthatcouldinturnbeusedas(AAA-rated)collateraltoobtainaliquidityfacilityfromthe

40 This section is based largely onGuidotti and Powell (2003) that contains a detailed discussion of the dollarizationdebate.41 SeeFischer(2001)foradiscussionofthebipolarviewonthechoiceofexchange-rateregimes.42 Other close observers of the Argentine economy suggested full dollarization as another alternative route for thegovernment to pursue to restore investor confidence and produce a turnaround in the Argentine economy. See, forinstance, Steve Hanke, “Argentina’s Current Political-Economic Crisis,” Statement before the Subcommittee onInternationalMonetaryPolicyandTrade,CommitteeonFinancialServices,UnitedStatesHouseofRepresentatives,ofMarch5th,2002.Availableathttp://www.cato.org/testimony/ct-hanke030502.html. 43 The US Senate Banking Committee held hearings on possible dollarization in 1999, seewww.banking.senate.gov/docs/reports/dollar.htm.

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USFederalReservetotheArgentinecentralbank.Thus,suchcreditlinewouldprovidetheArgentinecentralbankwithaUS-dollarcapacitytoactaslenderoflastresortinpotentialsystemiccrises,resolvinganimportantargumentputforwardbycriticsofdollarization:that,underdollarization,thecentralbankwouldloseitscapabilitytoactaslenderoflastresort.44

GuidottiandPowell(2003)estimatedtheamountofseigniorageassociatedwithfulldollarizationand thepotential sizeof the liquidity facility thatcouldbeobtainedbycollateralizing its rebate.Although the estimates dependon a number of technical assumptions and the on the discount(risk-free)rateused,GuidottiandPowell(2003)reachedtheconclusionsthatthepotentialsizeoftheliquidityfacilitywassignificant. EstimatedataroundUSD20billion—equivalenttoabout7%ofGDP—theliquidityfacilitywouldhavemorethandoubledtheArgentinecentralbank’sabilitytoactasalenderoflastresort,whencomparedtowhatwaslegallypossibleunderConvertibility.

While full dollarization would not resolve the issue of currency overvaluation—although somearguedthatthegovernmentcouldhavedevaluedbeforedollarizing(theso-calledD&Doption)—themainbenefitfortheeconomywouldaccruefromareductioninthesovereignriskpremium.45Therefore,animportantfactorweighingonthedecisionwasbyhowmuchsovereignriskwouldbereduced in the event of dollarization. The estimation of the impact of full dollarization on thesovereignriskpremiumiscomplexastheriskpremiumcontainsbothdevaluationriskanddefault(orcredit) risk. Moreover, the tworiskscertainlymay interact. GiventhecurrencymismatchesexistingintheArgentineeconomy,adevaluationofthecurrency,dependingonitssize,mayforcethe sovereign intodefault.Usingdifferentmethodologies,Guidotti andPowell (2003)estimatedthat full dollarization may have reduced the sovereign risk spread between 120 and 325 basispoints from a spread of about 600 basis points, namely the potential reduction would rangebetween20%and54%ofthedefaultspread.

Thedollarizationdiscussion,although itstimulatedawidedebate inpolicyandacademiccircles,both domestically and internationally, required significant political actions to take place both inArgentina and in theUS,which involvedbothCongresses. 46 The timingof thedebatewasnotalignedwithArgentina’spoliticalcalendarastheMenemadministrationwasenteringitslastyearinoffice,withnopossibilityof re-election. Afteranewadministration tookofficeat theendof1999,thediscussionoffulldollarizationwasultimatelyabandoned.

44 WhiletheUSresponsetotheseignioragequestionandtothecollateralizedliquidityfacilitywaspositive,threeissuesremained clear from the start: 1) Argentina would get no say whatsoever in the conduct of US monetary policy;ArgentinebankswouldhavenoaccesstothediscountwindowoftheUSFederalReserve;and3)theUSwouldhavenobanking-supervisionresponsibilitiesvis-á-visArgentinebanks.45 ThereductionintheriskpremiumdirectlyrelatedtotheinterestrateconvergencethatthesouthernEUeconomies,suchasItaly,Portugal,andSpain,hadexperiencedwiththecreationoftheEuro.46 Aroundthattime,EcuadorandElSalvadorhadunilaterallydollarized.

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8. Concludingremarks

ThispaperhasanalyzedtwobankingcrisesoccurredinArgentinain1995and2001,inthemidstofsignificantreformsintermsofbankingregulationandsupervision,andinamacroeconomiccontextdominatedbya“hardpeg”exchange-rateregimeknownasConvertibility.Asusual,macroeconomicstressandbankingcrisesareeventsthattendtobecloselyassociatedandwherethedirectionofcausalitytendstobedifficulttoidentify.

Thetwocrisesanalyzedinthispaperarearareexamplewhere,fromthebehaviorofdepositors,wecangetlightonthedirectionofcausalitybetweenmacroeconomicstressandbankingcrises.Wehaveshownthat,despitethesignificantreformsputinplaceintheearly1990s,thecrisisexperiencedbytheArgentinebankingsysteminearly1995(aftertheDecember1994devaluationoftheMexicanPeso)canbeattributedlargelytointernalweaknessesofthesystem,whichwasstillintheprocessofadaptingtothenewprudentialregulatoryenvironment.Inthatcase,asmacroeconomicpolicystayedthecourse,andreformswereconsciouslydesignedtomeetthelimitationsofthelender-of-last-resortfunctionofthecentralbank,aswellastomaintainfiscalsustainability,thebankingcrisiswasvirulentbutshortlivedanditssuccessfulresolutiontranslatedintorenewedpublicconfidenceinthesystem.

The2001crisisshowsthereverse.Theconsolidationofthebankingsystemandthenewmacro-prudentialregulationsimplementedafter1995hadmadethefinancialsystemmoreresilient,bothintermsofcapitalizationaswellasintermsofliquidity.However,themacroeconomicsideofthe2001crisisprovedtobeaninsurmountableobstacleforthefinancialsystem,andthemacroeconomiccrisisledtoabankingcrisisaswell.Aswehavediscussed,Argentinahadpolicyoptionsthatcouldhavemitigatedandevenavoidedthe2001crisis,buttheseoptionsnowremainaselementsforanex-postanalysisofthecausesofthecrisis,ratherthanpartofitsfactualhistory.

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