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The Wizard of Oz

November 04, 2003

Argentina today is living a fantasy. President Kirchner is the Wizard of Oz who has created the sense that his country is recovering rapidly from the domestic despair and international disgrace that were caused by President de la Rua’s colossal mismanagement.

The economy is growing at a 7% rate; the IMF has extended a new program with surprisingly mild conditionality; Kirchner has won a series of regional elections and is consolidating his power; the President, who won only 22% in the first round of last year’s presidential election, now has an 80% popularity rating. Compared to the economic depression, soaring poverty, social conflict, rising crime, political confusion, and default of the recent past, the transformation seems miraculous.

Unfortunately, it may be too miraculous. The Kirchner miracle rests on two fallacies. The first is that economic growth can be sustained without economic reform and new investment. The second is that a serious country can walk away from its international commitments without lingering consequences. The result is that, like in the classic movie, the Wizard’s fraud will sooner or later be discovered.

This year’s growth burst is largely the consequence of the dramatic exchange rate devaluation that followed the collapse of convertibility. Coupled with rising commodity prices and increasing demand for Argentina’s agriculture and energy exports, the attraction of fire sale priced assets to some vulture investors, and the breathing space that any debtor gains while the judge looks at his reorganization plan, the economic rebound is not surprising.

Unfortunately, it is not sustainable. Once the exchange rate effect wears off, the economy will fall victim to Argentina’s antiquated labor laws, the lack of a functioning banking system, and the weakness of the manufacturing sector. Companies that won’t hire and can’t get credit are unlikely platforms to drive a new Argentine economic renaissance.

Even worse, Kirchner’s war against foreign-owned utilities and foreign creditors is poisoning the investment environment. The government has attacked the privatized utilities, denying them the rate relief that is guaranteed in their contracts, but insisting that they maintain their contractually obligated investments and meet performance criteria defined for a dramatically different context. The President has hinted that the foreigners may lose their operating licenses and publicly said he hopes that Argentine capital will replace international capital in these companies. This stand-off, which is already producing brownouts, worries investors in other sectors who fear that the same reactionary logic could someday be turned against them. Sooner or later this will matter since, sooner or later, the country will need new investment.

What Argentina is considering doing to its utility investors, it is already doing to its creditors. In 2001 the country defaulted on its foreign debt, including dollar bonds owned by domestic pension funds. Today, Kirchner is trying to renegotiate around $107 billion of indebtedness; his current proposal would, in effect, impose losses equal to approximately 90% of the face value of the debt. Nothing of this magnitude has ever been attempted by a middle income country, but Kirchner has justified his proposal by arguing that creditors should share the impoverishment of the Argentine people and that he will not mortgage future growth to pay for the past mistakes of either borrowers or lenders. More importantly, he probably figures that he has nothing to gain politically by asking the country to sacrifice in the name of debts run-up by Presidents Menem and de la Rua.

Amazingly, the IMF and the U.S. government have remained more or less silent during the early phase of these negotiations. When Kirchner threatened to default on Argentina’s maturing IMF loans, Washington forced the IMF to accept a deal with Argentina that had weaker conditionality than the standards of recent agreements signed by other Latin countries. In effect, this meant that, contrary to accepted practice, the private creditors were left to fend for themselves after the official creditors had been satisfied. The result has been a proliferation of lawsuits as creditors seek legal leverage in the negotiations and an even greater proliferation of international ill will toward the Kirchner government.

One theory is that none of this really matters, since existing creditors were never going to lend more money to Argentina anyway. Just as the commercial bank lending of the 70’s and 80’s was followed by the privatizations and then the bond issues of the 90’s, Argentina could hope to find a greater fool to finance future growth. It’s not that creditors have short memories or that their greed trumps their experience, but that Argentina always seems able to find new pockets to pick.

On the other hand, it is possible that the magnitude of the most recent disaster and the continuing querulous negotiations with creditors, utility companies, and others have exhausted even Argentina’s ability to find new fools, at least anytime soon. The only alternative to using other people’s money is to use your own. However, a domestic savings rate high enough to finance economic autarchy would condemn the country to depression, especially since many Argentines continue to ship their capital out of the country.

There should be no doubt that creditors and investors have an obligation to play appropriate roles in the revitalization of Argentina. But unless these roles are defined in ways that attract rather than repel future investments, the country will suffer in the long run.

What does all this mean for the United States in Latin America?

A year ago, the U.S. Treasury mindlessly pushed President Duhalde’s government to take policy actions that it lacked the legitimacy to impose. As a result, the United States was widely criticized for failing to assist the Latin country that had most enthusiastically embraced the Washington consensus. This time, the United States switched gears, apparently to gain credibility with Kirchner, forcing the Fund to accept a watered down program.

There are competing theories circulating to explain this about face. First, romancing Kirchner is part of the Bush Administration’s strategy to isolate Brazil in the drive toward an FTAA. Second, the Administration is increasingly nervous about growing anti-Americanism and the lack of friendly faces in Latin America. Third, with Washington’s foreign policy apparatus focused on Iraq, the economic policy apparatus focused on China and the U.S. recovery, and the political apparatus focused on re-election, there was no appetite for yet another Argentine crisis. Fourth, the United States did not want to deal with the financial problems at the IMF and the Inter-American Development Bank that might have followed from Kirchner’s threatened default on the country’s multilateral debts.

Of course, the real answer may be all or none of these. What we know for sure is that, if Kirchner’s economic gains have as little staying power as seems likely, his embrace of the Bush Administration—which has been tepid at best—would quickly disappear.

Undermining IMF orthodoxy, without replacing it with something else, may have more lasting impact. Countries like Ecuador and Uruguay are going to have even more difficulty sustaining their stabilization programs in light of the Argentine example. And a failed debt negotiation—if that is the path on which Argentina is headed—will do little to encourage the flow of capital into Latin America more generally.

But it is also possible that Argentina is unique. No one in the region wants to imitate the mistakes that successive Argentine governments have made or to pass through the intense dislocations that have devastated that once proud country.

The bottom line is that the Kirchner government seems on a track that, like the yellow brick road to Oz, actually leads nowhere. As much as Argentines like fantasies, this one seems destined for a tragic ending.

*Alan Stoga is President of Zemi Communications and Vice Chairman of the Americas Society.