26
December

Structural Problems of Pakistan's Economy: The Way Forward

Published in Hilal English Jan 2014

Written By: Dr Zafar Mehmood

What are the structural problems of an economy? These are essentially the structural imbalances that act as binding constraints to sustained economic growth and development. In case of Pakistan the structural problems include: disproportionately higher involvement of government in economic activities, large informal economy, agriculture remains a major employer of workforce, concentration on cotton-related production activities, policies biased toward import-substituting activities, neglect of services economy in public policies, low rate of savings and consequently inadequate investment to develop human resources and infrastructure, inability of the government to collect enough tax revenues, neglect of small and medium enterprises, ineffective governance and institutional structures, lack of accountability, etc.

Deep rooted economic reforms are thus needed to remove these structural imbalances to increase efficiency, improve competitiveness, stimulate entrepreneurship, and technological progress. It may be noted that when cyclical macroeconomic measures stop producing results then the only way left with economic managers is introduction of fundamental structural reforms. Pakistan is currently at this crossroad.

Pakistani economy is currently trapped in low growth, high inflation and unemployment, falling investment, excessive fiscal deficits, and a deteriorating external balance position. Foreign exchange reserves are steadily dwindling owing to low foreign capital inflows, heavy debt repayments and slow growth in foreign earnings. Currently, Pakistan has foreign reserves to pay only about a month's import bill. These are the outcomes of failure to timely address the structural problems faced by the economy. Failure to deliver 'inclusive' growth in turn is threatening the social stability of the society.

Savings rate in Pakistan is persistently low as compared with the investment requirements. This is one of the main reasons as to why we have to rely on foreign capital. When foreign capital is not available then the investment rate further goes down, which has adverse implications for growth and employment. Main reasons for low private savings in Pakistan are: low or negative real interest rate, unstable income, large family size, low education level, high inflation, lack of culture to save, etc.

Energy crisis being faced by the country is believed to be mainly due to circular debt, untargeted subsidy, distribution problem, and theft. Government provides large subsidy owing to high generation cost compared to the price charged by distribution companies. Why the cost of electricity is high in Pakistan? We often find arguments explaining that it is high because oil price is high and line losses including the theft, are high. But I think there is more than this, and that can be attributed to inefficiency in power generation due to the use of obsolete technology by power generation companies, their wastage and frequent breakdown of plants, and the outdated transmission system. On the demand side, government does not take measures to curtail demand for electricity. Demand side measures must be introduced in Pakistan. In contrast, what we see in Pakistan, as per report of a major international electric appliance company, that its sales increased by 60% in just one year during 2012. What is the policy response to such an uncontrolled demand? Probably none.

Large informal segment of the economy escapes from national laws and regulations. Due to unrecorded nature of the informal economy, it is not covered in official statistics. As a result, most of the official economic indicators present a dismal position. There is a need to document the informal economy.

Besides huge debt servicing, loss-making State-Owned Enterprises (SOEs) are consuming large sums of budgetary resources, which constitute a drag on the public finances as well as on economic growth. Losses of SOEs are mainly due to corruption, inefficiencies, over staffing, and incompetent staff. Government has been providing resources to SOEs to ensure that these enterprises keep running. However, no effective effort is made by SOEs to improve their productivities, efficiencies, etc., to make themselves viable on sustainable basis. Consequently, each year a huge sum is used by the government for the survival of SOEs.

The ill planned tax reforms have failed to deliver the desired results. Tax reforms are introduced in an ad hoc manner, which lack commitment to take hard decision. Frequent introduction of withholding tax itself speaks of lack of government's competence or will to directly collect the taxes. It is hard to imagine why exemptions to certain activities are given in the tax system without any public debate. Why most of the services sector and businesses remain outside the tax net? Why the agricultural income tax is not collected by the Centre like income tax on other sectors? Why the formal sector industries do not fully pay the sales taxes they collect on behalf of the government from consumers? Why amnesty schemes are introduced by every other government with a clear understanding that tax avoiders and evaders will again indulge into such practices? Is this the acceptance of our failure? Answers and solutions to these questions can substantially increase the tax base.

Many of the problems being faced by the economy are due to weak regulatory system. In turn, the lax enforcement of laws and regulations is due to weak institutional capacity. This can be seen especially when it comes to the application of tax laws and competition law. In case of taxes, people evade and avoid taxes with connivance of tax officials and loopholes in the system. Inapplicability of competition law facilitates sellers in general, to not only cheat on price, but on quality as well.

Given its deep rooted structural problems, Pakistan needs to introduce economic reforms. It should introduce strategically planned reforms without haste. While introducing reforms, the government must keep in front social implications of reforms such as unemployment, environmental degradation, and economic dislocation. Reforms should also be designed in such a manner that they do not create any disparity between the provinces. All of this requires a strong political will and consensus between federal and provincial governments.

Introduce structural reforms in the areas of trade, SOEs, and business climate, which in turn will encourage higher investment. Restructuring and privatization of SOEs should aim to ultimately help restore fiscal stability as well as boosting investor confidence in Pakistan's future economic prospects and opportunities, leading to higher growth and job creation. In the area of trade, remove bias in policies against exports, remove commodity concentration, diversify export markets and improve international competitiveness of exports. This will enlarge our export share in global and regional markets.

Business environment should be made friendlier by simplifying start-up procedures, internationalization of companies, education of entrepreneurs, reducing administrative burden, and introducing reward of excellence for promoting entrepreneurship.

Urgent policy actions are needed to place Pakistan on a higher and inclusive growth path including: (i) strengthen public finances through revenue mobilization, cuts in wasteful and low-priority expenditure, and a strengthened fiscal decentralization framework; (ii) reform the energy sector to remove power deficit and untargeted subsidies, (iii) reduce government's involvement in the economy; (iv) implement financial policies to reduce inflation, protect the external position, and safeguard the stability of the financial sector; (v) remove imperfections in the market by strengthening competition law and its enforcement; (vi) remove unnecessary controls so as resources are reallocated in desired direction; and (vii) remove policy bias against the private sector, non-agriculture sectors, and non-textile sectors. An important structural change would be to make the economy less dependent on foreign assistance for sustaining growth. This may take time, but the process must begin now. In this regard, measures should be introduced to induce more savings by all agents of the economy.

Private sector is the engine of economic growth in any economy. Unfortunately, most of the economic policies, especially financial, are biased against the private sector. Consequently, this sector has failed to make desired contributions in the economy. The private sector should be allowed to play the leading role in all economic activities; of course, within a well-functioning regulatory environment. The govern-ment's primary role should be limited to provide social and physical infrastructures, and social protection to poor.

The writer is an HEC Foreign Professor and presently on the faculty of NUST Business School, Islamabad. This email address is being protected from spambots. You need JavaScript enabled to view it.
17
December

THE BALI PACKAGE

Published in Hilal English Feb 2014

Written By: Dr Zafar Mehmood

After many ups and downs during the intensive consultations between developed and developing countries, the 9th Ministerial Conference of the World Trade Organization (WTO) concluded successfully in Bali, Indonesia on December 7, 2013. WTO Members have adopted a number of ministerial decisions on several important issues of the Doha Round, including agriculture allowing developing countries more options for food security, development/ Less Developed Country (LDC) issues to boost trade and Trade Facilitation designed to streamline the activity.

This is the first major agreement that has been reached by the WTO Members ever since it was established in 1995. Other agreements struck since then are on financial services and telecommunications, and among a subset of WTO members, and an agreement on free trade in information technology products.The Bali Package comes on the back of the Doha Development Agenda (DDA), which was launched in 2001. The Bali Package is a small but a significant component of the DDA setting out a path for a successful conclusion of the DDA at some future date.

The most significant for international trade is the Trade Facilitation part of the Bali Package, which is about speeding up customs procedures; making trade easier, faster and cheaper; providing clarity, efficiency and transparency; reducing bureaucracy and corruption, and using technological advances. It also has provisions on goods in transit, an issue particularly of interest to landlocked countries seeking to trade through ports in neighbouring countries. Part of the deal involves assistance for developing countries and the least developed countries to update their trade infrastructure, train customs officials, or for any other cost associated with implementing the agreement.

The benefits to the world economy from the Bali Package are calculated to be between $ 400 billion and $1 trillion by reducing costs of trade by 10 to 15 %, increasing trade flows, creating a stable business environment and attracting foreign investment. Pakistan will also benefit from this pie if it takes timely actions. The agreement's positive spin-off will be in terms of growth, creation of more jobs and enhancement of revenue for governments. Much of the rest of the Bali Package focuses on various issues related to development, including food security in developing countries and cotton and a number of other provisions for the least developed countries. Agreement on the agriculture, a part of the Bali Package, required sorting out two issues. Much of the focus of negotiations was on shielding public stockholding programmes for food security in developing countries, so that they would not be challenged legally through the WTO Dispute Settlement Mechanism even if a country's agreed limits for trade-distorting domestic support were breached.

Pakistan fully supported agricultural development schemes to enhance food security and develop food stocks but the ones that are based on transparent, predictable and market based policies that do not distort production and international trade. In this context, it may be noted that the proposed solution will be interim, and much of the discussion was about what would happen at the end of the interim period. The outcome of consultations was for the interim solution to exist until a permanent one is agreed, with a work programme set up aiming to produce a permanent solution in four years. The Bali Package asks member countries to open up their agricultural subsidy regime for scrutiny and not use its subsidy regime to distort agricultural trade through exports. The Bali Package allows improving market access for cotton products from the least developed countries, and with development assistance for production enhancement in those countries.

The package also includes a political commitment to reduce export subsidies in agriculture and keep them at low levels, and to reduce obstacles to trade when agricultural products are imported through quotas. Agriculture subsidies and import quotas are widespread in the European Union that hurts exports of agricultural products from countries like Pakistan. Therefore, any development in this context will be in our benefit. The other issue was about “tariff quota administration”; that is, how a specific type of import quota (a “tariff quota” where volumes inside the quota have a lower duty) is to be handled when the quota is persistently under-filled. Members have agreed on a combination of consultation and providing information when quotas are under-filled. This will increase transparency in the use of import quotas.

Under development issues, four documents remained unchanged from their Geneva versions. These include:

• Duty-free, quota-free access for the least developed countries to export to richer countries' markets. Many countries have already implemented this, and the decision says countries that have not done so, for at least 97% of products, “shall seek to” improve the number of products covered.

• Simplified preferential rules of origin for the least developed countries, making it easier for these countries to identify products as their own goods, and qualify for preferential treatment in importing countries.

• A “services waiver”, allowing the least developed countries' preferential access to richer countries' services markets.

• A “monitoring mechanism”, consisting of meetings and other methods for monitoring special treatment given to developing countries.

Finally, the Ministerial Conference adopted five decisions on the WTO's regular work. They are the following:

• In intellectual property, members agreed not to bring “non-violation” cases to the WTO dispute settlement process – “non-violation“ is shorthand for the technical question of whether there can be legal grounds for complaint about loss of an expected right under the WTO's trade related intellectual property agreement, even when the agreement has not been violated.

• A similar extension was agreed in electronic commerce, members agreed not to charge import duties on electronic transmissions. The Work Programme at the WTO also encourages continued discussions on electronic commerce in relation to commercial issues, development and new technology.

• Ministers decided to give special consideration to issues of small economies. Ministers instructed the Committee on Trade and Development to consider proposals on small economies and make recommendations to the General Council of the WTO.

• Ministers reaffirmed their commitment to Aid for Trade, an initiative that assists developing countries, and in particular the least developed countries' trade. They welcomed progress on Aid for Trade since its launch in 2005 and mandated the Director-General of the WTO to continue support of the programme.

• Ministers directed their Geneva delegations to continue examining the link between trade and transfer of technology and make possible recommendations on steps that might be taken to increase flows of technology to developing countries. The mandate was given at the 2001 Doha declaration.

The text adopted in Bali is not final, although the substance will not change. It will be checked and corrected to ensure the language is legally correct, aiming for the General Council to adopt it by 31stJuly 2014. In conclusion, the Bali Package is a successful development for global trade. Had it failed, it would have dire consequences for the multilateral trading system. Had it failed, Pakistan would have been in difficult position as it is not part of any major regional trading bloc.

The writer is an HEC Foreign Professor and presently on the faculty of NUST Business School, Islamabad. This email address is being protected from spambots. You need JavaScript enabled to view it.
17
February

Effects of Plummeting Oil Prices

Written By: Dr. Zafar Mahmood

Like prices of other commodities, the price of crude oil experiences wide price swings in times of shortage or oversupply. Unlike many other commodities, the crude oil price cycle may extend over several years responding to changes in global demand and supply. Global oil prices have fallen sharply over the past seven months, leading to significant revenue shortfalls in many oil exporting nations. On the other hand, consumers in oil importing countries, including Pakistan, are now paying less.

Between 2010 and mid-2014, world oil prices remained fairly stable at around $115 a barrel. Among the reasons attributed to this trend was the higher consumption pattern by major oil importing nations like China and India. Also, the geopolitical tensions in nations like Iraq and Libya too kept the prices high. As oil producing nations could not keep up with the world demand, as a result the prices rose. But since June 2014 prices have more than halved. Brent crude oil has now dipped below $50 a barrel for the first time since May 2009. US crude, which is lighter and sweeter, has also fallen below $50 a barrel.

The reasons for plummeting oil prices are twofold – weak demand in many countries of Asia and Europe due to weak economic growth, coupled with surging US oil production due to shale gas and oil. Shale is a natural gas found in shale formations – a type of rock in the earth's crust. It is being considered as the new source of natural gas as other sources are fast depleting. US is at the forefront of exploring and producing shale gas. It accounted for 39% of its natural gas production in 2012.

Added to this is the fact that the oil cartel OPEC is determined not to cut production as a way to prop up prices. OPEC members are losing large export earnings but do not want to cut their production at this stage. They are increasingly using their accumulated future generations’ fund to bridge the current account and fiscal deficits.

Russia is one of the world's largest oil producers. Its economy heavily depends on energy revenues, with oil and gas accounts for about 70% of export earnings. Russia is expected to lose about $2 billion in revenues for every dollar fall in the oil price. Consequently, its economy is likely to shrink by at least 0.7% in 2015 if oil prices do not recover. Russian Government has predicted that its economy will sink into recession. Despite this, Russia has confirmed it will not cut production to shore up oil prices. This is because with a cut in oil production, Russia expects that its importing countries will increase their production, which means a loss of its niche markets.

Saudi Arabia, the world's largest oil exporter and OPEC's most influential member, could support global oil prices by cutting back its own production, but there is little sign it wants to do this. Two reasons: first, to try to instill some discipline among OPEC members and second to put pressure on USA's promising shale oil and gas industry, as OPEC now recognizes the challenge of US production. Although Saudi Arabia needs oil prices to be around $85 in the longer term to balance its budget, it has large reserve fund of about $700 bn, so it can bear lower prices for some time. Like Russia, OPEC believes that lower prices would force some higher cost producers to shut down their production so that it can pick market share in the longer run. OPEC has also learned from its history. In the 1980s, OPEC cut its production significantly in order to boost prices, but it had little effect, although it badly affected the member countries’ economies. So this time OPEC is cautious and has shown unwillingness to cut its production level.

The growth of oil production in North America, particularly in USA, has been staggering. US oil production levels were at their highest levels in almost 30 years. It has been this growth in US energy production, where gas and oil is extracted from shale formations using hydraulic fracturing that has been one of the main drivers of lower oil prices. Despite many US shale oil companies have far higher costs, $60 to $70, than conventional rivals; many of them need to carry on pumping to generate sufficient revenues to pay off debts and other costs. With Europe's weakening economies currently characterized by low inflation and weak growth, any benefits of lower oil prices would be welcomed by stressed governments. China, which is set to become the largest net importer of oil, should gain from falling prices. However, lower oil prices won't fully offset the far wider effects of a slowing economy.

Japan imports nearly all of the oil it uses. But lower prices are a mixed blessing as high energy prices had helped to push inflation higher, which has been a key part of Japanese government’s growth strategy to combat deflation. A 10% fall in oil prices should lead to a 0.1% increase in economic output, some experts predict. In general, consumers benefit through lower energy prices, but eventually, low oil prices do erode the conditions that brought them about. Pakistan’s imports of petroleum and its products account for about 33 percent of its total imports. Falling oil prices are expected to ease its current account deficit, which will strengthen Pak Rupee. With low oil price, industrial production cost will go down hence our exports may become internationally competitive. At the same time, revenue from petroleum-related levies will fall because Pakistan imposes ad valorem taxes instead of specific duties. To recover falling tax revenue, government has announced to impose additional 5% sales tax on petroleum products. Lower oil prices are helping government to contain inflation rate. Current inflation rate is 4.3% (December 2014), which is likely to further go down; both consumers and government are cheering. Pakistan’s projected recoverable shale gas is estimated at 105 trillion cubic feet of recoverable gas and 9.1 billion barrels of shale oil reserves. However, its production costs in Pakistan will be considerably high due to the advanced technological requirements and relatively unknown terrain. Pakistan needs a policy to attract technology for its exploration.

The steep fall in crude prices is de facto, a fiscal stimulus. It is likely to boost growth and employment. Consequently, unemployment and poverty will fall. However, fall in earnings of oil exporting countries, especially in the Arabian Gulf region, is likely to reduce inflow of FDI to Pakistan. Default in loans given to shale gas developers in USA could affect the global banking industry which in turn could cause imbalances, and hence a fall in capital inflow from these sources to Pakistan.

All in all, the biggest fall in oil prices since the 2008 global recession is shifting wealth and power from oil producing states to oil importing states. Surging U.S. and other Organization for Economic Cooperation and Development (OECD) shale supply, weakening Asian and European demand and a stronger dollar has pushed oil to a five-and-half-year low, with a price below $40 a barrel not out of sight.

Even as cheaper fuel stimulates the global economy, it could aggravate political tension by squeezing government revenue and social benefits. Pakistan government is quick enough to announce 5 percent additional sales tax on petroleum to account for the falling revenue on this account. Political tensions in some of the oil exporting countries may increase if the fall in oil prices persists.

Pakistan needs to carefully manage falling oil imports bill. With lower oil prices if demand goes up proportionately then import bill will not go down. Pakistan’s domestic crude oil production may fall if marginal producers become uncompetitive. Thus, government needs to make all efforts not only to stabilize the currency but properly manage demand and domestic production, too.

The writer is a Professor of Economics at School of Social Sciences and Humanities at NUST, Islamabad. This email address is being protected from spambots. You need JavaScript enabled to view it.
16
March

From Poor Economy to Debt Default

Written By: Dr Zafar Mahmood

A sovereign debt default occurs when a country does not meet a debt payment (principal or interest), i.e., it fails to meet the terms of a contractual agreement. A country that repudiates its debt faces the threat of sanctions such as loss of access to short-term trade credits, trade sanctions, seizure of assets, etc. In practice, however, the observed punishment does not correspond to what some might think. It may be noted that whereas domestic loans are supported by substantial collateral, the assets that can be appropriated in the event of sovereign country's default are often negligible. International experience suggests that defaulting governments have seldom been punished, either with direct sanctions or with discriminatory denial of credit. Countries try to avoid default not because of the collateral damage associated with default but because of the country's reputation. A country's incentive to make loan repayments is to preserve its future access to international credit and trade. Moreover, defaulting on sovereign debt may undermine the country's capacity to obtain beneficial deals in multilateral organizations. A default thus can have lasting effects on the country's growth, trade and the financial sector.

Why do then countries default? Studies distinguish three different causes: (a) liquidity problem (only a cash flow problem); (b) sustainability problem (the country may never be able to service its debt out of its own resources); and (c) unwillingness to pay (a country decides to stop paying it well before it is insolvent). Ultimately the decision of defaulting however, resides in the political sphere. The cheerful celebration of the December 2001 Argentine default by its Congress certainly suggests that losses for the defaulter were not big enough. Some studies indeed show that the welfare effects of the default are unambiguous: on the one hand there are output contractions and financial crises; on the other hand it alleviates the fiscal situation because debt payment falls. Why do, then, markets lend to countries that defaulted? An explanation is found in the procyclical nature of capital markets that lent vast sums to emerging markets in boom periods (associated with low returns in industrialized countries). In fact, it may be argued that lenders are paid accordingly for the risk they take. However, it is this same process that produces “sudden stops” in borrowing countries, and that triggers default episodes. Sometimes there is “excusable default” defined as a default triggered by bad shocks. In such a case, both creditors and debtors have incentives to renegotiate, and it is optimal to have a debt relief (or partial default) than a total disruption of debt. The incentives of lenders and borrowers to reschedule or restructure debt obligations are quite different. The incentive for lenders is to recover as much possible value of defaulted debt (provided that the penalty, in terms of seizure of assets, is much smaller than the amount defaulted). The incentive from the borrowers' view point is to minimize the output and other economic costs of a default.

Historical evidence suggests that countries that have defaulted on their external debts have done so repeatedly. Including the recent episode, Argentina has defaulted 5 times since 1824. This is not an exclusive characteristic of Argentina provided that other countries in the region have defaulted on a similar number of occasions. For instance, Brazil and Colombia have defaulted 7 times while Venezuela 9 times. If this historical account tells anything is that defaulting is not new. However, the latest Argentine's default of 2001 has some distinctive characteristic that puts it in the Guiness Book of World Records of the default history: it was the largest in the history of international bonds with over $82 billion. Argentine Debt Default Background: During most part of the early 1990s, Argentina outperformed most other countries in Latin America in terms of economic growth. However, in the late 1990s, due to the decision to peg its currency to the U.S.Dollar, pro-cyclical fiscal policies and extensive foreign borrowing left Argentine unable to deal with a number of global economic shocks. This ultimately led to the outburst of a severe currency, sovereign debt and banking crises. To understand the causes of crises, few important background events are in order. As government spending could not be matched by taxation and financial market borrowing, the authorities became dependent on inflation to finance the rising deficits (known as inflation tax, seigniorage). This led to a sharp rise in inflation (hyperinflation). By 1989, inflation reached to an annual rate of 3,080 %. Political support to deal with hyperinflation once-and-for-all grew.

The government introduced radical economic reforms in line with the dictate of the Washington Consensus. Beside others, the reforms included the privatization of state-owned enterprises, deregulation of the economy, reduction in trade restrictions, etc. With the implementation of these reforms, Argentina won great admiration from all international finance institutions, especially from the IMF. On the Wall Street, Argentina had become one of the most favourite emerging market; the country was able to borrow relatively cheap in U.S. Dollars and thus became the biggest issuer of emerging markets debt in the late 1990s. This made the country increasingly dependent on foreign capital. Earlier in 1991, to tackle hyperinflation, Argentina also introduced a Currency Board (the so-called Convertibilidad). The Convertibilidad acted like a monetary authority, which was required to maintain a fixed exchange rate with a foreign currency. This policy objective required the conventional objectives of the Central Bank to be subordinated to the exchange rate target. Among its major features were; (1) the introduction of a new currency, the peso (which amounted 10,000 Australes), which was set at an exchange rate of one peso to one U.S. dollar, and which was perfectly convertible and; (2) a new law was introduced, which permitted the Central Bank to issue new pesos only against new foreign exchange reserves. The Convertibilidad had many aspects of a dollarization: contracts made in dollars acquired the same status as those made in the local currency (including bank deposits and credits).

The Convertibilidad laid the foundation for (temporary) exchange rate stabilization. Argentines could now freely convert their pesos into dollars. Since then bank deposits and loans in dollar became widespread. After the implementation of these reforms, the Argentina economy entered a period of economic growth between 1991 and 1997. Under the Convertibilidad regime – inflation came to an end, there was an initial period of high growth rates, and there was a substantial surge in capital inflows. This new regime did not prohibit the state from having budget deficits. However, such deficits could not be financed by the Central Bank, but only through borrowing. Much of the latter consisted of foreign borrowing. The public sector continued to be in deficit due to: (1) the payments of the debt services, which grew from approximately 4% of the GDP around 1993 to more than 10% by the end of the decade and; (2) the need to finance the social security system with pesos, as most of the young taxpayers had transferred to the private system. In 1994, the Argentine government partially privatized the public pay-as-you-go social security system that had been in existence since 1967. This decision was strongly promoted and supported by the World Bank and the IMF and had a major impact on Argentina's fiscal accounts. The loss of revenue, plus accumulated interest costs, amounted to nearly the entire government budget deficit in 2001. As a side-effect of the Convertibilidad, the Argentine economy was especially vulnerable to foreign crises. The outbreak of currency crises in Asia, Russia and Brazil in 1997 caused capital to flow out and the Brazilian devaluation made the trade deficit worse. As Dollars were flowing out of the Currency Board, the decline of the Dollar reserves reduced the money supply and raised interest rates. Moreover, the currency crises raised the cost of borrowing for emerging markets. Brazilian devaluation reduced the competitiveness of Argentine producers. Meanwhile, the prices of Argentina's agricultural export products fell. All this led to a sharp reduction in exports, which caused sharp rise in current account deficit that pushed the country into recession.

The growth rate of Argentina's GDP began to slow down in 1998 and in 1999 it began to experience a negative growth rate, which continued until 2003. The most pronounced decline occurred in 2001 and 2002, when the country experienced the collapse of the Convertibilidad system. This decline in growth also produced dramatic increases in poverty. For instance, unemployment grew from 13.2% in 1998 to 21.5% in 2002; the proportion of the population living below the poverty line grew from 35.9% in 1998 to 57.5% in 2002. Moreover, the rate of investment, which was already declining in the late 1990s, took a plunge from 1999 on, dropping from 19.1 % of GDP to 11.3 % in 2002. By the time of De la Rua's government (December 1999 to December 2001), there was a consensus among economists that devaluation was imperative. Policymakers hesitated due to devaluation's perceived financial and political risks involved and the De la Rua's government adhered to the view that the main problem was not the exchange rate overvaluation but fiscal deficit. This view led the government to have a tight fiscal policy with the expectation that fiscal adjustment would entail lower risk premiums and consequently interest rates, which in turn would reduce the debt service payments, one of the principal components of the public expenditure. However, these policies reinforced the recessionary trend and undermined market confidence in the viability of the Convertibilidad.

Argentina kept on maintaining its peg with U.S. Dollar, which left it unable to respond to the growing economic problems, as it could not apply monetary policy under fixed exchange rate regime. In fact, when U.S. Dollar appreciated (between 2000 and 2002), its highest level in 15 years, the peso became overvalued. Moreover, the exchange rate peg was not supported by nominal price and wage flexibility which further reduced Argentina's instruments to deal with currency overvaluation and decreased the credibility of the exchange rate regime. As foreign investors lost their confidence in the Argentina economy, it had to face increase in cost of borrowing. Consequently, the country virtually lost its access to the international financial markets in July 2001. By the second half of 2001, the public began to fear the possibility of devaluation and there was increasing speculation against the peso. The situation was worsened by a unique feature of the Convertibilidad. In particular, local banks were able to offer deposits in foreign currency to the general public, and the Central Bank guaranteed that these were secured. Therefore, the peso speculation converted into a bank run, as the public withdrew their savings from foreign based accounts into cash.

In order to sustain the Convertibilidad, the government established severe restrictions on capital movements and cash withdrawals from banks in December 2001. This measure infuriated the general public and produced massive social unrest and political turmoil. To avoid a massive peso withdrawal from the banks the government declared a bank holiday on December 20th, which lasted until January 3rd, 2002. The collapse of the De la Rua's government and the successive governments led to the abandonment of the Convertibilidad. Argentina abandoned its Convertibilidad in January 2002 after a severe recession. To some, this emphasized the fact that the currency boards are not irrevocable, and hence may be abandoned in the face of speculation by foreign exchange traders. However, Argentina's system was not an orthodox currency board, as it did not strictly follow currency board rules – a fact which many see as the true cause of its collapse. They argue that Argentina's monetary system was an inconsistent mixture of currency board and central banking elements. It is also thought that the misunderstanding of the workings of the system by economists and policymakers contributed to the Argentine government's decision to devalue the peso in January 2002. The economy fell deeper into depression before a recovery began later in the year.

The new government of Duhalde (2002-2003) decided to compulsively convert foreign-currency bank deposits into pesos at a rate of 1.4 pesos per dollar when the market rate was 2 and even reached 4 pesos per dollar. Additionally, to avoid a generalized bankruptcy bank credits in dollars were converted at a rate of one-to-one rate. On December 24th the service payments of a significant part of the public debt were suspended (it initially affected $61.8 billion in public bonds and $8 billion in other debt instruments). It did not include debt contracted with multilateral institutions (such as the IMF, the World Bank and the Inter-American Development Bank) of about $32.4 billion and guaranteed loans of $42.3 billion. This turned out to be the largest default in Latin American economic history, as the foreign private debt amounted to $ 82 billion out of $ 153 billion. Besides, the extra premium paid by Argentine bonds significantly influenced the Menem (1989-1999) and De la Rua's governments' decisions. As financial markets disbelieved the country's capacity to repay its foreign debt, those governments introduced tighter fiscal policies. However, following the contractionary policies, markets offered a higher discount on those bonds, which in fact worsened the country's financial situation. As expected, the default followed. How did then the 2001-2002 Argentinean default impact it?

• Immediate Sanctions: The value of Argentine's foreign assets was very small compared to its foreign debt. Threat of sanctions and seizure of assets occurred only rarely. Some of its bondholders tried to take legal actions in the courts of New York to attach Argentinean Central Bank funds in the New York Federal Reserve. However, it proved difficult for them to convince the courts. The latter held that since Argentinean funds belonged to Argentina's Central Bank, which was considered an entity separate from the Argentinean government, the claims had to be denied.

• Future Sanctions: Another type of sanction is the loss of access to international credit. It may be noted that the amount of credit declined dramatically in 2001 and reached a low point in 2005 (there is no information for 2002 to 2004 because the country was in total default and there were no financial operations). Credit began to flow in again in 2005 and by 2006 reaching the levels of 1994-95. Thus, these types of sanctions were of short durations.

Interestingly, net foreign credit to Argentina began to decline before the default. Net foreign portfolio investment dropped from U.S$ 11.5 billion in 1998 to U.S$ 8.7 billion in 1999 and to U.S$ 6.8 billion in 2000. Although, the decline in 2002 can be interpreted as reflecting the default, this is not the case of the previous years. Thus, the decline in the inflow of portfolio investment cannot be solely blamed in the default, but rather on the deterioration of the economic situation and especially the increased evidence of the lack of sustainability of the Convertibilidad. It must be underscored that the end of the Convertibilidad entirely changes the dependence of Argentina on foreign capital. During the 1990s, the emission of debt was mainly associated with the necessity of acquiring foreign reserves to maintain the currency board and the payment of interest. After 2002, both conditions disappeared, and this gave the Argentine government more room to negotiate.

• Immediate Effects: Aerolíneas Argentinas was one of the most affected Argentine companies, cancelling all international flights for various days in 2002. The airline came close to bankruptcy, but survived. Several thousand newly homeless and jobless Argentines found work as cartoneros, or cardboard collectors. An estimate in 2003 put the number of people scavenging the streets for cardboard to sell to recycling plants at 30,000 to 40,000 people. Such desperate measures were common given the unemployment rate of nearly 25%.

Argentine agricultural products were rejected in some international markets, for fear they might arrive damaged by the chaos. The United States Department of Agriculture put restrictions on Argentine food and drug exports.

• Impact on Growth and Trade: The default had little impact on either growth or trade. The dramatic decline of growth in the years 2001-02 was a direct consequence of the collapse of the currency board, and it can be claimed that the default was the result of the crisis rather than the cause of it. The default may not be separated from the deep economic recession and regime's collapse, and therefore its specific contribution may be difficult to quantify.

In addition, the resumption of spectacular rates of growth in 2003 had little to do with the default. As far as trade is concerned, exports stayed at about the same level in the years 1997-2002, while dramatically rising in the years 2003-2006. As far as imports are concerned, their decline began in 1998, plunging in 2002, but recovered rapidly after 2003. Import declines cannot be explained by a lack of credit related to the default, but rather by the dramatic decline of the GDP, the decline of investments and the spurt in import prices due to the devaluation of the currency.

• Impact on the Banking Sector: The contraction of the economy in 1998 resulted in rising non-performing loans. The January 2002 economic reforms, including the abandoning of the Convertibility Board, the pesofication of bank deposits and loans at two different exchange rates caused a wave of defaults and liquidity problems for companies. The default rate of rated issuers was as high as 60%. The apparent solid position of the banking sector could not prevent the sector, including both domestic and foreign banks, from being affected by the crisis too. Amongst others, Argentina's largest privately owned bank, Banco Galicia, and several foreign banks such as the Bank of America, CitiGroup, FleetBoston and J.P. Morgan Chase & Co suffered heavy losses.

• Foreign Direct Investment (FDI): The default did not reduce FDI, which was a feared consequence. Even in the worse time of the crisis, that is 2002, FDI, though substantially lower, never disappeared. Also, the collapse of the financial system should certainly not be attributed to the default but to the non-sustainability of the Convertibilidad. The internal financial system recovered very fast after the new macroeconomic equilibrium was put into place.

• Recovery from Crisis: Negotiations with bondholders, which began in 2002, dragged on until June 2005, when President Kirchner made an offer which consisted of the exchange of old bonds for new ones. The new bonds amounted to 25% of the value of the old debt. Kirchner made it clear that this offer was not negotiable and he gave bondholders one month to accept or reject the offer.

Within that time 76% of the bondholders accepted the offer. The remaining 24% were not repaid and kept on trying to regain their investment through foreign legal actions. The unilateral offer was indirectly supported by other actors' inaction and lack of initiative, together with extraordinarily good international conditions. Both the IMF and developed countries' governments adopted a laissez-faire approach to the sovereign crisis resolution. Moreover, the low interest rates in the United States, and the narrowing of emerging bond spreads improved the conditions of the offer. The government also took for granted the position of local financial investors (mostly retirement and pension administrators who were obliged to invest a certain proportion of their capital in public bonds), which provided a “floor of acceptance” of about 30%. The default itself eliminated one of the principal components of the public deficit, that is, the need to pay huge sums as interest on the debt, and by 2002 the prices of the Argentinean exports were rising dramatically.

Argentina's recovery from the economic crises was indeed due, mainly, to the improvement in the trade balance. It went from being negative in the late 1990s to a surplus in 2000, and this surplus rose dramatically in the subsequent years. The surplus was the result of two factors: (i) the country's exports, which hardly ever declined, rose substantially, as a result of both a strong world demand for the country's products, and also the substantial devaluation of the peso; and (ii) there was a dramatic decline of imports, due to both the rise of poverty levels and the decline of investments. Overall the collapse of the Argentine's financial system did not have any significant effect on international trade. The fact that there were no disruptions after the default may be explained by the fact that Argentine's exports were concentrated on traditional agricultural markets and primary goods with well-established financial services and prices on the rise, or tied to the Mercosur with politically managed quotas. The strong growth of exports also strengthened the finances of the government, as the major export items were taxed. In fact, the government's budget had a surplus from 2003 on. However, as in the case of government revenues, the level of expenditures also expanded, which, in turn, contributed to economic expansion.

The devaluation of the currency after loan default did not produce an immediate rise in the level of prices, mostly due to the existing high unemployment rate and to the freeze of public utilities' prices and other price controls introduced by the Duhalde and (mainly) Kirchner (2003-2007) governments. Economic recovery was attributed to the achievement of a new macroeconomic equilibrium. Those authors stress that the policies implemented were different from those common in the 1990s. In particular the new governments imposed new exchange rules that compelled exporters to liquidate dollars in the local market and imposed capital controls. In fact these measures were so successful that the Central Bank was compelled to absorb the excess of foreign currency to avoid the appreciation of the peso.

• Lessons for Emerging Economies: Argentina crises were due, mainly, to internal problems: the lack of an internal adjustment to accompany the Convertibilidad, which led to an unsustainable external debt situation. The default was a “way out” and Argentina got away with it due to the favourable external conditions, leading to huge trade surpluses, which led to growth and the growth, in turn, led to a softening of the country's bad reputation in global financial markets. The default thus could certainly not have been declared at a better time. Also, the fact that Argentina was smart enough not to default with the multilateral institutions was crucial because this line of credit remained open and the Argentine government made the announcement regarding the debt restructuring.

• Was the Argentina default really necessary? Evidence shows that default dramatically alleviated the government's burden, as debt servicing as a proportion of total government expenditures declined to 9.2% in 2004. However, the servicing of the debt might have been quite manageable in an expansionary period.

The fact that the default was done in a climate of political turmoil, mostly as a reaction to the failure of the policies implemented in the previous decade showed that the default was an immediate necessity rather than an unwillingness to recognize the debt. It was celebrated by the Congress as a political triumph with the expectation that it was necessary to avoid further macroeconomic restrictions. In a framework of fiscal, financial and political crisis, defaulting on foreign creditors was a short-term fiscal alleviation whose consequences would be the responsibility of an unknown future government.

All in all, two important points need to be made that are special features of the Argentine case. First, Argentina faced several favourable conditions in the aftermath of the 2002 economic crisis. The abandonment of the Convertibilidad alleviated the government's dependence on foreign capital and placed the country on a positive growth path that lasted several years. Moreover, the country's terms of trade entered in a favourable phase, which significantly contributed to the economic growth. Second, the default was declared concomitantly with a catastrophic economic, political and social crisis reduced its significance and it made multilateral institutions more sympathetic to the Argentine government debt restructuring process. Many analysts thought default would lead Argentina into a long period of stagnation and would keep it outside the world's financial markets for a long period of time. This did not occur! Argentina's experience indeed corroborates the historical fact that many, if not all, defaulters “get away with it.”

Argentina default was caused by the undesirable convergence of several economic events: a hard currency peg, currency overvaluation, economic rigidities, inappropriate fiscal policy, external shocks, large scale foreign currency borrowing followed by a “sudden stop” in capital inflows and continuing support of IMF played an important role in the course of crises. This together with the political and social turmoil that accompanied the events made the Argentine crisis one of the most severe emerging market crises in history. As world economic growth in the early 2000s was strong, Argentine producers benefited from the strong depreciation of its currency. The Argentine economy was able to recover rather quickly. Nevertheless, deep structural reforms were never implemented.

The writer is an HEC Foreign Professor and presently on the faculty of NUST Business School, Islamabad. This email address is being protected from spambots. You need JavaScript enabled to view it.

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