Washington and Wall Street: The Interplay of Financial Influences on the Course of Debt and Currency Crises in Argentina, Brazil, and Uruguay, 1998-2002
77 Pages Posted: 1 Jul 2010
Date Written: May 30, 2005
During 2001, market measures of Argentina’s ‘country-risk’ soared, the economy contracted, and the government collapsed. Over the first half of 2002, Uruguay followed Argentina into an economic and financial tail-spin, and Brazil encountered financing problems that endangered government solvency. Each of these phenomena was associated with disruptions to international capital flows.
Increasingly, capital flows rather than current account features have determined the balance of payments for peripheral countries. For the most part, capital flows have meant portfolio flows, and for this reason perceptions of country-risk on the part of financial markets – loosely referred to here as Wall Street – are all important. An accurate measure of Wall Street’s perceptions of country-risk can be found in sovereign spread levels – the difference in yield between dollar-denominated obligations of a peripheral government and US Treasury bonds. Extensive use will be made of this indicator to gauge not only the perceptions, but also the influence of Wall Street on the course of the debt crises.
Overseeing international financial events have been Washington-based institutions. In the short run, the US Treasury, acting through the US Federal Reserve Board, sometimes the New York Federal Reserve Bank, and the Bank of International Settlements (BIS), has taken the lead in crisis-prevention and resolution for countries with a strategic importance to the United States. The institution overseeing arrangements for restoring normality has generally been the International Monetary Fund (IMF), either acting independently or with the guidance of the US Treasury and other OECD countries. The World Bank (IBRD) and organisations such as the Inter-American Development Bank (IADB) play peripheral roles, typically as conduits for funds. These institutions each have separate, sometimes conflicting mandates, but uniting them is the goal of a smooth functioning international financial system: countries should not be allowed to become bankrupt because of problems in the system; conversely, moral hazard issues should prevent Washington from bailing- out countries guilty of economic malfeasance. Given the task of balancing these considerations, Washington’s perceptions of domestic culpability for a crisis are critical.
Rather than solely reflecting domestic policy errors and exogenous shocks, it will be argued that these disruptions had endogenous characteristics: feedback loops developed in which each iteration of the vicious cycle reinforced the first. These self-fulfilling cycles, facilitated by Wall Street’s perception of country-risk, continued in the direction of their momentum until, for reasons to be analysed, Washington institutions intervened to stop them.
Section two offers an historical context into which these crises fit. In section three, a short technical framework is presented, providing the conditions for stable long-term capital flows. In section four, competing explanations for the crises are then examined and found inadequate: the budgetary position of each of the countries is studied; both changes to the terms-of-trade and the degree to which capital flows were disrupted by the Russian default are explored; the impact of domestic politics on the crises is discussed.
In all of these sections a circularity between the perceptions of Wall Street and Washington and domestic economic and political dynamics can be found. This recurrent theme is brought into focus in sections five, six and seven.
Section five considers the developments in currency and financial system crisis theory over the last twenty-five years, and applicable aspects of financial crisis models are then applied to each of the countries under consideration. Within this framework an argument is made that each of the crises had self-fulfilling characteristics, fueled by market pessimism.
Section six addresses the question as to why, if each crisis was endogenously defined, each crisis did not end in financial collapse. In answering this question, the relationship between official credit and the market is examined, and it is suggested that large-scale lightly-conditioned provision of official credit in the case of Uruguay, and the not insubstantial provision of strategically-conditioned credit to Brazil had a determining influence upon the sustainability of these countries’ debt and subsequent terms of market access. Conversely, it is argued that the IMF exercised its negative catalytic power in relation to this country, sealing its fate.
Section seven examines the factors that determined differential treatment between Argentina and Uruguay, finding not only that Uruguay benefited from special treatment on account of its small size and friends in high places, but also that Argentina was poorly treated, much of this treatment being explained by internal management change at the Fund.
In conclusion, doubt is thrown over the concept of fundamental-driven economic equilibrium: the financial equivalent to the Heisenberg uncertainty principle is at work and it is not possible for markets to look at a country’s fundamentals without changing them. Economic and political instability, and perceptions of fragility are shown to be mutually constitutive in the absence of positive exogenous shocks.
Keywords: Argentina, Brazil, Uruguay, Debt, Financial Crisis, Sovereign Crisis, Currency Crisis
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