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European Debt Crisis

Last Tango in Paris – lessons from the Argentine default of 2002


Another day, another discouragement. Italian bonds are back above 7% (apparently Monti fails to convince markets) while the Spanish Treasury must be girding its loins to face tomorrow’s markets with their bond selling at 6.34%, very near it’s euro-historic high of 6.48%. Let’s look at another market indicator, credit default swaps. As a reference, let’s take a look at the Portuguese 5-year CDS:
















Portugal was “rescued” on 16 May, which led to a very short-term decline in the price of the swap as well as in the bond price (close on 09 May was 9.89%, close on 19 May was 9.59%). At the time of the rescue, the Portuguese CDS was priced at 658 basis points.

Here are the one year CDS charts for Italian and Spanish bonds:









Both of these derivatives are at historic highs and they are a good indication of the growing fear and distrust in the markets. They are, in effect, the leading indicator that markets are pricing in a default in both countries. Here is the chart for the CDS on French bonds:










France is nowhere near the levels of Italy or Spain yet, much less Portugal, but the trend is difficult to ignore, especially for a AAA rated sovereign. If I were the French Finance Minister, or the head of the IMF, which amounts to the same thing nowadays, I’d be losing sleep.

Regardless of whether we believe that one or more nations may default on their sovereign debt, or whether one or more nations might be forced out of the euro, it would be prudent for businesses and individuals to be aware of what a worst case scenario would look like, how it would likely impact them, and what they could do to hedge against it. Luckily, we have a very recent example of a nation not only defaulting on its obligations, but also switching currencies. In 2002, Argentina defaulted on US$93 billion in government bonds – making this the largest default in history to date – and also unpegged their currency from the US dollar – in effect, “reintroducing” the peso.

A brief history of the Argetine crisis

  • Following a second bout of hyperinflation in late 1990, the Menem government took executive measures that fixed the value of Argentine currency at ₳ 10,000 per USD. To secure this “convertibility” the Central Bank of Argentina had to keep its U.S. dollar foreign exchange reserves at the same level as the cash in circulation. This eventually became the Currency Board;


  • As a result of the convertibility law inflation dropped sharply, price stability was assured and the value of the currency was preserved. This raised the quality of life for many citizens who could now afford to travel abroad, buy imported goods or ask for credit in dollars at very low interest rates;


  • Argentina still had external debts to pay and it needed to keep borrowing money. The fixed exchange rate made imports cheap, producing a constant flight of dollars away from the country and a progressive loss of Argentina’s industrial infrastructure which led to an increase in unemployment;


  • Government spending continued to be high and corruption was rampant. Argentina’s public debt grew enormously during the 1990s. The International Monetary Fund, however, kept lending money to Argentina and postponing its payment schedules;


  • A series of external macroeconomic shocks buffeted the vulnerable Argentine economy – Mexico (1994), Asia (1997), Russia (1998), Brazil (1999). These financial crises raised the cost of debt to all Latin American countries and depressed the overall economy of the region. After the Brazilian devaluation of 1999, Argentine exports were seriously harmed and Argentine trade within Mercosur declined even more;


  • By 1999, newly elected President Fernando de la Rúa faced a country where unemployment had risen to a critical point and the undesirable effects of the fixed exchange rate were showing forcefully. Argentina’s gross domestic product dropped 4% and the country entered a recession.


The pace of events accelerated very rapidly in 2001 leading to a November default:





Two things are evident from this timeline:

  1. The economic and financial crisis in Argentina had become “the new norm” which led investors and citizens to discount the possibility of a default and a removal of the dollar peg, even though all the fundamental macroeconomic indicators pointed towards the unsustainability of the Argentine debt;
  2. When the break came, events unfolded with shocking rapidity. Three weeks passed from the default on 06 Nov to the “corralito” imposed by the Argentine government; the government collapsed three weeks after that; and only two months passed from the default to the collapse of the dollar peg.

In the event of a major European default, we could expect an even more rapid transition, especially if it is a planned default in concert with the rest of Europe (i.e. with German agreement). If Germany decides that the Italian situation becomes untenable, I would expect a “corralito” and exit from the euro to precede a default on the debt. It would be messier the other way around, but also very rapid.

This is because a default will cause a run on the banks as citizens desperately try to withdraw their euro deposits on the (largely correct) assumption that a defaulting nation will not be able to stay in the euro. To avoid this, the government would anticipate the reaction by declaring a bank holiday or other severe limitations on withdrawals until it were able to convert the monetary base to the new currency.

The consequences of the uncontrolled default and conversion were devastating to Argentina. GDP collapsed in 2002, inflation exploded, and the mass of Argentines living in poverty soared.


















Spain and Italy are, of course, much richer countries than Argentina, so it is unlikely that the deep poverty experienced in the South American country would be so widespread. However, I would expect the following impacts:

  • Access to credit – already slim in Spain – would dry up completely as the defaulter was locked out of international capital markets for a number of years, deepening the recession and worsening unemployment;


  • Inflation would increase substantially as the government would most likely expand the money supply very quickly to first create sufficient new specie for business and then in an attempt to stimulate the economy through liquidity injections (a popular process also known as quantitative easing);


  • The new currency would rapidly depreciate, destroying the purchasing power, overall wealth and patrimony of citizens, as well as driving inflation. The Argentine peso depreciated 50% in the first couple of months after the default and stabilized after a 70% depreciation;


  • The government would impose temporary withdrawal restrictions to prevent bank runs, limiting the availability of cash to consumers. A temporary withdrawal from Schengen would also be necessary in order to impose border controls to prevent large-scale smuggling of cash and other assests out of the country.

On the bright side, any European nation exiting the euro would not have to depend exclusively on its own resources, as Argentina did. It would still be a member of the European Union, with all the advantages that entails. It would be in the EU’s interest to ensure a quick recovery of any defaulting member; so while a return to membership in the EMU might be a very long way off, a rapid economic recovery could be expected. Germany, after all, still wants to sell Volkswagens in the Mediterranean, whether they’re paying in euros or lira or pesetas.

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