Feb 05 2010

Economics in plain English: Understanding Argentina’s budget woes

Argentina’s reserves and its debts: Central Bank robbery | The Economist

I received the following email from an Econ teacher who wonders if I had any insight on a question posed by one of his students:

The email reads: “I have alittle query i was hoping you could help clear up for me..a year 13 student has asked a question relating to Argentina’s prime minister, Cristina Fernandezde De Kirchner’s, decision to sell the central bank’s dollar reserves to fund part of the country’s decifit against the advice of the director of the central bank who resigned.”

The student’s question is on the following passage from the Economist article above:

Fernández (Argentina’s president”) justified her raid on the reserves by saying that the Central Bank had more than it needed, because they exceeded the size of the monetary base. Economists disagree about what is an appropriate target for the reserves, but Mr Redrado’s view is that a highly dollarised emerging economy like Argentina’s needs an abundance of Treasury bonds (the form in which most reserves are held) as insurance. Even if Ms Fernández might find support from some economists for her argument, her plan to swap the dollar reserves for a non-transferable government bond would not.

The student’s question is: “I do not know what a monetary base is, nor why Argetina needs treasury bonds.”

This article really caught me off guard at first as well. One thing I love about the Economist newspaper is its use of economic jargon that requires a real understanding of the subject to be able to interpret. The first time I read the article, I will be honest I was completely confused as to what the Argentinean president was up to. But after some reflection and rough sketches of graphs on scrap paper, I think I have “translated” the article’s jargon into plain English.

Below is my reply to the teacher and his student:


The president of Argentina wants to sell the country’s US dollar reserves, which are held in the form of US treasury bonds, and then use the US dollars she receives to buy Argentinean government bonds in order to finance her own government’s budget deficit. In essence she wants to swap Argentina’s central bank reserves of US debt (considered a very stable and safe asset due to America’s low inflation rate and relative solvency of the US government) for Argentinean government debt (less stable and safe, especially in the wake of the country’s 2002 default on its debt). Argentina’s central bank would then hold fewer transferable, stable US bonds and more “non-transferable”, Argentinean government bonds. And since the bonds represent Argentina’s government debt, the country as a whole reduces its assets and increases its liabilities.

It is important for a developing country like Argentina to keep large reserves of US dollar-denominated assets (i.e. US treasury bonds) in reserve in order to assure foreign investors that the country would be able to stabilize its currency’s value in the face of a currency crisis such as that which Argentina experienced in 2001-2002. If the value of the peso began to decline on foreign exchange markets (due, for instance, to a decline in international investor confidence in the government’s ability to pay the interest on its foreign debt or inflation fears caused by excessive monetary growth or government spending) then the central bank could use its large dollar reserves to intervene in the forex market and stabilize the value of the peso, reestablishing investor confidence and maintaining the government’s ability to attract foreign creditors in the Argentinean bond market. A collapse of the peso would have ripple effects throughout Argentina, driving up imported products and raw materials and causing spiraling inflation, forcing the government to print more money to finance its budget in the face of falling demand for its debt in domestic and international bond markets.

Argentina must be sure to keep its balance sheet (i.e. its liability to asset ratio) in check. Its assets are US government bonds, its liabilities are the Argentinean bonds it issues to finance its budget deficits. If this ratio become too heavy on the liability side, foreign investors and speculators will lose confidence in the both peso and the Argentinean government’s solvency and dump their holdings of Argentinean currency, assets, and bonds, driving interest rates through the roof and the exchange rate through the floor, grinding the economy to a halt.

The article says,

Argentina’s economy is on course to rebound this year and grow at 3-5%. But the government is spending money so fast that this growth will not finance current spending on its own, says Daniel Marx, a former finance minister. Ordinarily, a government faced with a shortfall would turn to domestic and international bond markets. But this has been difficult since Argentina defaulted in 2002.

The country cannot count on private creditors to make up its budget shortfall, so the president is planning to finance her country’s deficit by buying Argentinean bonds with the country’s own US dollar reserves. Such behavior concerns economists because it could send a message to international investors that the country is on the path towards another unsustainable build-up of debt that could culminate in another default and economic collapse. The article is a word of caution to the president that all leaders should heed: balanced budgets are a good idea, and debt is dangerous!

About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

3 responses so far

3 Responses to “Economics in plain English: Understanding Argentina’s budget woes”

  1. Benon 08 Feb 2010 at 11:32 pm

    Thanks Jason – excellent clarification of my pupil´s query who passes on a big thank you!

    Another not wholly unrelated query i get is also about bonds. Scenario – understood that bond prices and yields are inversely related. If a government offers 4.5% on a $10k gilt or treasury bill this should pay lender $450 per year. Now if in a time of recession, the government wants to increase it´s budget deficit and sells more bonds, this will have effect of lowering the price of the bonds (to say $9000) and pushing up yield to 5%. What actually happens when the bond matures? Even though the face value of the bond is $10k, the government sold it for $9k so it will only have to pay back $9k to the lender?


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