The macroeconomic history of Argentina has always been a tumultuous one. The country has defaulted on its external and internal debts many times, has experienced a couple of episodes of hyperinflation, and has also faced several banking crises. These events can be explained by a plethora of endogenous and exogenous factors. These factors though, it must be stated, might be inextricably linked, and if considered in isolation might account for only a few specific Argentinian economic woes. Through this article, Achyut Mishra attempts to demonstrate the effects one such factor- liquidity crunch, has had on Argentina, especially its banking sector, over the years.
To understand what constitutes a liquidity crunch and the implications it has had on Argentina over the years, it is imperative to first understand what liquidity is. Liquidity is a multifaceted term whose meaning derives probably more from the context in which it is used. However, if one were still to look for a common denominator which underpins liquidity in all its myriad manifestations, then it will be the “ease of conversion of X to Y”. The more readily X can be converted to Y with as little a loss in value of X as possible, the more liquid X is said to be. Thus, cash is considered as one of the most liquid assets because it can be readily converted to anything with very little or no loss in its value.
Market liquidity refers to the ease with which an asset can be sold or purchased in a market at stable prices. A stock market is more liquid than a real estate market as stocks can be sold or purchased very quickly without much reduction in their value. However, if a real estate property needs to be sold really quickly, the seller might be forced to incur some loss. Funding liquidity refers to the ease with which a borrower can obtain external funding. Usually, it involves a collateral, and thus if funding liquidity is more collateral requirements are lesser vis-à-vis a situation where if funding liquidity is less collateral requirements are more. Accounting liquidity refers to the ease of exchange (payoff) of short term debts/liabilities when they become due with a liquid asset. Here, it is also important to distinguish between liquidity and solvency. An entity is solvent but not liquid if it has the assets to take care of its long term obligations but lacks the liquidity/cash to meet its short term ones.
A liquidity crisis/crunch occurs when there is a shortage of liquidity. In the context of market liquidity, it means that sellers might find it difficult to sell their assets for cash and may be forced to incur losses. In the context of funding liquidity, the borrowers might find it difficult to obtain funds. In the context of accounting liquidity, firms or entities may find themselves short of liquid funds to take care of their short-term obligations. Many a times, they might be interlinked and a small shock may amplify the consequences and lead to a bigger crisis. An entity (say a bank) may have the need for liquidity to meet its short term obligations but it may be short of it (Accounting liquidity risk). It may decide to sell its assets on a large scale and this may drive down the prices of assets and lead to a market liquidity crisis. Thus, market liquidity crisis and accounting liquidity crisis can be interlinked. Similarly, market liquidity and funding liquidity might be interlinked and an adverse impact on one might be transmitted to another.
Argentina has had a long experience with liquidity crises and its best manifestations are the bank runs the country has seen. A bank run occurs when a large number of depositors withdraw their money from a financial institution fearing that it might become insolvent. The financial institution might be solvent but may lack the liquidity to take care of so many withdrawals at the same time. This may go out of hand and the financial institution might be forced to declare bankruptcy in case no external help materializes.
The 1890 Baring Crisis where Argentina defaulted on its external debt saw a total of three bank runs wherein the last one led to a complete banking crisis. It was a result of deep structural flaws which existed within the Argentinian system. The first run happened on two banks- Banco Nacional and Banco de la Provincia de Buenos Aires in the first quarter of 1890 and was triggered by the news that Baring Brothers had failed to fully float a loan of 25 million gold pesos. Both these banks maintained a cash deposit ratio which was far lesser than the 34% maintained by the private banks. The reason they were able to get away with that was because they also served as the fiscal agents of the national and provincial governments and provided loans to them in exchange for treasury bills which were not floated on the stock market and thus were not very liquid. They also invested heavily in real estate, the price of which declined abruptly during the crisis. Again, the reason they could invest in risky assets with higher yield was because of moral hazard.
When the first run occurred, the national bank came to the rescue of the two banks. The government was now forced between two options- to liquidate official banks and resume external payments with emergency loans or to continue lending to the official banks and default externally. The government continued to lend and a second bank run occurred. Finally, in January 1891, Argentine government and Bank of England reached a deal and a loan was provided to Argentina. However, there were conditions attached and when a third bank run occurred, the government attempted to manage it without printing money and instead floated a 100 million pesos-issue in the bond market. However, it managed to raise only 28 million, mostly from private banks. The official banks closed at the end of April 1891 and a financial crisis erupted.
While these bank runs happened before the beginning of the 20th century, a few others happened right after the end of it during the 2001 debt crisis. In 1991, Argentina adopted a convertibility plan to combat inflation which pegged the peso one-to-one to USD. Though this led to a revival of Argentinian economy (barring a minor crisis because of Mexico’s Tequila crisis), conditions again started to deteriorate from 1998 onwards as Argentina slumped into recession. This was more a result of exogenous factors, particularly the crises in East Asia, Russia, and Brazil’s depreciation of its currency which affected Argentinian exports. Investors also lost faith in the Argentinian economy and it lost its access to International financial markets in July 2001.
During this period, depositors started to transfer their funds into dollar denominated accounts, thus contributing to a growing dollarization of the banking system. This move towards dollar denominated deposits ultimately evolved into a full-fledged run affecting all types of deposits. It started with a run in July 2001 and culminated in a 3-day period in November 2001 wherein 6% of the banking system’s deposits were withdrawn. To ensure that banks don’t face a liquidity crisis and go bankrupt, the government imposed extreme restrictions on withdrawal from accounts. Another important point to note is that the domestic banks started to provide finance to government since the government’s access to international capital became restricted. In the process, banks exposed themselves to greater risk in the event of a government default.
Thus, it can be seen that a liquidity crisis in Argentina gave way to a banking crisis on both occasions. There are a few commonalities which increased the likelihood of such an event on both occasions. First, the currency was pegged to dollar in the latter case while in the former the government intended to peg it to gold at an older parity. It reduced the government’s (in 1890)/ central bank’s monetary sovereignty. The important point to note, however, is that in the latter case the government eventually removed the fixed peg while in the former it dropped the plans of going to an older parity. Second, the loans domestic banks provided to the government increased their exposure to the crisis.
These are thus important lessons which may be incorporated to mitigate some of the adverse impacts a liquidity crises can have. A market determined exchange rate, coupled with a central bank which people believe will act as a “lender of last resort” can preclude the possibility of bank runs. In fact, the latter can hardly be called a remedial suggestion as the responsibility to act as a “lender of last resort” for central banks has already overtime come to be recognized as one of its essential responsibilities.
Achyut Mishra is a student at Jindal School of International Affairs.
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