IMF in the firing line as Argentina faces collapse

Refusal to pay $28m of interest marks the start of world's biggest ever public debt default
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Almost a century ago the phrase "rich as an Argentine" was common currency as Europeans turned their envious eyes towards the Latin American economic miracle.

Some 100 years later, and Western investors can only watch in horror as riots engulf the capital Buenos Aires amid growing signs of imminent economic and constitutional collapse.

Yesterday Eduardo Duhalde, Argentina's fifth president in a fortnight, appointed his cabinet in his "government of national salvation". He inherits an economy that has suffered four years of recession ­ the only nation in the world to achieve such a record in that time.

The new president is expected imminently to announce that Argentina will devalue its currency in an attempt to pull the economy out a terminal decline. Argentina's currency board ­ a strict monetary regime that has tied the peso to the dollar for the past decade ­ is seen as the final hope of averting a complete economic collapse.

The new government yesterday finally defaulted on its massive $155bn (£108bn) public debt after missing a $28m 2007 Italian bond payment. Now nervous foreign investors wait to see if the new leader can restore order after rioting that has left scores of people dead.

But while all eyes are on Buenos Aires, the focus of attention is shifting towards questions such as the role of the global investment community in Argentina's transformation from model Latin American nation to economic basket case.

When the currency board was established 10 years ago, it was seen as a vital tool in reining in inflation that had peaked at some 3,000 per cent a year. The then Peronist administration ­ ironically of the same political hue as Mr Duhalde ­ pegged the peso to the dollar at a one-to-one exchange rate. It guaranteed the system by insisting every peso in circulation was backed by one dollar in the reserves.

At the same time Argentina adopted tough free market policies, tight budgetary controls and set out to attract international investment. As inflation fell, overseas money flooded in to take advantage of the latest economic boom. This had both an internal and an external effect. Argentines took on personal debt, which was in effect denominated in dollars. At the same time the country built up a large stock of overseas debt.

However, by the end of the 1990s the remedy of the currency board was starting to have unpleasant side-effects. As the US boom pushed the dollar's exchange rate higher, Argentina found it harder to export. This was compounded by Brazil's decision to devalue its currency, improving its competitiveness.

As Argentina struggled with an overvalued exchange rate, an economic recession, soaring debt payments and tight budget controls, public rioting led to the collapse of the government. As devaluation became inevitable housewives and bond traders alike scrambled to protect themselves as they realised they would not be able to pay off dollar-denominated debt with their peso earnings.

As Kenneth Rogoff, the economic counsellor of the International Monetary Fund, put it: "It's clear that the mix of fiscal policy, debt and exchange rate regime is not sustainable."

But many independent experts believe the IMF, by making loans in effect conditional on fiscal austerity,is to blame. They also accuse the IMF of repeating mistakes it made in the Asian and Russian crises of the 1990s.

According to Sheetal Radia, the senior emerging markets economist at the credit ratings agency Standard & Poor's, the IMF adopted a "one size fits all" attitude towards all emerging markets. "If you want to borrow money then you have to have the ability to finance it and you can't do it with a contracting economy," he said.

Mr Radia said the correct remedy would have been to adopt tax cuts to stimulate economic activity rather than tax rises in the hope of shoring up the public finances. He compared the Argentine crisis with the action taken after the 1929 Wall Street crash when the Federal government raised taxes.

"Russia adopted a simplified tax reform, it grew by 8 per cent last year and had not had an IMF programme for three years ­ you can draw your own conclusion," he said, adding that Standard & Poor's now treated IMF involvement with an emerging market as a bear signal.

Yesterday, the IMF was saying it was waiting to hear from the new administration but has insisted that the mix of economic policy was the responsibility of the elected government. No one was available for comment yesterday on the causes of the Argentine crisis.

Paul Krugman, the economist and outspoken critic of the IMF, believes the fund knew for years that the currency board was unsustainable. As recently as September a senior IMF official told The Independent abandoning the peg would cause an "extraordinary mess" for the Argentine people.

But as Professor Krugman wrote in The New York Times this week: "The IMF could have offered Argentina guidance on how to escape from its monetary trap. Now Argentina is in utter chaos. Some observers are even likening it to the Weimar Republic and Latin Americans do not regard the US as an innocent bystander."

Mr Radia said the blame lay with the mix of fiscal and monetary policy that the IMF imposed, rather than with the currency board itself. "It does not matter what regime you follow, whether it is a currency board or an exchange rate peg. At the end of the day you cannot escape the need for a sound fiscal policy," he said.

He pointed out that Bulgaria has controlled inflation by adopting a currency board with the old German mark at a one-to-three rate without following Argentina's ruinous path.