We are approaching the October presidential election in Argentina, in which Javier Milei—who caused a stir in the PASO primaries—is putting forward one of the most controversial proposals. In his own words, he wants to blow up the Central Bank. By this, he means dollarizing the country in order to eliminate inflation, which has devalued the Argentine currency over the past few decades. While this measure has both supporters and detractors, it’s worth asking what happened in Argentina in 2001 after the country had maintained a fixed exchange rate policy throughout the 1990s.

In 1989, Carlos Menem became president of Argentina, at a time when the economy was suffering from hyperinflation and was in recession. Against this backdrop, the convertibility plan was introduced in 1991. This plan involved pegging the new currency—the Argentine peso—to the dollar at a 1-to-1 exchange rate. The government convinced investors that it would manage the country’s economy responsibly and pledged not to devalue its currency against the dollar, keeping it fixed. 

Inflation is influenced by expectations, so the government had to be credible in its mission to set the exchange rate and refrain from devaluing it. To do this, it needed to hold sufficient dollar reserves at the Central Bank and avoid printing pesos in order to maintain the 1-to-1 exchange rate. If the government is credible, inflation expectations can stabilize, thereby reducing inflation.

This, along with other economic liberalization policies—such as tariff and tax cuts and the privatization of public enterprises, among others—yielded positive results despite initial skepticism: inflation fell to 17.5% in 1992; 7.4% in 1993; 4.2% in 1994; and remained close to 0% for the rest of the decade. At the same time, the economy was growing at a rapid pace. Argentines—both businesses and individuals—began to have greater access to credit, and, confident in the fixed exchange rate, took on debt in dollars at a lower interest rate.

However, pegging one currency to another has drawbacks: it means giving up the ability to conduct monetary policy, since the amount of dollars in the economy begins to depend on the balance of payments, because the Central Bank cannot print dollars. A country that cannot conduct monetary policy must be extremely responsible with its public debt, because during recessions it needs to implement more aggressive expansionary fiscal policy to compensate for the lack of changes in the MPR.

Although the economy was on the right track, Argentina slipped back into a recession in 1999. This occurred as the dollar appreciated against other currencies in the second half of the 1990s, and other emerging economies suffering from financial crises (Russia, Mexico, Asian countries, and Brazil) were trying to recover by devaluing their currencies. This put pressure on Argentina and made investors nervous. Since the currency was pegged to the dollar, it also appreciated, causing the peso to become overvalued.

This, combined with the devaluation of the Brazilian currency—a country that accounted for a significant portion of Argentina’s exports—led to a decline in exports, an increase in the trade deficit, and a drop in production. As a result of the recession, the Argentine government’s revenue declined, leading to larger budget deficits. Investors began to wonder whether Argentina would devalue its currency to address the decline in production, so they began demanding higher yields on Argentina’s public debt. This made it increasingly difficult for the Menem administration to sustain the situation without devaluing the currency. 

In 2001, Argentina defaulted on its debt and subsequently abandoned the convertibility plan. This caused the Argentine peso to plummet. All individuals and companies that had taken out loans in dollars saw their debts increase (calculated in pesos). Furthermore, since banks were more exposed to the dollar and did not have the central bank as a lender of last resort due to a shortage of dollars, limits were placed on the amount of dollars that could be withdrawn from banks to prevent the liquidity crisis from turning into solvency problems. This sparked protests that culminated in President De la Rúa’s resignation and led to a succession of presidents within a few weeks, turning into a political crisis.

If Milei is elected, he will have to convince Argentina and investors that his proposal is serious and responsible, so that it can achieve the desired results and thereby reduce the inflation that Argentines have endured for decades.

Vicente Dourthé

Fynsa AGF Private Debt Team