The probability is increasing that Argentina will be the site of the next emerging market crisis.

Though rating institutions are happy with Argentina, and international financial institutions continue to lend to it, markets could get very nervous if Argentina's external deficit continues to grow.

And that could mean a messy devaluation, with all the problems we have seen for banks operating in other emerging markets where problems have arisen.

For U.S. banks, a devaluation would have an adverse effect on the financial condition of correspondent banks to which they have exposure. U.S. banking companies with large operations in Argentina, such as BankBoston Corp. and Citicorp, also run risks, since a devaluation of the Argentine peso against the dollar could mean losses on investments in Argentine securities as well as on loans to local borrowers who run into difficulties servicing their debts.

Probably the single biggest spur to a potentially sharp peso devaluation is the rigid and increasingly untenable currency regime Argentina has adopted.

It is important to emphasize that the improved performance of the Argentine economy since 1991 is attributed to the high quality of its management in terms of fiscal and monetary restraint, privatization, and regulatory reforms that have let the private sector enhance productivity.

Today, rating agencies are very happy with Argentina, and international financial institutions continue to lend. There is good reason for being upbeat about the success of economic reforms in that country.

The convertibility program, however, has created some distortions in the economy that could undermine the success of President Carlos Menem's reform agenda. First, monetary expansion is possible only through an increase in foreign exchange reserves. That is, every peso of the central bank's monetary liability must be matched by a U.S. dollar asset. This rule is aimed at preventing excessive expansion of the money supply. However, a very negative side effect of this policy has been an excessive growth in the external debt of Argentina. At 4.3 times exports, Argentina's debt is twice the Latin American average of 2.2.

Of external debt totaling $109 billion in December, the government, including the central bank, owed 68%, the financial sector 19%, and nonfinancial corporations 13%. About 60% of the debt is in the form of bonds and other debt securities.

The other side of the coin is that international financial institutions have been quite willing to lend to Argentina. Lenders need to do additional sensitivity analysis of Argentina's debt servicing capacity.

The second distortion created by the convertibility plan has been a stop-and-go pattern of economic management. At the end of 1994, when the external deficit was headed into the danger zone, the government had to slam on the brakes to contain the red ink in the balance of payments.

This coincided with the crisis in Mexico, and was conveniently labeled the "tequila effect." The Mexican crisis served to awaken lenders and investors to the fact there is a limit on how much capital a country can digest. After last year's Asian problems, international financial markets turned cool on Argentina.

The lesson from Asia is that an impressive rate of growth and a rigid exchange rate do not cure fundamental economic distortions. Nevertheless, Argentina's current account deficit is headed this year to a much higher level than in 1994, and it may take a considerable jolt to prevent the economy from crashing into a wall.

Before 1991 Argentine companies rarely borrowed in dollars for fear that a devaluation would dramatically increase their debt service burden. Since then, businesses have gotten a big bonus in terms of lower costs for U.S. dollars.

Both the Mexican crisis in 1994 and the Asian problems of 1997 raised concerns about the sustainability of Argentina's convertibility program, and there is an inconsistency between the pro-market reforms and the rigidity of the current exchange rate mechanism, which could seriously backfire.

Fixing the exchange rate was necessary to eradicate hyperinflation, but this mechanism has outlived its usefulness. In fact, it is now undermining the sustainability of Argentina's economic and financial reforms. u

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