Learning from Argentina's downfall continues.
Dear International Friend,
Yesterday we began looking at why Argentina has run into an economic quagmire, what we can learn from this as investors and what opportunities we might gain from this now.
Argentina pegged its currency to the US dollar to stop inflation and currency devaluation some years ago. But the government continued to spend more than it earned. This by the way is not a government problem. This is a voter problem. Voters have to demand honest politicians who spend wisely and in a balanced way (easier said than done). Argentina's government spent more than it earned and instead of making up the shortfall by printing pesos, it borrowed dollars instead. Expenditure debt like this is perhaps even worse than inflation and devaluation. Inflation and devaluation at least acknowledges the problem of over expenditure and slowly makes such expenditure more difficult. Debt masks the problem until it grows so large that the deficit can only be resolved in a huge crisis (as is the case in Argentina today).
Argentina built its debt to such unacceptable levels that when a pitfall in the form of Brazilian currency devaluation finally came along, the financial system fell apart. You can learn more about why countries devalue by taking the course International Currencies Made EZ which is available free at this site.
Brazil's devaluation was a pitfall because it made Argentina's export business uncompetitive. Picture for example what would happen if both the Brazilian and Argentine currency were equal to a U.S. dollar. If a cow was worth 1,000 dollars Argentina and Brazil would both be selling cows to North America for 1,000 cruzeros and 1,000 pesos (1000 dollars). Imagine what happens when Brazil suddenly devalues its currency to the U.S. dollar by 25%. Then one cruzero would be equal to seventy five cents. Yet Brazil still sells its cows for 1,000 cruzeros which means that in North America that cows from Argentina still cost $1,000 but cows from Brazil now only cost $750.
North American cow buyers stop buying cows from Argentina and buy their cows from Brazil instead. Argentine ranchers stop making money and hence pay no tax. The loss of exports contributes to a recession. Taxes drop even further. The Argentine government in turn has no revenue to service its debt.
This puts the government in double trouble. First it cannot borrow additional money to continue its excessive spending. Those who have been receiving money and services from the government (such as salaries and pensions) become very upset when their cash flow stops. This makes the recession worse and a negative spiral begins. Finally the government reaches a point where it can no longer serve its debt and it defaults on its debt payments..
Yet a default is not as simple as it sounds. The government cannot just stop paying its debts. There are a variety of reasons why it must come to some resolution, mainly because every country still needs to do business with other countries.
This is why such defaults can offer opportunity for those who know how to choose the correct debt (that which is likely to be paid). We'll look at such debt in the next message. Until then, good global investing!