Question

The Economist observed, "In Argentina, many loans were taken out in dollars: this had catastrophic consequences for borrowers once the peg collapsed." What does the article mean when it says that Argentina's "peg collapsed"? Why was this collapse catastrophic for borrowers in Argentina who had taken out dollar loans?

Short answer

A 'peg collapse' refers to the inability to maintain a fixed exchange rate between two currencies. In Argentina's case, the peg collapse meant the devaluation of the Argentine peso against the US dollar. This was catastrophic for borrowers who had taken dollar loans because they were earning in pesos but had to pay back in dollars. When the value of peso decreased, they needed more pesos to buy the same amount of dollars, hence their debt increased substantially.

Step-by-step solution

Understand the 'Peg' in Economics

A 'peg' in economics refers to a policy that links the exchange rate of one currency to another. For Argentina, the 'peg' would refer to the fixed exchange rate where one Argentine peso was equal to one US dollar. This was done to stabilize the Argentine peso and prevent inflation.

What is 'Peg Collapse'

A 'peg collapse' refers to a situation where the fixed exchange rate can no longer be maintained. In the case of Argentina, the government could not support the 1:1 peso to dollar ratio leading to the devaluation of the peso.

Impact of Peg Collapse on Dollar Loans

Now, to understand why this was catastrophic for the borrowers who had taken out dollar loans: these borrowers have to repay their loans in dollars, but they earn in pesos. When the peg collapsed, the value of peso decreased drastically. So, to buy the same amount of dollars, they now need more pesos. Therefore, the amount they have to pay back in terms of pesos increases, leading to increased debt, making it catastrophic for the borrowers.

Key concepts

Exchange Rate

Exchange rates are the values at which one currency can be exchanged for another. In daily life, these rates determine how much of one currency you receive when you trade it for another. For example, if you travel from the United States to Europe, you'll exchange dollars for euros. The exchange rate tells you how many euros you get for each dollar you exchange. This rate can fluctuate based on supply and demand, inflation, and other economic factors.

In a currency peg, a country fixes its currency's value to another currency, usually more stable. For instance, Argentina pegged its peso to the US dollar in a 1:1 ratio in the 1990s.

• This means that one Argentine peso was meant to always equal one US dollar.
• The goal was to create economic stability and gain control over inflation.

By doing so, the country hopes to make its economy more predictable for businesses and investors. However, maintaining a peg requires the government to intervene in the foreign exchange market to buy or sell its currency, depending on the market conditions. This can become financially challenging and eventually lead to a peg collapse if the central bank runs out of reserves.

Devaluation

Devaluation refers to the decrease in the value of a country's currency relative to another currency. When a currency is devalued, it becomes cheaper for foreign buyers but makes imports more expensive for people who use the devalued currency.

In the case of Argentina, when the peso was devalued, it meant that more pesos were required to purchase the same amount of goods or to exchange for the same value in dollars.

• Before the peg collapse, one peso equaled one dollar.
• After the collapse, this was no longer the case, and it significantly affected the local economy.

Businesses that depended on importing goods had to pay more, leading to increased prices. Likewise, individuals with savings in pesos saw their purchasing power diminish as their currency lost value. Devaluation often leads to inflation, as prices for imported goods shoot up and increase the cost of living. This can be destabilizing and makes repayment of foreign currency loans challenging, as seen in Argentina's financial crisis.

Dollar Loans

Dollar loans refer to borrowing money in US dollars rather than in the local currency. This practice is common in countries with unstable currencies, as dollars are viewed as a stable and strong currency. However, this can become problematic when the local currency devalues.

For Argentine borrowers who took out loans in dollars, the peso's devaluation was disastrous.

• Their loans were fixed in dollars, but they earned wages in pesos.
• After devaluation, they needed more pesos to cover the same dollar amount of their loan repayments.

For instance, if someone borrowed 1000 dollars when 1 peso equaled 1 dollar, they would owe 1000 pesos. However, once the peg failed and the pesos devalued, they might need 2000 pesos to meet the same 1000-dollar loan obligation. This effectively doubled their repayment burden in peso terms, increasing their debt significantly and leading to potential financial hardship or default.