The Argentina Effect The collapse of Latin America's third-largest economy hasn't unleashed a financial contagion. But it could produce a political contagion, which is far scarier.
By Nelson D. Schwartz

(FORTUNE Magazine) – In another country, Guillermo Perez, who will soon graduate from an elite university with an economics degree, could probably look forward to a bright future--a career in finance, perhaps a job with a U.S. multinational. But this is Argentina, so Perez, 24, isn't home polishing his resume. Instead, he's in downtown Buenos Aires on New Year's Day, clutching a banner emblazoned with the hammer and sickle. Surrounding him are fellow protesters holding wooden sticks, metal pipes, and assorted projectiles. They're preparing to rumble with supporters of the ruling Peronist party.

A few minutes before the rival mobs begin hurling stones and pieces of sidewalk at each other, Perez explains what's brought him to the streets. His parents, both professors, used to live in a four-bedroom house in an upper-middle-class neighborhood. But years of recession and political mismanagement have forced them into smaller and smaller apartments in poorer and poorer areas. "Before, you knew you would be able to eat till the end of the month," he says. "But for the last five years, it's been down, down, down."

A few blocks away Argentina's Congress is choosing the country's fifth President in two weeks, but Perez doesn't hold out much hope. "This was a wealthy country, but it's been devastated by its leaders," he says, echoing the views of everyone from members of the ultraswank Yacht Club Argentino to unemployed workers in the poor industrial suburb of La Matanza. What about the reforms that turned Argentina into Latin America's free-market avatar and led to the privatization of big banks, the oil industry, and even the post office? "It didn't work in Argentina with corrupt politicians," says Perez. "The free market only worked for big companies, not common people."

By the time the police break up the battle a few minutes later, Perez and his university comrades have ducked down a side street. But their anger with Argentina's leaders, their frustration over years of economic decline, and their pessimism linger in the air along with the tear gas. It's not just students who are fed up; middle-aged housewives have taken to the streets in the past two months, banging pots and pans to protest rules that restrict bank withdrawals to about $1,000 a month. The kind of grinding poverty and crime that Argentines once associated with other Latin American countries, not their own, is on the rise. And stories like that of 48-year-old Carlos Zunino, who once earned more than $40,000 a year as a bank treasurer but now drives a taxi and makes roughly a third of his old salary, are common. Indeed, there's a nickname for the country's middle class: la clase tuvo, the class that once had.

Despite its bleak outlook, Argentina doesn't seem likely to unleash the kind of "financial contagion" that spread from Thailand to other Asian countries in 1997 and 1998. So far, investors have stuck by Brazil and Mexico, Latin America's largest economies, and the region's currencies and stock markets have remained reasonably stable despite the chaos to the south. Instead, the danger now is what's being called "political contagion"--increasing social turmoil and the rise to power of either the old military juntas or new, left-wing populists. The generals, still under a cloud from the last time they stepped into politics, in the 1970s, seem unlikely to return. But a populist, anti-Washington leader, Hugo Chavez, is already in power in Venezuela. And experts worry that Argentina's problems could help populists with a similar agenda gain ground in Brazil, which is set to hold a presidential election this fall.

The threat of political contagion is, if anything, more alarming than its economic corollary. After all, Mexico and Brazil both suffered through economic panics and devaluation in the 1990s but quickly bounced back. The effects of a political shift in the region would be longer-lasting and much harder to fix. That's why the decline of Argentina's economy--which 70 years ago ranked among the world's ten largest--isn't merely another tale of financial problems in a far-off land. The deepening turmoil threatens to undo a decade of free-market reforms that have transformed societies all the way from the Rio Grande to the Strait of Magellan. The collapse of Argentina, Latin America's third-largest economy, could help drive a region once firmly in the democracy-oriented, laissez-faire camp back toward the old, state-dominated political and economic model that retarded development for decades.

In the meantime, U.S. companies are facing an imminent hit as a result of Argentina's one-two punch: the default on its $142 billion foreign debt in December and the recent devaluation of its currency. Citigroup is estimated to hold several billion dollars in Argentine loans, while J.P. Morgan Chase has already said it has roughly $500 million in exposure. On Jan. 14, FleetBoston Financial delayed reporting earnings because of the Argentine meltdown. And the results of companies as diverse as GM and Avon are already suffering because of Argentina. If the situation worsens, the effect on U.S. and European business will be even more pronounced. Foreign investment in Argentina totaled roughly $50 billion over the past five years, and companies like Ford, Coke, and ExxonMobil each had more than $1 billion in sales there in 1999.

In recent weeks things have gotten only grimmer for la clase tuvo. The President who came into office on New Year's Day, Eduardo Duhalde, has kept the bank restrictions largely in place while abandoning the ten-year-old policy of pegging the Argentine peso to the U.S. dollar. The resulting 30% drop in the currency's official value means that anything imported--medicine, technology, consumer goods--now costs roughly a third more. And because everything from car loans to utility bills to mortgages was dollar-denominated, the devaluation will likely mean a huge jump in living expenses. In a bid to spare consumers, the new government is making loans and other bills payable in pesos, but there's fierce opposition from banks and other creditors that lent dollars but will now receive far less valuable pesos in return.

With the government unable to borrow money from the IMF or any other outside source since its default, the only alternative would be to print pesos. That would bring back the triple-digit hyperinflation that set off Argentina's last economic crisis in the late 1980s. "It's like a labyrinth," says economist Orlando Ferreres, who likens his nation's plight to the complex, bizarre fantasy worlds created by Argentina's most famous writer, Jorge Luis Borges.

As rioters dodge rubber bullets near the Congress building and the fate of the currency hangs in the balance, residents of the chic San Telmo neighborhood a few minutes away fill cafes and sip cappuccinos. What makes them so calm? Part of the answer lies in the charming 18th-century town of Colonia in Uruguay, a 45-minute ferry ride across the Rio de la Plata from Buenos Aires. Uruguay is South America's answer to Switzerland, and its secret banking laws make Colonia a magnet for Argentines eager to evade the bank restrictions and the freeze on dollar deposits. Some banks, like the local branch of Amsterdam-based ABN AMRO, open on Saturday so that Argentines can still get to their money. When I walk in and ask if people are from Argentina, everyone nods. But undeclared offshore accounts are illegal in Argentina, so customers and employees are uneasy about having a reporter and photographer from FORTUNE in the branch. They order us out and threaten to call the police if we don't turn over our film, citing the bank secrecy laws that protect the identity of depositors.

In many ways, it's fitting that Uruguay is where Argentines go to get their money out of the country. Before Argentina's independence in the early 19th century, smugglers used Uruguay to spirit gold out of the Spanish empire, of which Argentina was then a part. That legacy lives on today in corruption among the political class and a corresponding lack of respect for the government among all levels of society. Fewer than half of the people pay income taxes, and a whopping 28% of the Argentine economy is estimated to be "informal," or off the books.

"There's no respect for the politicians, and the politicians don't respect the people," says Ferreres. As an example, he cites what Argentines call "gnocchi workers"--the government employees who take their name from the pasta that's traditionally eaten on the 29th of each month. The gnocchi workers come to work one day a month--near the 29th--just to collect their paycheck, hence the nickname. "The politicians get a share of the gnocchis' salaries, so it's like a business," says Ferreres.

Such corruption is one reason the government has been unable to balance the budget over the past decade, running up huge deficits that forced it to borrow billions of dollars. The IMF's refusal to lend Argentina more money to pay the interest on that debt is what set off the current crisis, but economists like Ferreres don't think more foreign loans are the solution. Instead, he says, the government should balance the budget, improve tax collection, and restore faith in the banking system so that citizens don't have to stash money abroad. Cutting the salaries of Argentina's two million government workers by 20% would help balance the budget, Ferreres adds, but that would be wildly unpopular with the politicians. So instead of two million people suffering, all 37 million Argentines feel the pain.

Will Argentina be able to emerge from the labyrinth? Probably not any time soon. Unlike Mexico in 1994 or Brazil in 1999, Argentina is facing profound problems that are as much political as economic. And the government remains in the hands of a small circle of cronies, many in their 60s and 70s, who are unwilling to take on special-interest groups like the public-sector employees. Younger Argentines, who came of age after the military dictatorship of the 1970s and early 1980s, say their biggest hope now is that the crisis will open the way for a new generation of leaders. But that's likely to take years. The one bright spot in the short term is that the recent devaluation should at least make Argentine exports more competitive on the global market.

These days the only thing harder to find than dollars in Buenos Aires is optimism. But if Argentina does bounce back, it'll be thanks to people like Andy Freire, 29, and Santiago Bilinkis, 31. Six years ago, after a stint at Procter & Gamble in Buenos Aires, the two men founded Officenet, which sells business supplies via catalog and online. Today it is a rare Argentine success story: The company employs 200 people at its Silicon Valley-style offices (complete with Foosball table) and expects revenues to rise from $55 million last year to $80 million in 2002.

Although Bilinkis and Freire are tempted to leave their chaotic country and join the growing diaspora of successful Argentines in Europe and North America, they're staying put--for now. "I tell myself, Give Argentina a few more months," says Bilinkis. "Stay involved in Argentina." Which will triumph--Freire and Bilinkis' guarded optimism or the frustration and anger of protesters like Guillermo Perez? The future of Latin America, and U.S. interests in the Western Hemisphere, will depend on the answer.