Argentina pension reform, a valuable lesson
Guillermo A. Calvo and Ernesto Talvi, Project Syndicate
As Argentina's economy lost access to credit in late 2001, the government resorted to desperate measures in a vain attempt to avert disaster. Privatized pension funds -- created in 1994 as a result of a Social Security reform based on individual accounts vested in bonds and equities -- were one casualty. The government forcibly rescheduled the public debt holdings of these funds, known locally as AFJP. It also "pesofied" these holdings, which in mid-2001 amounted to more than 60 percent of the pension funds' portfolios, in effect converting dollar-denominated assets into local pesos overnight.
This "confiscation" occurred after several years in which high-risk government securities obtained very large returns. Between September 1994 (the year of their inception) and January 2001, the AFJP yielded an average annual rate of return of 10.9 percent in US dollars -- nearly 600 basis points above the return obtainable from US Treasury Bills.
There is an obvious lesson to be learned from Argentina's experience: if pension funds invest heavily in risky public- sector obligations -- a common strategy in Latin America throughout the transition from state-funded pay-as-you-go systems to schemes based on individual capitalized accounts -- repayment will be at risk from the outset. Pension funds might be subjected to arbitrary treatment. But this is precisely the situation that Social Security reform was supposed to eliminate.
How badly were the AFJP's actually treated? As the dust settles, it is becoming apparent that they have fared rather well. The rate of return on their portfolio holdings from September 1994 to December 2002 is around 9.5 percent per year in real terms, which appears more than reasonable by any account. Even accounting for the very large peso devaluation, the US dollar rate of return varies between -2.5 percent and 4 percent per year, depending on the real exchange rate used to value the peso assets of AFJP's after the devaluation in January 2002.
This outcome stands in stark contrast to that of external private creditors, who have not seen a cent of what they are owed for more than one year and so far do not have even a hint about terms of repayment. Based on market valuation, their US dollar rate of return over the same period is around -11 percent per year.
Put differently, even after default, `pesofication' and devaluation, Argentina's pension funds yielded a very decent return in real terms. Furthermore, they fared well relative to other classes of creditors, especially foreign bondholders. Thus, pension funds were de facto treated as senior creditors, but by means of a highly disruptive mechanism: huge excess returns followed by default and pesofication.
This brings us to the second, less obvious lesson from Argentina's experience, namely that privatizing Social Security at a time when the government's fiscal credibility is suspect may give rise to favoritism toward pension funds and, as a result, impose burdensome (and unjustified) fiscal costs.
Suppose pension funds are de facto treated as senior creditors (as suggested by the case of Argentina). Under these conditions, the premium paid on pension funds' holdings of government bonds involves a rent on those holdings, because pension funds would be willing to hold government bonds even if they yielded a lower- than-market interest rate. There is no justification for this rent if the retirees' income is never at stake.
Moreover, the interest premium paid on government bonds held in pension funds imposes burdensome and unjustified fiscal costs, since it adds to budget deficits and the public debt. In fact, experience indicates that the interest-rate gap increases dramatically when fiscal crisis looms. Thus, until crisis erupts, and the government defaults on its bonds, the (excess) financial costs of government bonds held by pension funds could represent a large portion of the total fiscal deficit and actually help provoke the crisis.
In sum, privatizing Social Security under conditions of weak government credibility may lead to actions that betray the fundamental principles on which such a pension reform are based and unduly increase the fiscal burden.
There are at least two ways in which these pension reform transition problems might be diminished. First, the status of senior claimants of pension funds could be made explicit and, to the extent that there is no solvency risk, the above problems could be addressed by creating a pension fund bond that yields a rate of return that is not subject to repudiation risk.
Second, and more radically, pension funds could be barred from investing in domestic government bonds that are not rated, say, A- or higher. Moreover, pension funds could be allowed to invest in low-risk foreign assets such as US government securities, and the government could finance transitional fiscal gaps by placing bonds at market rates and among market participants who are in the business of taking risks.
In practice, these proposals are likely to remove pension funds from the list of large investors in high-risk domestic securities (including public debt), which may partially impair the development of the local capital market. Even if that is the case, the costs of letting pension funds bet on high-risk securities may ultimately be far greater.
Guillermo A. Calvo is Chief Economist, Inter-American Development Bank and Director, Center for International Economics. Ernesto Talvi is Director, Center for the Study of Economic and Social Affairs, Uruguay.