Argentina’s central bank goes bare-knuckle to deliver knock-out punch?

In February we wrote that while Argentina’s economic path to growth was unlikely to be smooth, it should remain positive. Recent events are proving bumpier than we anticipated.

Argentina is now in the midst of a full-blown currency crisis. Currency markets are bolting at this year’s on-off approach to bump-start growth, cuts to inflation targets and changes to borrowing costs. And it’s worth pointing out that the crisis is for now limited to monetary rather than fiscal policy concerns, as investors are wary of a central bank that has lost credibility over inflation management and is struggling to reaffirm its political independence.

Investors have looked on incredulously as the central bank has spent USD 6.9 billion of its currency reserves, in an effort to support the peso, now the worst-performing emerging market currency this year. That equates to around 10% of its total international reserves, and is clearly unsustainable.

Given the limits to selling dollars in the currency market the central bank announced a 300 basis point increase in interest rates on May 3, followed by another 675 basis points the following day, the third hike in a week, making Argentina’s 40% interest rate the highest in the world. The market has clearly interpreted the rate moves as a sign that the central bank is firing the last shots in its armoury.

Enough already?

Yet even that may not be enough to do the job as the peso extended its decline to more than 10% since the first central bank intervention in early March, bringing the total decline to 17% this year.

The market had been giving Argentina the benefit of the doubt. It now expects to see the government enact the promised fiscal consolidation, as Mexico managed to do in 2016. Unless this happens, what has until now been limited to a currency crisis could deteriorate further into a political, and more damaging, fiscal crisis. The good news is that the Argentine treasury ministry announced May 4 its intention to be fully coordinated with the central bank.

In retrospect, the trigger to the current currency depreciation may be traced back to the end of December. At the end of that month the Argentine treasury surprised markets by curbing previous inflation targets. Rather than aiming at a rate of 8-12% for this year, the treasury is now targeting 15%, while the 5% target for 2019 was pushed back to 2020. The January communication worried investors about the central bank’s independence and its ability to fight inflation.

Still, inflation did dramatically slow from a high of 47% in July 2016 to 23% one year later. Naturally, that impressive reduction is an achievement, but the road is still long, and unfortunately for the government’s ambitions, that might have been the easiest part of the journey.

Going forward, higher interest rates should theoretically help to lower inflation expectations (and should) begin to stabilise the peso, possibly allowing for rate cuts to resume later in the year.

Fiscal credentials

But in the near term, the large current account deficit (-4.6% of GDP at the end of 2017), coupled with a rising trend in double-digit inflation and inflation expectations, mean that we can’t rule out more downside, as the currency needs to adjust in nominal terms to stabilise its real value.

Given the historic sensitivity of Argentinians to exchange rates, the experience of hyperinflation and the subsequent demand for dollars, the credentials of President Mauricio Macri’s government are being thrown into doubt. Reforms are now slowing, hitting the dual roadblocks of popular unrest and political hurdles from the opposition.

It was Macri who gave the central bank the green light to begin targeting inflation and the government moved to float the peso, cut energy and transport subsidies and end many export taxes, impose public borrowing targets and re-open Argentine access to foreign credit. Investors now need reassurance that a fiscal consolidation package is coming.

Conclusion

In the medium term, Argentina’s solvency credentials need to be closely monitored, given the current account deficit, a fiscal deficit of approximately 6% of GDP, public foreign currency debt equivalent to over 40% of GDP, a currency at an all-time low against the dollar and a 40% interest rate.