SANTIAGO – The late MIT economist Rudiger Dornbusch used to tell his students in the 1980s that there are four kinds of countries: rich, poor, Japan, and Argentina. No one frets anymore about Japan buying its way to world domination. But the world is worrying again about Argentina.
The country has just suffered another textbook attack on its currency. On April 24, the yield on ten-year US Treasury bonds broke 3% for the first time since 2014. On the same day, investors began dumping Argentine pesos and seeking the security of a surging dollar. To stabilize its currency at a much-depreciated rate, Argentina had to jack up interest rates to 40% and seek help from the International Monetary Fund.
After all the turmoil, markets have been calm for a fortnight. Now is the time to assess what went wrong, and what the country can – and must – do to prevent instability from returning.
Since December 2015, a market-friendly reformer has governed Argentina. Compared to the crooks and demagogues who preceded him in office (not long ago, one was filmed stashing millions in cash behind the altar of a local monastery), President Mauricio Macri and his team of well-trained technocrats are a massive improvement. Because none of Macri’s team had previously held national office, analysts and investors initially underestimated their political skills. Until now, Macri has shown he can be an able administrator and an astute politician.
The currency crisis could not have happened to a nicer guy. But it did.
It all began with an ill-fated press conference last December, at which the 2018 inflation target was relaxed from 8-12% to 15%. The new figure was a reasonable admission that the earlier target could not be reached without wrecking the economy. But having Macri’s chief of staff seated at the table during the announcement, alongside the economic team, raised concerns of political meddling. Two subsequent interest-rate cuts, totaling 150 basis points, did not help credibility.
Argentina’s monetary policy is based on inflation targeting and a floating exchange rate. But in late March, concerned by the effect of a weakening currency on inflation, the central bank once again began intervening and appeared to be fixing the exchange rate at around 20 pesos per dollar. Investors naturally asked whether this amounted to a change in policy regime.
Mindful of a long history of failed attempts at economic “shock therapy,” Macri decided to fix the fiscal mess he inherited only gradually. He cut fuel and power subsidies and some unnecessary expenditures but also decided – quite reasonably – to reduce export taxes in order to spur growth. The result is that the fiscal deficit has fallen, but still hovers at 5.5% of GDP. The government has had to borrow abroad massively to cover the shortfall.
Critics claim that the fiscal adjustment was too slow for comfort, yet markets seem unconcerned that in neighboring Brazil the headline budget gap is 8% of GDP. Yes, Argentina’s current-account deficit exceeds 5% of GDP, while Brazil’s external position is nearly balanced. But that only shows that Argentina’s private sector is investing what it saves, while Brazil’s private firms are deleveraging fast and investing very little, if at all.
In Argentina, gradual fiscal adjustment seemed like a plausible strategy until US interest rates spiked and the dollar surged. With concerns over emerging-market creditworthiness making a comeback, Argentina and Turkey were first in line to take the hit.
But while the Turkish government has dithered and the situation there continues to deteriorate, Argentine authorities bit the bullet and took decisive action. Going to the IMF imposes a political cost, but it had to be done: only with sufficient firepower can Argentina convince investors that debts will be paid and the currency will not keep plunging. Shock and awe is now the name of the game.
The sharp rise in domestic interest rates was necessary not only to stabilize the currency but also to make it attractive for investors to roll over large amounts of peso bonds coming due in early May. The rollover succeeded, and the peso stabilized at 25 per dollar. What comes next?
The carry trade today is very attractive, especially for longer-maturity securities, because the break-even point occurs at the most depreciated real exchange rate in decades. If the Argentine peso turns out to be stronger than that in real terms, which it probably will, investors stand to profit handsomely. So the smart money right now is betting on the peso, not against it.
But interest rates at 40% cannot be sustained for long without harming credibility. Markets must be persuaded that a gradual reduction in rates is both plausible and sustainable. To avoid an unsustainable snowball, the central bank is likely to lower interest rates gradually after the details of the IMF package are announced. One bit of good news is that rollover risk on domestic bonds is not nearly as high as some newspaper headlines have suggested, because the lion’s share is held by local banks and public-sector entities that have large and stable liquidity needs.
The IMF, for its part, must move quickly. But it also must understand that too abrupt a fiscal adjustment can cause a political backlash that jeopardizes the credibility of the overall package. The Peronist opposition, until now weakened and divided, is hoping to make a comeback by triggering protests against budget cuts and additional energy-price adjustments. The Fund, precisely because it is an international institution that is above local politics, should be careful not to give one of the competing sides all the ammunition it needs in the run-up to the October 2019 presidential election.
None of this amounts to handing the Argentine authorities a blank check. In addition to some additional fiscal tightening, the Fund should insist that the authorities clarify the rules of the exchange-rate regime as the emergency recedes. Occasional interventions when the exchange rate is severely misaligned are not uncommon under inflation targeting and floating rates. It is incumbent upon the central bank to ensure that market participants understand this.
The success of a liberal reformist approach in Argentina matters far beyond the country’s borders. Populists of the right and the left, some with authoritarian leanings, lead opinion polls in Brazil and Mexico ahead of presidential elections in both countries later this year. With populists already holding power in the US, Europe, and Asia, their return in Latin America’s two most populous countries would have global ramifications. With the right policies and strong support from the international community, Argentina can show that another way is possible.
Andrés Velasco, a former finance minister of Chile, is the author of numerous books and papers on international economics and development. He has served on the faculty at Harvard, Columbia, and New York Universities.
Project Syndicate, 2018.
By Andrés Velasco