Argentina: Balance of payments crunch?

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This post is a guest contribution by Daniel Volberg of Morgan Stanley.

No sooner had President Cristina Fernandez de Kirchner declared victory in her re-election bid less than a month ago than the challenges for the administration had taken on new urgency. At the time we highlighted that the two most pressing issues for the administration would likely come on the fiscal front where a reduction in energy subsidies was likely and on the currency front. While the authorities have made some initial announcements on the subsidies front, the first moves on the currency front appear to have created an even more challenging environment. The decline in international reserves – which have fallen by $5 billion (just under 10%) since July – has accelerated in the first days of November after having slowed somewhat in October.

A Balance-of-Payments Crisis?

At first glance, the reserve losses suggest that Argentina is suffering a balance-of-payments crisis where an overvalued currency has become unsustainable. Indeed, the view that recent turmoil is driven by an unsustainably overvalued peso appears to be gaining traction. However, we caution that based on Argentina’s fundamentals, there should be no balance-of-payments crisis for two reasons.

First, while the real exchange rate has appreciated in recent years, it is by no means overly stretched. After all, the real effective exchange rate is still below the average of the 1990s. Of course, any conclusions drawn from looking at a long series of the multilateral real exchange rate must be taken with some skepticism. Still, given the terms-of-trade improvement that Argentina has experienced in recent years, it is hard to argue that the peso is dramatically overvalued.

Second, Argentina still has a current account surplus. While the current account has deteriorated, in the first half of the year it still posted a surplus of roughly $800 million. And in the following months the trade balance data have remained supportive, suggesting that the current account should have stabilized in surplus territory.

Expectations Challenge

We suspect that the recent turmoil is largely driven by a question of confidence. Recent policy actions and fundamental dynamics have resulted in deteriorating confidence in the value of Argentina’s currency. We suspect that there are three key elements behind the recent currency turmoil.

First, the status quo does not appear to be sustainable. With annual inflation (near 24% according to our measurement) running well above the current nominal peso depreciation (7-10%), the real exchange rate has been steadily appreciating. Indeed, the deteriorating balance of payments suggests that a decade of an undervalued Argentine peso has come to an end. The status quo – single-digit nominal depreciation and double-digit inflation that result in real appreciation of the peso – does not appear to be sustainable and, if unchecked, seems likely to lead to an overvalued peso in the near term. That, in turn, could spark pressure for more rapid peso depreciation. Thus, some foreign currency demand in recent months may have been driven by the desire to preserve savings (in dollar terms) in light of the concerns that without major adjustments to currency policy, the peso would have to devalue within months.

Second, the tightening of capital controls announced in late October has led some to be concerned that a devaluation may come sooner rather than later. At the end of October the authorities introduced new restrictions on buying foreign currency for individuals and companies. Those buying currency now need prior approval from the tax agency (AFIP). The measures appear to have been prompted by the loss of international reserves and the FATF investigation of Argentina’s anti-money laundering regime. Since the measures have been announced, there has been considerable confusion about the new regulatory landscape. The authorities claim that the measures are largely informational (identifying those who purchase foreign exchange) rather than a more substantial tightening of capital controls. Authorities note that the approval rate for dollar purchases under the new regime is roughly 80%. However, some banks suggest that it may be significantly lower. And while dividend payments by large companies in foreign currency are currently exempt from the AFIP approval requirement, there are concerns that additional measures could be forthcoming that would further restrict access to foreign currency. Our concern is that the authorities have not clearly communicated the logic behind the tightening of capital controls and the result has been an increase in expectations of devaluation and hence increasing demand for hard currency.

Third, others have viewed the latest capital controls as a sign that the authorities might be leaning towards some form of a multiple exchange rate regime. As we argued last month, there is some risk that the authorities may be considering a move to split the currency market into two parts: a stronger nominal exchange rate applied to agricultural exporters and a weaker one for the rest of the economy. The move would presumably boost the authorities’ peso revenues by allowing the central bank to buy dollars at a cheap rate that agricultural exporters are forced to sell to the central bank (within 180 days of exporting) and then allow the central bank to turn around and sell the dollars to others at a higher rate. Furthermore, the move might allow the industrial sector to “regain competitiveness” by allowing them to export at much weaker exchange rate. However, we suspect that if implemented, this policy alternative could create significant market dislocations as uncertainty about policy and the need to preserve savings may prompt more widespread dollarization and significantly raise the risk of a hard landing.

Room for Optimism?

As the administration engages in an internal debate on currency policy, there is a proposal that could calm the recent currency stress: higher interest rates to compensate a gradual, but somewhat faster, pace of nominal exchange rate depreciation. Since 2009 Argentina has maintained domestic interest rates on large peso deposits near 10-11% and has allowed the nominal exchange rate to depreciate at a pace of 7-10% per year, preserving demand for local currency savings by making domestic savers largely indifferent between saving in dollars or in pesos. But that policy appears to have changed recently. In recent weeks the authorities have restricted liquidity in the banking system, carrying out an orderly increase of interest rates. Indeed, after averaging near 11% in the first half of this year, the interest rate on large peso deposits now stands at near 20%. We suspect that this may be the first step in an orderly policy shift towards a faster pace of nominal exchange rate depreciation where rates at 20% could be associated with nominal peso depreciation of around 15-20% per year. This policy shift towards a tighter monetary and looser currency policy – if it does not result in higher inflationary pressure – could provide an important offset to the 25% inflation driven real exchange rate appreciation that is threatening Argentina’s ‘competitiveness’ that is the foundation of the current import substitution mode

Bottom Line

Argentina’s policy-makers are facing a serious challenge. The direction of currency policy continues to evolve, with two-sided risks to our outlook. Currency policy appears to be in the center of an internal debate within the administration: with some calling for higher interest rates and an orderly, gradual acceleration in the pace of nominal peso depreciation while others are proposing a severe tightening in controls and a multiple exchange rate regime. While the new controls announced late last month could ultimately be consistent with either track (an accelerated pace of depreciation or a multiple exchange rate), we are concerned that the downside risks appear to be gaining ground. Argentina’s fundamentals do not warrant a full-blown currency crisis; how the authorities handle the current situation, however, is likely to determine if such an outcome can be averted.

Source: Daniel Volberg, Morgan Stanley, November 15, 2011.

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