Argentina Devalues, but Inflationary Pressures Persist, Indicating that the Peso Has Further to Fall

On Thursday, January 23, the Argentine peso experienced its worst single-day decline in value since 2002, as the official exchange rate dipped below 8 ARS/USD and then rallied slightly as the Central Bank intervened toward the end of the day to close at 7.88 ARS/USD. This worrisome and somewhat unanticipated drop was echoed in the movements of the parallel exchange rate, which currently stands above 12 ARS/USD, reflecting a spread of approximately 50%.

The Argentine government has also announced a selective relaxation of capital controls, meaning that individuals earning more than $900 USD/month —but not private companies—will be able to apply to purchase up to $2,000 USD for the purpose of savings. The tax rate on dollars purchased for foreign transactions and international travel was originally slated to be reduced, but the government has since reversed that decision, indicating instead that the tax rate will remain at 35%. As things currently stand, this modification appears to be largely symbolic, and may do little to actually improve access to dollars, as the government controls the approval process and will still be able to dictate if and how many dollars Argentines receive.

How will these measures impact the Argentine economy and my business?

Last week’s devaluation is too little, too late, and more FX volatility is on the horizon:

  • Last week’s devaluation is a step in the right direction in that it will help shore up reserves, reinforcing the government’s ability to service its external debts and foot the bill for increasingly costly energy imports
  • However, the peso was allowed to depreciate without any corresponding adjustments to fiscal and monetary policy, which are ultimately at the heart of Argentina’s inflation problem.
  • Until action is taken to curb government spending, reduce subsidies, and meaningfully increase interest rates in real rather than nominal terms, the spread between the official exchange rate and the black market rate will persist, as will Argentines’ preference to convert peso holdings into dollars at any cost
  • This means further devaluation is both necessary and likely, particularly given that reserves are dangerously low. The pace, magnitude, and consequences of future devaluations will ultimately depend on whether the government is able to convince Argentines that it has a credible plan for defending the currency and re-anchoring inflation expectations—as of now, the risk of a downward spiral is high
  • Signposts to monitor here: the spread between the official and parallel exchange rate; CDS spreads

The business environment will remain complex and has the potential to spiral out of control:

  • No provision has been made to allow companies to petition the government for access to dollars, and such an adjustment is unlikely at this point, given that such a move would result in massive capital flight. Additionally, balance of payment dynamics indicate that import controls are likely to remain in place—the purpose here is to keep dollars in the country and prioritize scarce dollars for staples, even at the expense of stifling production and consumption of intermediate and luxury goods.
  • The potential for an inflationary downward spiral and a rapid, poorly managed devaluation of the peso is high at this point, given that the Central Bank has signaled that it is less willing—and less able, given the pace of foreign reserve depletion—to intervene in defense of the peso than it has been over the course of the past year. Venezuela’s current state of economic mismanagement provides a sobering picture of how bad things could get.

How will these events impact the rest of the region? Is there potential for contagion?

  • Emerging market currencies, including many Latin American currencies, have depreciated since the peso fell, and will continue to depreciate in the days ahead. It warrants mention that this is in many ways a secular trend: since the US Federal Reserve announced that it would begin to taper bond purchases, emerging markets currencies have experienced bouts of volatility and downward pressure, and recent developments are best viewed as a continuation of this trend, exacerbated by, but not sparked by, recent events in Argentina.
  • Argentina’s pariah status in international capital markets means that the risk of financial contagion is limited; this is fundamentally a story about expectations and risk-aversion on the part of investors and corporate centers. To the extent that concerns about Argentine stability encourage investors to pull back from Latin America or emerging markets more broadly, we may see capital outflows and currency depreciation, but we are unlikely to see a ripple effect on par with that of the recent Eurozone crisis.
  • The impact on Venezuela will be minimal, as Venezuela’s troubles are homegrown and fundamentals are deteriorating of their own accord. Brazil, however, is likely to feel the spillover effects of Argentina’s troubles in three ways:
    • The devaluation of the peso has exacerbated already-weak investor sentiment, exerting downward pressure on the Brazilian real. Given the pass-through effect of a weaker Real on already-high inflation, the Brazilian Central Bank will be motivated to intervene in defense of the currency to help shield consumers from the effect of rising prices, which will be costly.
    • Additionally, the government will be compelled to increase spending to continue subsidizing many consumer staples, as the removal of such subsidies would amount to higher inflation.
    • This will result in the deterioration of Brazil’s already weak fiscal balance, increasing the likelihood of a credit ratings downgrade before elections in 2015.
    • All of this taken in tandem means consumers will face higher interest rates and slower growth in an election year, increasing the likelihood that the government will lose credibility with respect to inflation and fiscal targets, setting the stage for higher sovereign borrowing costs down the road—none of which make for a particularly rosy outlook in 2015 and beyond.

What can you do today to help protect your business?

  • FSG has a host of resources on contingency planning and management challenges in risky markets, including Argentina and Venezuela. We encourage you to take a look at our service offerings online for further information at http://frontierstrategygroup.com/offering/
  • We will soon be releasing a piece on scenario planning for Brazil, which will help you set expectations regarding the implications of Brazil’s near- to medium-term outlook for your business. Stay tuned for more, and don’t hesitate to reach out with comments or questions – simply send an email to info@frontierstrategygroup.com.

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