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Instead of Reform, Argentina Tries Managing Currency

  • The government has increased the pace of currency depreciation to close the gap with the black market and end the drain on international reserves.
  • Absent a comprehensive fiscal and monetary plan, the country's economic imbalances will persist.
  • The outgoing administration may lack the political will to make necessary changes to subsidies and wages.
  • Continued economic intervention could mean slow growth, high inflation, and simmering social conflict.

After suffering big losses in last fall's legislative elections, the current government has shifted its policy strategy and now acknowledges, at least somewhat, the need for economic improvement. The most visible change has been an acceleration in the pace of currency depreciation; in December, the peso's value against the U.S. dollar fell 6%. The government hopes both to reduce the gap between the official and black market—a gap that currently stands at 53%—and to stabilize its stock international reserves, which fell by US$12.6 billion in 2013.

The government also hopes that nominal currency depreciation will outpace inflation, reversing the rise in the currency's real value that has eroded Argentina's competitiveness since the 2002 devaluation. Inflation accelerated in December to an estimated 2.5% monthly pace.

Yet the government’s effort faces many challenges. Expectations for a faster devaluation rate are producing unwanted side effects. Exporters are currently withholding commodities, anticipating a higher future exchange rate for their foreign sales. The government is attempting to address this by selling exporters central bank bonds linked to the official exchange rate, but this will have only marginal effects since it doesn’t secure a steady flow of foreign currency.

Similarly, importers are attempting to accelerate purchases of foreign goods as much as allowed under the government's import license system. This could exacerbate the shortage of dollars in the country, neutralizing the government's efforts to curb black-market exchange. The unofficial or “blue” peso-dollar exchange rate ended 2013 at ARS10/USD, compared with an official rate of ARS6.5/USD.

The peso's depreciation is expected to quickly raise domestic prices. Given high inflation expectations, consumer demand may also rise, pushing up inflation in the short run. This could accelerate the shortage of foreign currency, worsening the very conditions that the policy aims to alleviate.

Fiscal adjustment

Isolated policy initiatives are unlikely to be effective without a comprehensive plan to address economic imbalances and distortions. Adjustments to the currency's value should be accompanied by reductions in government spending and corrections in other prices such as wages and tariffs. Argentina's government spending has grown more than 30% annually for the past four years, turning a primary budget surplus into deficit in 2012. The official fiscal deficit is estimated to end 2013 at around 2.5% of GDP, although private estimates place it closer to 4%. Fiscal policy has been expansionary regardless of the business cycle.

Increasing public subsidies, an effort to keep tariffs frozen, have deepened the government's deficit. In 2013, subsidies equaled more than 5% of GDP and were largely focused on energy and transportation. This policy discouraged private investment by keeping revenues stagnant as costs rose. Public services deteriorated, making consumers even more resistant to the significant increase in tariffs that would be needed to reduce the dependence on public subsidies.

High public wages

At the official dollar exchange rate, Argentina’s wages are the highest in Latin America, creating another major driver of high fiscal expenditures. The bulk of salary negotiations will occur during the first quarter of 2014, and the government may attempt to put a lid on them and trim real wages. Yet recent nationwide police strikes over wage discussions ended in riots and looting. Any adjustment in this area will have high political costs and is thus unlikely to be undertaken as elections approach.

As a result, the flexibility of public spending is limited, as are the government's financing choices. With some lawsuits over the 2001 default still unresolved, international markets remain closed, and the government has relied heavily on intra-public sector debt. Almost 60% of gross national public debt is in the hands of public sector agencies such as the social security administration, the state-owned Banco Nacion, and the central bank.

The drain on international reserves

Argentina's central bank has been financing government spending by lending directly to the Treasury. Given the inflationary environment, the central bank has been sterilizing its monetary actions by selling dollars and dollar-linked bonds, putting pressure on international reserves. Adding to this pressure are energy imports, which in 2013 totaled US$13 billion, and debt payments.

Argentina ended 2013 with international reserves of US$30.7 billion, although a third of that was tied to banks’ dollar deposits and liabilities, implying a lower level of freely available reserves. Approximately US$15 billion in debt payments are due in the next two years (including the GDP-linked bonds issued to exchange bondholders that are triggered when growth exceeds 3.2% as it did in 2013), exacerbating the scarcity of foreign exchange.

Letting the currency float while implementing a monetary and fiscal adjustment to tame inflation would help reduce economic imbalances and correct relative prices. However, the Argentine government has avoided this path, and continued to rely on unorthodox interventionist policies, controlling prices and restricting external trade and foreign currency access.

Gradual and isolated measures such as the acceleration of peso depreciation will fail to correct price distortions in the economy and may indeed exacerbate them. If the current approach persists, the Kirchner administration's remaining two years will be marked by slow economic growth and high inflation, with the further downside risks of increased social conflict.

Elena Resk is an Economist at Moody's Analytics.

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