| | Thinking
the unthinkable in Argentina
By
Joshua Goodman in Buenos Aires 15th
November, 2001. For
more than a decade, no matter how dire the straits Argentina's economy was in,
one option was unthinkable--devaluation. Miserable memories of hyperinflation
made the rigid regime that locked the peso's value at $1 sacrosanct. Argentines,
delighted at the stability and buying power of a peso with greenback characteristics,
never dreamed the dollar peg could become a trap.
All that changed on
Nov. 1, when a solemn President Fernando de la Rúa asked Argentina's foreign
and domestic creditors to accept lower interest rates and longer maturities on
some $95 billion in bonds. With that--effectively the largest sovereign default
in history--Argentina surrendered to market forces. For nearly four years, successive
governments tried to impose enough fiscal austerity so Argentina could pay its
national debt--now $132 billion. But that put the economy into perennial recession.
Joblessness is 16.4%.
HOT TOPIC. Now, the government has admitted
it can't sustain its old policies, of which the dollar peg is the last vestige.
As Argentina's officials try to put South America's second-largest economy back
on track, all bets are off. de la Rúa and Economy Minister Domingo Cavallo
keep repeating the no-devaluation mantra. But the peso's future is the hot topic
for everyone from editorialists to cab drivers. Worried Argentines are stashing
cash in mattresses again, just like in the bad old days. "Overnight, we've gone
from three years of agonizing recession to rapid implosion," says Benny Thomas,
Latin American equity fund manager for T. Rowe Price International Inc. "Who's
not looking at the currency issue?"
Emerging markets from Brazil to Taiwan
rebounded when the de facto default, which investors expected for at least a year,
didn't spark a global market meltdown. But there is little relief in Argentina,
where investors now want 2,500 basis points over the yield on U.S. Treasuries
to hold Argentine debt, up from 1,825 before the default news. Many investors
doubt the proposed debt swap, supposed to save $4 billion in interest costs, will
free up enough cash to stimulate Argentina's $280-billion economy.
All
this leads to the question of what to do about the dollar peg. Economists say
that to get the economy moving, Argentina must free itself from the stranglehold
of an overvalued currency. Since the 1994-95 Mexican peso crisis, most emerging
markets have devalued or floated their currencies, while the dollar has strengthened.
The harshest blow came in January, 1999, when Brazil, Argentina's biggest trading
partner, floated the real, making Argentine exports uncompetitive and sending
manufacturers fleeing across the border.
One reason the government still
insists it will keep the peg is that outright devaluation has such alarming implications.
Indeed, officials say they would rather just adopt the dollar as the nation's
currency. Devaluation would boost exports. But it would have a brutal impact on
households and the banking sector, since 65% of private-sector debt is in dollars,
including mortgages and car loans. Argentines would suddenly have to pay off these
loans in devalued pesos. Many would default, leaving banks with ballooning numbers
of bad loans.
Theoretically, nothing stops the government from sticking
to convertibility and defending the peso with overnight interest rates as high
as 120%. Eventually deflation would make Argentina competitive again. But consumers
don't trust the government's resolve. Fearing a default will weaken banks, which
hold a good deal of public debt, they have been spiriting money out of the country.
Deposits fell 11%, to $76.8 billion, from late June to Oct. 26, and an additional
$1.9 billion the week before the Nov. 1 debt-exchange announcement.
The
more cash flees, the shakier the peg. "Abandoning the currency peg is inevitable
unless something miraculous happens and capital flight is reversed and interest
rates are brought down soon," says Amer Bisat, emerging-market debt portfolio
manager at Morgan Stanley Dean Witter & Co.
Privately, analysts say
the dollar peg's end could be weeks away. Reserves must stay above $10 billion
for the government to be able to defend the peso, they say. At just under $18
billion, reserves are at their lowest level in five years.
CHOICES.
The question is: What shape would a new Argentine currency regime take? There
are three choices: outright devaluation; adopting the dollar at the current rate;
or adopting the dollar but at a less than 1-to-1 parity. The easiest to implement
would be dollarization at current parity. That would eliminate the currency risk
on Argentina's debt so rates could come down. "You'd immediately eliminate the
risk premium of a devaluation from fanning out over the rest of the economy,"
says Steve H. Hanke, an economics professor at Johns Hopkins University in Baltimore
who advised Cavallo in creating the currency board. "It's the quickest and cleanest
way out of the mess."
But dollarization would also lock in the uncompetitive
cost structure everyone agrees Argentina can't sustain. For the policy to work,
say Hanke and other proponents, politicians would need to get serious about the
budget. "What Argentina needs to do is the same thing it has had to do for the
past 10 years--cut spending and return the savings to the private sector [through]
lower taxes," says Abel Viglione, senior economist at Buenos Aires think tank
Fiel. Meanwhile, dollarization at less than 1-to-1 would make Argentina more competitive,
but wouldn't fix its fiscal profligacy.
Analysts say the real danger
would be from a sloppily orchestrated devaluation. That may be where Argentina
is heading. The government has authorized the cash-strapped provinces to pay workers
in one-year notes that circulate like currencies on par with the peso. Soon the
federal government will introduce its own version of Monopoly money, called Lecops,
to pay monthly transfers to the provinces. This scrip increases the money supply--and
it isn't backed by dollars, unlike the peso. "It's easy to see how this could
get out of hand fast and lead to the emergence of a parallel currency," says Christian
Stracke, Latin America strategist at Commerzbank in New York. In that case, inflation
could resurge, and foreign investors would completely shun Argentine assets.
One way to limit the fallout from devaluation would be to combine it with
an immediate dollarization, at the same time revaluing dollar-based obligations
at the new exchange rate. In other words, if the peso were devalued by 20%--which
analysts say is the minimum needed to be effective--a $100 debt would be reduced
to $80. Although some parties, especially the banks, would suffer, a deadly chain
of bankruptcies would be avoided. Says economist Barry Eichengreen, an influential
emerging-markets expert at the University of California at Berkeley: "It would
be a radical step, but the time for radical steps has come." Argentina is in a
deep, deep hole.
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