Argentina’s foreign exchange regime is broken
When it comes to saving the peso, Argentina has tried everything under the sun, from an assortment of crawling bands and pegs in the 1970s and 80s, to a legal peg to the US dollar in the 90s, to (very) dirty floats in the 2000s. Sooner or later, they all ended in tears. The latest failure, the demise of a float-cum-inflation targeting scheme prematurely launched in 2016, took place last year after the central bank spent more than $25bn of reserves in a fruitless attempt to forestall a currency crisis that eventually cut the value of the peso by half. The episode occurred while Argentina was receiving support from the IMF, which had provided much-needed finance on condition that it should not be used to defend the currency. This condition, which is customary and, in a different context, even logical, may have been the last nail in the peso’s coffin. Argentina at first broke it, to the annoyance of the Fund, which then insisted it be respected, at which point the peso slumped again.
The current system, born in a second IMF programme in October 2018 out of the ashes of the first IMF programme, tried to reconcile the Fund’s reluctance to see its dollars being used to defend the currency with the central bank’s urge to build a trench against a spiral of depreciation and inflation. The compromise solution involves a “non-intervention” band, with its ceiling 30 per cent above its floor. Within that band, the central bank stays on the sidelines; whenever the market rate hits the ceiling, the bank has a modest stock of dollars available for sale. In practice, this unprecedented arrangement is an invitation to speculators to test the bank’s resolve. For the past six months, Argentina has been living with a floating exchange rate that succeeded in keeping the IMF-lent reserves untouched at the cost of defeating the programme’s targets.
On currency issues, Argentina is not your typical developing country. Argentines have historically saved in dollars and, after decades of instability in the peso, the dollar is the unit of account of the economy. As a result, the pass-through from depreciation of the peso to an increase in prices is large and fast. This means that a large depreciation quickly causes flight to dollar safety that often becomes permanent. Argentina is trapped in a vicious circle. Demand of just a few million dollars in an illiquid market can weaken the peso, as has been the case since early March. Exchange rate depreciation leads quickly to increases in inflation, portfolio dollarisation and higher interest rates — now the central bank’s only means of defending the currency. High interest rates, in turn, punish economic activity and postpone a long overdue rebound.
They also raise political uncertainty in an election year, adding further depreciation pressure. Left to its own devices, the programme is likely to fail, killing one of the last chances to avert a twin currency and debt crisis. Something must be done before it is too late. The current IMF agreement rules out any active intervention within the band, even if its purpose is to reduce volatility. Instead, this year, the Treasury will sell dollars, lent by the IMF to fund the deficit, in predictable $60m daily auctions that can easily be traded around by savvy investors well-versed in the Argentine markets. This is because, once the bank has used up its dollars for the day, just a small action by speculators can have a big impact. On March 7, for example, trades of just $7m in the market’s closing minutes pushed the peso down by 70 cents.
True, transparent rules are needed to address short-term volatility. But, under the current minimalist, ill-designed rules, the central bank faces two equally undesirable options: tolerate disruptive exchange rate volatility that ultimately defeats the programme’s stabilising objectives (inflation has accelerated above an annualised 50 per cent in the first quarter and is pointing at close to 40 per cent for the year); or resort to unsustainably high interest rates to attempt a doomed defence of the currency, deepening the recession (in March, the central bank hiked rates by more than 20 per cent, casting doubt on projections of economic activity and fiscal revenues).
Schemes to reduce exchange rate volatility are not exotic inventions; they have been successfully applied by most floaters in the region. Indeed, as documented in a recent IMF study, foreign exchange interventions have been more the rule than the exception among inflation targetters in Latin America, based on both rules and discretion. Currency stability is the most cited motive for official interventions in foreign exchange markets among central banks. Such interventions were a common stress therapy during the 2008/09 global financial crisis and, again, during the 2013 “taper tantrum”.
We believe the IMF programme in Argentina has a missing piece: an intervention rule within the band. A policy of leaning against the wind would go a long way to containing speculative short-term attacks and avoiding the creeping peso scepticism that is eroding the bases of the programme. Such spot interventions would not attempt to protect an overvalued peso: the peso misalignment has corrected considerably in the past 12 months, and its current weakness is almost entirely driven by speculative bets in an illiquid market.
To be sure, more is needed to heal Argentina’s peso problem, including, possibly, more earnest efforts to manage expectations about a credible target. But such efforts would be of little effect in the event of a full-blown currency crisis — not an improbable scenario in the current political context. Now is the time to act to avoid a massive dollarisation and a run on the peso that would compromise the country’s fiscal consolidation, the stability of the financial sector and, most importantly, Argentina’s chances of bringing its currency back to life.
Marcos Buscaglia is founding partner, Alberdi Partners; Miguel A Kiguel is executive director, Econviews; and Eduardo Levy Yeyati is dean of the School of Government at Universidad Di Tella and a visiting professor at Harvard Kennedy School