Argentina’s central bank (BCRA) is running out of FX reserves to prop up the peso and it may soon devalue the currency. Even so, it would take an overhaul of the monetary policy setup, probably under the guise of a new IMF agreement, to prevent a more disorderly adjustment of the currency in the medium term.
- Argentina’s central bank (BCRA) is running out of FX reserves to prop up the peso and it may soon devalue the currency. Even so, it would take an overhaul of the monetary policy setup, probably under the guise of a new IMF agreement, to prevent a more disorderly adjustment of the currency in the medium term.
- After the sharp sell-off in the Argentine peso last year, the central bank imposed capital controls to manage the depreciation of the currency and stem the bleed in its FX reserves. This system initially worked. But downward pressure on the peso has been mounting in recent months, and the BCRA has been put on the back foot as it tries to defend the currency.
- Three underlying forces are weighing on the peso. First, high inflation (which rose to 37.2% y/y in October) means that, all else equal, the real exchange rate is becoming less competitive. Second, the money supply has ballooned, largely due to central bank monetisation of the budget deficit. Third, confidence in the peso seems to be waning because of the dire economic outlook and the unclear path of policymaking.
- The authorities are clearly wary of letting the peso drop sharply. Since July, the BCRA has sold almost $5bn in FX markets to manage the slide in the currency. (See Chart 1.) And various measures have been adopted to help the central bank maintain its grip on the peso without burning through its reserves.
- The first was to tighten capital controls but, as we expected, that has backfired. As dollars became scarcer, the spread between the official and unofficial exchange rates shot up. (See Chart 2.) Meanwhile, the move to trim export taxes on agricultural goods to generate more FX revenues has made little difference.
- The more recent shift towards orthodox policies has had some success. The BCRA switched to a managed float FX regime to allow greater influence from market forces on the peso. It also tinkered with interest rates to guide interbank rates higher, incentivising more savings in pesos. And the pace of expansion in the money supply has slowed. These measures have helped the official and unofficial rates to converge in recent weeks. (See Chart 2 again.)
- But the big picture is that the BCRA continues to dip into its FX reserves to prop up the peso, and it has limited firepower to continue this fight. Gross FX reserves have dropped below $40bn, 12% lower than their level at the start of the year. Worse still, we estimate that net reserves, which strip out FX liabilities, are just $4bn. (See Chart 3.) At the current pace of decline, net reserves would turn negative in Q1 2021.
- That wouldn’t be a disaster in the near-term. Around $20bn of the BCRA’s FX liabilities are owed to China via a swap line which was renewed in August for another three years. But it’s clear that continually sliding reserves isn’t a sustainable approach. And the distortions from the large premium for dollars on the black market will be a drag on economic activity.
- As a result, policymakers will soon have to take more drastic action to tackle the currency dilemma. One approach would be a large devaluation of the official exchange rate. Although this has been dismissed by the government, it may be the path of least resistance in the near term. Letting the peso depreciate at a faster rate, and/or allowing a big one-off devaluation, would narrow the gap between the unofficial and official exchange rates and give the BCRA some much needed breathing room.
- Crucially, though, Argentina’s recent history suggests large currency devaluations alone are not enough to rebuild FX reserves and restore investor confidence. Distortionary policies and a heavily-managed peso were also the norm under Cristina Kirchner’s reign during 2011-2015. To stem the bleed in the BCRA’s reserves, her government routinely let the official exchange rate depreciate at a faster rate, and even allowed the peso to drop by 15% within 48 hours in early 2014. But in the absence of a wider policy shift, the same downward pressures on the peso built again, pushing up the premium on the unofficial exchange rate. (See after the dashed circle in Chart 3.)
- The most sustainable approach would be to overhaul the current monetary policy regime. Indeed, it was only when capital controls were eventually lifted, and the peso was floated, at the start of President Macri’s term in late-2015 that the black market spread was effectively eradicated and the BCRA could rebuild its reserves. Policymakers are making tentative steps in this direction. But a more convincing policy shift would probably have to come as part of a new IMF arrangement.
- The government is in talks with the Fund over an Extended Fund Facility deal (EFF) to repackage the current $44bn loan owed to the IMF. That would probably come with conditions including structural reforms and higher interest rates to tackle inflation, a gradual phasing out of capital controls, and an end to deficit monetisation. Our baseline assumption is that an EFF agreement will be thrashed out ahead of the government’s deadline of April 2021. This would help to restore confidence in policymaking, and the added funds from the IMF would replenish some of the BCRA’s depleted FX reserves.
- Even under that (perhaps optimistic) assumption, we think that the peso would need to fall a long way to be competitive. Although the real exchange rate doesn’t appear as grossly overvalued as it was in late-2015 or 2018 (see Chart 4), we estimate that a 5-10% depreciation is needed from its current level to prevent a renewed build up in external vulnerabilities. In nominal terms, that entails a 33% drop in the peso to 120/$ by the end of next year, from 80/$ now.
- As always with Argentina, there’s a risk that things could turn ugly. For one thing, there is no guarantee an IMF deal will be reached. Peronist senators wrote a letter to the Fund explaining that conditionality will not be tolerated, which could scupper an agreement between both sides. In that light, even if there is an EFF deal, it’s easy to imagine some slippage on unpopular reforms advocated by the IMF. In either scenario, without significant policy reforms, the BCRA’s reserves would remain under pressure and there would probably be a bigger and more destabilising currency adjustment in the medium term.
- There is also the small matter of the huge FX public debt burden. Even if the government complies with the IMF’s conditions, a necessary drop in the peso would put upward pressure on the newly-restructured public debt burden – most of which is still denominated in FX. If the peso were to converge with the current unofficial rate, we estimate it would increase the public debt-to-GDP ratio by around 20%-pts. To ensure the government isn’t hamstrung by the public debt when tackling its currency headache, another debt restructuring may ultimately be required.
Chart 1: BCRA Intervention & ARS/US$
Chart 2: Diff. between Unofficial & Official Peso vs. US$ (3-day Moving Ave., %)
Chart 3: BCRA FX Reserves (US$bn)
Chart 4: JPM Argentina REER (CPI-Basis, 2010 = 100)
Sources: Refinitiv, BCRA, Capital Economics
Nikhil Sanghani, Latin America Economist, firstname.lastname@example.org