May 7, 2018 / 11:31 PM / 15 days ago

Argentina stems peso bleeding but remains vulnerable to capital flows

NEW YORK (Reuters) - Argentina’s three recent interest rate increases to halt the peso’s collapse can be traced back to a late-December government press conference which have left the country more vulnerable to international investor sentiment and capital flows.

A man walks past Argentina's Central Bank in Buenos Aires' financial district, Argentina May 7, 2018. REUTERS/Marcos Brindicci

A spike in the U.S. dollar in recent weeks and higher U.S. interest rates tested investor’s confidence in emerging markets and Argentina in particular, forcing the government of Mauricio Macri into shocking the peso back to life just four months after easing monetary policy.

After the peso hit an historic closing low versus the U.S. dollar of 22.40 last week, Argentina lifted its benchmark interest rate to 40 percent while tightening the fiscal deficit target to 2.7 percent of gross domestic product from 3.2 percent.

The Argentine authorities seem to have stopped, for now, a run on the country’s currency, but the higher interest rates and tighter fiscal policy needed to stabilise the peso could be costly down the road.

“It’s now becoming a more delicate balancing act to deliver low inflation, stable GDP growth and continue to finance a large fiscal deficit that requires a quick normalization of market stress,” said Siobhan Morden, New York-based head of Latin America fixed income strategy at Nomura in a note.

“The revised fiscal deficit target looks achievable only if financial stress recedes and only if officials convince the markets on their commitment to low inflation,” she said.

That commitment to low inflation was put in doubt back in December, when the government announced a rise in its inflation target to 15 percent from a previous band with a 10 percent midpoint, arguing that it had acquired room to recalibrate monetary policy. Two weeks later, in early January, the benchmark rate was cut to 28 percent.

The government was seen as making a bet on supporting economic growth at the expense of controlling inflation and the credibility of the central bank was called into question.

“Everything changed for worse in December when they changed the target for inflation and then reduced interest rates on the back of that,” said Claudio Irigoyen, head of Latin America economics and fixed income strategy at Bank of America Merrill Lynch.

EXTERNALITIES

Months later, the external shock hit.

With U.S. economic growth looking more robust than Europe’s in the first quarter of the year, market expectations for further Federal Reserve interest rate rises were confirmed, leading to a rise in the U.S. yield curve, and a surge in the U.S. dollar which put pressure on both developed and developing market currencies.

Investors with emerging market exposure, especially those involved in the carry-trade, borrowing in U.S. dollars to invest abroad, began to reduce their exposure and developing market currencies, like Argentina’s, were badly hit.

Traders work on the floor of the Buenos Aires Stock Exchange, Argentina May 7, 2018. REUTERS/Marcos Brindicci

“When the external environment became more challenging, if you screened across the emerging markets landscape Argentina stood out among the most vulnerable,” said Alberto Ramos, head of Latin America Economic Research at Goldman Sachs in New York.

Though it is still early to say if last week’s central bank measures worked, some analysts agree they were needed and the coordinated action helped appease investors.

“They seem to have done enough given what we know now in terms of key external variables,” said Alejo Czerwonko emerging markets strategist at UBS Global Wealth Management’s Chief Investment Office in New York, pointing to the recent strength of the U.S. dollar and higher Treasury yields.

“If those change, further action might be needed.”

If the greenback remains near current levels against its peers, the last two weeks could be just a hurdle in the Argentina government’s plans to grow the economy further.

“Of course market developments of the last few weeks will have an impact on key macro variables, but we don’t think ultimately they will derail the improvement in the growth-inflation mix nor the improvement in addressing key imbalances,” Czerwonko said.

THREATS

The biggest threat to the government’s plans could come from within.

Macri’s centre-right government, a global financial markets darling through last year, could face stagflation if interest rates have to remain this high for too long or if Argentineans decide to buy more U.S. dollars as protection against inflation.

“What you need to monitor now is how the opposition tries to capitalise on this and puts some stone in the road in congress in order to make it more difficult for the government to adjust fiscal policy,” said Irigoyen.

Argentina could find itself needing external financing at high financial cost or having to turn to the International Monetary Fund which would incur a big political cost.

“Politics are going to be very fluid going forward.”

Reporting by Rodrigo Campos; Editing by Daniel Bases

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