Argentina’s Currency Devaluation: Back to the Future

Over the last two weeks, Argentina has experienced its largest currency devaluation since the 2002 crisis, with the official exchange rate devalued by about 20 percent. This major devaluation occurs after a turbulent summer in Buenos Aires, where demand for U.S. dollars kept skyrocketing, resulting in an exchange rate premium (defined as the difference between the parallel and the official exchange rate) of 70 percent.
[1]
Since early January, the Central Bank of Argentina has sold more than 8 percent of its foreign reserves (about $2.3 billion), but exchange premiums have persisted at high levels.
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Last Friday, foreign reserves reached their lowest levels ($28.1 billion) since October 2006. Clearly, it is time to batten down the hatches.

Argentina’s problems are very different from those of other unsteady emerging markets like the so-called “Fragile Five” (South Africa, Turkey, India, Indonesia and Brazil). For them, depreciation pressures and financial turmoil are mainly derived from the U.S. tapering and the slowing Chinese economy. For Argentina, problems are largely unique and very much domestic. They are the consequence of many years of self-inflicted policies that have led to an unstable macroeconomic environment and, even worse, social uprising.

Delays in policy reform and macroeconomic policy inconsistencies over the last few years are taking their toll. The government is now in a position where any effort to try to solve the current unsustainable situation will involve painful reforms for an already suffering and vulnerable population. As per usual—and particularly during President Cristina Fernández de Kirchner’s last term—Argentinean policymakers have decided to maintain macroeconomic inconsistencies, introducing some symptom-targeted policy changes, kicking the ball down the field (in a field where the policy “space” keeps shrinking). If Argentina’s crisis further develops into another mega-devaluation, it will certainly raise the possibility of regional crises. Neighboring countries already facing unstable international financial markets could also suffer regional trade problems due to increased integration in trade flows in the region.

Macroeconomic  Timeline

For over a decade, Argentina has been governed by the Kirchners: President Nestor Kirchner (May 2003 through December 2007) and President Cristina Fernández de Kirchner (December 2007 to present). While some politicians still claim that their economic macroeconomic policies are similar, this could not be farther from the truth.

President Nestor Kirchner’s term was characterized by twin superavits (i.e., fiscal and current account surpluses) and high levels of foreign reserves:

• Current account surpluses resulting from high commodity prices and competitive real exchange rates due to (1) administered depreciations in a managed floating exchange rate regime and (2) low inflation.
• Fiscal surpluses.
• High levels of foreign reserves resulting from capital inflows and current account surpluses.

Since President Cristina Fernández de Kirchner has been in office (and more evidently during her second term), misguided macroeconomic policies have caused many key macroeconomic indicators to deteriorate, including:

• Smaller current account surpluses turning into deficit. This shift has been driven by a reduction in commodity prices and an unsettling fall in competitiveness due to (1) a low exchange rate for exporters, (2) export taxes on some important agricultural products like soybeans, and (3) high and increasing inflation of about 30 percent.
• Smaller fiscal surpluses turning into deficits. The fiscal deficit in 2013 (which was about 3 to 5 percent of GDP depending on the source) occurred in spite of having the highest tax pressure over the last 50 years. Tax revenues currently represent more than 40 percent of GDP. The fact that the increasing fiscal deficit is coupled with the highest tax pressure in contemporary history is worrisome as it hints at the reduced policy “space” on the fiscal revenue front.
• Diminishing foreign reserves.  This trend has resulted primarily from (1) a chronic energy deficit (energy imports exceeded exports by $6.2 billion in 2013) and (2) the monetization of fiscal deficits—the real culprit behind the high and increasing inflationary pressures. In a world dominated by inflation rates of about 5 percent, Argentina has become a true outlier with inflation rates of about 30 percent, with some analysts forecasting rates to grow above 45 percent.
• Political struggles between intra-party factions. Internal fighting within the Peronist party has not helped restore the much-needed confidence in the economy and the credibility of the government.

In response to the continuous deterioration of macroeconomic fundamentals and low credibility, the government has once again relied on improvised and shortsighted economic policies. After allowing the peso to plunge, the government announced an ease of the exchange controls so that workers earning more than $900 per month (which represent less than 20 percent of population) can start buying U.S. dollars for saving purposes. The main objective of this policy was to reduce the exchange rate premium and inflationary pressures. Although the exchange rate premium has decreased a little, it is still not enough to credibly anchor devaluation and inflation expectations. The absence of a comprehensive and consistent economic plan explains the continued skyrocketing demand for U.S. dollars and erosion of the central bank’s foreign reserves.

What Should Be Done?

Argentina’s policymakers need to act quickly with a comprehensive economic plan that must include the following:

• Increase public spending efficiency by reducing corruption and political clientelism. Since President Cristina Fernández de Kirchner took power in December 2007, government spending (as a share of GDP) has increased to 45 percent. This is the highest level during the last 50 years. Shockingly, this figures come close to some Scandinavian countries like Norway, yet the provision of public goods—such as health, education and safety—have very low standards. For example, in spite of significant increases in education spending (which currently represents about 6 percent of GDP and is among the highest in the region), 2012 PISA scores (Program for International Student Assessment) ranked Argentina in the bottom 10 (out of 65 countries).
• Reduce monetization of fiscal deficits.  This is a necessary measure to anchor devaluation and inflation expectations.
• Improve private sector productivity via public infrastructure investment.  This policy will help complement the dynamism of the private sector.
• Increase the judiciary’s power and independence, enforce the rule of law, and reduce economic uncertainty. By creating strong, independent institutions, Argentina can improve relations with international institutions and regain the trust of domestic and international private investors.

It is uncertain whether the current administration will change its shortsighted approach to one in which problems are no longer patched but solved. Recent evidence is not encouraging. However, the long distance to the next presidential elections in 2015 will provide a test for Argentineans, the government and the opposition as to whether Argentina has the intention of becoming a prosperous and stable democracy in the region or if it wants to continue living in a never-ending Latin American soap opera. 

[1] The black-market exchange rate emerged as a consequence of the capital and exchange controls introduced soon after President Cristina Fernández de Kirchner got re-elected in October 2011.

[2] Foreign reserves at the Argentinean Central Bank were $30.6 billion on January 2, 2014 and $28.3 billion on January 30, 2014.