Argentina Tested as Peso Selloff Spurs Third Abrupt Increase
(Bloomberg) -- Argentina stepped up the fight against the collapse of its currency with a third interest rate increase in one week and the announcement of tighter government spending targets.
In another surprise move, the central bank on Friday raised the key interest rate by an additional 675 basis points to 40 percent - the highest among major economies -- as the Treasury Ministry committed to reducing spending on infrastructure, and to target the country’s primary fiscal deficit at 2.7 percent of GDP, down from 3.2 percent this year.
The peso rebounded following the announcement to close 5.5 percent higher at 21.8 per dollar. It posted its biggest one-day decline since December 2015 on Thursday even after two surprise rate hikes. The currency is still down 15 percent this year against the U.S. dollar and dropped more than 6 percent this week, the worst decline since June 2016.
Behind the peso weakness is growing concern that President Mauricio Macri is dragging his feet on taking the possibly painful steps needed to revamp the economy -- and that both inflation and government spending are spiraling dangerously high.
The magnitude of the central bank moves underscores the challenges facing Macri as he attempts to improve the economy and roll back protectionist measures put in place by his predecessor, Cristina Fernandez de Kirchner.
“Investors gave Macri about a year and a half of a grace period to put the house in order. After that they started to worry,” said Claudio Loser, founding member and director of Centennial Group Latin America and a former head of the International Monetary Fund’s operations in the Western Hemisphere. “Now that the fiscal adjustment remains weak, inflation unwavering, and U.S. bonds more attractive, investors are evidently losing their patience.”
It’s a disappointment to many investors who saw Macri’s election in 2015 and his promises to bring predictability and lure foreign capital as a turning point. For years, Argentina had suffered from state interference in the economy and lawsuits with disgruntled creditors that locked it out of international capital markets.
“External conditions will not accommodate the government’s strategy of gradually removing the country from its medicine -- it’s time to rip the Band-Aid off,” said Sean Newman, a money manager who helps oversee $3.8 billion in assets at Invesco Advisers in Atlanta. “The pace at which the fiscal deficit is closed needs to be accelerated.”
On Friday, Treasury Minister Nicolas Dujovne announced Argentina will reduce spending on infrastructure by 30 billion pesos ($1.4 billion) this year and will find savings of about $3.2 billion.
Alberto Ramos, the head of Latin America research at Goldman Sachs Group Inc. in New York, said the dramatic interest-rate hike, coupled with tighter fiscal targets, are “fast and bold” steps in the right direction, but more may need to be done to stabilize the distressed currency market.
“Success is not guaranteed," Ramos, an economist, said in a note to clients. "But the probability of succeeding is higher than if the authorities had not reacted the way they did.”
It couldn’t come soon enough for currency and bond traders, who have seen the country’s overseas bonds -- including a 100-year note it sold last year -- also among the world’s worst performers. Telecom Argentina and Petroquimica Comodoro Rivadavia SA have had to postpone debt sales amid the carnage.
The central bank said in a statement the rate hikes were aimed at reducing volatility from external factors and making sure inflation heads toward the 15 percent target. The presidency said Thursday that it backs the central bank in its fight against inflation and reaffirmed that the bank is independent and has all the tools necessary.
The selloff has its roots in an unconventional move in December. That’s when central bank President Federico Sturzenegger, after pumping up rates to the highest in the world in a bid to rein in price increases, loosened inflation targets after coming under pressure from the government. In January, the bank cut rates by 1.5 percentage points, even as annual inflation running at about 25 percent showed no signs of abating. It’s accelerated since then.
Macri has stuck with a plan of only gradually tackling the government budget deficit, something he predicted would be made easier by quicker economic growth. But with analysts expecting the combined current-account and budget balance to exceed 10 percent of gross domestic product this year, investors are growing skeptical of the strategy.
“We’re in the emergency room now and we need bold moves to anchor the system,” Ramos said. “The policy mistake was cutting rates when inflation expectations were deteriorating rapidly. They’re now doing the right thing in order to bring order to the foreign-exchange rate market and to regain some of the lost credibility, but it’s going to be tough.”
Before the recent rate increases, the central bank had been relying on selling dollars in the currency market to try to buoy the peso. This year, they’ve spent $6.9 billion on the efforts, or about 10 percent of the country’s international reserves.
On Wednesday night, policy makers seemed to be rethinking that strategy and planning to reduce the amount of dollars they sell, according to people with direct knowledge of the matter. They say officials attribute the peso’s decline mostly to external shocks.
And there’s no doubt there have been global reasons behind the peso’s drop. Pessimism toward riskier assets and renewed dollar strength have been factors. But also at play is an exodus of overseas investors from Argentina after a new income tax for foreigners took effect.
On the fiscal side, Macri is facing pressure from labor unions to boost salaries to keep up with inflation at the same time he’s running into resistance against efforts to curtail energy subsidies and pass the higher costs on the consumers.
“If the government backslides on the fiscal area to ease people’s pain, the market will keep the pressure on,” said Greg Lesko, a money manager at Deltec Asset Management in New York.
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