Argentine Economic Woes Raise New Doubts About Currency Peg

With U.S. and IMF loan policy eschewing pegged exchange rates, Argentina's onetime solution is looking more like a problem.
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You can bet that Robert Rubin is now persona non grata in Buenos Aires.

In a seismic speech Wednesday, the


secretary said the U.S. and the

International Monetary Fund

would, by and large, stop making loans for the purpose of defending pegged exchange rates, the type of currency regime in Argentina.

Rubin remarked that exceptions would be made for countries with "institutionalized" currency arrangements. For now, this would seem to include Argentina's currency board, which has successfully pegged the peso against the dollar at a strict one-to-one parity since 1991.

But it's clear that Rubin's key point -- that it's futile to defend unsustainable currency regimes -- could apply to Argentina sooner than some think.

In the last few months, Latin America pundits have begun to seriously question the viability of Argentina's exchange-rate regime.

"The environment is being set up that could lead to Argentina shedding its currency straitjacket," said Ed Cabrera, Latin America strategist at

Merrill Lynch

, at a seminar on Argentina's October presidential and congressional elections at the

Americas Society

in New York Tuesday.

Due to its failure to enact important structural reforms, the country is running down the considerable kudos it gained from slaying the hyperinflation of the '80s and keeping the peso solid throughout the '90s when others -- Brazil in January this year and Mexico in 1994 -- devalued.

In short, the currency board has shifted from being the solution to the problem.

Argentina is like a once very bad soccer team that has adopted drastic new tactics (the currency board) to prevent it from being relegated to a lower league. The new approach requires huge exertion and stamina, but little in the way of skill and intelligence. It works for a while -- keeping the team in the league -- but soon starts to exhaust the players, who can only be sustained by large infusions of very expensive steroids.

Dollar Debt Overload

In Argentina's case, the steroids take the form of heavy government borrowing in the international bond market.

According to

Santander Investment

, the government's foreign debt will probably reach around $103 billion by the end of this year, which would be a 25% increase since 1995.

With yields of around 11%, this money doesn't come cheap. The high interest rates -- themselves a sign that the market has only cursory confidence in Argentina -- are exacerbating the government's budget deficit, which then has to be covered by yet more bond issuance. The government needs to issue a hefty $9 billion worth of dollar bonds in the next 12 months, according to Santander.

In the soccer analogy, the players represent the Argentine people. With peso-dollar rate fixed, Argentina can't gain competitiveness through devaluation. Instead, they have to make reductions in the real wages and prices. This has been savage: Wholesale prices deflated by 6% last year, and unemployment is around 14%. Most depressing, the deep cost cutting isn't even doing what it's supposed to: Exports are expected to stay flat this year.

And the tough environment is doing nothing to solve Argentina's chronic tax collection problem. Partly as a result of lower tax revenues, the government recently admitted that its fiscal deficit for 1999 is going to be two-thirds larger than expected: $4.95 billion rather than $2.95 billion.

The Argentina bulls say the country can get out of this fix by enacting an ambitious range of reforms. They include: a labor law to reduce payroll costs; a law allowing the central government to cut back revenue flow to the provinces; and a law mandating the government to hold back revenue during boom years in a reserve fund for slower periods.

It's Up to the Pols

At first glance, Argentine politicians do not look eager to administer strong medicine. A few weeks ago, the opposition


distanced itself from one of its top economists because he suggested that public workers accept wage cuts.

Some hope is being placed on a comeback by

Domingo Cavallo

, the former finance minister with a record of getting tough stuff done. While Cavallo's own bid for the presidency is unlikely to succeed, he may be appointed to a powerful economic post by the likely Peronist contender,

Eduardo Duhalde

, if he were to win.

"If Cavallo agreed to that sort of deal, he'd insist on some heavy push for reform," says Raul Elizalde, Latin America strategist at Santander Investment.

But the Peronists may not win, not least because the incumbent president,

Carlos Saul Menem

, a Peronist, is locked in a very public power struggle with Duhalde. And Cavallo probably won't be welcome with the center-left Alliance. What's more, Cavallo may not be the staunch defender of the economic status quo many believe him to be. Earlier this month, he was quoted in the Argentine newspaper

La Nacion

as speculating on ways to tamper with the currency board. To regain competitiveness, Argentina could carry out a one-off devaluation within the currency board, he reportedly said.

Of course, another possible escape route for Argentina is to dollarize its economy, getting rid of the peso altogether. But even if the U.S. were to agree to this (highly unlikely, Rubin implied on Tuesday), this sort of monetary union would be economically nonsensical.

It took about 50 years for Europe to reach a stage where it felt ready to try economic and monetary union. "And individual Latin American countries are far less integrated than those of the euro area," says Richard Fox, analyst at

Fitch IBCA

in a recent research note on dollarization in Latin America.

Argentina is not going to blow up tomorrow -- it has a

Maginot Line

of defenses to guard against a run on its currency. But in about a year -- if the elections do not produce reform -- Argentine assets "will be become a screaming short," comments Walter Molano, Latin economist at

BCP Securities