What is happening in Argentina?

The Argentine stock market fell 8.4% Monday, bringing down the stock markets of Mexico and Brazil with it. Argentina is now weighing on markets in the region, reducing the chances that the Latin American recovery will resume soon.

Strike No. 1: Debt and Recession

In the past six months, Argentina has sold approximately $12 billion worth of foreign currency bonds, increasing its $100 billion foreign-debt load by about 10%. This has sapped investor (albeit institutional investor) appetite for emerging-market exposure and contributed to the decline of investor demand for older debt issues, driving up yields of Argentine (and Mexican and Brazilian) bonds. Argentina's recession, now into its third consecutive quarter, already has bitten hard into investor appetite while the country is still looking to borrow $2 billion more in international and domestic debt markets.

Strike No. 2: Politics

Argentina's politicians have added fuel to the fire by making public statements implying that the country may not live up to its foreign-debt commitments. With the Argentine economy mired in recession, unemployment rising and debt-servicing costs eating up larger and larger portions of the Argentine budget (already deeply in deficit), Argentina's willingness to service its foreign debt has become a political hot potato in front of the most contested election in 12 years. One leading candidate for the presidency has already said that Argentina must consider a restructuring of the foreign debt. (Argentine newspaper reports are that he even asked the


for help!) While outgoing

President Menem

and other Argentine officials have repeated that Argentina will continue to service its foreign debt, what happens after the change of regime is now a big unknown (and markets don't usually care much for unknowns).

Strike No. 3: Convertibility straitjacket

The Argentine currency system, known as convertibility, is quietly under attack. (So far, it is not getting much press attention.) Argentina's economic stability relative to other emerging-market economies (not to mention its relatively higher debt rating) in recent years rests on the back of convertibility laws that fix Argentina's peso exchange rate to the U.S. dollar at 1-to-1. Essentially, convertibility mandates that Argentina maintain a 1-to-1 ratio of Argentine pesos in circulation to U.S. dollars (or hard currency equivalents) held at the Argentine Central Bank.

This has allowed for stability of the Argentine currency, a sharp drop in the inflation rate and relatively low Argentine domestic interest rates. But now, that crucible of stability may be cracking.

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Dollars have been flowing out of Argentina, and its exports position has been weakened. Brazil, Argentina's main trading partner, devalued its currency in January following the devaluations of quite a few other emerging-market economies in 1997 and 1998. As a result, Argentine exports to Brazil, not to mention the U.S. and the developed world, have suddenly been priced out of the market, reducing dollar inflows and demand for Argentine assets by foreign investors (the


takeover by Spain's


being a notable exception). Without fewer dollars at the central bank, peso liquidity must fall (as per convertibility) and interest rates rise.

The Asian and Mexican crises taught us that a strong defense of a pegged currency regime can exacerbate a recession in the economy by tightening liquidity precisely when greater liquidity is needed. In other words, the mechanism that leads to rising liquidity when times are good is causing declining liquidity when times are bad, the opposite of the situation a central bank may normally want.

Argentina could break convertibility in a bid to remove restrictions on its ability to increase monetary liquidity and spur growth. Breaking the peg, however, would be a sharp reversal in policy and change in the regime, which could undermine remaining investor confidence. While an end to the currency regime may be welcomed as eventually improving Argentina's ability to run its macroeconomic policy and possibly help it lift out of its recession, the immediate effect will be to drive down prices of stocks and bonds.

Argentina's problems can be summed up with its tight monetary restrictions and shortsighted politicians. Precisely when greater resolve and leadership are required from political circles, politicians are not delivering. Until they do, the rising debt, deflation, high interest rates and recession will continue to plague both the country and investors.

Scott Grimberg is the emerging-market fixed-income strategist for Miller Tabak Roberts Securities. At the time of publication, he held no positions in the instruments discussed in this column, although holdings can change at any time. The opinions expressed in this article are Grimberg's and do not necessarily reflect those of Miller Tabak Roberts Securities. While he cannot provide investment advice or recommendations, he invites you to comment on his column at