Peso Depreciation, Inflation, and Interest Rate Hike: Is Argentina Looking at a 2018 Recession?

Panic is a word that one could use to describe the Argentinian economy right now. The Wall Street Journal recently referred to it as a death spiral. The value of the Argentinian peso (ARS) fell 6.6 percent relative to the U.S. dollar on May 3. This devaluation has been occurring for quite some time, although this decline was the largest. In order to stop further depreciation, the Argentinian central bank (Banco Central de la República de Argentina) raised the interest rate to 40 percent a little over a week ago. For context: less than a month ago, the interest rate was 27.5 percent. It is bad enough where the Argentinian government asked the International Monetary Fund (IMF) for a bailout loan. I thought the IMF would not have given Argentina money considering that Argentina defaulted on an IMF loan in 2003. However, an agreement for a $30 billion loan of emergency aid is underway. What I have to wonder is what is the magnitude of the problem here.

Positive Economic Indicators

• Inflation fell from 40 percent in 2016 to 24 percent in 2018. 
• Argentina has recovered from its 2015 recession, although at a slower rate than the last two recessions (IMF, p. 4).
• Argentina is in a better position to accept an IMF adjustment program since it no longer has its peso pegged like it did in the 1990s.
• The public sector is projected to reach its deficit target of 3.2 percent (BBVA).
• Argentina's economic volatility is balanced by high per-capita income, a large and diversified economy, and improved governance scores (Fitch).
• The GDP is expected to grow considerably and inflation is expected to slow down (IMF, p. 9).
• "The removal of foreign exchange controls...resolution of the dispute with bond holders, and realignment of utility tariffs have corrected Argentina's most urgent macroeconomic imbalances (IMF, p. 4)."

Negative Economic Indicators

• Argentina will experience forex (foreign exchange) pressure from an unsustainable current account, lack of central bank credibility, and worsening external financial conditions (BNP Paribas). 
• Currency risk for companies based in Argentina is going to be high through mid-2019, according to Moody's.
• A combination of a high interest rate and currency depreciation will make further capital outflows costly. 
• Argentina has a budget deficit of 6 percent. Without new budget measures, the budget will increase precipitously. 
• Because of the increase of foreign financing and low global risk premier, there has been an upward pressure on the real exchange range. This has left the Argentinian peso overvalued by 10 to 25 percent, thereby exacerbating external imbalances (IMF, p. 9). 
• The low percent of exports will make it more difficult for Argentina to recover from its external debt (Council on Foreign Relations; IMF, p. 7).
• 30 percent of Argentina's foreign exchange reserves are non-transferable letters of credit (letras intransferibles). This means it will be more difficult for Argentina to pay off its liabilities or withstand a currency crisis (American Institute for Economic Research).

What Will Happen?

It might be fun to prognosticate, but at the end of the day, this is still speculation based on economic analysis. Nevertheless, I'll give it a go. I know that these economic shifts will both undermine Macri's economic policy of gradualism and diminish his odds of re-election. With the Argentinian central bank depleting its foreign reserves, there is little it can do to stop the capital outflow, which is worrisome. The silver linings are that Argentina is not anywhere near defaulting, and that the private sector-denominated debt is low. Even so, there are a few ways that Argentina can proceed. BNP Parnibas suggests that because of the trap of fiscal dominance, either fiscal adjustment (lowering the budget deficit) or further depreciation of the peso are the main options. Another option is currency reserve management and making sure Argentina buys enough local currency. Years of populist and protectionist policy will make any adjustment painful. What will make this more painful is that this is the canary in the emerging market coal mine. I don't think there will necessarily be a recession by the end of the year, but I anticipate a tough road ahead for the Argentinian economy. 

For more reading, read the main sources here:
- IMF's 2017 Article IV Consultation for Argentina
- Banco Central de la República Argentina [BCRA] (Report of Financial Stability, First Half of 2018)
- BBVA Research
- Heritage Foundation Economic Freedom Index