By Mali Chavikul, emerging market economist at J. Safra Sarasin Sustainable Asset Management
In light of Javier Milei’s election win, we outline Argentina’s situation and how the new government could carry out its election promises which include a fiscal reform and dollarisation. The Presidential inauguration is on 10 December.
How bad is the economic situation in Argentina?
Argentina has had a lost decade. Its real GDP has barely grown compared to 10 years ago, and real GDP per capita has been falling. About 40% of the population is now below the poverty line, a sharp increase from 25% in 2017. Investment, including foreign direct investment, has been weak throughout the decade, and productivity growth has been falling. Micro-level distortions (such as trade barriers and price controls) are rampant and have prevented the economy from gaining more efficiency.
The economy has instead been supported by large fiscal deficits, financed by money creation, which has contributed to high inflation and an overvalued exchange rate. Large fiscal deficits have also contributed to large current account deficits which peaked in 2018 at around 5% of GDP, given that export base is small. The deficits were funded through portfolio debt until it faced a sudden stop of capital inflows in 2018 as the external environment turned negative. In June 2018, the IMF approved $57 billion to support Argentina’s economic adjustment program—the largest stand-by arrangement in its history. The program went off track within one year after disbursing $45 billion. Argentina restructured its debt in 2020 after the pandemic hit.
After the recovery from the pandemic and an extension of the IMF adjustment program in 2022, Argentina was hit by a historic drought this year with larger-than-expected losses in agricultural production, exports and fiscal revenues. The adjustment program went off track again by mid-2023 with the main fiscal and reserves targets missed. Inflationary pressure has risen as central bank financing of the fiscal deficit has continued. Inflation expectations as well as devaluation expectations have risen. Weak exports mean that the balance of payments pressures and reserve losses have intensified. The IMF projected net international reserves at $3 billion by end-year, a dangerously low level compared to Argentina’s need for external debt services next year. Debt service to the IMF alone, which is due in 2024, already amounts to $8 billion.
How overvalued is the Argentinian peso?
Inflation has risen rapidly while the official Argentinian peso (ARS) has weakened more slowly. The result is a sharp appreciation of the real exchange rate since 2022. The official ARS is managed with various capital control tools. The IMF’s estimates of the real exchange rate overvaluation is in the range of 15-20 percent. The parallel market (unofficial exchange rate) is offering an exchange rate that is up to 150% weaker than the official rate.
Is a swift fiscal reform a good idea? Is it feasible?
In our view, an ambitious fiscal consolidation is needed and the President-elect could gain market support through his determination in this area. Given that Mr. Milei’s party only has a small number of seats in both the upper and lower houses, a swift fix will be difficult even if he has the support of the centrist politicians. The incumbent Peronists remain the largest group in congress and his push for drastic fiscal reforms will likely meet strong opposition. This could lead to a watered-down fiscal proposal which would mean more of the same results. While a sharp consolidation will hurt the economy in the short term, it will pave a way for the country’s fiscal sustainability in the medium term.
What about dollarisation? Didn’t the previous currency board with the US dollar fail?
Argentina had a currency board with the US dollar between 1991 and 2001 under the convertibility rule (one peso to one dollar). This is the closest to dollarisation without using the dollar. It was introduced after Argentina experienced hyperinflation and financial distress in 1980s. It helped bring down inflation and stabilise the economy to a certain degree. However, without the required flexibility in other parts of the economy such as wages, the peso in real terms became overvalued over time, external debt grew and growth slowed. Once capital inflows stopped largely due to Brazil’s 1999 devaluation, Argentina faced significant balance of payment pressures and had to abandon convertibility in 2001 after a massive run of bank deposits. The crisis also led to a default on its sovereign debt.
Is dollarisation desirable?
Dollarisation offers stability for Argentina given the credibility of the currency. The optimum currency area theory provides classic conditions also for a hard peg (or dollarisation). A currency area works best with capital and labour mobility across the area and price and wage flexibility. The peg country and the main currency country should share similar economic cycles and face similar shocks as the peg country relies on the other country’s central bank for its monetary policy to smooth out the business cycles. A risk sharing mechanism between the participants (such as through fiscal policy or trade) could support the system. It is clear that Argentina fulfils little or none of these conditions. Argentina is in fact not very open (export to GDP ratio of 14% in 2019) and its labour market is not very flexible (worse than Latin American average in the stringency of job protection). It trades most with Brazil and China, with the US coming only in the third place both on the export and import side. Beyond the loss of its ability to have an independent monetary and exchange rate policy, dollarisation also implies the loss of the country’s ability to be a lender of last resort for the financial system. The government will also loses revenues from seigniorage, the difference between interest earned on securities the central bank acquires in exchange for money it “prints.”
Is dollarisation and/or a central bank closure feasible?
To formally dollarize, the President-elect will have to pass a law in congress which could already be challenging. The government will have to be able to back all monetary liabilities with its existing stock of US dollars. Given that its reserves are very low, an immediate dollarisation would imply a weak conversion rate to cover all the liabilities. A too weak conversion rate is not desirable as it could create high inflation in the transition period. At the current level of $20 billion gross reserves, it is not possible to cover the entire monetary base (8.6 trillion peso) at the current official exchange rate of around 350, but is possible at a 20% lower rate. It will require a much weaker rate to fully cover other BCRA liabilities of around 26 trillion peso and all the other bank deposits, however. In addition, Argentina still needs US dollars for external debt repayment. Closing a central bank is also feasible except that the central bank of Argentina (BCRA) still has a lot of outstanding securities (the 15% of GDP mentioned above). The financial system would be in distress if BCRA securities are not honoured. They will need to be resolved somehow before one can close the central bank.
What could happen in the next few days?
If the population believes that dollarisation is coming and the exchange rate at which the conversion will take place will be much lower (as suggested by the current parallel rate), there may be an incentive for the public to start converting today. Argentinians could go in drove to withdraw their pesos from the banking system and convert them into US dollars before being forced to convert at a worse exchange rate. Bank runs and de facto dollarisation could force the government to adopt dollarisation. But if other reforms are credibly announced first and generate some trust in the new government, Argentinians may first stay put to see if the government may get more external funding which could make the transition less painful. A reform and market friendly Minister of Economy will be key.
