Argentina’s Peso devaluation “bites the bullet” without a full set of teeth

The pronounced move in the official USD/ARS yesterday (6.9 to 7.14) and the rapid follow-through today (7.14 to 8.30)—a cumulative 20% move—has investors scrambling to understand where policy goes next.

Unfortunately, authorities have not signaled whether the decision to stop guiding the official FX level through spot intervention represents either (a) a formal end to the long-standing crawling-peg regime or (b) a temporary deviation from it which will end once the market reaches an (undisclosed) new preferred level.

Independent of the scenario that the government has in mind the initial impression of the policy move is negative.

A devaluation unanchored (at least so far) by a needed broader anti-inflation plan can only induce expectations of further devaluation (if the government is effectively adopting a free-float) or a resumption of reserve loss (when and if the government intends to subsequently resume its FX intervention).

In theory, Argentina is correctly embracing a weaker FX

Given markets have been worried over Argentina’s international reserve decline, the fact that authorities are adjusting FX and therefore “biting the bullet” would normally be considered a positive—liquidity preserving (and credit enhancing)—event. In an economy suffering reserve loss, the decision is one to transfer the burden of adjustment away from falling reserves and onto the shoulders of the currency.

But the problem lies in the fact that (at this stage) Argentina is “biting the bullet” but without a full set of teeth.

In practice, Argentina’s devaluation does not insure against further reserve loss

First, given the crawling peg regime, from a financial perspective the FX move was too sharp—it signals a departure from gradualism and creates market uncertainty. At the same time, from a macro perspective the 20% FX movelooks too timid—in terms of the BoP adjustment it will not secure the economy converges to a stable equilibrium (supported by stronger trade accounts and reduced private sector demand for saving in USD). After all, inflation was running at 26% and is accelerating toward 30%.

Consequently, it adds new uncertainty regarding the government’s desired path for the FX in a context where 20% does not look like a “final destination” for the peso. The current devaluation is unlikely to stabilize money demand and therefore it will not contribute to expectations of a needed stabilization in Argentina’s reserves in the foreseeable future. In fact, note that though yesterdays move was “sharp” the central bank lost reserves anyway yesterday. So the shift in the adjustment burden from quantities to prices has not been achieved.

In practice, Argentina’s devaluation invites greater instability

Second, the devaluation was not accompanied by a consistent increase in interest rates. Given this one can only interpret that the authorities continue to take aim at the symptoms of high inflation/instability while leaving unaddressed its root causes.

Therefore, de policy move leaves Argentina without an anchor for expectations. Insufficient interest rate or fiscal adjustment leaves the devaluation vulnerable to generating more inflation pass-through than achieving real competitiveness gains the government desires. Ultimately, it’s a dog-chasing-its-tail scenario with faster FX probably leading to faster wage adjustment, leading to faster inflation, leading to need for faster FX adjustment.

The FX was the nominal anchor (even if an inefficient one) hitherto and now it no longer has that role. But in its absence it is unclear whether the government is ready to embrace a different nominal anchor, and if it comes around to doing so, whether that anchor can be credible—given the government’s longstanding aversion to cooling off domestic consumption and sensitivity to being blamed for inducing real wage losses.

Parallel FX rate gap remains a moving target

As a side note, it is also important to consider the feedback loop of official FX devaluation and parallel FX market response (and its impact on credit market).  Argentina has 3 main FX rate markets: A controlled official FX (traded formally and explicitly in spot electronic market within banking system), A quasi-controlled parallel FX (traded formally but implicitly in OTC and exchange-based bond market) and An free-floating parallel FX (traded informally and explicitly in spot cash market outside banking system)

In the weeks preceding the sharp FX move, authorities were effectively trying to manage the weakening in the bond-implied parallel FX rate by selling local law USD bonds.

Authorities did achieve some stability this way in the quasi-controlled parallel FX market but this intervention does not affect the free-floating parallel FX market and consequently that rate moved to even weaker levels. The local press has shifted to highlighting the latter parallel FX as the benchmark. Consequently, the impression that this delivers is that the authorities have failed in their bond intervention and may be inclined to supply even more bonds ahead in attempt to achieve that goal.

This is negative for uncertainty around short-term bonds. It also implies that despite the official devaluation the FX spread with parallel can continue to widen. After all, financial demand for USD is not channeled to the official market which is available to exporters and importers and corporates paying debt. A still wide FX gap between official and (cash) parallel FX ultimately maintains alive expectations that the devaluation is not complete and more official FX rate depreciation lies ahead (amid still negative real peso interest rates offered by banks

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