FX forces at work in the making of the largest loan in IMF’s history.
By now it has been all over the news that the International Monetary Fund approved an exceptional $50 Billion Stand-By Arrangement (SBA) for Argentina, with $15 billion immediately available for disbursement. This is the largest loan in the IMF’s history. What Foreign Exchange (FX) forces were at work creating a confluence of internal and external factors that put Argentina in this position? What will the implications of this deal be on the market now and in the future? We explain the FX forces at work behind this monumental deal.
Argentina is the second largest economy in South America, but a confluence of internal and external factors have contributed to its currency, the peso, losing over a quarter of its value in the past year. A drought reduced major agricultural exports, reducing the demand for pesos by exporters who would have liked to convert their dollar earnings into the local currency. In addition, a strong U.S. dollar and the American 10-year Treasury bond yield reaching 3% for the first time in four years, attracted global investors away from emerging market currencies. Following a rapid depreciation in April 2018, the Argentinean Central Bank increased the Interest Rate for the third time consecutively, up to 40% in an attempt to quell increasing inflation to no avail. This year’s inflation stands at about 25%, the second highest in South American after Venezuela. Attempts by the Central Bank to sell foreign currency reserves to stabilize the peso versus the U.S. dollar, without having to print more pesos, failed and have reduced reserves by an estimated $5 Billion. This year alone the peso depreciated 25% and this sharp downturn sent investors fleeing from international markets. In May 2018, Argentinean officials began talks with the IMF to arrange a credit line.
The three-year $50 Billion Stand-By Arrangement was approved by the IMF’s Executive Board on June 20th. $15 Billion is immediately available for disbursement, half of which will be used for budget support, to reduce its budget deficit, while the remaining $35 Billion will be held available for the duration of the deal subject to quarterly reviews by the Executive Board. The Argentine authorities have indicated that they view the $35 Billion remaining as a precautionary amount. The goals of the program are to achieve federal government primary balance by 2020, bring inflation down to 17% next year (from 25.6 currently) then to single digits by end-2021, and commit to a floating market-determined exchange rate. These benchmarks are seen as ambitious by many, especially since 3 consecutive interest rate hikes this year have done little to quell increasing inflation. The hope is that this deal will stabilize inflation and exchange rates to attract investors. At the moment, the view is that the current stability is short term in large part because the new central Bank chief, Luis Caputo, is selling foreign currency on a daily basis in an attempt to slow the peso’s depreciation. This should also lower the currency’s volatility but selling foreign currency decreases the demand for pesos in favor of an increase in the demand for dollars, creating an unbalanced exchange market.
Risks and Recovery
Following the Argentinean economic crisis of 2001 and subsequent IMF intervention, that left many Argentines in poverty and set back living standards for the population, it is viewed with much mistrust and apprehension. The decision to go back to the same institution that inflicted so much damage on the country incurs significant political risk for President Macri who faces tough opposition from the Peronsists in the election in October 2019. “IMF” may be the dirtiest word to mention in Argentina but this IMF has tried to set itself apart from the institution of two decades ago. There is a clause in the agreement to increase spending on social programs if needed, to protect the most vulnerable in Argentina’s society, showing that the IMF is committed to lowering poverty rates even if growth rates are lower than anticipated. This in a way also serves as risk mitigation for a President who wants to promise his people that this plan is different, that they will be protected from the effects of fiscal austerity, and hopes that this convinces citizens to keep him in office. The administration will have to commit to implementing monetary policy that will curb inflation and decrease deficits to give the Argentine economy the best chance to recover. A strong U.S. dollar will put more pressure on Argentina throughout this process, and other emerging markets, because the majority of their loans are in dollars. How well Argentina fares under these economic pressures will influence how quickly reluctant investors return to the country, and whether President Macri will return to office next year.