Argentina’s Fragile Economy Is Particularly Vulnerable to a Strong Dollar Exchange Rate

Argentina’s ‘Twin Deficits’ Help Explain the Peso’s Falling Dollar Exchange Rate³

Argentina’s current account balance—the difference between its income from foreign sources (including export income) and its payments to foreigners (including import payments)—has fallen considerably since 2009. At the end of 2017 the country was in deficit to the tune of nearly $31 billion,⁴ about 5 percent of GDP.⁵ Most of this imbalance is due to import growth considerably outpacing export growth during Argentina’s recovery from its recession in 2016, which resulted in a trade deficit of 4.8 percent of GDP and external debt of 36 percent of GDP by the end of 2017.⁶ External debt is the money that Argentina has borrowed from foreign sources to finance its current account deficit. It is denominated in U.S. dollars.

Concurrently, the government’s budget position worsened. At the end of 2017 Argentina’s primary fiscal deficit (the excess of government spending over revenue before debt service) was 4.7 percent of GDP, up from 1.9 percent three years before, while the rising interest cost on government debt had pushed up the overall deficit to 6.9 percent of GDP.⁷ Argentina’s federal government debt, about 80 percent of which is denominated in dollars, stood at 52.8 percent of GDP.⁸

When a country’s currency exchange rate falls against the dollar, if that country has a current account deficit funded largely by private sector debt it can experience a painful adjustment, as the cost of obtaining dollars to service dollar-denominated debts rises sharply. Corporate and household defaults can ripple across the economy, causing bankruptcies and rising unemployment. If banks are involved, there can be a banking crisis. Slumping domestic demand may trigger a recession.

But if there are twin deficits of the kind described above—current account and government budget—a falling currency exchange rate can threaten the solvency not just of the private sector, but also of the government.

How Rising Inflation Can Threaten Private-Sector Solvency

For a government that issues its own currency, the risk from a falling currency exchange rate is inflation. The local currency price of imports rises, and if those imports include oil and other raw materials, this can trigger an increase in the prices of end goods. Workers may then demand wage increases to compensate for their rising cost of living, setting off a wage-price inflationary spiral.⁹

Additionally, Argentina’s central bank has for some time partially financed the government deficit by creating new pesos ex nihilo—i.e., “printing money.” This action tends to raise inflation.

Currently, Argentina’s inflation is running at about 34 percent per year.¹⁰ The central bank raised interest rates to 60 percent, the highest in the world, to try to bring inflation down.¹¹ But this move could inhibit business investment, as businesses may be unwilling to borrow at such high rates. Households, too, might cut back spending rather than borrow, while already-indebted businesses and households may be forced into default due to extremely high interest payments. Falling business investment, a household demand slump, and rising bankruptcies could combine to trigger an economic slowdown or recession.

How a Falling Foreign Currency Exchange Rate Can Raise the Risk of Sovereign Default

However, if the government has borrowed in foreign currency, the risk is both inflation and sovereign default—failure by Argentina’s government to repay its debts.

The sequence of events that ends in sovereign default typically goes like this: The falling currency exchange rate raises the cost to the government of meeting its dollar obligations. The government either must run down its foreign exchange reserves to meet dollar obligations, raising the risk that it will simply run out of dollars; or it must create more and more of its own currency so that it can buy ever-more expensive dollars on international markets to service its dollar debts, which raises inflation and widens the overall fiscal deficit.

But international investors may be unwilling to hold the bonds of a government that is running down its FX reserves or printing money to buy dollars. If investors start selling government bonds, bond yields can spike, raising the interest cost of government borrowing, and the currency exchange rate can fall sharply, further raising the dollar cost of servicing and refinancing dollar-denominated debt. This scenario can render the government unable to obtain enough dollars to meet its foreign currency obligations. When this happens, the government is forced to default, which can result in debt restructuring and an International Monetary Fund (IMF) bailout program.

Argentina has defaulted on dollar-denominated sovereign debt before.¹² Part of the reason for the peso’s weakness is international concern that the country could default again.¹³

Argentina and the IMF

Perhaps because of its recent default experience, this time Argentina obtained assistance from the IMF before the currency crisis spiraled out of control. In June 2018, the IMF agreed to a standby credit arrangement of $50 billion, of which $15 billion would be drawn immediately and the remainder would be made available as needed over the next three years. Half of the $15 billion would be used for government budget support.¹⁴

However, the initial disbursement of $15 billion proved insufficient due to the deepening FX crisis. In September, the IMF agreed to front load and slightly increase the standby arrangement, giving the Argentine government an additional $13.4 billion in 2018 (for a total of $28.4 billion), then $22.8 billion in 2019 and $5.9 billion in 2020-21.¹⁵

In return, the Argentine government committed to the following measures to end the crisis and restore the economy:

• Implement tax rises and spending cuts so as to eliminate the primary fiscal deficit and start reducing debt/GDP by 2020.
• End central bank financing of the government deficit, and control inflation by restricting the amount of money in circulation rather than relying on high interest rates.
• Allow the peso’s exchange rate to fall freely, intervening only to smooth out sharp swings.

However, some analysts are skeptical that these measures will work. The Wall Street Journal reminds us that controlling the quantity of money failed to bring down inflation in the U.S. in the 1970s, warns that attempting to close the fiscal deficit by restricting the amount of money in circulation could do a lot of damage, and says that the real need is to reduce Argentina’s dependence on dollar-denominated debt.¹⁶