High Likelihood Of Another Devaluation

BMI View: We believe that the recent devaluation of the Argentine peso is insufficient to reduce the selling pressure on the official rate, meaning that the central bank will soon be forced to resume its policy of gradual weakening of the currency. Furthermore, we see substantial risk that neither the devaluation nor a return to the crawling peg will halt the loss of foreign currency reserves, an outcome that could force another devaluation of the peso in the next 12 months.

Despite the 17.7% devaluation of the Argentine peso during the week of January 20, we believe that the currency remains overvalued, and that further depreciation is unavoidable over the medium term. While allowing the peso to fall to a low of ARS8.243/US$ at one point on January 23 was in all likelihood intended to avert a larger currency crisis in the future, it appears that the sudden drop in the official rate will almost certainly lead to much higher inflation, exacerbating demand for foreign currency, maintaining downward pressure on the peso, and draining foreign currency reserves. As a result, we forecast that the central bank will resume its policy of gradually weakening the peso to try and manage some of this downward pressure over the short term. However, over the medium term, we believe that gradual weakening will prove increasingly insufficient to manage the pressure on the external account. Unless reserves are replenished, most likely due to some exogenous shock - say, the announcement of a massive hard currency loan from China or the speedy resolution of outstanding issues with the Paris Club, allowing a resolution of multilateral lending to Argentina - we see high likelihood that Argentina will devalue its currency again over the next 12 months.

Selling Pressure Still High On Official Rate

Still Massively Overvalued
Argentina - Official & Implied Exchange Rates, ARS/US$ & M2-to-Reserves Ratio

High Likelihood Of Another Devaluation

BMI View: We believe that the recent devaluation of the Argentine peso is insufficient to reduce the selling pressure on the official rate, meaning that the central bank will soon be forced to resume its policy of gradual weakening of the currency. Furthermore, we see substantial risk that neither the devaluation nor a return to the crawling peg will halt the loss of foreign currency reserves, an outcome that could force another devaluation of the peso in the next 12 months.

Despite the 17.7% devaluation of the Argentine peso during the week of January 20, we believe that the currency remains overvalued, and that further depreciation is unavoidable over the medium term. While allowing the peso to fall to a low of ARS8.243/US$ at one point on January 23 was in all likelihood intended to avert a larger currency crisis in the future, it appears that the sudden drop in the official rate will almost certainly lead to much higher inflation, exacerbating demand for foreign currency, maintaining downward pressure on the peso, and draining foreign currency reserves. As a result, we forecast that the central bank will resume its policy of gradually weakening the peso to try and manage some of this downward pressure over the short term. However, over the medium term, we believe that gradual weakening will prove increasingly insufficient to manage the pressure on the external account. Unless reserves are replenished, most likely due to some exogenous shock - say, the announcement of a massive hard currency loan from China or the speedy resolution of outstanding issues with the Paris Club, allowing a resolution of multilateral lending to Argentina - we see high likelihood that Argentina will devalue its currency again over the next 12 months.

Selling Pressure Still High On Official Rate

Although government officials have expressed muted confidence that the peso can hold around ARS8.000/US$, we believe that such a level is still substantially overvalued. The implied rate and the ratio of M2 money supply to foreign currency reserves once tracked the official rate, but in recent years both have surged higher. We take this divergence as an indication of the massive depreciatory pressure on the official rate due to years of expansionary monetary and fiscal policy amidst deteriorating external account dynamics. Furthermore, local media report that the 'blue dollar' exchange rate was quoted at ARS12.15/US$ on January 24, indicating that demand still far outstrips supply at ARS8.000/US$.

Still Massively Overvalued
Argentina - Official & Implied Exchange Rates, ARS/US$ & M2-to-Reserves Ratio

Additionally, even if the current exchange rate were to reflect an equilibrium price, we believe that inflation is unlikely to slow in the near term, meaning that demand for foreign currency will continue to grow. Indeed, independent estimates show that consumer price inflation hit 28.3% year-on-year (y-o-y) in December, well above the government reported 10.9% y-o-y and the quickest price growth in three years. Furthermore, anecdotal evidence suggests that some durable goods on sale in Buenos Aires were marked up by as much as 30% overnight in the wake of the January 23 devaluation. As such, we have revised up our inflation forecast for end-2014 from 18.0% to 35.0%. We have also revised our exchange rate forecasts to reflect a return to the crawling peg policy by the central bank; we forecast an end-2014 exchange rate of ARS8.750/US$, up from ARS7.000/US$.

High Inflation Will Require Further Adjustment
Argentina - Consumer Price Inflation, % chg y-o-y

Reserves Picture Illustrates Downside Risks

While we believe high inflation is sufficient to prompt the central bank to resume a steady weakening of the peso over the short term, we highlight that the greatest medium-term downside risk to the exchange rate comes from still rapidly dwindling reserves. Foreign exchange reserves contracted by 31.0% y-o-y to US$29.1bn on January 24, a level that equates to roughly 3.9 months of import cover, the lowest in years. Complicating factors is the fact that grains farmers have reportedly begun to take additional steps to delay exporting their harvests ( see 'Soybean Exports No Panacea For Government Shortfall', January 27). As a result, we believe soy exports will not be the boon to Argentina's reserves that they have been in previous years.

We believe that the devaluation implemented on January 23 was designed to slow the loss of reserves, but if this does not pay dividends soon, market participants could lose confidence in the central bank's efforts to date, spurring a run on hard currency in the black market. The central bank has very little margin for error on this front, as years of unorthodox monetary policy have left the bank with little credibility. In the event of a blow out in the 'blue dollar' rate, we believe that the central bank would step in to prevent an all-out collapse in the peso, but only at significant cost to reserves, a scenario that would increase the likelihood of another devaluation in the future.

If Not Halted, Reserve Drop Will Prompt Another Devaluation
Argentina - Foreign Currency Reserves, US$bn (LHS) & Import Cover, months (RHS)

Risks To Outlook

If we were to see the types of price hikes that have hit some durable goods translate to consumer staples, we believe the country could rapidly approach an inflationary spiral, greatly increasing demand for dollars and lead to a collapse in the peso in the black market. This would, in turn, put further pressure on reserves and demand yet another major one-off weakening in the official rate. Alternatively, a large hard currency loan to Argentina from a foreign government, potentially the Chinese government, or the resolution of the country's outstanding claims with the Paris Club could pave the way for a stabilisation of the country's reserves over the next 12-24 months, resulting in less downside for the peso than we expect this year. However, absent a complete overhaul of fiscal and monetary policies, we believe such a measure would only be a temporary stop-gap, meaning that downward pressure on the peso would resume sooner or later.

×

Enter your details to read the full article

By submitting this form you are acknowledging that you have read and understood our Privacy Policy.

×

REQUEST A DEMO

By submitting this form you are acknowledging that you have read and understood our Privacy Policy.

Thank you for your interest

A member of the team will be in touch shortly to arrange a convenient time for your free demonstration and trial. If your enquiry is urgent, please email our Client Services team here.