Devaluation Signals Major Policy Shift

BMI View: Argentina's central bank has dramatically reduced its intervention in the currency market, allowing the peso to fall by 21.3% against the US dollar at one point on January 23, as one of the key downside risks to our view for Argentina played out. We expect that there is potential for negative impacts on other Argentine financial instruments, and will be revising a host of macroeconomic forecasts in the days ahead to reflect a much weaker currency for the balance of the year.

A key risk that we had identified to our view on the Argentine peso has played out, with the unit falling by 21.3% to ARS8.234/US$ at one point on January 23, as the central bank abandons - at least temporarily - its multi-year policy of allowing only a slow, incremental weakening of the currency. The move represents a major policy change and the biggest drop in the peso since the 2001-2002 currency crisis and debt default. We see scope for additional weakness in the coming days, and potentially a period of instability across Argentine financial assets. We expect that the sell-off today will send inflation considerably higher in the months ahead, and we will be revisiting a host of macroeconomic assumptions in light of this week's move in the currency markets.

Although we had said as early as September 2012 that the currency would be devalued, we softened this view in fall 2013, writing that the central bank would instead allow a more rapid depreciation of the peso to stem the drop in reserves, a course that it had begun to pursue ( see 'ARS: Faster Depreciation Likelier Than One-Off Devaluation', September 4). The rate of month-on-month weakening has accelerated from an average of 0.9% in the first three quarters of 2013 to an average of 2.1% since then, with the unit falling by 5.8% in the four weeks ending on January 17. However, it appears that this strategy failed to halt the demand for foreign currency, with the Blue Dollar (the black market peso) continuing to depreciate rapidly.

Central Bank Allows A Free-Fall
Argentina - Exchange Rate, ARS/US$ (weekly)

BMI View: Argentina's central bank has dramatically reduced its intervention in the currency market, allowing the peso to fall by 21.3% against the US dollar at one point on January 23, as one of the key downside risks to our view for Argentina played out. We expect that there is potential for negative impacts on other Argentine financial instruments, and will be revising a host of macroeconomic forecasts in the days ahead to reflect a much weaker currency for the balance of the year.

A key risk that we had identified to our view on the Argentine peso has played out, with the unit falling by 21.3% to ARS8.234/US$ at one point on January 23, as the central bank abandons - at least temporarily - its multi-year policy of allowing only a slow, incremental weakening of the currency. The move represents a major policy change and the biggest drop in the peso since the 2001-2002 currency crisis and debt default. We see scope for additional weakness in the coming days, and potentially a period of instability across Argentine financial assets. We expect that the sell-off today will send inflation considerably higher in the months ahead, and we will be revisiting a host of macroeconomic assumptions in light of this week's move in the currency markets.

Central Bank Allows A Free-Fall
Argentina - Exchange Rate, ARS/US$ (weekly)

Although we had said as early as September 2012 that the currency would be devalued, we softened this view in fall 2013, writing that the central bank would instead allow a more rapid depreciation of the peso to stem the drop in reserves, a course that it had begun to pursue ( see 'ARS: Faster Depreciation Likelier Than One-Off Devaluation', September 4). The rate of month-on-month weakening has accelerated from an average of 0.9% in the first three quarters of 2013 to an average of 2.1% since then, with the unit falling by 5.8% in the four weeks ending on January 17. However, it appears that this strategy failed to halt the demand for foreign currency, with the Blue Dollar (the black market peso) continuing to depreciate rapidly.

Biggest Move Since 2001-2002 Crisis
Argentina - Exchange Rate ARS/US$, % chg m-o-m

Years of aggressive monetary and fiscal stimulus have led to inflation in the 20-25% range, according to independent estimates, which has not been matched by a concomitant weakening in the peso, creating strong domestic demand for foreign currency. Lower export commodity prices in recent years and eroding competitiveness have intersected with a deteriorating business environment and heightened political risk, which, combined with domestic demand for foreign currency, have created sustained downward pressure on reserves. The country's stock of reserves had fallen 31.0% year-on-year (y-o-y) as of January 21, roughly 3.9 months of import cover. We believe that the inability to stop the drop in reserves even with a faster weakening in the peso in recent months was likely one of the factors that precipitated the devaluation of the currency.

Failure To Stem Drop In Reserves Prompts New Tactic
Argentina - Foreign Currency Reserves, % chg y-o-y

In addition to the macroeconomic and financial market implications of the devaluation, we see potential for a surge in political risk and, potentially, violence and looting. Indeed, if wage growth is unable to keep pace with what we now believe will be accelerating domestic inflation, we could see political unrest similar to the December police strikes that led to riots and looting in Buenos Aires and other major cities.

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Related sectors of this article: Economy, Finance, Forex, Exchange Rate Policy
Geography: Argentina
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