Argentina put the financial cart before the horse

The Argentine peso’s free fall is providing a painful economic lesson to Argentine President Mauricio Macri.

In the same way that it is not a good idea to put the cart before the horse, it was not a good idea for Macri to completely lift his country’s capital controls before stabilizing the highly imbalanced economy that he inherited from Christine Kirschner.

{mosads}This raises the all-too-likely possibility that Macri is soon going to be forced to reintroduce capital controls to break the Argentine currency’s free fall.

Soon after coming to office in December 2015, Macri took the bold step of eliminating Argentina’s highly restrictive capital-control system. However, he did so without forcefully addressing the country’s serious macroeconomic imbalances.

Instead, he opted for a policy of gradual economic reform. As a result, on the eve of entering into a decisive tightening phase of the interest rate cycle, the Argentine economy was very much exposed to less-favorable global liquidity conditions and to U.S. dollar appreciation.

One indication of Argentina’s external vulnerability is the fact that it has simultaneous budget and current account deficits. Other indications are that it has an inflation rate of around 25 percent, an extremely high dependency on short-term financing of its government deficit and a government whose credibility has been tarnished by its attempt to interfere with its central bank’s independence.

These vulnerabilities have now exposed the Argentine currency to acute pressure. They have done so as a return to 3 percent 10-year U.S. Treasury yields and a strengthening dollar have caused investors to pare back on their exposure to risky emerging-market lending.

A measure of how acute the pressure now is on the Argentine currency is how rapidly it is falling despite heroic efforts to support it.

Over the past two weeks, it has fallen by some 18 percent even though the Argentine Central Bank has hiked interest rates to 40 percent and burnt through some $5 billion in international reserves to defend the currency.

Macri’s politically very difficult decision to call on the IMF for financial support also seems to have done little to break the currency’s free fall.

Macri now finds himself in a very difficult position. He must know that no economy can withstand 40-percent interest rates for very long. He also must know that a rapidly depreciating currency risks putting the country again in the grips of yet another debilitating inflationary spiral.

He also must know that however willing the International Monetary Fund (IMF) might be to help Argentina, it will take several weeks to negotiate an IMF program, and any such program will come with painful conditions that will be politically difficult to implement.

This all seems to leave Macri in a quandary as to what to do next about the free-falling currency. Burning through international reserves, hiking interest rates through the roof and calling on the IMF,all seem to have done little to support the currency.

All of this has to raise the question as to how long will it be before Macri is forced to lose face and take the painful decision of reintroducing capital controls to stabilize the currency?

All of this offers a cautionary tale to other emerging market economies. As they say on Wall Street, when the winds are strong, even turkeys fly. However, when the global liquidity winds begin to lose force, one better have one’s economic house in order especially if one’s economy’s currency is not protected by capital controls.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.