Do cry for Argentina

All is not well for the Argentine economy. Despite the recent approval of a $50 billion IMF support package and the maintenance of sky-high domestic interest rates, the Argentine peso is again in free fall as illustrated by a 7-percent drop in the currency last week.

This makes it all too likely that the Argentine economy will succumb once again to economic recession and that inflation will accelerate anew. It also heightens the chances that the Argentine government will soon fall out of compliance with its recently inked International Monetary Fund (IMF) program as its budget deficit widens.

{mosads}It would seem that two critical mistakes are coming back to bite Mauricio Macri’s government, which took office in early 2015. The first was the premature lifting of all exchange controls at the start of his administration. Surprisingly, the government did so before first stabilizing the economy and reducing inflation.

This was very much a case of putting the cart before the horse, thereby leaving the economy acutely vulnerable to any reversal in international capital flows.

The second was the pursuit of an economic policy of gradualism to correct the major economic imbalances that Macri inherited from years of gross economic mismanagement under the Kirchners. This was especially the case with respect to restoring budget balance and reducing the country’s external current account deficit.

This gradualist approach reduced the chances of successfully slaying Argentina’s inflation dragon and left the country highly dependent on foreign capital flows.

Such a gradualist policy approach might have been sustainable had global liquidity conditions remained as extraordinarily favorable as they were over the past few years.

With very low U.S. interest rates, foreign investors might have continued to stretch abroad for yield as they evidently did last year when they eagerly snapped up an Argentine 100-year bond despite the country’s checkered debt default record.

This whole picture changed early this year as the Federal Reserve proceeded with its program of monetary policy normalization and as U.S. 10-year Treasury yields approached the psychologically important 3-percent level.

With more favorable U.S. risk-free rates now on offer, investors are no longer willing to turn a blind eye to Argentina’s serious economic weaknesses.

Instead, they now began to focus on the country’s large twin-deficit problem — federal budget and current account. This made Argentina, along with Turkey, one of the two most externally vulnerable emerging market economies to a sudden stop in international capital flows.

The more challenging global liquidity conditions that now prevail would seem to put Argentina’s stabilization efforts at serious risk. It has to be of concern that since the start of the year, the Argentine peso has lost a full one-third of its value.

It also has to be of concern that since the announcement of the IMF support program in May, the Argentine peso has depreciated by almost 15 percent. The peso has plummeted despite the maintenance of domestic interest rates at 40 percent and despite a $15 billion IMF loan disbursement.

All of this does not bode well for the successful implementation of the IMF stabilization program. With the currency in free fall and with every prospect that global liquidity conditions will continue to tighten, barring the re-imposition of exchange controls, Argentina will be forced to keep interest rates sky high to defend the currency and to prevent inflation from accelerating.

However, no economy can sustain 40-percent interest rates for long without succumbing to a recession. This would seem to be especially the case with the Argentine economy, which is already being battered by a prolonged drought and by rising international oil prices.

An economic recession is the last thing that the Macri government needs as it tries to meet its IMF program goals. By negatively impacting tax revenue collections, an economic recession would cause the budget deficit to widen, which would necessitate yet more budget belt tightening.

Yet, a recession would also undermine political support for the Macri government ahead of next year’s elections. That would make it all the more difficult for him to introduce yet more budget measures.

It would be an understatement to say that the policies choices now facing the Macri government are not enviable. With the currency still falling like a stone even after having played the IMF card, Macri might have little option but to reinstitute the capital controls that he too hastily dismantled at the start of his administration.

Unenviable as this choice might be, it would seem better to do so early rather than burn through yet more international reserves and prolong the need for punitively high interest rates in a futile effort to defend the currency. 

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