Argentina’s reliance on U.S. dollar funding, coupled with the depreciation of its own currency is sending the country in to the all-too-familiar direction: financial turmoil.
The Argentine peso USDARS, +4.2379% sold off to a new historic low against the U.S. dollar last week. The country’s central bank, the Banco Central de la Republica Argentina, meanwhile, has been trying to stave off the peso’s weakness to prevent the situation for Buenos Aires from getting measurably worse.
“BCRA hiked [interest rates] 1,275 basis points in the space of two weeks to arrest peso depreciation,” said Brad Bechtel, managing director in FX at Jefferies. That equates to a rise of a whopping 12.75%, with a basis point translating to one-tenth of a percentage point.
“They also put in some FX controls on local financial institutions, which is usually not a good thing to do and can lead to pain down the road.”
Argentina’s key interest rate hit 40% last week and foreign reserves dropped by more than $5 billion. Exchange-traded funds tracking Argentina’s equity markets rose. More intervention, at a slower and more sustainable pace, say below $300 million a day, would likely be needed, market participants said.
“When it comes to [currency] intervention it’s about how many reserves you have,” said Kuniyuki Hirai, head of FX trading at MUFG, “otherwise how would you fund it?”
Propping up currencies often entails selling a major counterpart, like the U.S. dollar, and buying local currency to support its price or even drive it higher, Hirai explained emphasizing that currency-reserve management is crucial in such a scenario.
The Argentine peso has depreciated by 12.7% over the past two weeks, and has also declined by 22.3% so far this year. One dollar last hit a new historical high against the peso on Tuesday, buying 22.7588 pesos, up 3.7% from Monday.
“The run was initiated by foreign funds closing peso positions, especially Lebacs, which rapidly propagated to other investors and locals which triggered a large demand for peso hedges,” wrote Bank of America Merrill Lynch analysts, including Claudio Irigoyen. Lebcas stands for Letras del Banco Central, which translates to letters of credit offered by Argentina’s central bank.
The selloff also highlighted the “unfavorable impact of the higher dollar and U.S. funding costs,” wrote Morgan Stanley currency analysts including Hans W. Redeker. Rising interest rates in the U.S. and a strengthening dollar make funding for dollar-dependent countries like Argentina more expensive.
An already weaker performance of emerging-market currencies spurred the sell-of in the peso, that was “exacerbated by the vulnerable situation of Argentina in terms of current account deficit and lack of clarity in monetary policy and FX intervention timing,” said the BAML analysts.
Moreover, the peso might have room to fall lower. “With the peso depreciation so far, Argentina is just catching up with the real depreciation of the Brazilian real this month,” Irigoyen & Co., wrote. Brazil’s real USDBRL, +0.8308% last at 3.5756 per one U.S. dollar, has fallen 4.8% over the past two weeks.
The economic turmoil in Argentina comes about 2 ½ years after the election of President Mauricio Macri, who was meant to lead the country out of the crisis and back into the community of global markets. When Macri took office in December 2015, he lifted currency controls, causing the peso to weaken.
But with issues bubbling up again, the specter of previous Argentine economic dilemmas has re-emerged, haunting the market once again.
Back in 2001, worries over devaluation of the peso led to spikes in overnight interest rates, ballooning bond spreads between Argentine and U.S. government debt, which accelerated into a full-fledged run on the country’s banking system, with many rushing to withdraw money from the country’s financial institutions. Argentina’s economy and its people suffered greatly in the years following these events, and much of government debt needed to be restructured.
For now, the plummeting peso hasn’t yet led to a financial crisis on par with those of yesteryear. At least the BCRA was willing to take action, which has widely been viewed as constructive, said the BAML analysts. For now the peso’s depreciation should add 2% to this year’s inflation level, and at least 1% next year, they wrote.
Currency risk for companies based in Argentina will remain high through the middle of 2019, wrote credit-ratings firm Moody’s Investors Service on Monday, given corporate exposure to dollar-denominated debt.