Argentina’s economic quagmire was the focus of the country’s November 19 presidential election. And the citizens have decided that they want… radical solutions. That’s why they nominated Javier Millay as the new president, who appeared several times with a… chainsaw.
He promised to put a… “chainsaw” on public spending, in Latin America’s 3rd largest economy, in order to deliver an economic shock. In his first remarks, Javier Millay, who took advantage of the Argentine people’s growing discontent with both the Peronists and the rightists who have ruled the country for at least two decades, promised an end to the decadence and the beginning of a new political era for Argentina. , stating that there is no place in “half measures”.
Annual inflation in Argentina rose to 143% in October 2023, the highest in three decades. The fiscal situation is dire and central bank financing has fueled deep monetary imbalances. Net – foreign exchange reserves fell to minus US$10 billion despite tight controls as the government tried to avoid devaluing the peso.
Javier Millay has proposed swift and decisive measures to address these imbalances, including dramatic cuts in federal spending, full dollarization, a central bank shutdown, and privatization.
Domestic financial markets could remain volatile until Millay lays out his plans more clearly, especially on the dollarization of the economy. “A significant devaluation of the peso seems inevitable as a first step, which would lead to higher inflation and recession, but could improve external imbalances and stabilize expectations if accompanied by strong policies. Javier Millay’s emphatic victory gives him the necessary political capital to take bold action.
But what are the main issues he has to solve for the country’s troubled economy?
Argentina has an incredibly high inflation rate, now well 143%, and that rate is rising. Its currency, the peso, does not trade at one rate against the US dollar (or any other currency), but at several: there is an official rate, a black market rate known as the “blue dollar” and special rates for certain sectors of the economy.
The current official interest rate is not really sustainable for much longer, so the peso is almost certain to suffer another devaluation. Argentina is also out of liquid foreign exchange reserves.
The central bank has no dollars except those deposited by banks as part of their required reserves, which cannot be used for other purposes.
The government has undertaken to make payments in Chinese yuan when possible, as China has been willing to let Argentina tap into a permanent exchange line, which allows Buenos Aires to exchange pesos for yuan.
This has helped Argentina maintain its real dollars, as it can now pay, say, the International Monetary Fund (IMF) in Chinese currency.
Meanwhile, the economy is short of foreign exchange, partly due to prolonged drought and poor harvests. According to the IMF, importers have added about $15 billion to the country’s external borrowing to maintain reserves.
And Argentina has no reasonable way to repay either the $67 billion in international bonds or the $45 billion or so it borrowed from the IMF over the next few years.
What urgent decisions does the new president face?
1. Reducing inflation
Finding a way to reduce inflation is a top priority. But the foreign exchange deficit makes it much more difficult as the government will have to allow the peso to depreciate, which will push prices up. Solving the inflation problem requires, among other things, restructuring the central bank’s balance sheet.
The central bank has issued many short-term peso-denominated bills in the market. The outstanding balance of accounts is about 15% of gross domestic product (GDP). Many of the assets held by the central bank are special low-interest dollar bonds known as non-transferable Treasuries. Therefore, the bank does not have sufficient interest income to cover its interest and often fills the gap by printing more pesos, a move that is not sustainable and contributes to the inflationary corridor.
While the new president, libertarian economist Javier Millay, wants to dollarize the economy and central bank accounts, that wouldn’t really solve the problem. The central bank would still lack the liquid dollar assets to pay its new dollar liabilities—and would have to pay the dollar rate on its accounts while receiving a very low interest rate on non-negotiable securities. A more realistic solution would be for the central bank to exchange its dollar bonds for peso bonds. But that would raise the government’s interest and make the already large budget deficit even bigger.
2. Cut spending and raise taxes
The government also needs to tighten its purse strings and cut spending (and raise some taxes). This will be painful, but it is the only permanent cure for inflation in a country that does not have the capacity to borrow. Fiscal deficits measuring 10% of GDP are unsustainable and will not be reduced without severe cuts.
3. Alignment of exchange rates
In addition, the new president will need to unify Argentina’s exchange rates – the distortions with a different exchange rate for different economic activities have become impossible to manage.
4. Negotiation with the IMF
It is important that the government renegotiate the IMF program. The current program is off track and the government needs the IMF to lend new funds to repay its existing IMF loans.
This is part of Argentina’s main problem, as the country has already exhausted its external borrowing capacity. Argentinians are looking to the IMF to find a way to reduce the extra charges it imposes on countries that have borrowed heavily and on countries that have not repaid the lender on time.
And they have a point: the current interest rate on Argentina’s IMF loan is about 8%, which is high. Sanctions that made sense when the IMF’s key charges were low make no sense now, when the fund’s key lending rate is close to 5%.
5. Restructuring of bonds
Finally, Argentinians will need to develop a plan to restructure, once again, their government bonds. The last restructuring in 2020 was based on the assumption that Argentina could return to the market in 2025 to refinance part of its bond debt. This is no longer a realistic result.
Why do Argentina’s debt problems matter to the rest of the world?
Somehow, they don’t have a big global effect. Argentina’s $67 billion in outstanding international bonds are trading at about 30 cents on the dollar, so the market values them at only about $20 billion. A restructuring is clearly priced. It will not shock and cause contagion to other emerging markets.
But Argentina still matters
Just as important, it matters to the IMF, which has about $45 billion in Argentina, far more than it has lent to any other country.
For the sustainable health of the IMF, the fund needs Argentina to have a realistic repayment plan. The IMF’s difficulties in Argentina also appear to have made it more cautious about borrowing large sums, so the country has cast a shadow over the design and size of the fund’s other major lending programs around the world – with mixed results.
Argentina could also set an important example for the international bond market if it acts proactively and restructures its bonds in 2024 before the wall of bonds maturing in 2025. The terms of the 2020 swap did not work for Argentina or bondholders of—partly because of Argentina’s policies and because global interest rates have risen. The new restructuring must combine a significant reduction in the nominal value of the bonds with an increase in the contractual coupon (the interest rate) that the bonds ultimately pay and a redetermination of the maturity dates of the bonds.
A 5% coupon might have made sense in 2020, when long-term US Treasuries were trading at 2%. But it is clearly too low for 2024, when these bonds are expected to trade at rates between 4% and 5%.
Argentina’s creditors have a long history of pioneering new legal innovations in enforcing public debt — both because it is so heavily indebted and because it has frequently defaulted. Even if Argentina doesn’t matter as much to the bond market these days, it still indirectly has a proven ability to set important legal precedents.
Finally, Argentina tends to be a good crucible for testing theories about what determines a country’s debt carrying capacity.
The IMF’s 2019 program was based on the argument that Argentina’s public debt was not particularly high, but this analysis did not take into account the country’s modest export capacity and minimal foreign exchange reserves, which limited its ability to repay the debt. its external debt.
If Millay goes ahead with his proposal to dollarize Argentina’s economy, his experiment will test whether dollar reserves are actually required to be dollarized and help assess whether dollarization helps limit default risk.
The bet is that dollarization increases the risk of a deep default, since dollarization turns all domestic debt into a claim on Argentina’s nonexistent dollar reserves.
