Countries have different economic models. Economists and politicians can debate which countries have the optimal levels of state regulation, foreign investment, government and social spending, but few would put forth Argentina as something to be emulated. For a nation with a highly educated population, abundant natural resources and a relatively low violent crime rate, 1 1 Close Education is high and crime is low relative to other South American countries. Argentina has gone through more than its fair share of economic crises. If you look at the past 30 years, it would seem as though the Argentinian model is to enact reforms to attract international investment, borrow and spend, and then write-down the debt. Argentina defaulted in 1989, 2001, and technically in 2014. 2 2 Close All through the wild days, the mad existence of the EM crisis, they did not keep their promise to repay their creditors. Subsequently, investors kept their distance. While borrowing money and then not paying it back may seem appealing, it has led to political and economic turmoil, and perhaps most importantly, a lack of credibility. As a result, Argentina has suffered multiple recessions and chronic high inflation.
When current Argentinian President Macri was elected in 2015, he promised major changes in economic policies. He removed currency controls, lowered taxes on exports, and took measures to restore confidence in the accuracy of Argentina’s economic data. 3 3 Close For many years, Argentina officially reported low and stable inflation numbers despite strong evidence of rising prices. This may or may not have had something to do with the fact that some government payments were tied to the reported inflation rate. Source: The Economist: “Don’t lie to me, Argentina,” 6/20/14. He renegotiated outstanding debt with creditors, and Argentina finally emerged from default. The economic results of the reforms were mixed. Argentina had another weak growth year in 2016, though it did improve in 2017. 4 4 Close GDP for Argentina in 2016 was -1.82% YoY, but improved to +2.85% YoY in 2017. Source: Bloomberg. From the perspective of financial markets, however, it was a huge success. Argentina was able to borrow again: a little more than one year after returning to markets, Argentina issued a 100-year bond. 5 5 Close A common disclaimer on investments is that past performance does not guarantee future results. In this case investors better hope not. Argentina has defaulted eight times since its independence in 1816. Source: Financial Times: “How did Argentina pull off a 100-year bond sale?” 6/20/17. It was quite a turnaround.
Unfortunately, it wasn’t long before problems started to appear. Inflation rose from already high levels. The government budget deficit widened to 1.6% of GDP at the end of 2017. 6 6 Close Source: Bloomberg. The Argentinian peso came under pressure beginning last December. In the following months, other emerging markets also suffered. Argentina was frequently paired with Turkey in news articles. Argentina and Turkey. Turkey and Argentina. Both had large deficits and funding problems, and were challenged by competition for capital as rates rose in the U.S., but the circumstances and reactions have been very different.
As we discussed a few weeks ago, Turkey has been very reluctant to raise rates to fight its currency depreciation or seek help from international organizations. At times, President Erdogan has been openly hostile to markets. 7 7 Close Long before the lira fell, he famously warned certain market participants: “it will be you who will crash.” Source: Wall Street Journal: “Turkish Premier Takes His Fight to the Capital Markets,” 6/10/13. In contrast, Argentina has aggressively fought the depreciation. The central bank hiked its target rate to 60%. 8 8 Close And folks say you can’t earn any interest in the age of QE. That means it’s 60.4% higher than the deposit rate in the euro area and 60.75% higher than the deposit rate in Switzerland. Sources: Central Bank of Argentina, European Central Bank, Swiss National Bank. The Argentinian government reached out to the IMF for help, which is a particularly bold move in a country where the IMF could very well be the least popular institution with a three letter acronym. And this week, in an effort to reduce the budget deficit, Macri agreed to reverse tax cuts on corn and soybean exports which had been a centerpiece of his economic plan. 9 9 Close Source: Reuters: “Argentina unveils ‘emergency’ austerity measures, grain export taxes,” 9/3/18. So anyone who guessed that Argentina was just planning to borrow and default is probably rethinking that. It’s hard to imagine a country that’s been more active in its attempts to fight the crisis and avoid default. 10 10 Close I mean they could raise rates to 70% or enact more reforms or cut spending, but come on, they’ve done a lot. Nonetheless, the Argentinian peso has underperformed the lira and just about every other non-Venezuelan currency this year.
The reason could be credibility. The lira’s fall occurred after Turkey damaged its credibility in international markets by reducing the independence of its central bank. Argentina may not have regained it after the 2001 default. Even though Argentina was able to issue bonds again, the market’s confidence was an illusion. Investors may not trust that Argentina will have the wherewithal to maintain high interest rates and tight budget policies. Credibility matters as much internally as it does externally. Argentinian citizens have been hurt by the frequent currency devaluation and have seen their savings eroded by inflation. It is possible that the recent move has been caused by Argentinian individuals and companies moving their savings out of pesos and into other currencies.
The other problem Argentina faces is the inertia of currency crises and inflation. The general pattern is that when a country’s currency drops meaningfully, inflation rises as imports become more expensive. The interest rates which the country offers become less attractive because inflation eats up the value of the interest paid. This leads to investors shunning the currency, and it falls more. Then inflation rises more. It can quickly become a downward spiral which ends in default. 11 11 Close Many economic historians have charted this effect in one form or another. Often authorities are unable or unwilling to react.
Argentinian authorities are well aware of this, which is why they have acted so aggressively. What makes Argentina’s experience sobering is that despite all of this action, which will likely choke off domestic growth, the currency has continued to depreciate. Other countries have the luxury of more credibility both internally and externally. They may be able to fight off any devaluation without bringing rates anywhere near 60%, but this credibility is not unlimited. The EM contagion that everyone fears is really the loss of credibility of the entire sector. Such an outcome may require coordinated policy, which is unlikely in the current environment. Argentina is an important test: if it can regain investor confidence, it would be a positive sign that it is possible to reverse even the most difficult situations. More generally, Argentina shows the importance of sentiment in financial markets, a lesson which applies to all countries. It is rare to see a similar credibility crisis in developed markets, but when it does appear, we all remember it.
What We Are Watching
Sweden General Election (Sunday) Swedish voters will head to the polls this Sunday to determine the composition of the country’s legislature, the Riksdag. While Swedish politics features a large number of parties, recent governments have all been led by either the left-wing Social Democratic Party or the center-right Moderate Party. However, opinion polls suggest that support for these mainstream parties has declined since the last election. 12 12 Close A similar dynamic has played out in several European countries in recent years. The 2017 German elections saw diminished support for traditional centrist parties, while the current French and Italian governments are both headed by parties of very recent origin. Surveys indicate that the Sweden Democrats, a nationalist anti-immigration party, could win around 20% of the vote. This would mark a dramatic rise for a group that won seats in the Riksdag for the first time only two elections ago. The Social Democrats and the Moderates have both ruled out forming a coalition with the Sweden Democrats, and it still appears likely that one of these traditional parties will head up the next government. However, a stronger than expected showing for the Sweden Democrats could complicate the process of selecting a Prime Minister and might lead to an unusual degree of political uncertainty.
Turkey Central Bank Meeting (Thursday) Over the last year, the Turkish lira has lost nearly half of its value against the U.S. dollar, with a decline of roughly 25% in the month of August alone. Higher import costs and rising inflation expectations have fueled accelerating increases in consumer prices, and CPI hit 17.9% in August. 13 13 Close Turkish Statistical Institute. While the Turkish central bank (the CBRT) has made a few technical policy adjustments aimed at shoring up the currency, it has refrained from the sort of aggressive interest rate hikes often seen in the midst of currency crises. Turkish President Erdogan has long been critical of high interest rates, and the CBRT’s recent passivity suggests that the independence of the central bank may have been compromised. After the most recent CPI data, the CBRT released a statement declaring that “recent developments regarding the inflation outlook indicate significant risks to price stability” and promising that the “monetary stance will be adjusted at the September Monetary Policy Committee Meeting.” If the CBRT does indeed take forceful action at this month’s meeting, it could help to rebuild the central bank’s credibility in the eyes of market participants.
U.S. CPI (Thursday) Recent U.S. data has pointed to a modest pickup in price pressures. Core CPI, which excludes the direct impact of changes in food and energy prices, rose 2.4% YoY in July, up from 1.7% a year earlier and the highest reading (by a very small margin) since 2008. 14 14 Close Bureau of Labor Statistics. Higher inflation may be the result of diminished economic slack, as strong growth has pushed the unemployment rate to a multi-decade low. At present, the Fed appears relatively unconcerned about upside risks to inflation, with Chair Powell commenting recently that “there does not seem to be an elevated risk of overheating.” 15 15 Close Federal Reserve Chair Powell: “Monetary Policy in a Changing Economy,” 8/24/18. However, if CPI readings continue to accelerate, policymakers and markets may begin to attach more significance to this risk.