|Will Argentina Devalue Its Peso?
In November 2000, Mike Lanning was reacting to reports that Argentina might devalue its peso. Such a decision would have important ramifications for his company, Wessen Development Inc., (WDI). WDI is contemplating entering a joint venture with IRSA, the largest developer of shopping malls in Argentina, to construct a new shopping mall on the outskirts of Buenos Aires. The new shopping center, codenamed Mega, would include a Jumbo supermarket, 150 retail outlets, a movie theater with sixteen screens, a video game center, and a bowling alley. Mr. Lanning believes there is still much room for growth in shopping centers, especially outside of Buenos Aires. He notes that Argentina has 0.04 square meters of shopping center space per habitant. By comparison, in the U.S. there are 0.7 square meters of shopping center space per habitant, or nearly twenty times the space found in Argentina. Moreover, in Argentina’s interior, where entertainment opportunities are limited, shopping centers—with their movie theaters, entertainment centers, restaurants, and stores—make a good place for a family outing.
Despite these promising prospects for Mega and other shopping projects, he is greatly concerned that the slowdown in Argentine economic activity and high unemployment rate could lead to renewed pressure to rescind the Convertibility Act and devalue the peso. Exhibit I 1.1 contains key Argentine economic indicators. One of the problems pointed to by opponents of convertibility is that Argentina is especially vulnerable to external shocks because of its currency board, which fixes the peso at par with the dollar and requires that the monetary base be fully backed by international reserves. Any turmoil in global capital markets, such as occurred during the Mexican, Asian, Russian, and Brazilian crises, leads to capital outflows, which push interest rates up and restrict the government’s access to international debt markets. The currency board also makes Argentina exposed to devaluations by its Brazilian neighbor, such as occurred in January 1999. Argentina sends more than 30% of its exports to Brazil, so a devaluation of the Brazilian real makes Argentine business less competitive in its most important market. A real devaluation also gives Brazilian producers a competitive edge over their Argentinian counterparts in the Argentine market as well.
A rise in interest rates and reduced access to capital or a devaluation of the real will slow down economic growth or even push the country deeper into recession, something Argentina does not need with its double-digit unemployment rate.1 Under the currency board system, Argentine prices will drop in response to a recession, thereby bringing the economy back to equilibrium, but the adjustment mechanism is costly and protracted.
A peso devaluation, on the other hand, could improve the competitiveness of Argentine exports and import-competing products as well as reduce real interest rates (once the threat of devaluation was gone). A decline in real interest rates along with improved trade prospects, in turn, would stimulate Argentine economic activity and reduce unemployment. The latter effects would help boost government tax revenues as well and could reduce its unemployment compensation and other social spending.
However, devaluation has its own problems. For one thing, most of Argentina’s liabilities are denominated in dollars (see Exhibit I 1.2 for an accounting of these dollar-denominated liabilities). A devaluation of the peso would lead to a redistribution of wealth to creditors from debtors, with much of this redistribution occurring between foreign creditors and Argentine debtors. However, the inflation that would follow a devaluation of the peso would mitigate this wealth redistribution somewhat although it would bring its own set of problems.
Peso devaluation would also reduce the equity of Argentine banks and private companies. Even if all domestic private and public dollar-denominated debt were to be honored in pesos, a devaluation of the peso would put substantial pressure on bank capital. As shown in Exhibit I 1.3, at a new peso:dollar exchange rate of 1.7:1, bank capital would go to zero. It would take a much larger peso devaluation (1 to 3.5) to wipe out non-bank capital. The higher peso costs of servicing the Argentine government’s foreign debts following a peso devaluation would increase the budget deficit as well. According to Exhibit I 1.4, a devaluation of the peso to 1.7 would increase the Argentine deficit by over 50%, to 2.9% of GDP from 1.9%.
In talking to some investment bankers, Mike Lanning was made aware that pressure for a peso devaluation would likely decline if the promised monetary easing by the Federal Reserve takes place. Lower U.S. interest rates would lead to lower Argentine rates and stronger economic growth.
Another option being considered is unilateral dollarization, whereby Argentina would replace the peso with the dollar. Dollarization, it is argued, would enhance the credibility of Argentina’s commitment to monetary and exchange rate stability. Despite the currency board, the Argentine peso is not fully credible. Hence, any shocks from global financial crises result in widening spreads between peso- and dollar-denominated bonds, leaving the Argentine economy with high credit costs, less investment, and slower economic growth. Proponents claim that dollarization, by reducing the risk of devaluation, would result in lower Argentine interest rates and faster economic growth. The tradeoff is the loss of monetary policy options that would ensue once the Argentine peso is completely abolished. Most important of these is that dollarization appears to preclude a “lender of last resort.” However, Argentina has a limited lender of-last-resort capacity through its Contingent Repurchase Facility, which offers a temporary source of funds to illiquid banks. This facility, which was arranged in 1996, gives Argentina the option to sell government bonds to a group of international banks under a repurchase agreement. Another cost of dollarization would be the Argentine government’s loss of seignorage. Currently, the currency board stands ready to convert pesos into dollars but it invests its dollars in interest-bearing assets. These assets would have to be sold off to get the cash to replace the pesos currently in circulation.
Mike Lanning also realized that he had to consider the consequences of these alternative currency scenarios for his own projects as well as the likelihood of their materializing.
1. What are the pros and cons of Argentine peso devaluation?
2. Given these pros and cons, what is the likelihood that Argentina will devalue its peso?
3. What are the pros and cons of dollarization?
4. What are the likely consequences of peso devaluation for the Mega project?
5. What effects would dollarization likely have on the Mega project?
6. What alternatives are available to stimulate Argentina’s economic growth independent of exchange rate policy?
Copyright © 2005 John Wiley & Sons, Inc.