Friday, June 15, 2018

A simple fix for Argentina's peso

Since April 25th, the day the country imposed a foolish 5% tax on non-residents' holdings of Central Bank debt, Argentina's peso has lost almost 30% of its value, falling from 20 to 28. In the past year, the peso has lost almost half its value. The tax was merely the catalyst for the peso's abrupt decline, however. The real source of its persistent weakness since 2010—when the peso was trading at a relatively stable 3.8 to the dollar—is a 30% annual increase in the supply of pesos. Until Argentina's central bank stops massively printing money, the peso will continue to decline.

Why so much money printing? Because it's an easy, sneaky way of financing the government's deficit. The Central Bank effectively allows the government to spend Monopoly money in exchange for a meaningless IOU. Whoever holds pesos suffers a loss of purchasing power on an almost daily basis. That loss of purchasing power is otherwise known as an "inflation tax." The government funds its deficit by effectively robbing holders of its currency. That hits the little guy hard, and destroys confidence in the country in the process. It's hard to make significant investments in a country with a constantly depreciating currency.

Rather than own up to its shenanigans, the central bank first tried to "defend" the peso by selling one-fifth of its foreign reserves. Then the government sought $50 billion of "help" from the IMF, which it is in turn selling to further try to defend the peso. None of this has worked, of course, because it hasn't addressed the underlying problem, which is that there are way too many pesos being created. Selling a large part of your monetary base without a corresponding decline in the money supply (there has been no decline at all in Argentina's money supply for months) only facilitates capital flight. Technically speaking, Argentina's central bank has been engaging in sterilized intervention in the currency market.

In the face of a big decline in the world's demand for pesos, the only way to support the peso's value is to make a big reduction in the supply of pesos. Until that happens the peso will continue to decline over time. Sure, at some point if the peso declines enough, it will prove an attractive bet and some foreign capital will return and the peso will stabilize for a time. But it will just be a temporary respite.

Chart #1

Chart #1 is my attempt to illustrate the fundamental problem of the Argentine peso. To begin with, the supply of pesos has been increasing by about 30% per year since 2010, while the supply of US dollars has been increasing by about 6% per year. So the supply of pesos relative to the supply of dollars has been increasing by about 24% per year. That implies that the value of the peso relative to the dollar should be declining by about 19% per year, and that is shown in the green line. (Equity investors can understand this if they consider that a two-for-one stock split—a 100% increase in the number of shares—implies a 50% reduction in the price of a stock.)

Today the government announced that Luis Caputo, a man with extensive Wall Street experience, will be the new head of the BCRA. Let's hope he understands the peso's fundamental problem and promises to sharply curtail future money printing. If he does, confidence would be immediately restored and the peso could stabilize and even firm a bit. If he doesn't, then Argentina will eventually squander the IMF's $50 billion and the country will continue to suffer.

4 comments:

Andrew Ross said...

Digging deeper into the problem, isn't it a matter of balance between spending and collections?

That is, the Gov't is spending more than what it collects in regular Taxes. So, to "balance" the budget, it just prints money.

There are lots of ways a Gov't can collect taxes: income, property, sales or even thru utilities such as electric, water, telephone for example.

So, while the new leaders may understand the problem, the best fix is simply more difficult to enact than the easy way out.

Argentina also has a sad history of State Terrorism and deeply entrenched Corruption. Could this be another even more fundamental reason? That is, printing money provides greater control for the corrupt to flourish?

Scott Grannis said...

Andrew: yes, it really boils down to how Argentina deals with it budget deficit. Printing money is easy, because only the smart ones realize how it works. Most of the population struggles along, inflation a constant fact of life to be tolerated. To stop printing money, the government has to either 1) cut spending (not popular), 2) raise taxes (not popular either), and/or 3) borrow money legitimately, like the US government does. Of the three, I'd prefer the latter approach. And your point is well taken, since the corrupt are usually smarter than the rest.

Mississippi Snopes said...

The Argentine peso is an interesting topic, but it seems pretty minor in light of all the tariffs and trade threats erupting daily.

Unknown said...

Aren't the US, Eurozone Countries, and China headed in the same direction?