Tuesday, January 28, 2014

Argentina's problem is not Fed tapering

The media meme which posits that Fed tapering has caused big problems in the emerging market world ignores lots of facts to the contrary, especially in Argentina.

Argentina experienced a significant devaluation of its peso last week, but the bigger picture is that the peso has been falling for years. The peso has been falling because of the misguided and inflationary policies of the Argentine government and its central bank.

The decline of the Argentine peso began three years ago. The magnitude of the recent decline was fully anticipated by the black market exchange rate (the so-called "blue" rate) one year ago. 

The underlying symptoms of the peso's weakness have been evident since 2011, when Argentina's foreign reserves began to decline. Reserves are now down 45% from their 2011 high. This was a direct result of efforts by the central bank to support its currency peg at an unrealistically high level: with capital fleeing the country, the central bank was forced to sell dollars almost continuously in order to avoid a faster depreciation of the currency. What happened last week was inevitable.

With a pegged exchange rate such as Argentina's, a decline in foreign reserves would ordinarily result in a decline in the domestic money supply, because declining reserves are the result of capital flight. If the central bank were following the "rules" of a pegged exchange rate policy, declining reserves would be matched by a decline in the money supply, which in turn would put downward pressure on prices. This would continue until the peso's effective exchange rate repriced to a level consistent with stable capital flows. 

Yet Argentina's currency in circulation has been expanding by over 30% a year despite a 45% drop in its international reserves. This can only mean one thing: the Argentine central bank is literally "printing money" that has no backing. This is the proximate cause of Argentina's inflation, which appears to be in the range of 25-30% a year. The peso is down because its value has been undermined by years of reckless monetary expansion and inflation. Unable to borrow money from the capital markets to finance its ongoing fiscal deficit, the Argentine government has been resorting to the printing press to pay its bills. This is the problem in a nutshell, and it has almost nothing to do with the Fed's QE policy or the tapering of QE. 

An emerging meme posits that the recent weakness in quite a few emerging market currencies (e.g., Argentina, Venezuela, Brazil, Chile, Turkey) is a replay of the S.E. Asian currency crisis of 1997-98, and as such this may persuade the Fed to back off on its intention to continue its QE taper. I disagree, because there are some very important differences between now and then. 

In 1997, the Fed was in full-bore tightening mode, having raised the real Federal funds rate by over 300 bps in the prior two years. Today, the Fed is still extraordinarily accommodative, since the banking system is flush with excess reserves and the real Federal funds rate is decidedly negative. The tapering of QE has begun, but only in very modest fashion. The Fed is still supplying the world with oodles of bank reserves every month, and is many months away from even modest hikes in the real Fed funds rate. 

In mid-1997, just prior to the big collapse of S.E. Asian currencies, the dollar was over 10% stronger in real terms, against a broad basket of currencies, than it is today. 

Today, industrial commodity prices are almost 60% higher than they were in mid-1997. In 1997, the S.E. Asian currencies were under tremendous outside pressures, in the form of a) very tight monetary policy, b) a strengthening dollar, and c) relatively weak commodity prices. Today, those pressures are far less: U.S. monetary policy is still very accommodative, the dollar is weak, and commodity prices are much stronger. 

Arguably, the problems in emerging market countries that have surfaced recently have been brewing for quite some time and are only tangentially related to the Fed's decision to taper. For example, the Turkish lira has been in decline for over 3 years, and the Brazilian real and the Chilean peso for two and a half years. Thus there is little reason to think that the Fed needs to back away from a decision to continue tapering its QE bond purchases.


Mark said...

What is causing the broad and resonably rapid decline in emerging market curriencies?

Scott Grannis said...

The simplest answer is this: an excess supply of money in these countries relative to demand. M2 in Argentina, Chile, Brazil, and Turkey has been growing at strong double digit rates for years. Meanwhile, demand for the currencies has weakened in line with a weakening in the prices of commodities.