Argentina: Having His Cake and Eating It, Too
Merrill Lynch
Pablo Goldberg
April 17, 2001
Some of the securities discussed herein are rated below investment grade and
should therefore only be considered for inclusion in accounts qualified for
speculative investment.
o Minister of Economy Domingo Cavallo announced that the government will
send today a bill to Congress to introduce the euro as a backing for the
Argentine peso.
o The new 50% euro, 50% US-dollar basket would start when the US$/EUR
exchange rate reaches one. According to Merrill Lynch's forecasts, this will
not happen in the next 12 months.
o The government's objective is to reduce deflationary pressures by reducing
the volatility of the real exchange rate, but not to target a level.
o While we recognize some long-term benefits in this move (also some
disadvantages), its short-term implications are, in our view, negative.
o The timing of the move is a consequence of the government's perception
that the market was concerned about a devaluation. However, while the wrong
interpretation, some players could see the new basket as the first step in that
direction. Therefore, the announcement might not calm fears that, in any case,
appear to be self-inflicted.
o In times when rebuilding confidence is crucial, mingling with such a
sacred cow could just add too much noise.
o External and local debt will likely remain weak and volatile for the time
being until it is clear that the chances of economic recovery have not been
affected by the change in rules. We would focus on whether locals remain
nervous and switch out of peso deposits into US dollars.
The Announcement: 50% Euro, 50% US Dollar
Minister of Economy Domingo Cavallo announced over the weekend that the
government is ready to send a bill to Congress to expand the backing of the
Argentine peso to 50% US dollar and 50% euro. A draft of the bill that would be
sent to Congress includes only one important article (see below).
According to Merrill Lynch's currency forecast, the inclusion of the euro will
not happen in the next 12 months. Our Global Economic Team sees the euro as low
as 0.97 in 12 month's time; thus, the trigger of the double-currency backing
could not occur in the near future.
The Objective: Real Exchange Rate Volatility
According to the government, the move aims at reducing the volatility of the
real exchange rate, but not at targeting a level. One of the main issues
regarding the existing currency peg is that it ties the currency to a basket
(currently, only one currency) that it is not representative of the composition
of the country's exports. As a result, to remain competitive, Argentina had to
undergo deflation partially to compensate for the effect of the overvaluation
of the reference currency against the trade-weighted exchange rate. Given that
the new system will be balanced on two currencies, the volatility of the US
dollar against other world currencies will be smoothed. The chart on the next
column shows that had the 50%-50% basket been adopted at the beginning of the
Convertibility, the volatility of the real exchange rate would have been 1.5%
rather than 1.8%, i.e. 20% lower than it actually was.
However, more striking than the volatility differential is that of the level.
Had the basket been implemented 10 years ago, the real exchange rate would have
been 20% weaker. However, this ex post evidence was impossible to forecast at
the time. Also the euro was nonexistent.
The change in the basket does not imply a devaluation per se, given that the
peso could end up being stronger than the US dollar. Should the US$/EUR rate
continue with its current trend of reaching the one-to-one, the peso will be
stronger than the US dollar. In order to avoid a jump in the dollar value of
the currency at the time of the launch of the new backing, the government has
set the launching date when the US$/EUR parity reaches one. However, the parity
with the dollar could last as long as a second.
The new basket does not address the issue of competitiveness, which should be
dealt with structural reforms. Clearly, the deflation pressures come only
partially from the overvaluation of the dollar, as other factors like low
commodity prices, indexed public services, low labor flexibility, high
inflation during the first years of the currency board, and a high tax burden
are the result of other factors. For this reason, what Cavallo does with the
powers granted by the Competitiveness Law continues to be the most important
policy tool to improve Argentina's external position.
The Timing: It Could Be the Wrong Choice
While we recognize some long-term benefits of this move, its short-term
implications are, in our view, negative. In times when rebuilding confidence is
crucial, mingling with such a sacred cow could just add too much noise. The
government indicated that it accelerated the legal discussion on the topic to
confront market speculation about the government's plans for the currency. It
believes that given fears that the government was considering devaluing the
currency, the best alternative was to make as explicit as possible the idea of
the basket. We are concerned that, at this point in time, while the wrong
interpretation, some market players could see the basket-pegging as a first
step toward a devaluation.
Given our expectations that the new rule will not kick in within the next year,
it makes no sense to risk weakening consumer confidence at such a crucial point
in the economic cycle. The economy remains too dollarized and people continue
to think of the US dollar as the ultimate store of value. While it might make
sense to move away from such a myopic view, for the time being, there could be
a shift of energy toward hedging strategies, which were not needed before (by
those who believe that the one-to-one was immutable). For this reason,
investors should focus on locals reactions to the issue, particularly whether
there is a move out of pesos and into dollar deposits, or an increase in US$-
peso spreads.
On the negative side, in the eyes of many, the fact that Cavallo has shown that
the Convertibility Law is not carved in stone opens room for future, and not
necessary responsible, reforms of the law. While the core of the Convertibility
is, in our view, untouched - that is, there is still a rule in place that
forbids money printing financing of the government and discretionary transfers
of wealth among different agents through exchange rate policy - the law will
lose its sense of invulnerability. In the future, it will be less of a taboo to
discuss the Convertibility Law and to propose enhancements.
There is an increasing use of discretion in policy making by the current
economic team, which could set a dangerous precedent. Using discretion is not
necessarily bad, in fact developed countries enjoy the benefit of ample degrees
of freedom, but it assumes that institutions in Argentina are mature enough to
prevent a misuse of such discretion by less credible administrations. Recent
attempts to use the central bank as a source of financing could be perceived as
opening room for mingling with monetary policy in the future.
The Weights: Too Much Euro
While simple, the 50-50% weight does not jive with the export basket, or the
public-sector balance sheet. As the table below shows, only 14% of exports last
year went to the NAFTA countries (largely the US), compared to 18% to the EU.
It is thus likely that the appreciation of the dollar relative to most
countries in the world in the past two years has had some negative effect on
Argentine trade, especially to Europe. We note, however, that industrial
manufactures, which are typically more sensitive to the real exchange rate, are
largely sold to South America. This region accounts for 62% of the total,
versus just 11% for Europe. These have been performing relatively well, with
growth of 17% last year. In this sense, the government appears to believe that
the euro is a good proxy for all other non-US$ currencies. While the weakening
of the Brazilian real has mapped that of the euro for some time, this might not
be the case in the future.
(Panel 1)
Table 1: Argentina Product Exports by Geographic Region
Primary commodities Agricultural manufactures
Total
South America 46% 32% 22%
NAFTA 14% 6% 12%
EU 18% 25% 30%
Rest of World 23% 37% 35%
Total 100% 100% 100%
(Panel 2)
Table 1: Argentina Product Exports by Geographic Region
Industrial manufacts.
Fuel
South America 62% 71%
NAFTA 17% 21%
EU 11% 1%
Rest of World 9% 7%
Total 100% 100%
Source: INDEC
From a balance-sheet point of view, the government's liabilities continue to be
mostly denominated in US dollars. Therefore, a depreciation against the US
dollar could raise doubts about the currency mismatch of government
liabilities, and thus in its ability to pay.
Table 2: Public-Sector Debt Currency Composition
Currency Million US$ Percent
US Dollar 87,061 68.01
Euro 26,027 20.33
Peso 5,677 4.43
Yen 7,233 5.65
Other 2,020 1.58
Total 128,018 100.00
Source: Argentine Treasury
Copyright 2001 Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S).
All rights reserved. Any unauthorized use or disclosure is prohibited. This
report has been prepared and issued by MLPF&S and/or one of its affiliates and
has been approved for publication in the United Kingdom by Merrill Lynch,
Pierce, Fenner & Smith Limited, which is regulated by SFA; has been considered
and distributed in Australia by Merrill Lynch Equities (Australia) Limited (ACN
006 276 795), a licensed securities dealer under the Australian Corporations
Law; is distributed in Hong Kong by Merrill Lynch (Asia Pacific) Ltd, which is
regulated by the Hong Kong SFC; and is distributed in Singapore by Merrill
Lynch International Bank Ltd (Merchant Bank) and Merrill Lynch (Singapore) Pte
Ltd, which are regulated by the Monetary Authority of Singapore. The
information herein was obtained from various sources; we do not guarantee its
accuracy or completeness. Additional information available.
Neither the information nor any opinion expressed constitutes an offer, or an
invitation to make an offer, to buy or sell any securities or any options,
futures or other derivatives related to such securities ("related
investments"). MLPF&S and its affiliates may trade for their own accounts as
odd-lot dealer, market maker, block positioner, specialist and/or arbitrageur
in any securities of this issuer(s) or in related investments, and may be on
the opposite side of public orders. MLPF&S, its affiliates, directors,
officers, employees and employee benefit programs may have a long or short
position in any securities of this issuer(s) or in related investments. MLPF&S
or its affiliates may from time to time perform investment banking or other
services for, or solicit investment banking or other business from, any entity
mentioned in this report.
This research report is prepared for general circulation and is circulated for
general information only. It does not have regard to the specific investment
objectives, financial situation and the particular needs of any specific person
who may receive this report. Investors should seek financial advice regarding
the appropriateness of investing in any securities or investment strategies
discussed or recommended in this report and should understand that statements
regarding future prospects may not be realized. Investors should note that
income from such securities, if any, may fluctuate and that each security's
price or value may rise or fall. Accordingly, investors may receive back less
than originally invested. Past performance is not necessarily a guide to
future performance.
The bonds of the company are traded over-the-counter. Retail sales and/or
distribution of this report may be made only in states where these securities
are exempt from registration or have been qualified for sale. MLPF&S usually
makes a market in the bonds of this company.
Foreign currency rates of exchange may adversely affect the value, price or
income of any security or related investment mentioned in this report. In
addition, investors in securities such as ADRs, whose values are influenced by
the currency of the underlying security, effectively assume currency risk. |
