Thinking the Unthinkable in Argentina

For more than a decade, no matter how dire the straits Argentina's economy was in, one option was unthinkable--devaluation. Miserable memories of hyperinflation made the rigid regime that locked the peso's value at $1 sacrosanct. Argentines, delighted at the stability and buying power of a peso with greenback characteristics, never dreamed the dollar peg could become a trap.

All that changed on Nov. 1, when a solemn President Fernando de la R?a asked Argentina's foreign and domestic creditors to accept lower interest rates and longer maturities on some $95 billion in bonds. With that--effectively the largest sovereign default in history--Argentina surrendered to market forces. For nearly four years, successive governments tried to impose enough fiscal austerity so Argentina could pay its national debt--now $132 billion. But that put the economy into perennial recession. Joblessness is 16.4%.

HOT TOPIC. Now, the government has admitted it can't sustain its old policies, of which the dollar peg is the last vestige. As Argentina's officials try to put South America's second-largest economy back on track, all bets are off. de la R?a and Economy Minister Domingo Cavallo keep repeating the no-devaluation mantra. But the peso's future is the hot topic for everyone from editorialists to cab drivers. Worried Argentines are stashing cash in mattresses again, just like in the bad old days. "Overnight, we've gone from three years of agonizing recession to rapid implosion," says Benny Thomas, Latin American equity fund manager for T. Rowe Price International Inc. "Who's not looking at the currency issue?"

Emerging markets from Brazil to Taiwan rebounded when the de facto default, which investors expected for at least a year, didn't spark a global market meltdown. But there is little relief in Argentina, where investors now want 2,500 basis points over the yield on U.S. Treasuries to hold Argentine debt, up from 1,825 before the default news. Many investors doubt the proposed debt swap, supposed to save $4 billion in interest costs, will free up enough cash to stimulate Argentina's $280-billion economy.

All this leads to the question of what to do about the dollar peg. Economists say that to get the economy moving, Argentina must free itself from the stranglehold of an overvalued currency. Since the 1994-95 Mexican peso crisis, most emerging markets have devalued or floated their currencies, while the dollar has strengthened. The harshest blow came in January, 1999, when Brazil, Argentina's biggest trading partner, floated the real, making Argentine exports uncompetitive and sending manufacturers fleeing across the border.

One reason the government still insists it will keep the peg is that outright devaluation has such alarming implications. Indeed, officials say they would rather just adopt the dollar as the nation's currency. Devaluation would boost exports. But it would have a brutal impact on households and the banking sector, since 65% of private-sector debt is in dollars, including mortgages and car loans. Argentines would suddenly have to pay off these loans in devalued pesos. Many would default, leaving banks with ballooning numbers of bad loans.

Theoretically, nothing stops the government from sticking to convertibility and defending the peso with overnight interest rates as high as 120%. Eventually deflation would make Argentina competitive again. But consumers don't trust the government's resolve. Fearing a default will weaken banks, which hold a good deal of public debt, they have been spiriting money out of the country. Deposits fell 11%, to $76.8 billion, from late June to Oct. 26, and an additional $1.9 billion the week before the Nov. 1 debt-exchange announcement.

The more cash flees, the shakier the peg. "Abandoning the currency peg is inevitable unless something miraculous happens and capital flight is reversed and interest rates are brought down soon," says Amer Bisat, emerging-market debt portfolio manager at Morgan Stanley Dean Witter & Co.

Privately, analysts say the dollar peg's end could be weeks away. Reserves must stay above $10 billion for the government to be able to defend the peso, they say. At just under $18 billion, reserves are at their lowest level in five years.

CHOICES. The question is: What shape would a new Argentine currency regime take? There are three choices: outright devaluation; adopting the dollar at the current rate; or adopting the dollar but at a less than 1-to-1 parity. The easiest to implement would be dollarization at current parity. That would eliminate the currency risk on Argentina's debt so rates could come down. "You'd immediately eliminate the risk premium of a devaluation from fanning out over the rest of the economy," says Steve H. Hanke, an economics professor at Johns Hopkins University in Baltimore who advised Cavallo in creating the currency board. "It's the quickest and cleanest way out of the mess."

But dollarization would also lock in the uncompetitive cost structure everyone agrees Argentina can't sustain. For the policy to work, say Hanke and other proponents, politicians would need to get serious about the budget. "What Argentina needs to do is the same thing it has had to do for the past 10 years--cut spending and return the savings to the private sector [through] lower taxes," says Abel Viglione, senior economist at Buenos Aires think tank Fiel. Meanwhile, dollarization at less than 1-to-1 would make Argentina more competitive, but wouldn't fix its fiscal profligacy.

Analysts say the real danger would be from a sloppily orchestrated devaluation. That may be where Argentina is heading. The government has authorized the cash-strapped provinces to pay workers in one-year notes that circulate like currencies on par with the peso. Soon the federal government will introduce its own version of Monopoly money, called Lecops, to pay monthly transfers to the provinces. This scrip increases the money supply--and it isn't backed by dollars, unlike the peso. "It's easy to see how this could get out of hand fast and lead to the emergence of a parallel currency," says Christian Stracke, Latin America strategist at Commerzbank in New York. In that case, inflation could resurge, and foreign investors would completely shun Argentine assets.

One way to limit the fallout from devaluation would be to combine it with an immediate dollarization, at the same time revaluing dollar-based obligations at the new exchange rate. In other words, if the peso were devalued by 20%--which analysts say is the minimum needed to be effective--a $100 debt would be reduced to $80. Although some parties, especially the banks, would suffer, a deadly chain of bankruptcies would be avoided. Says economist Barry Eichengreen, an influential emerging-markets expert at the University of California at Berkeley: "It would be a radical step, but the time for radical steps has come." Argentina is in a deep, deep hole. By Joshua Goodman in Buenos Aires, with bureau reports

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