Argentina’s Peso Crisis, Capital Flows and Financial Fragility in Emerging Markets
On May 4, the Banco Central de la Republica Argentina, the country’s central bank, raised policy interest rates to a whopping 40 percent to stem the rapid depreciation of the national currency, the peso. The surprise rate increase was the third in a week after the central bank failed to halt the decline in the peso by spending $4.3 billion of foreign exchange reserves in just one week. In addition, the Argentine authorities reduced fiscal deficit target and announced new measures to calm the markets.
Market observers were confident that rapid-fire rate hikes and other measures will restore currency stability, but the Argentine peso plunged more than 5 percent to a new all-time low at 23.5 against the US dollar on May 8, thereby prompted the government to seek financial support from the International Monetary Fund (IMF).
It is yet unclear what kind of financial support will be sought from the IMF, but it may entail substantial political cost as many Argentines blame the IMF policies for exacerbating the financial crisis of 2001 which deepened the recession and triggered social unrest and political instability. Since the IMF loans usually come with tough conditions and policy surveillance, the Macri government will find it hard to garner popular support given the widespread scepticism in the country towards the IMF.
However, one thing is clear: the impacts of rates hike would be immediately felt by the real economy in terms of higher financing costs and contraction of economic activity in Argentina for some time.
What Caused the Currency Crisis?
The current bout of currency volatility in Argentina was triggered by a surge in the US dollar along with market expectations that the Federal Reserve might raise interest rates more aggressively than previously expected ‒due to rise in bond yields and poor US inflation data. To some extent, the imposition of 5 percent capital gains tax on LEBACs (peso-denominated central bank notes) held by foreigners also added a downward pressure on the Argentine peso.
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