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Martin Rapetti, Guest Blogger

Not so long ago, Argentina was considered a case of economic success. In 2001-02, the country suffered a severe crisis — a triple crisis involving the financial sector, the public debt and the balance of payments — that ranks as high as the worst crisis in Argentina´s history. However, in early 2002, soon after the devaluation of the peso, the default of the public debt and the collapse of the financial system, the economy began a sustained and very strong recovery that later on evolved into strong economic growth. By the end of 2006, GDP was 46% higher than the trough of 2002 and 17% higher than the previous peak of mid-1998; unemployment had shrunk from 22% to 8.7%, poverty from 58% to 28%, and extreme poverty from 28% to 9%. It is not difficult to understand why the experience became a very successful example of crisis resolution, especially for countries in the periphery of the European currency union like Greece.

Argentina’s post-crisis experience also represented a successful reference in terms of its macroeconomic policy regime. In the first years following the crisis, the authorities pursued macroeconomic policies that aimed to maintain a stable and competitive real exchange rate (RER) as a means to promote the expansion of dynamic tradable activities and thus promote economic development. The competitive RER was a key factor behind Argentina’s recovery and growth. Many economists consider a macroeconomic framework targeting a stable and competitive RER more development-friendly than the conventional inflation targeting.

Unfortunately, Argentina’s successful economic experience gradually began to fade away. As in the plot of Mario Vargas Llosa’s classic book Conversación en La Catedral, it is hard to determine at what precise moment this experience “f—d itself up”. A possible turning point was in early 2007, when the government fired civil servants of the National Bureau of Statistics (INDEC) and began to manipulate the official Consumer Price Index to openly hide the acceleration of inflation (since then the official inflation rate has been below 10% per year when actual inflation oscillated around 20-25% per year. The manipulation was later extended to other official statistics, including GDP). But regardless of the precise date, the issue is that the government gradually turned to an increasingly populist path based on excessively expansive fiscal, monetary and wage policies that fueled inflation. Instead of moderating the pace of aggregate demand, the government increasingly relied on the exchange rate as the main nominal anchor to curb inflation. This strategy was especially intense in 2010 and 2011. During these two years, domestic prices rose 54% whereas the nominal exchange rate (i.e., the domestic price of US dollar) only 12%. As a result the RER appreciated significantly.

Both the high rates of inflation and the appreciating RER (together with some discretional measures) eroded the economic environment. In such a context, GDP, investment, private employment and real wages growth suffered a substantial deceleration. In late 2011, the economy got stuck in a stagflationary trap, in which it still remains. (You can read more about this phase here).

Many analysts believe that Argentina wasted a very unique opportunity to sustain the rapid growth that it had achieved in the first years of the post-crisis period. A widespread view is that the populist turn has generated increasing opportunity costs, which will continue being paid until 2015, when a new government takes office and introduces changes in the economic policy orientation. I understand this assessment, but think that the economic problems no longer reside in the opportunities lost, but in the imbalances that are being accumulated which would would likely end up triggering another economic crisis.

Let me pose my concerns by first explaining the situation in which Argentina travels since the months prior to the Presidential election of October 2011. At that time, there was a generalized perception that the economy was uncompetitive (expensive in international terms), that the RER was appreciating at a rapid pace and that sooner than later the exchange rate would have to be corrected upwards (i.e. devaluation). Because devaluation is unpopular, people believed that it would occur only after the elections. Trying to anticipate this move, the public ran against the foreign reserves (FX) of the central bank to buy US dollar. However, once Cristina Kirchner was re-elected with 54% of the votes, the government decided not to devalue the peso. The excess demand for foreign currency continued and the central bank kept losing reserves.

The government could have tried to correct the excess demand for foreign exchange with a devaluation. This option would have surely accelerated inflation, reduced real wages and contracted the level of activity and employment.  In other words, the correction of the overvaluation of the RER would have implied an adjustment of real wages and a contraction of employment. The government considered this option unpopular even after winning the election and decided instead to impose controls on both imports and on the acquisition of foreign exchange for saving motives.

Although the motivation may be socially fair, a critical issue is whether controls represent a sustainable solution. Latin American countries have experienced controls in the past. A lesson learned from these experiences is that they can be very useful when implemented under conditions of sound macroeconomic fundamentals. By sound fundamentals, I mean that relative prices —like the RER— are not misaligned and that fiscal and external balances do not follow unsustainable trajectories. However, experiences have also shown that controls not only fail to correct macroeconomic imbalances, but also tend to aggravate them.

Take, for instance, the case of controls on the FX market to avoid devaluation when the RER is overvalued. Controls force a cut production by those who require FX to carry out their economic activities and have no access to the official market. Controls also imply that exporters are forced to sell their proceeds at an exchange rate that generates little profit or even losses. It is not difficult to see that in these circumstances, agents have incentives to leave the market. Why make a transaction in which I lose money? Controls therefore end up debilitating or destroying existing markets and stimulating the creation of others: black markets. Black markets undermine transactions and shorten planning horizons, thus negatively affecting the level of activity and employment. Historical evidence also shows that the black market exchange premium tends to increase the tighter controls are and the stronger the imbalances are. The widening of the premium is especially problematic because it generates incentives to reduce the supply and increase the demand in the official FX market. Exporters have incentives to postpone and under-invoice their proceeds and importers to anticipate and over-invoice their purchases. Firms and banks also try to have access to the official market to cancel up-front foreign debts. The proliferation of this kind of strategy creates a feedback loop that exacerbates the excess demand in the official market, the fall of central bank’s reserves, and the rise of the black market premium. At some point, when the stock of reserve is close to being exhausted, the central bank has no choice but to devalue. In most Latin American experiences, this devaluation has taken a traumatic form, involving large exchange rate overshooting, sharp accelerations of inflation and harsh drops in the real wage, economic activity and employment. (Those who read Spanish can see my entry on macroeconomic of populism in my blog).

We have been observing this stylized path in Argentina since the authorities started introducing controls in the FX market in late 2011. The black market exchange premium has been rising systematically, and it is around 70% (i.e., the official exchange rate is 5.3 AR$/US$ and the black market rate is around 8.7-8.9 AR$/US$). Central bank’s international reserves have been falling non-stop and are now equivalent to 6.7 months of imports, which is lowest figure in the last 18 years. It is common these days to hear stories about export under-invoicing, import over-invoicing and anticipated foreign debt cancelation.

Unfortunately, I believe that a devaluation-inflation crisis is very likely. The government is neither conscious of the probability of this kind of crisis, nor willing to correct the imbalances that can cause it. My fear is that as time goes by, the correction (i.e., a real devaluation) will end up being very traumatic. Here is why I think so. Because of the controls, many firms and households have been allocating their savings in domestic assets, instead of US dollar, which is the most common saving instrument in Argentina (portfolio dollarization is the result of a long history of high and persistent inflation). Because of this, M3 (broad money) in pesos has grown about 60% since October 2011 and the M3 to FX reserves ratio has jumped from 1.9 to 3 (i.e., M3 valued at the official exchange rate is now 3 times the stock of foreign exchange reserves of the central bank). My fear is that this “undesired” demand for the peso could dramatically fall if the private sector expects that the exchange rate will jump. To put it bluntly: there is no escape to a real devaluation; it could happen via either devaluation or a currency crisis. In either case, the most likely behavior for the private sector would be to switch its M3 holdings for US dollar. Given the relatively low stock of central bank’s reserves, this portfolio switch would add a very strong upward pressure on the exchange rate, which would most likely pull domestic prices up. The RER would overshoot, negatively affecting real wages and employment. This is the kind of inflationary crisis I am in fear of. I hope I’m wrong.

Martin Rapetti is an Associate Researcher at the Center for the Study of the State and Society (CEDES) and an Assistant Professor at the University of Buenos Aires, Argentina. He is interested in macroeconomics, finance, economic development and Latin American economics.

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