Argentina pegs out

An announcement of a package of economic measures from Argentina, including one that mimics a devaluation of the currency, has rattled financial markets. Is the next emerging-market crisis taking shape?

IT IS a well-known principle among central bankers and finance ministers that if you are planning to devalue your currency, you must deny as stalwartly as possible that you have any intention of doing so. For good reason: why allow currency speculators a one-way bet at your taxpayers' expense? Argentina has taken this notion one step further: it has introduced a subsidy for exporters and a tariff for importers, while denying this amounts to a devaluation. Whether the strategy works is vital for Argentina's hopes of climbing out of a recession, and for avoiding another financial crisis that would have the potential to unsettle markets elsewhere. Argentina's borrowings constitute more than a fifth of the index of tradable emerging-market debt.

Yet for most of the 1990s, Argentina was seen as an emerging-market success story, a former basket case that had been rehabilitated and trod the path of stability and growth. Much of the credit for that was given to a convertibility law, passed in 1991, that pegged the currency, the peso, at a rate of one to the dollar, by means of a currency board (in other words, every peso in circulation had to be backed by a dollar in reserves). The policymaker who basked in the peg's reflected glory was its designer, Domingo Cavallo, who was minister of the economy from 1991-96. So when Mr Cavallo was recalled to his old job in March this year to rescue the economy from a three-year slump marked by a 15% unemployment rate and punctuated by occasional market panics, hopes were high that a saviour had been found.

Mr Cavallo, a charismatic and popular if short-tempered minister, is known for his unorthodox approach. And the orthodoxy he has sought to attack this time is the one he established himself: the rock-solid but inflexible currency peg. Late on Friday 15th June he announced a package of measures to stave off a potentially disastrous debt default, boost competitiveness and revive growth. This involves, in effect, tinkering with the exchange rate through a fiscal mechanism called a “convergence factor”. Exporters will be able to claim a reimbursement when they convert their dollar receipts into pesos, equal to the average of the peso-dollar and peso-euro exchange rates. At present, the exporter would receive about seven extra pesos for every $100. The same procedure will apply in reverse for imports, which will become more expensive, though the effect will be offset by cuts in import tariffs.

Whatever virtues the system may have, simplicity and clarity—among the great advantages of the peg—are not among them. The reform follows a one-paragraph piece of legislation sent by Mr Cavallo to Congress in April, which would peg the peso to a currency basket made up in equal parts of dollars and euros. Mr Cavallo denies that the law amounts to a covert devaluation since it would only take effect when (or should that be if?) the euro reaches parity with the dollar. Even now, he denies that there has been any modification to the exchange-rate system since “one peso will continue to be equivalent to one dollar”, and the “convergence factor” will disappear as the euro appreciates against the dollar.

However, the measure is explicitly a response to some of the pain that the peg has brought in recent years. The peso has looked especially overvalued since Brazil allowed its currency, the real, to float in early 1999. The real has since fallen by about 50% against the dollar, and this week has reached new record lows in response to worries about Argentina's reforms. Mr Cavallo himself has estimated that the peso is 20% too expensive. But his is a high-risk strategy. The danger is that, in boosting exports, he sows uncertainty about Argentina's most secure policy anchor, the exchange rate. Many note that in the past, dual-rate regimes in other countries such as Brazil, Venezuela and China have had poor records: they offer too many invitations for arbitrage, fraud and abuse.

It is not only traders that may look askance at Mr Cavallo's move: the IMF and American Treasury also find themselves in a tough position. However much they disapprove of the measures, they can hardly say so in public for fear of the market reaction. On June 19th a senior Treasury official admitted there was “a difference of opinion” about them.

Mr Cavallo's priority is a return to economic growth—to which end his latest measures include a range of cuts in both income and consumption taxes. He argues that the extra revenue his reforms will generate will mean that the government will “strictly” meet the budget-deficit target it has agreed for 2001 with the IMF. Last December the Fund agreed a $40 billion rescue package with Argentina. That, combined with a massive refinancing early this month of much of its commercial debt by swapping it for longer-dated bonds, should enable Argentina to avoid a catastrophic default. But there is still no clear evidence that the economy is about to pull out of recession, and without growth, fiscal targets, debt-service commitments and now, perhaps, the exchange rate, will all come under pressure. In that context, Mr Cavallo's measures look like a rather desperate gamble.