Devaluation Risk Rising
A worst-case scenario in Argentina.

Mr. Malpass is the Chief International Economist for Bear Stearns.
November 5, 2001, 8:45 a.m.

rgentina appears to be moving into a default process, and the probabilities have shifted toward devaluation (a worst-case scenario) rather than dollarization (which would lower interest rates, increase tax receipts, and improve bond yields).

An Argentine default, if it occurs, will have a materially negative impact on Brazil’s economy and financial markets as expectations for an eventual Brazilian restructuring rise. An Argentine default would also add to the pressure on Brazil by decimating Argentina’s GDP level and increasing the size of the “haircut” on Argentina’s bonds (and, by implication, the bonds of even-more-heavily-indebted Brazil.)

Late last week, Argentina President Fernando de la Rua once again ruled out the “three d’s”: dollarization, devaluation and default. The markets were unconvinced. The price of the FRB Brady bond fell by 9% to 48, yielding 55%.

By ruling out dollarization, the likelihood of a devaluation and a worse restructuring outcome has increased. Argentina’s currency board has been dysfunctional now for over six months. In a properly functioning currency board, interest rates fall to the reference rate (in Argentina’s case, the U.S.). By taking dollarization off the table, and by taking steps to add the Euro to the convertibility system, confidence in the currency board has been reduced.

This loss of confidence in the peso can be seen in the sharp rise in short-term peso interest rates during 2001. The one-week peso rate spiked to 160% last Thursday, up from 55% on Wednesday. In a similar fashion, the three-month forward peso is trading at 1.20 pesos per dollar. This implies a 70% probability that the peso will be devalued (assuming 2 pesos per dollat) over the next three months.

A devaluation would make a bad situation worse. The “haircut” — the reduction in the value of the sovereign bonds — would be substantially greater under a devaluation than under a dollarization. This is because the haircut has some relationship to the country’s future GDP level, which would be substantially shrunk by a devaluation.

Polls show that the Argentine public supports the currency peg, since it is a promise of monetary stability. The credibility of the government would be severely damaged in a devaluation. This loss of credibility would spark a bank run not just on peso deposits but also on dollar bank deposits, as the fear of a freeze on bank deposits grows. Since the announcement of the IMF package in August, there has been a $2 billion rebound in dollar deposits. A devaluation would reverse that process, bringing instability and reducing wealth.