Argentina: the pace of devaluation?

There are various forces working both for and against the Argentine peso (ARS). However, according to HSBC Research the base case scenario is that the ARS will weaken from its current levels against the US dollar.

The implied exchange rate of ARS, via the bond market, decreased from being more expensive (to buy US dollars) than the official spot rate, to cheaper. This means that the implicit exchange rate has increased from the ratio between the price in ARS of a US dollar-denominated bond.

The gap between the implicit exchange rate and the spot rate is strongly influenced by the so-called 'contado con liquidación' market by which investors move US dollars in and out of the Argentine market.

A typical trade to wire US dollars out will imply purchasing a US dollar-denominated bond in the Argentine market and sell it offshore to receive US dollars. Therefore, a ratio larger than one implies capital outflows and vice versa (other things being constant).

The implication is that financial capital inflows are resuming following outflows witnessed in the sell-off of recent months. In addition, the decline in volatility confirms what the foreign exchange implied rate via the bond market is suggesting, given the noteworthy correlation between a decrease in volatility and capital flight.

Neighbouring currencies, in particular the Brazilian reais, have recently resumed their appreciating path relative to the US dollar. Given the importance of Brazil as a trading partner of Argentina, this importantly relieves the government of the need to offset competitiveness lost by higher relative inflation.

The government is implicitly targeting the multilateral trade-weighted real exchange rate. The trade-weighted real exchange rate (as measured by the central bank) weakened 0.8 per cent in July and 5.3 per cent in the last 12 months. The weight of Brazil within that index is 35 per cent.

Another supportive factor for the peso is the Argentine government's need to keep a lid on inflation. In fact, the wholesale price index is strongly correlated with the nominal exchange rate. In addition, the stability of the price agreements in place is contingent on stable production costs. As the wholesale price index is a good proxy for corporate costs, a weaker peso would translate into higher production costs and therefore less stable agreements among the government and companies. Therefore, the need to avoid cost-push inflation acts as a constraint against a weaker Argentine currency.

As well as these forces acting to support the ARS, there are other conflicting forces that appear to be weakening the currency. During the second half of the year, US dollar proceeds from exporters are lower due to seasonal effects. As the harvest season ended later this year, it typically ends at the end of July, heavy US dollar sales continued until end-August.

US dollar monthly sales were of $1.1 billion during June-July, however, this should decrease to around $600 million a month until the end of the year. As US dollar sales subside, there will be less pressure on the ARS to appreciate.

The Argentine central bank is expected to continue purchasing US dollars aggressively, both to preserve the currency's competitiveness - a weak peso is the cornerstone of economic policy - and as a means to build foreign exchange reserves, a policy goal monetary authorities have verbalised several times.

Argentina's international reserves stand at US$27 billion and it is expected that officials will target US$30 billion by the end of the year. This implies average monthly purchases of US$600 million that coincides with estimates of US dollar inflows from grain exporters.

While such aggressive intervention to buy US dollars might raise monetary policy concerns, the recent increases in reserve requirements have significantly eased the pressure to sterilise this activity through the issuance of central bank bills and notes.

Factoring in the pros and cons, the belief is that what is in store for the peso is only a marginal weakening against the US dollar. That is consistent with single-digit inflation and stronger currencies in neighbouring countries.

The Argentine central bank will continue to aggressively purchase US dollars to maintain a competitive real exchange rate (proxied by the trade-weighted real exchange rate). Argentina's reserves should reach US$30 billion by year-end. Barring sharp changes on the external front, whether the nominal exchange rate will be at the ceiling or the bottom of the forecast band will ultimately depend on the performance of portfolio flows and the level of private demand for US dollars.

This report was compiled by Peter Calleya, manager, Corporate Strategy & Research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.