 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.
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