Argentina - Economic Briefing February 2002

Government Floats Peso and Promises Fiscal Dicipline as Unrest Persists

The government has succeeded in complying with two key conditions imposed by the International Monetary Fund (IMF) to begin negotiations for a new aid package: the passage of a new co-participation agreement with the provinces and the adoption of fiscal adjustment to the 2002 budget. Nevertheless, important barriers to any further aid remain as the government has not yet

The persistence of social and political unrest and the need to break the economic policy stalemate imposed by the deposit freeze (the so-called corralito), forced the Duhalde government to announce a new economic plan on 3 February via executive decree.  The new measures include:

-  Fully floating exchange rate regime.  The government decided to abandon the exchange rate policy announced in early January, which maintained an official exchange rate of 1.40 pesos to the US$ for export, import and capital transactions and another free floating exchange rate for tourism and other transactions.  The new exchange rate policy will allow for only one foreign exchange rate market and will let the peso float freely, permitting Central Bank intervention when deemed necessary.  The foreign exchange market will be accessible for import and export transactions but all financial operations that involve fund remittances abroad must receive Central Bank approval.  Additional monetary policy guidelines state that the target for expansion in the monetary base for this year will be 3.5 billion pesos (a 29.2% increase over 2001) and that the Central Bank will be required to report monthly to Congress on the progress of monetary policy.

-  The pesification of the economy.  According to the government, all US$ deposits will be converted to pesos at an exchange rate of 1.40 pesos to the US$.  Principal will be indexed on a Central Bank Reference Stabilization Coefficient (based on consumer price variations) and the Central Bank will be responsible for setting a floor on interest rates provided to depositors.  Depositors with balances up to US$ 30,000 can opt for exchanging balances for a US$-denominated, treasury backed bond.  Account holders will have free access to funds up to a limit determined by the monthly salary.  Salary, severance and workers’ compensation payments, as well as retirement and pension benefits, will no longer be subject to restrictions on withdrawals.  All US$ bills and coins held in banks are to be deposited in the Central Bank and will be converted to pesos at 1.40 pesos to the US$.  Furthermore, all US$ denominated loans are to be converted to pesos at an exchange rate of one to one with principal amounts indexed to variations in the consumer price index and interest rate caps set by the Central Bank.  Indexation will become effective in six months.  Moreover, US$ denominated government loans obtained from the sovereign debt swap in December last year can be voluntarily redenominated in pesos. 

-  Strengthening fiscal discipline.  The government commits to fiscal austerity and deficit reduction and has re-drafted the 2002 budget accordingly, the third draft since the end of last year.  Underlying the new 38 billion peso budget proposal is the assumption that GDP will contract by 5.6% this year and inflation will reach 15%.  Since tax collection is not expected to increase over last year, the draft contains a 10% across the board spending cut, a 1% cut to primary spending and a 30% slashing of outlays for goods and services.  The government has highlighted its intention to focus additional resources on social spending with outlays earmarked for a 1 billion peso employment programme, a 350 million peso food programme and a 50 million peso medical supply programme.  The government hopes to succeed in reaching a fiscal deficit of 3 billion pesos (approximately 0.7% of GDP given Consensus data).  The government also promises to introduce a comprehensive tax reform by the end of the year and to restructure the existing tax and customs administration.  Officials have also announced that they intend to progress on several structural reforms, most importantly, a new co-participation regime with the provinces and the adoption of new Central Bank statutes. 

Preliminary reports from Standard and Poor’s rating analysts estimate that the cost to the financial system of adjusting the deposits may reach approximately 16.1 billion pesos or approximately the system’s entire equity.  The government has said that the losses will be compensated for through the issuance of a US$ denominated bond and the conversion of government loans in financial institutions portfolios at an exchange rate of 1.40 pesos to the US$.  Even if the government is able to successfully lower the costs to the financial system, the longer term effect on the relatively weak Argentine credit culture is likely to further weaken the economy.

Currency tumbles in first month post-Convertibility

The peso lost significant ground in the first month following the introduction of the new currency regime.  In January, the free floating peso depreciated 49.0%, closing the month at 1.96 pesos to the US$.  A Supreme Court ruling on 1 February declared the government mandated deposit withdrawal restrictions an unconstitutional infringement on private property rights.  The ruling caused the currency to depreciate an additional 3% and prompted the administration to declare a bank holiday through 8 February.  The currency is expected to recover some lost ground in the first quarter but will, nevertheless, depreciate further by the end of the year.  The currency depreciation is seen to slow substantially in 2003.

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