Argentina Tested as Peso Selloff Prompts Third Abrupt Increase

© Bloomberg. Federico Sturzenegger Photographer: Sarah Pabst/Bloomberg

(Bloomberg) — Pressure mounted on President Mauricio Macri of Argentina to do more to restrain government spending as the nation’s central bank raised interest rates for a third time in a week to stem a sell off in the peso.

Friday’s move is fresh evidence of how Macri, who rose to power with bold promises to revamp the nation’s economy, is trying the patience of global investors. More than two years into his efforts to revive South America’s second-largest economy, his government is suddenly being tested by an abrupt decline in the nation’s currency, the peso.

Behind the weakness is growing concern that the center-right leader has dragged his feet on some painful, deeper reforms — and that both inflation and government spending are spiraling dangerously high.

For the third time in less than a week, the central bank on Friday moved to shore up the peso after its two previous attempts had little effect. The currency had its worst decline since December 2015 on Thursday to reach a new low. It rebounded on Friday after the bank announced an additional 675 basis point-increase on its key interest rate to 40 percent, the highest among major economies. The peso jumped 4 percent to trade at 21.48 per dollar in morning trading in New York.

Still, the magnitude of the central bank moves underscores the challenges facing Macri as he attempts to improve the economy and roll back protectionist measures put in place by his predecessor, Cristina Fernandez de Kirchner.

“Investors gave Macri about a year and a half of a grace period to put the house in order. After that they started to worry,” said Claudio Loser, founding member and director of Centennial Group Latin America and a former head of the International Monetary Fund’s operations in the Western Hemisphere. “Now that the fiscal adjustment remains weak, inflation unwavering, and U.S. bonds more attractive, investors are evidently losing their patience.”

What the first two rate hikes failed to fully convey is a sense that government officials — not only at the central bank, but also at the treasury and finance ministries and the presidency — will be acting in a coordinated manner to tackle inflation and shore up finances, according to strategists, economists and traders.

It’s a disappointment to many investors who saw Macri’s election in 2015 and his promises to bring predictability and lure foreign capital as a turning point. For years, Argentina had suffered from state interference in the economy and lawsuits with disgruntled creditors that locked it out of international capital markets.

“External conditions will not accommodate the government’s strategy of gradually removing the country from its medicine — it’s time to rip the Band-Aid off,” said Sean Newman, a money manager who helps oversee $3.8 billion in assets at Invesco Advisers. “The pace at which the fiscal deficit is closed needs to be accelerated.”

On Friday, Treasury Minister Nicolas Dujovne announced Argentina will reduce spending on infrastructure by 30 billion pesos ($1.4 billion) this year and will find savings of about $3.2 billion. The government will target a primary fiscal deficit of 2.7 percent of GDP, lower than the previous target of 3.2 percent, Dujovne told journalists in Buenos Aires.

Alberto Ramos, the head of Latin America research at Goldman Sachs Group Inc (NYSE:)., said monetary policy needs to be accompanied by strong signals officials will shore up the budget.

It couldn’t come soon enough for currency traders, who have made the peso the worst performer in emerging markets this year as it sank 19 percent. The country’s overseas bonds — including a 100-year note it sold last year — are also among the world’s worst performers, and Telecom Argentina and Petroquimica Comodoro Rivadavia SA have had to postpone debt sales amid the carnage.

The central bank said in a statement the rate hikes were aimed at reducing volatility from external factors and making sure inflation heads toward the 15 percent target. The presidency said Thursday that it backs the central bank in its fight against inflation and reaffirmed that the bank is independent and has all the tools necessary.

High Inflation

The selloff has its roots in an unconventional move in December. That’s when central bank President Federico Sturzenegger, after pumping up rates to the highest in the world in a bid to rein in price increases, loosened inflation targets after coming under pressure from the government. In January, the bank cut rates by 1.5 percentage points, even as annual inflation running at about 25 percent showed no signs of abating. It’s accelerated since then.

Macri has stuck with a plan of only gradually tackling the government budget deficit, something he predicted would be made easier by quicker economic growth. But with analysts expecting the combined current-account and budget balance to exceed 10 percent of gross domestic product this year, investors are growing skeptical of the strategy.

“We’re in the emergency room now and we need bold moves to anchor the system,” Ramos said. “The policy mistake was cutting rates when inflation expectations were deteriorating rapidly. They’re now doing the right thing in order to bring order to the foreign exchange rate market and to regain some of the lost credibility, but it’s going to be tough.”

New Strategy

Before the recent surprise interest-rate increases the central bank had been relying on selling dollars in the currency market to try to buoy the peso. This year, they’ve spent $6.9 billion on the efforts, or about 10 percent of the country’s international reserves.

On Wednesday night, policy makers seemed to be rethinking that strategy and planning to reduce the amount of dollars they sell, according to people with direct knowledge of the matter. They say officials attribute peso’s decline mostly to external shocks.

And no doubt there have been global factors in the peso’s drop. Global pessimism toward riskier assets and renewed dollar strength have been factors. But also at play is an exodus of overseas investors from Argentina after a new income tax for foreigners took effect.

On the fiscal side, Macri is facing pressure from labor unions to boost salaries to keep up with inflation at the same he’s running into resistance against efforts to curtail energy subsidies and pass the higher costs on the consumers. Opposition lawmakers have put forward bills looking to partially roll back the price increases, a move that shook utility stocks. After talks with coalition members, Macri will allow consumers to pay increases in installments.

“If the government backslides on the fiscal area to ease people’s pain, the market will keep the pressure on,” said Greg Lesko, a money manager at Deltec Asset Management.