Oct 23 / Alef Dias

Macroeconomics Weekly Report - 2023 10 23

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"Massa's lead in the first round gives him the incentive to postpone the realignment of the official peso rate. After a devaluation of almost 20% following the August primaries, the official peso was frozen at 350 per dollar. High inflation has eroded its competitiveness, and the currency is now almost 10% stronger than before the primaries, in real effective terms."

Surprise in the first round raises uncertainty in Argentina

  • Once again, the Argentine elections brought surprises as the candidate of the situation, Sergio Massa, pulled off a surprising victory, in the first round, beating Javier Milei - that was ahead in most polls.
  • Massa's partial victory could delay the revision of the official Argentine peso rate. Rising inflation has undermined the currency's competitiveness, making it almost 10% stronger than before the primaries. Although an increase in interest rates is likely, in order to impact the parallel market and inflation, it must be substantial enough to offset the increased political risk.
  • Regardless of the outcome of the second round on November 19, Argentina faces the need to implement significant reforms to its fiscal policy in order to overcome the current economic crisis. The absence of a solid and transparent fiscal plan could worsen the crisis if there are abrupt changes to exchange control policies.

Introduction

Another surprise at the polls in Argentina will prolong the already high political uncertainty for another four weeks. The result of the first round - with Economy Minister Sergio Massa in first place and libertarian Javier Milei in second - is possibly the worst-case scenario for the markets.

Most polls showed Milei - who surprised with a victory in the August 13 primaries - in the lead. One of the main conclusions of the primaries - that support for the government was waning - is now weaker.

First round developments

It is not expected that either candidate will provide detailed details about their political plans before the second round on November 19. In the meantime, Massa could reinforce his populist approach of an artificially strong peso, interventionism and high fiscal cost measures.

Massa's lead in the first round gives him the incentive to postpone the realignment of the official peso rate. After a devaluation of almost 20% following the August primaries, the official peso was frozen at 350 per dollar. High inflation has eroded its competitiveness, and the currency is now almost 10% stronger than before the primaries, in real effective terms.

A further increase in the interest rate is a possibility - with few dollars in the reserve coffers, the government may want to increase financing costs to reduce demand for dollars and relieve pressure on the parallel markets.

The reaction of the parallel peso markets will depend on whether the combination of a frozen official exchange rate and potentially higher interest rates drives a carry trade that overcomes the high electoral uncertainty and additional monetary issuance - especially if Massa accelerates his spending policy ahead of the next vote.

Image 1: Official and Parallel Argentina Exchange Rate (USD/ARS)

Source: Refinitiv


A further weakening of the peso in the parallel markets could push inflation even higher in the October and November readings - with monthly figures possibly in the double digits for four consecutive months - and make policymakers' task of controlling rising prices much more difficult. Annual inflation rose to 138.3% in September, and the consensus forecast in the central bank's latest survey of analysts is for it to close the year at 180.7%.


Fiscal policy is the new administration's main issue

During the presidential campaign, the debate on dollarization took center stage. After the election, the new president will have to prioritize a fiscal plan. Premature changes to the exchange rate regime or a change in the approach to fighting inflation, before there is any clarity on a fiscal plan, would probably limit the effectiveness of these new policies.

Image 2: Inflation and Policy Interest Rates (%)

Source: Refinitiv

Argentina's budget has been in the red for more than 10 years. The government's latest measures, which include tax cuts and higher public spending, will take the primary deficit to over 3% of GDP. This puts the next government in a difficult situation, and it will have to act quickly.

A balanced budget for 2024 is needed to curb the reliance on currency issuance to finance the deficit - one of the main factors behind Argentina's triple-digit inflation. A large primary surplus is needed to stabilize public debt, especially if the new government stops maintaining an artificially strong currency and the central bank keeps real interest rates well above zero.

Any fiscal plan must be credible in order to create confidence in the next Argentine government, stimulate savings and investment in pesos and attract capital flows. The new government will also have to clarify how it intends to refinance the country's short-term debt, mainly domestic, and deal with the primary deficit in the meantime.


Image 3: FX Reserves (bi USD)

Source: Refinitiv

A weaker peso and the realignment of regulated prices - fundamental to any fiscal plan - will probably keep inflation very high at first. The Central Bank of Argentina (BCRA) will tend to raise interest rates to control inflationary pressures, reduce the demand for dollars and attract investors to finance the public debt. The extent of monetary tightening will depend on how much the fiscal plan and monetary measures reduce inflation expectations.


Exchange rate policy depends on fiscal credibility

Javier Milei proposed dollarizing the Argentine economy. This would mean exchanging the pesos in circulation for US dollars. This seems like a risky move, given that Argentina's international reserves are historically low, or even negative, when you take into account the BCRA's liabilities. The situation is even worse when you take into account the delays in import payments - which the country will eventually need to settle.

Removing all exchange controls at once could lead the currency into a devaluation spiral in the absence of a reliable fiscal plan and a clear exchange rate policy. Committing to a specific date for removing controls would probably lead exporters to "delay" their sales in order to obtain a more advantageous exchange rate.

Alternatively, Argentina could maintain the current exchange rate policy - which should happen with the election of Sergio Massa - but given all the current macroeconomic imbalances, this policy would hardly continue for long, requiring some realignment. The current official exchange rate is 35% less competitive than when President Alberto Fernandez took office in December 2019.

Conclusion

Once again, the Argentine elections surprised most economic and political analysts, as the situation candidate - Sergio Massa - came first in the first round, ahead of Javier Milei. Milei had won the primary on August 13 and was ahead of Massa in most polls. Both candidates will run in the second round on November 19.

Massa's lead in the first round could postpone the realignment of the official Argentine peso rate. High inflation has eroded its competitiveness, and the currency is now almost 10% stronger than before the primaries. A further increase in the interest rate is a possibility, but to have an effect on the parallel exchange rate and inflation it must be high enough to compensate for the greater political risk.

Regardless of the outcome on the 19th, Argentina needs drastic changes to its fiscal policy to reverse the current economic crisis. Without a credible and clear fiscal adjustment plan, abrupt changes in exchange control policies could deepen the economic crisis.
Given all these uncertainties, the differential between the parallel and official exchange rates is likely to continue accelerating in the short term, discouraging Argentina's export sectors from accelerating their sales.

Image 4: Budget Balance Argentina (% GDP)

Source: Bloomberg

Weekly Report — Macro

Written by Alef Dias
[email protected]
Reviewed by Victor Arduin
[email protected]
www.hedgepointglobal.com

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