World News

Argentina Raises Key Rate to 40%, Bringing Economic Uncertainty

Posted May 4, 2018 4:08 p.m. EDT
Updated May 4, 2018 4:12 p.m. EDT

BUENOS AIRES, Argentina — In a bid to stabilize the country’s currency, Argentina’s central bank on Friday increased its benchmark interest rate to 40 percent, dampening the prospects for President Mauricio Macri’s ambitious economic reform agenda.

It was the third rate increase in a week, and came a day after the Argentine peso fell 8.5 percent against the dollar. The central bank said it would use “all the tools at its disposal” to slow inflation, which reached 25 percent in March, to 15 percent this year, a goal most analysts now see as unrealistic.

In parallel, the ministers of treasury and finance announced that they would aggressively cut government spending, and reduce the primary budget deficit to 2.7 percent. Their decision was seen as a response to criticism from investors that Macri’s government had not been cutting spending quickly enough.

Macri was sworn into office in December 2015 with grand plans to open the economy to the world. Argentina had been closed to international markets for more than a decade amid a long-running legal fight with bondholders that followed a default on its debt in 2002.

Early on, Macri’s policies — which included ending capital controls intended to keep money from flowing out of the country, and restarting publication of accurate government economic data — were greeted with widespread optimism by financial markets.

Initially, the currency fell, but then stabilized. And in a show of market confidence, prices for the country’s government bonds rose, pushing interest rates lower. Those lower rates helped to stimulate economic growth. Argentina was even able to borrow in the international markets again, raising $16.5 billion by selling debt in 2016.

“There was overconfidence on the part of policymakers about how much could be done given the constraints they had,” said Alvaro Vivanco, a strategist for covering Latin American bond and currency markets for the Spanish bank BBVA.

In recent months doubts about the government’s commitment to reform have emerged. In January, Argentina’s central bank cut interest rates and increased its inflation target, a move interpreted by some as weakening the government’s commitment to getting consumer prices under control.

“The central bank was cutting, with inflation expectations deteriorating,” said Gabriel Gersztein, head of Latin American strategy at BNP Paribas. “And this was a wake up call for international investors.”

The global economic backdrop was also changing. With the U.S. economy on solid footing, its short-term interest rates are rising. That puts upward pressure on the U.S. dollar, and also resulted in a slide for the peso. That decline in the peso has accelerated in recent days, as foreign investors began to see their returns vaporized by the falling currency.

More people moved to the exits, in part related to a new income tax on foreign investors. And as they began to pull out en masse, Argentina was suddenly facing a currency run.

Governments have a few tools they can use to stem the outflows of capital. One of them is to sharply raise interest rates. Those higher rates translate into potentially stronger returns for investors. As such, they can attract money into an economy, which helps to prop up a currency.

But it’s a tricky play to pull off.

Brazil raised interest rates sharply to stop an outflow of capital in the late 1990s, ultimately pushing benchmark interest rates to roughly 40 percent. More recently, in 2014, Turkey suddenly ratcheted a key central bank rate from 4.5 percent to 10 percent, to stop a sell-off in the lira.

That same year, the Central Bank of Russia pushed interest rates sharply higher — from 10.5 percent to 17 percent — to keep the ruble from collapsing in response to sanctions over the annexation of Crimea and a sharp drop in oil prices. Russia also has one of the biggest interest-rate jumps on record, when in 1998 its rates reached 150 percent in an effort to try to stem another impending collapse of the ruble.

But high interest rates have economic costs. They makes it particularly difficult for businesses and consumers to borrow money. The lack of spending, in turn, can slow growth, and can ultimately spark a recession.

The key for Argentina will be to keep rates high just long enough to inspire confidence that policymakers have halted the currency run, but not so long that it drains the economy.

“This was done in order to stop the bleeding. It’s like you have someone in the ER. You need to take very short-term, bold decisions,” said Gersztein, of BNP Paribas. “Then once you stabilize the patient, you need to take different decisions in order to make the patient get better and recover.”