MICHAEL JOSEPH BELLANTONI

APRIL 14, 2014

Argentina Slips. Will Brazil Stumble? The Argentine peso experienced an 11 percent drop against the U.S. dollar on January 23 2014, its sharpest decline since the country’s colossal 2002 sovereign default. As the peso fell, so did Argentina’s foreign reserves, reaching a seven-year low of $28bn that same month. This free fall of both the exchange rate and foreign reserves makes the peso unaffordable, resurrecting fears of another balance of payments crisis. In total, the peso fell by approximately 17 percent between January 20 and January 24, prompting Jorge Capitanich, Argentina’s Chief of the Cabinet of Ministers, to announce the country’s attempt to stop the bleeding. Capitanich’s proposed solutions include reducing the tax rate on dollar purchases from 35 to 20 percent and allowing the purchase of dollars for the first time in two years. In total, the peso fell from approximately 6 to one dollar to over 8 to one dollar. Furthermore, inflation continues to remain a growing problem in Argentina. Inflation was recorded at 3.7 percent in January 2014 over the previous month, reaching its highest level since Argentina’s 2002 sovereign default. The Argentine government is currently reworking its price index in conjunction with the International Monetary Fund (IMF) to formulate more accurate and realistic price data. If Argentina cannot right its macroeconomic ship, should Brazil be worried? Given Brazil and Argentina’s extensive trade history and presence in Mercosul another Argentine crisis could have another contagion affect on Brazil similar to the one Brazil experienced during the 1998 – 2002 Argentine financial crisis. However, Brazil’s macroeconomic situation is stronger and more stable than it was over a decade ago, making it more resilient in the event of an economic meltdown of a strategic trade partner and regional neighbor.

Background: Brazil, Argentina and Mercosur Trade between Brazil and Argentina exploded in the wake of Argentina’s financial crisis, growing 290 percent between 2003 and 2013. More than 8 percent of Brazil’s exports head to Argentina. Specifically, the primary exports destined to Argentina include cars, iron ore, and aluminum.

Brazil's Trade with Argentina! (USD Millions FOB)! 25,000   20,000   15,000   Exports   10,000  

Imports  

5,000   0  

Source:            The  Brazilian  Ministry  of  Development,  Industry,  and  Trade  

     

Brazil and Argentina are also the two main players in Mercosur, the economic and political agreement among Argentina, Brazil, Paraguay, Uruguay, and Venezuela. As such, Brazil and Argentina exhibit considerable amount of power over the organization. However, trade through Mercosur for both countries has fallen in recent years. Brazil in particular experienced a 5 percent decrease in exports and an 18 percent decline in imports between 2013 and 2014. The vast majority of Brazil’s trade within Mercosur comes directly from Argentina, highlighting the importance of the trade partnership between the two large South American economies.

2    

Argentina  Slips.  Will  Brazil  Stumble?  

Brazilian Trade Balance, 2013 / 2014! (USD MIllions FOB)! 1,800     1,600     1,400     1,200     1,000     800     600     400     200     0    

Exports   Imports  

Mercosur         (2013  /  2014)  

Argentina       (2013  /  2014)  

Paraguay         (2013  /  2014)  

Source:            The  Brazilian  Secretary  of  Foreign  Trade  

Uruguay             (2013  /  2014)        

Argentina’s Vulnerabilities  

Argentina is currently experiencing symptoms that are reminiscent to those prior to its

1998 – 2002 financial crisis. Indeed, Moody’s cut Argentina’s bond rating in March 2014, citing that the sharp drop in the country’s central bank dollar reserves created apprehension about Argentina’s ability to service its foreign debt. The credit agency downgraded Argentina’s rating from ‘B3’ to ‘Caa1,’ revising its outlook from stable to negative. A Caa1 rating indicates poor quality and very high credit risk, according to the credit agency.

Unstable Exchange Rate The peso has officially traded slightly above 8 pesos to one dollar since the end of March. At the same time, Argentina heavily relies on its illegal currency called the “blue dollar,” which is an informal market that trades pesos for dollars. This rate has also depreciated in response to government action, further eroding investor confidence in the peso. In mid April the blue dollar has been trading about 29 percent above the official rate.

Official Dollar vs. "Blue" Dollar! 14  

Peso to USD!

12   OFICIAL  

10  

BLUE  

8   6   4   2   0  

July-­‐13  

August-­‐13  

September-­‐13   October-­‐13  

Source:            DolarBlue.net  

November-­‐13   December-­‐13  

January-­‐14  

     

 

If depositors perceive the unpredictability of the peso as a loss of trust in the local currency, Argentina could face another bank run as it did in the beginning of 2001. The mass simultaneous draw on deposits increases the probability of default and increases the risk of a multiple bank crisis.

Elevated Inflation The reliability of inflation data is suspect in Argentina. In 2013, Argentina became the first country to be censured by the IMF for providing inaccurate inflation and economic growth data. More specifically, The Argentine government understated inflation and overestimated economic growth, painting an positive, albeit inaccurate, macroeconomic picture. The IMF is now asking Argentina to “rewrite” history, pressuring Argentina to go back and correct their old estimates with more accurate and reliable data. Fickle inflation statistics corrupt other economic indicators, including government debt. It is plausible that one reason government debt in Argentina is reportedly on the decline is due to the underreporting of inflation. It is also likely that Argentina’s growing high inflation rate contributed to the increase in the country’s current account deficit. High prices make Argentina’s exports less competitive, reducing its exports.

4    

Argentina  Slips.  Will  Brazil  Stumble?  

 

Argentina’s central bank has begun raising interest rates in order to control inflation.

Plummeting Reserves  

Argentina’s foreign reserves are freefalling, raising fears about the country’s ability to

repay its foreign debt and experiencing another financial crisis. Argentina experienced a 25.56 percent decline in foreign reserves between June 2013 and February 2014. Argentina’s current account balance is also on the decline. The country recorded a current account deficit of $4.49bn in 2013, a significant increase from the $1.57bn deficit in 2011.

Argentina  International  Reserves  (USD  Millions)   40,000   35,000   30,000   25,000   20,000   15,000   10,000   5,000   0   Jun-­‐13  

Jul-­‐13  

Aug-­‐13   Sep-­‐13  

Oct-­‐13   Nov-­‐13   13-­‐Dec  

Source:            Central  Bank  of  Argentina  

   

Jan-­‐14  

Feb-­‐14  

 

 

A large deficit by itself is not necessarily a cause for concern. However, if Argentina’s exports continue to slide it will be pressed for alternative measures to service its debt. Acquiring additional loans will also be difficult considering Argentina’s high risk and history of default.

The 1998 - 2002 Currency Crisis After experiencing a boom in the 90’s, with low inflation rates, surging capital inflows, and rapid GDP growth, Argentina faced one of the worst economic crises in its history. Argentina’s output fell approximately 20 percent in three years, inflation grew to uncontrollable levels, the value of the Argentine peso plummeted, the banking system was essentially

paralyzed, and the government defaulted on its sovereign debt. The financial crisis evolved from a combination of feeble balance sheet management and the government’s inability to effectively construct an effective policy response (Timothy Geithner 4). Contagion from the 1998 Russian crisis and Brazil’s 1999 crisis and consequent devaluation of the Brazilian real also contributed to the economic downturn building up to the climax of Argentina’s crisis in 2001-2002 (Timothy Geithner 7).

Financial Contagion in Brazil In response to the large devaluation of the Brazilian real in 1999, Brazil’s government enacted an inflation-targeting framework with the goal on containing growing inflation to single digit figures. The framework built transparency and accountability between the central bank and the public, producing considerable economic success in the process. The central bank met its inflation targets in in 1999 and 2000 and the Brazilian economy grew by 0.8 percent in 1999 and 4.3 percent in 2000. The SELIC, the central bank’s overnight rate, fell and confidence in Brazil rose, lowering the country’s risk premium (Alfaro and Di Tella, Brazil 2003: Inflation Targeting and Debt Dynamics 7). However, Brazil’s early successes waned in 2001, missing its inflation target and experiencing only 1.4 percent economic growth. The Brazilian central bank attributed the economic slide to financial contagion from Argentina’s economic crisis, stating that Argentina’s looming default brought a loss of confidence to the entire Latin American region. The contagion, in combination with the world economic slowdown and 9/11 terrorist attacks, led to another massive depreciation of real (Alfaro and Di Tella, Brazil 2003: Inflation Targeting and Debt Dynamics 8). The central bank did not believe the economic downturn to become a permanent problem. Interestingly, Arminio Fraga Neto, the president of the central bank, concluded his open letter to the Brazilian Minster of Finance by stating that the shocks to the economy “are not expected to reoccur with the same magnitude as observed in the previous year” (Neto).

6    

Argentina  Slips.  Will  Brazil  Stumble?  

Brazil: 2001 – Present: Stronger Foundations Brazil’s low foreign debt, healthy dollar reserves, strong banking system, and flexible exchange rate have made the country less vulnerable to external shocks since 2001. Brazil’s net public debt as a percent of GDP has fallen to 33.1 percent at the beginning of 2014, down from its peak of 60.3 percent in 2003.

Brazil Net Public Debt (% of GDP)!  70.0      60.0      50.0      40.0      30.0      20.0      10.0      0.0     2002     2003     2004     2005     2006     2007     2008     2009     2010     2011     2012     2013     2014     Source:            Central  Bank  of  Brazil  

   

 

Moreover, as Argentina’s reserves continue to plunge Brazil’s reserves are on the rise. Brazil has over $363bn compared to Argentina’s approximately $27bn. Brazil’s impressive reserves serve as one element of the impressive growth its economy experienced since 2001. Brazil already successfully sustained the damaging external shock brought by the 2008 global financial crisis, falling into recession for just two quarters from December 2008 through March 2009 (Alfaro and Di Tella, Brazil 2003: Inflation Targeting and Debt Dynamics 2). With the exception of the recession, Brazil experienced a rising GDP growth rate between 2003 to present and fairly stable inflation rates. The financial crisis that affected Brazil and other emerging markets in the early 2000’s can be attributed not only to the effects of an external shock on the economy, but also to the volatility of the world financial system in place during the crisis. Argentina’s economic dip is not only a result of the global recession, but also due to the

fragility and unpredictability of the policies and institutions currently in place by its own government. Brazil, on the other hand, greatly improved its institutions and reduced its exposure to external shocks.

Brazil International Reserves (USD Millions)! 400,000   350,000   300,000   250,000   200,000   150,000   100,000   50,000   0   2001   2002   2003   2004   2005   2006   2007   2008   2009   2010   2011   2012   2013   2014   Source:            Central  Bank  of  Brazil  

     

Argentina’s Recent Slide Historically, Argentina has been one of Brazil’s main trading partners. That has changed in recent years with the country’s slow growth and protectionist measures. At the same time, Brazil has diversified its export partners, reducing exposure to Argentina. Brazil exported over $19.6bn to Argentina and imported approximately $16.4bn Argentine goods in 2013. It is plausible that Argentina’s erratic financial situation and unstable prices could affect this relationship. Indeed, both exports and imports to and from Argentina have already decreased through February 2014. Both the Brazilian and Argentine governments have already taken steps to counteract the impact of the devaluation of the peso is having on trade between the two nations. The peso’s decline has led to a scarcity of United States dollars in Argentina, which has curbed Brazilian exports of manufactured goods, lowering the country’s trade surplus (Soto). In the end of March Brazil and Argentina signed a deal that hopes to guarantee importers will have enough

8    

Argentina  Slips.  Will  Brazil  Stumble?  

greenbacks to pay for exports by adopting financial instruments to lower currency exchange risk and pledging to reduce red tape at customs (Soto).

Winners? Losers? Manufacturing Industry: The trade between the two countries mainly consists of manufactured goods, which are susceptible to foreign industry shocks. In general, a large devaluation of the peso could increase competition relative to Argentina by providing the country with lower wages to create similar products. However, lower wages may also benefit Brazil’s industries with highly integrated production chains with the same cheap labor, reducing the costs of cars exports. These decreases in costs may also help Brazil lower its inflation, which soared to its highest level in 11 years in March 2014. Tourism Sector: It is possible that tourism in Argentina could benefit from the depreciation of its currency. Argentina’s tourism industry has already grown around 3 percent from 2013 to 2014, with the bulk of the increase coming from foreign tourism. If this scenario played out Brazil’s economy would experience an outflow of foreign currency, which may weaken the real.

Fears of Contagion It is plausible that Argentina’s decision to let the peso depreciate may also have a contagion affect on the Brazilian real. Brazil’s currency immediately began depreciating after Argentina’s decision to allow the depreciation of the peso. Though the real is appreciating to its level before the January announcement, a further drastic devaluation of the peso could have a more damaging effect similar to the massive depreciation the real faced between 2000 and 2001. A depreciation of the real can create a number of economic problems for Brazil, including a further increase in inflation, a mass flight of funds out of Brazil, and a distortion of imports and exports on the country’s balance of payments. Yet, Brazil has a stronger foundation than it did in 2000, and full-blown contagion does not appear to be likely in the coming months.

Bibliography Alfaro, Laura and Hilary White. Brazil’s Enigma: Sustaining Long-Term Growth. Case Study. Harvard Business School. Cambridge: Harvard Business School, 2013. Alfaro, Laura and Rafael Di Tella. Brazil 2003: Inflation Targeting and Debt Dynamics . Case Study. Harvard Business School. Cambridge: Harvard Business School, 2010. "Argentina Imposes $2,000 Limit on Purchase of US Dollars." BBC News. N.p., 27 Jan. 2014. Web. 20 Mar. 2014. "Argentina Launches New Inflation Index." FocusEconomics. N.p., 18 Mar. 2014. Web. 20 Mar. 2014. "Argentina to Ease Foreign Exchange Controls after Peso Slump." BBC News. N.p., 24 Jan. 2014. Web. 20 Mar. 2014. "El IPC-Congreso Fue Del 4,3% En Febrero." Clarin. N.p., 12 Mar. 2014. Web. 20 Mar. 2014. Kaminsky, Graciela , Carmen Reinhart and Carlos Vegh. The Unholy Trinity of Financial Contagion. National Bureau of Economic Research. Cambridge: National Bureau of Economic Research, 2003. Gilbert, Jonathan, and John Paul Rathbone. "Argentina Vows to Prevent Further Fall of the Peso." Financial Times. N.p., 24 Jan. 2014. Web. 20 Mar. 2014. Pallares, José Hidalgo. "A La Espera Del Nuevo IPC Del Indec, La Inflación Del Congreso Registró En Enero Otro Récord." Lanacion.com.ar. N.p., 13 Feb. 2014. Web. 20 Mar. 2014. McCandless, George, Maria Florencia Gabrielli and Josefina Maria Rouillet. "Determining the Causes of Bank Runs in Argentina During the Crisis of 2001." Revista de Analisis Economico 18.1 (2003): 87-102. Neto, Arminio Fraga. "Open Letter to Pedro Sampaio Malan." 2001. Central Bank of Brazil. 1 April 2014 . Rapoza, Kenneth. "How Argentina's Currency Crisis Will Hurt Brazil." Forbes. Forbes Magazine, 29 Jan. 2014. Web. 10 Mar. 2014.

10    

Argentina  Slips.  Will  Brazil  Stumble?  

Soto, Alonso. Brazil and Argentina ink deal to bolster dwindling trade. 28 March 2014. 1 April 2014 . Timothy Geithner. "Lessons from the Crisis in Argentina ." International Monetary Fund, 2003.