Shortly after interest rates in Argentina were unexpectedly raised by 150 basis points to 26.25 per cent last month, a joke began to circulate on Twitter with a picture of Federico Sturzenegger, the central bank governor, above the caption: “Keep calm and carry trade”.
The adaptation of the British wartime slogan was apt. The “carry trade”, where investors borrow at lower interest rates in one currency to invest at higher rates in another currency, has been raging in Argentina since a pro-market government led by President Mauricio Macri freed up capital flows after taking power in December 2015. Today there is almost $27bn invested in central bank debt instruments that mature in 30 days or less, investors’ favourite vehicle for the carry trade.
“Over the course of the last year, Argentina has certainly been one of the juiciest carry trades in emerging markets,” says Patrick Esteruelas, global head of research at Emso Asset Management in New York.
However, this has happened before. The economic conditions in Argentina mean that it is often ripe for the carry trade. It has a long history of high inflation, and just as long a history of trying to keep it down with a strong currency — the key ingredient to any good carry trade. At the same time, high tax evasion and a low savings rate (thanks to high inflation that has bred a generalised aversion to local banks) means that governments have long had to attract foreign capital.
The key difference this time is that Argentina now has a floating exchange rate — unlike in the 1990s, say, when the peso was pegged at parity with the dollar. Instead, the new government has moved to an inflation-targeting regime, although this is still in its infancy.
The latest craze for the carry trade in Argentina comes after Cristina Fernández de Kirchner — Mr Macri’s populist predecessor — bequeathed an economy on the brink of crisis, ravaged by one of the world’s highest inflation rates. The new government is convinced that the economy cannot grow sustainably without crushing inflation, so a hawkish central bank has increased interest rates — some of the highest nominal rates around. Few expect rates to start falling again until at least June.
The combination of a tight monetary policy and a loose fiscal policy, which for now is being financed by some of the heaviest foreign debt issuance in emerging markets, has recently pressured the exchange rate. The peso will be buttressed over the coming months by seasonal and technical factors: a strong harvest and the inflow of funds from the world’s second-largest tax amnesty ever, which saw some $117bn declared to authorities — even if most of those funds will remain in offshore accounts.
However, the peso’s current strength is fuelling growing imbalances in the economy. Although some — albeit limited — progress is being made in reining in the fiscal deficit, the current account deficit is widening, and will continue to do so if the peso remains strong. “When the twin deficits approach 10 per cent, you have a problem, and a big one — and Argentina is approaching that level right now,” says Walter Stoeppelwerth, head of research at Balanz Capital, an investment bank in Buenos Aires.
And authorities are beginning to take action. Last month, the central bank announced that it would increase reserves from about 10 to 15 per cent of gross domestic product, ostensibly to bring Argentina closer to investment grade. But markets interpreted this as a clear signal it was setting a floor for the peso, since it implies massive dollar purchases, bringing reserves up to $93.1bn, or $44.5bn above their current level, according to Sebastian Rondeau, an economist at Bank of America Merrill Lynch.
Thus, the carry trade’s days may be numbered — although it is worth remembering that the Brazil carry trade ran for about a decade from 2003 to 2013.
A big inflection point will be the midterm legislative elections due in October. Most analysts expect the government to perform reasonably well, mainly because of the dire state of the opposition — although a recovering economy should help, too. That would maintain calm among the investors who have been betting that Mr Macri’s economic reform programme will be able to cure Argentina’s economic ills.
But the fact that speculative funds have been piling into local debt instruments to take advantage of the carry trade leaves Argentina exposed should circumstances change, either at home or abroad. A sharp exit of this “hot money” could cause considerable collateral damage to the domestic economy, warns Daniel Marx, who was finance secretary at the time of Argentina’s 2001 default. For now, though, he suspects that the government will manage to “muddle through”.