Sweating In Buenos Aires

Now, investors are asking `What else can go wrong?'

Once again, the remarks of a rebellious politician set off a rout in Latin America's financial markets. On July 12, after Argentine presidential candidate Eduardo Duhalde said he would ask Pope John Paul II to support a one-year moratorium on foreign debt payments, Argentine stocks and bonds plunged: The Buenos Aires bolsa fell by 9%. Markets around the region quickly followed. The near-panic was similar to what occurred in Brazil in January, when a state governor announced that he wouldn't pay debt owed to the federal government. A week later, Brazil was forced into a chaotic devaluation that sent investors racing for the exits.

Argentina does not look as if it will unravel imminently. The day following the sell-off, the stock market rallied when investment banks, including Salomon Smith Barney and Lehman Brothers Inc., discouraged clients from pulling out and after Duhalde appeared to backtrack. Furthermore, Buenos Aires has $27 billion in currency reserves--more than enough to stave off a speculative attack on the peso. The country also has a $2.8 billion line of credit available from the International Monetary Fund. "There was an over-reaction in an already nervous market," explained Economy Minister Roque Fernandez.

Perhaps. But the economy is in a precarious position, and it could worsen in coming weeks and months. The lame-duck government of President Carlos Saul Menem must fund a budget deficit expected to exceed $5 billion this year--1.7% of GDP. That will be tough. Recession-weary Argentines are fed up with tax increases and spending cuts. Investors are increasingly reluctant to buy Argentine debt.

Adding to the uncertainty is the campaign for October's presidential election. Menem, who has pushed Argentina into the global economy, is leaving office after ten years. The leading contenders to replace him--Fernando de la Rua, the mayor of Buenos Aires and candidate of the opposition Alliance, and Duhalde, who is a Peronist--have unsettled investors by wavering in their commitment to open markets and fiscal austerity. Under Argentina's currency board system, in which each peso in circulation is backed by reserves, the government does not adjust monetary policy. That makes fiscal discipline essential to market credibility.

Meanwhile, Argentina's second recession in four years is expected to shrink the economy by 2% to 3% this year. Unemployment is now approaching 15%. Exports, hurt by Brazil's 33% devaluation and low commodity prices, will drop 15% or so, to $22 billion. The automotive industry, which accounts for 13.5% of national output, is reeling. Fears are growing that the country might be forced to devalue the peso. But Menem and both candidates insist that they won't.

Menem, as a strategy for discouraging currency speculators, has promoted adoption of the U.S. dollar as the nation's currency. The thinking is that speculators would leave Argentina alone since there would in effect be no currency to attack. However, dollarization would not resolve the budget deficit, and it wouldn't eliminate the 800-point premium over U.S. Treasuries investors now demand on Argentine bonds.

In fact, Argentina already is semi-dollarized. Under the currency board, the peso and dollar are exchanged freely everywhere, from banks to restaurants. Prices are set with the dollar as a reference, and more than half of all bank deposits are in greenbacks. Both Duhalde and De la Rua say they favor the board, but both have dodged the question of dollarization to avoid being seen as stealing the idea from Menem. Talks with the U.S. on adopting the dollar will be stalled at least until the next President takes office in December.

THE BIG PICTURE. But Duhalde's remark has raised a longer-term concern: Can Argentina pay off its debt, which will grow to $140 billion this year, from $116 billion two years ago? At a July 13 auction, the Treasury gave investors as much as five percentage points more than a month earlier. Argentina, which has issued $8 billion worth of paper abroad this year, is Latin America's leading foreign borrower. Its 6-to-1 debt-to-export ratio is the region's highest. A $500 million debt swap in Buenos Aires was postponed on July 14 because of market turmoil. "This is an inopportune time," says Treasury Secretary Pablo E. Guidotti. "The market is expensive."

Sweating in Buenos Aires

Argentina still has time to wriggle out of its predicament. But it will have to cut spending to appease the markets. It could also use the crisis as a rallying point to push stalled measures that investors and the IMF have urged for years. One is the proposed "fiscal convertibility law." It would limit public spending and debt and create a rainy day fund to soften the blows of future financial crises. Menem could also revive reform of inflexible labor laws. "Labor reform is the big one," says Abel Viglione, an economist at FIEL, a Buenos Aires think tank.

With the populace restless and investors skeptical, the government must act boldly or risk handing over a country in turmoil to a new President.

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