Is Cavallo Crazy Like a Fox?

His peso plan is risky, but it could buoy his presidential hopes

Domingo Cavallo likes to dish out Easter surprises. During his first stint as Argentina's Economy Minister, Cavallo took advantage of the long holiday weekend in April to tie the peso to the U.S. dollar at a rate of 1-to-1. A decade later, the Harvard University-trained economist is at it again. On Apr. 14, Cavallo announced that he would submit a bill to Congress to modify Argentina's exchange-rate regime by linking the peso to a basket made of equal parts greenback and the euro.

Wall Street was caught off-guard by the announcement. With Cavallo, 54, back at the Economy Ministry since Mar. 20, fears that Argentina was heading toward a disastrous default on its $128 billion public debt were just beginning to subside.

Now, that cautious optimism is again in jeopardy: Worries are that Cavallo is seeking a back door to devaluation, which would make it more expensive--perhaps impossible--to service Argentina's foreign debt. "I don't understand why a clever economist like Cavallo would open this Pandora's box now," says Amer Bisat, who manages a $3 billion emerging-markets portfolio for Morgan Stanley Dean Witter & Co. in New York.

"SLIPPERY SLOPE." Is Cavallo playing with fire? For the past decade, Argentina's convertibility scheme has been the bedrock of currency and price stability, as well as a constant source of comfort to investors. The local economy is highly dollarized, with some 70% of public debt denominated in dollars. Therefore, any attempt to repeg the peso is fraught with risk. "By altering the fundamentals of convertibility, he's immediately sending Argentina on a slippery slope," says Stephen H. Hanke, an economics professor at Johns Hopkins University in Baltimore who advised Cavallo in creating the currency board.

To dispel worries about a devaluation, Cavallo has stressed that a switch will not take place until the euro and the dollar reach parity. In the meantime, he has been busy selling the public and foreign investors on the benefits of his plan. Cavallo claims that since nearly 20% of Argentina's exports go to Europe, compared with less than 10% to the U.S., a euro-dollar combo makes sense. He also argues that Argentina must curb its dependence on the strong greenback if it is to break out of its deflationary spiral.

Cavallo could be right. Yet most analysts believe the chances of the euro reaching parity with the dollar in the next 12 months are slim. That means relief could come too late for Argentina's recession ravaged economy.

But Argentines suspect other factors may be at play. "The fact that Cavallo is assuming immediate risks in exchange for a theoretical, long-term gain suggests that some ulterior motive is at work," says Guillermo Jofré, chief financial officer of Impsat Fiber Networks Inc., a local telecom outfit.

GEOPOLITICS. One theory is that the politically ambitious economist may be laying the groundwork for a presidential bid in 2003, following an unsuccessful try in 1999. If, despite critics' fears, he manages a smooth transition to a euro-dollar basket that boosts the economy, his candidacy would be tremendously strengthened. Changing the peg would also undercut his likely opponent, former President Carlos Menem, who wants to ditch the peso outright and replace it with the greenback.

Another hypothesis has Cavallo playing a geopolitical game. Some veteran Argentina watchers suspect that the Economy Minister may be playing Europe against the U.S. Cavallo wants the Europeans and Americans to pledge extra aid in case the $40 billion rescue package arranged by the International Monetary Fund in December is not enough to cover the country's financing needs in 2001. Cavallo's tour of European capitals in mid-April lends some credence to this theory. A partial peg to the euro could draw active European support--and prompt Washington to be more active, if only to limit European influence. "Argentina could be sending a stern message to the U.S. not to take it for granted," says Walter Molano, a Latin America strategist at BCP Securities LLC in Greenwich, Conn.

No matter how you look at it, Cavallo's gamble is daring. By tinkering with Argentina's dollar peg, he could well be inviting disaster. But convertibility is the house that Cavallo built. And he may be the only one who can tear it down.

By Josh Goodman in Buenos Aires

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