Last month, along with several emerging economies, the Argentine peso suffered a rapid and severe depreciation, taking the largest fall in value since the countries 2002 financial crisis. The devaluation, caused by decreased expected growth rates for emerging economies and an anticipated increase in interest rates for developed economies, was initially prevented by the Argentine Central Bank through large scale sales of foreign currency reserves. Yet this monetary intervention was soon abandoned by the Argentinian central bank “in an effort to preserve foreign exchange reserves that have already fallen by almost a third in the past year.”
Overall, the peso has weakened 28% compared to the dollar over the past year. This rapid dive in currency value, combined with a healthy mistrust of the Argentine Government after the 2002 crisis, could result in a capital flight that would be devastating to the Argentine economy. Liquidity in the market has already disappeared as investors fear a Venezuela style Capital Control policy being implemented.
Many have been surprised that the Argentinian Central Bank has allowed for such a rapid devaluation. The course of action certainly raises an interesting decision in monetary policy: Should the Central Bank step in to prevent the depreciation or should they allow the currency to fall to prevent further erosion of foreign reserves? To what extent can and should a central bank fight the market forces in the currency markets?
For the Argentine Central Bank, the decision was clearly to pull support for the currency. “The cost of intervention has become too great” with foreign reserves reaching a minimum level that the bank is unwilling to breach. Unfortunately, this austerity will likely have severe consequences for the Argentinian economy. With an economy that relies heavily on imports, such as machinery, to help fuel growth, a decline in the purchasing power of the peso will inevitably lead to lower growth rates. Furthermore, the steep depreciation will fuel inflation rates, already officially at 14% with many non-government sources predicting levels as high as 28%.
Despite clear consequences, the decision by the Argentinian Central Bank to curb their intervention serves as a reminder that monetary policy, while clearly a powerful tool, does have it’s limits. Argentina could continue to sell reserves to prop up the value of the Peso, but at what point should central banks concede these limitation and let market forces take over?
Source: Financial Times