Argentina’s Warning: Currency Reserves Aren’t Everything
Latin American country had a record hoard of dollar reserves just before it was forced into the arms of an IMF bailou.
Argentina went from robust to bust in a matter of months, leaving investors scratching their heads. Among the mysteries: why the country’s record hoard of currency reserves—often seen as shield against foreign-exchange volatility—did so little to stem the crisis.
The lesson seems to be that loads of dollar reserves alone can’t make up for weakness in a country’s economic underpinnings. Foreign investors who had been burned by Argentina’s repeated defaults over the years, reassured by the country’s rising reserve bulwark, edged back into the country in recent years, buying up assets like a 100-year government bond issued in June last year.
“If they thought they could defend the currency by selling the reserves, to be honest they wouldn’t have raised interest rates to 40%,” said Carl Shepherd, portfolio manager at Newton Investment Management. When a currency is falling, central banks can sell dollar reserves and buy the local currency to prop it up. But in Argentina’s case, the maneuver failed to reassure investors.
Argentina’s situation may also shed light on whether reserves will prove more useful against a rising dollar elsewhere among the world’s most vulnerable economies. Turkey, whose currency has weakened sharply against the dollar this year, is a clear focus for investors.
When local currencies weaken as the dollar strengthens, this can stoke inflation by making imported goods more expensive. Countries that issue debt in dollars but raise revenue in a local currency may also struggle to pay back their debts, something holding dollar reserves should help to avoid.
For Argentina, however, its reserves, which hit a record high in January, didn’t do much to prevent the situation from spiraling. The root problem: Roaring inflation was eroding the value of the peso as the dollar began rallying against global currencies. The peso has lost nearly a fifth of its value this year against the dollar. Concern grew among investors that Argentine borrowers could afford to pay back their dollar-denominated debts.
In theory, Argentina entered the year with a decent amount of dollar reserves. It was close to one International Monetary Fund measure of reserve adequacy, based on its exports, short-term debt, money supply and other liabilities. The IMF indicated that reserves of $65.23 billion would be appropriate to help the country preserve economic and financial stability. In March, Argentina’s reserves reached $61.73 billion.
It put those reserves to use last month, when it used around $5 billion, around 8% of the country’s total, to buy up pesos. It had little effect, with the peso falling 1.6% in the final week of April.
The Argentine central bank also repeatedly increased interest rates over an eight-day period, a failed attempt to attract money back into the economy.
Deciding that selling reserves and raising rates wouldn’t turn around the peso’s fortunes, Argentina turned instead to the IMF for a flexible credit line.
The usefulness of foreign-currency reserves for emerging-market governments has been debated for decades. Following the Asian financial crisis of 1997, many built up currency reserves in an attempt to avoid the austere conditions attached to IMF assistance.
Argentina, like many other emerging economies, also took the IMF’s advice by allowing a somewhat flexible exchange rate, which in theory should help absorb economic shocks.
The trouble is, using reserves, while meant to increase confidence in a currency, can actually have the opposite effect, stoking fear among investors that there is worse to come, according to Gary Smith, who works with sovereign-wealth funds and official institutions at Barings Asset Management.
The Korean won’s fall in 2008 led the country to spend more than a fifth of its foreign-exchange reserves. Yet what helped stop the falling won was the U.S. Federal Reserve’s offer of a currency swap line to South Korea. Russia spent a similar share of its reserves to stop the ruble’s drop in 2014 and 2015, but arguably the rebound in the price of oil stemmed the pain there.
Currency reserves are helpful, if employed correctly, according to some researchers. Using data from 33 countries between 1995 to 2011, a recent paper by four economists found that intervention could be effective in stabilizing exchange rates, especially when sales were large and well-communicated.
Though Argentina began its current distress with high foreign-exchange reserves, the country also has deeper foreign debts than other emerging markets. Over two thirds of the country’s government debt is issued in a foreign currency, according to the IMF. In comparison, equivalent levels are 4.4% for Brazil and 33.5% for Mexico.
A further rise in the dollar could put more emerging-market economies under stress.
“Our asset class never trades well when the greenback is strengthening and recent price action illustrates how quickly sentiment can turn,” said Paul Greer, portfolio manager at Fidelity International.