Latin Sell-Off Continues Amid Economic Concerns

This week’s Latin American market sell-off turned into a headlong rush to the exits Thursday as investors dumped stocks, bonds and currencies, fearful that Argentina lacked the political will and financial resources to avoid financial disaster.

Fiel, a think tank affiliated with the government, estimated depositors pulled $1 billion in pesos from accounts on Thursday in anticipation that Argentina might devalue the currency, breaking the 1-to-1 peg to the U.S. dollar that the nation has maintained since the early-1990s.

Official figures won’t be available until next week, but economists were concerned that a run on the banks might be beginning.

Fallout from Argentina’s woes could be felt as far away as the Pacific Rim where currencies lost value and in markets across the Western Hemisphere. Even the Mexican peso, recently a safe haven, declined. Standard & Poor’s downgraded Argentine bonds to B- minus.

With financial markets crashing down around him, Economy Minister Domingo Cavallo decreed a sweeping series of budget cuts and new taxes late Wednesday to trim $1.5 billion from spending and achieve a “zero deficit” for the second half of the year. Most affected were retirees’ pension benefits and government salaries.

But the plan received tepid political support even among congressional members of President Fernando de la Rua’s party, who criticized it as inadequate. That exacerbated fears among investors that Argentina’s newfound spending discipline might not be enough to avert catastrophe. Argentina’s total budget deficit for the year is expected to be $6 billion.

When he took office in March, Cavallo received extraordinary powers to decree spending cuts. But for the cuts to stick, especially in areas as sensitive as retirement and health benefits, he and De la Rua must have broad political support. That support was visibly lacking Thursday, worrying investors.

“The president and Cavallo are part of a political system and if the outcry is great enough and not supported by the political class then this will not be supportable,” said Michael Gavin, an economist with UBS Warburg in Stamford, Conn.

The lack of political consensus fed the conviction among investors that Argentina’s collapse is a matter of when, not if, and that a default on $128 billion in external debt could be inevitable. Those fears drove markets down to new depths Thursday with damage extending throughout Latin America, even Mexico, which has been a relative bulwark.

The main Argentine stock index, Merval, plunged as much as 13.5% before rallying back to close off 8.2% at 311.65, its lowest since 1998. In Mexico City, the IPC share index slid 1.4%. Brazil’s Bovespa index also sank early on, then rebounded to close up 0.8% at 13,916.

But Brazil’s currency continued to sink in tandem with Argentina’s declining prospects, ending the day off 2% at its third straight all-time low at 2.553 reals to the dollar. Brazil’s economy is closely tied to Argentina’s and would suffer in a devaluation and the recession sure to follow.

Mexico’s peso fell 1.6% to 9.41 to the dollar. Mexico also was hurt by new government data that show its recession deepened in May as industrial output declined by 3.4%. Construction spending was down 8% from May 2000.

Argentina’s floating rate bond has weakened to the point that it now offers an annual yield of 34.67%, up from 25% on Wednesday. The average “risk premium,” or additional interest yield on Argentine bonds is now 15.62 points above comparable U.S. Treasury bonds, said James Sha of ABN Amro of New York. Brazil’s bonds also weakened, with yields on the most widely traded bond moving up to 15.3% from 14.6% Wednesday.

Several observers, including economist Barry Bosworth of the Brookings Institution in Washington, likened Argentina’s current desperate situation to that of Russia just before its collapse in 1998.

“This [market] reaction is the judgment by participants that Argentina is going to have to default,” Bosworth said. “The momentum has picked up too much. Interest rate costs are up too high for any budget cuts to make it balance.”

Others, such as Lawrence Krohn of ING Barings investment bank in New York, say Argentina can avoid default this year if Cavallo’s cuts and the hike in the financial transactions tax to 0.60% from the previous 0.45% hold firm. But chances of an Argentine default rise dramatically in early 2002 when its debt load will rise even higher.

“The more likely scenario is that early next year Argentina will face some block of loans due that it won’t be able to finance, forcing it into default,” Krohn said.

This week’s market sell-off was touched off by Argentina’s bimonthly sale of $828 million in 91-day notes on Tuesday that offered an exorbitant 14.1% interest rate, a cost that many economists described as unsustainable.

The markets also reacted negatively to Argentina’s unsuccessful attempts to raise $3.5 billion in syndicated bank loans in one shot to get around the monthly debt auctions like Tuesday’s, said Walter Molano, economist with BCP Securities in Greenwich, Conn.

Larry Goodman, with Globalecon economic consultants in New York, said Cavallo also disappointed the markets by not setting specific spending and revenue collection targets Wednesday with which the market can “gauge the success of the new measures.”

Molano and Goodman both said the International Monetary Fund should step up to Argentina and, in Molano’s words, “provide moral support to weather this storm.” This week the IMF said it thought Argentina had sufficient resources to weather the crisis and avoid default. The IMF organized a $40-billion bailout for Argentina in December.

The drain on bank deposits, if it continues, could be the most destructive development. Abel Viglione of the Buenos Aires-based Fiel research firm said his discussions with bankers Thursday led him to estimate that outflows may have reached $1 billion each on Wednesday and Thursday, the bulk of which are being converted to dollars.

A rush by depositors to withdraw pesos and convert them to dollars in advance of a possible abandonment of the U.S. dollar peg would rob the Argentine economy of liquidity and all chance of growing itself out of its problems.

“Cavallo acknowledged in his speech Wednesday night that there was a crisis of confidence among international investors and among local depositors,” Viglione said.

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Contagion

How key emerging-market stocks and currencies have slumped since June 29, when Argentina’s markets began to free-fall:

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Stock Drop since indexes June 29 Chile --0.2% Mexico --2.9% Brazil --4.4% Russia --7.1% Turkey --18.5% Argentina --22.5%

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Drop since Currencies June 29* Russia --0.2% Mexico --3.5% Chile --5.3% Turkey --6.4% Brazil --10.5% Argentina --**

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* Versus the U.S. dollar

** Argentina’s currency still is pegged to the dollar.

Source: Bloomberg News