June 20,2001

The introduction of a new economic reactivation package in Argentina constitutes the most dramatic event in Latin America in the past two weeks. The package, already approved by the Argentine Congress for immediate implementation, includes a number of tax measures designed to spur an economic rebound. However, the most important and far reaching measure establishes a two tier currency system in Argentina. The official exchange rate remains at a par with the US$, while a foreign trade exchange rate, determined by a mini-basket comprised of 50 percent US$ and 50 percent euro, will be used for import/export transactions. Therefore, the peso will actually trade at 1.08 per dollar. This constitutes a de-facto devaluation of the peso, although, as we have been predicting, there should be a much more pronounced devaluation possibly before the end of this year.

The so-called trade exchange rate is derived from the mini-basket as follows: One peso = (US$ + US$ value of the Euro) / 2 = ($1.0 + $0.86) / 2 , based on the actual US$-Euro rate of US$0.86 per Euro. Thus One peso = $0.93. In order to get the Pesos per US$ rate, we take the inverse of this rate: 1US$ = (1/ 0.93) pesos = 1.0753 pesos, which can be rounded up to pesos 1.08 per US$.

The new law, called Extended Convertibility, anchors the peso to the Cavallo mini-basket (Canastilla Cavallo), and was to become effective whenever the value of the euro would reach one US$. However, the economic czar, Domingo Cavallo, established the new exchange rate for foreign trade, without even waiting for the Congressional approval of his proposed system. He calls the two-tier system a temporary measure to spur growth. We detect a sense of urgency in Mr. Cavallo’s sudden announcement, which belie the official government position that Argentina’s economy is basically in good shape and only in need of a jump start to help it out of its long and painful recession.

Mr. Cavallo’s move comes after a partial "voluntary" rescheduling of Argentina’s foreign debt, recently completed, although Argentine officials prefer to call it a debt swap. The swap was supposed to give Argentina considerable relief in the service of its foreign debt. Argentina has already received a substantial sum of new money from multilateral lending agencies, but apparently, none of the above was enough to avert a devaluation.

The devaluation corroborates StratInfo’s long-held opinion that it is the only way out from Argentina’s economic malaise (See our detailed analysis in the April Argentina Update report, which you can download by clicking on the "Sample" button in our Home page ). However, an 8 percent devaluation falls far short of the required adjustment to the currency. We think dual or multi-tiered exchange rate systems have never worked. They give rise to capital flight and corruption as the government attempts to control access to preferential rates. We think Mr. Cavallo’s measure will backfire as Argentinians begin to fear another much bigger devaluation and start to send their capital abroad.