To avoid a run on the peso the Argentinian Central Bank has increased interest rates from 27.5% on 27th April to 40% on 4th May. Argentina’s peso has lost 20% of its value against the US dollar since the start of the year making it the worst performing emerging-market currency.
The problems began in January when the central bank wanted to ease interest rates by increasing the inflation target from 12% to 15% – the government were concerned that the high interest rates were having a detrimental effect on economic growth. However when the Central Bank eased interest rates by 0.75% expectations about inflation started to rise and then investors began to question what the Argentinian Central Bank and Government were trying to achieve with economic policy.
In order to prop up the peso the Argentinian Central Bank sold $4.3bn of its dollar reserves over 5 days and it raised interest rates by 6%. But the peso lost 7.8% of its value during trading on 3rd May so inevitably came an interest hike to 40%. However if inflation figures continue to disappoint the peso will continue its downward slide.
Interest rates are set to continue at high levels and if the central bank cuts rates too early they run the risk of a rerun of the crisis. Fitch (credit rating agency) recently downgraded their outlook for Argentina from positive to stable citing high inflation and economic instability.
But high interest rates are damaging to an economy. By increasing the borrowing costs you make it very difficult for business grow and the economy slows with the threat of a recession and higher unemployment. The key for Argentina will be to keep rates high just long enough to inspire confidence that policymakers have halted the currency run, but not so long that the increase drains the economy.