Jun 28, 2018 | 12:35 GMT

5 mins read

How a Rising U.S. Dollar Puts Argentina's and Brazil's Economies at Risk

Currency exchange values posted in Buenos Aires, Argentina, on June 15, 2018.
  • Argentina's financial capacity to deal with a rising U.S. dollar is limited, and a weakening peso will cause it to miss its inflation target this year. But not all news is bad news: The country recently was upgraded from frontier to emerging market status.
  • Brazil's currency is also expected to depreciate further against the dollar. But its trade surplus, low inflation rate and other economic strengths will ease the dollar's negative effects.
  • Uncertainty about the outcome of Brazil's presidential vote in October could cause the central bank to raise interest rates, which would slow economic growth.

The strengthening U.S. dollar is causing capital flight in emerging markets such as Argentina and Brazil. For the past month, the Argentine peso and the Brazilian real have been among the world's worst-performing currencies against the dollar. Despite that weak performance and the negative effect that a rising U.S. dollar will have on their economies, major differences exist between Argentina's and Brazil's financial capacity and level of vulnerability to a stronger dollar.

The Big Picture

The strengthening U.S. dollar will worsen the financial weaknesses of emerging markets, and Argentina's peso and Brazil's real are among the world's most vulnerable currencies. Despite this vulnerability, the two countries do not share the same level of financial risk.

Argentina: A Delicate Financial Situation

Aside from Venezuela, Argentina's financial situation is by far the most delicate one in South America. Buenos Aires has been running trade and current account deficits, and its international reserves are not large enough to tame the peso's depreciation. Its international reserves are more than $60 billion, and its current account deficit reached 4.8 percent of the gross domestic product last year. Additionally, Argentina has been issuing public debt in foreign currency to cover its fiscal deficit, which is expected to be about 2.8 percent of GDP this year.

Its inability to bring down inflation makes its case riskier than other emerging markets, and the weakening of the peso will put even more pressure on inflation. The government already has revised its inflation target for the year, raising it from 15 percent to 26 percent. Private consulting firms are more pessimistic; they say inflation could go as high as 32 percent.

Because of the weaknesses of the economy, President Mauricio Macri decided to turn to the International Monetary Fund (IMF) for help. On June 7, Argentina signed an agreement with the IMF to receive a $50 billion standby loan. The loan will provide Argentina some relief against the rising U.S. dollar. The IMF set some ambitious fiscal and inflation targets, however. The government lowered its fiscal deficit target from 3.2 percent to 2.8 percent of GDP. Next year's target will be 1.3 percent, while the inflation goal for 2019 will be 17 percent. To meet the IMF's conditions, the government will have to cut public spending.

The General Confederation of Labor, Argentina's largest labor union, went on a nationwide, 24-hour strike on June 25 to protest the government's deal with the IMF. Wage increases, negotiated with the government and private companies at the beginning of the year, are now well below the expected inflation rate. The union wants new negotiations. The government will want to keep wages in check to try to reduce inflation. Macri's political capital is likely to be severely diminished heading into next year's elections as he continues to pursue economic and trade reforms.

But not all is bad news for Argentina. This month, index provider MSCI upgraded the country's market status from frontier to emerging market, a designation that will allow it to attract long-term foreign investments. The key to the upgrade was a capital market bill approved by Congress in May. The bill lifted some of the restrictions that had prevented investment funds from putting money into real estate, farmland and other less risky areas of the economy.

A chart shows currency depreciation for Argentina and Brazil.

Brazil: Better but Still Not Great

South America's largest country is also part of a group of emerging markets that saw its currency drop significantly against the U.S. dollar in the past month. It is in a better position to deal with the depreciation than Argentina is, however. Brazil has been reporting trade surpluses the past three years, and its account deficit is just 0.5 percent of GDP. Additionally, its international reserves are about $380 billion — more than six times Argentina's. And Brazil's inflation rate is expected to be below 4 percent this year. Low inflation gives Brazil some room to moderate increases in interest rates.

While it is in a more comfortable position than Argentina, it still faces challenges. A rising U.S. dollar will force its central bank to stop its monetary easing cycle, probably slowing the country's economic recovery. Since 2016, Brazil's central bank has been gradually reducing interest rates as inflation fell from more than 10 percent in 2015 to below 3 percent last year. Its interest rates dropped from 14.25 percent two years ago to an all-time low of 6.5 percent this year. This trend, however, may be reversed if the real continues to depreciate against the dollar.

So far, the central bank has said it will not increase interest rates, choosing instead to tame the depreciation by offering currency swaps. In the past two weeks, the central bank has offered more than $30 billion in such swaps. Although they don't drain a country's international reserves, because they work as a hedge for investors, they could have a negative fiscal impact on the government should the real keep dropping in value this year.

Besides capital flight caused by a rising U.S. dollar, uncertainty about the outcome of Brazil's elections in October is contributing to the currency's depreciation. According to several recent polls, center-left candidate Ciro Gomes is tied in second place with environmentalist Marina Silva, indicating that he has a good chance to make it to a second round of presidential voting. Gomes has caused concern among investors by proposing to increase taxes on financial profits, to tax financial transactions and to expropriate oil fields that the government auctioned off over the past two years.

Uncertainty about who will assume Brazil's presidency on Jan. 1, 2019, could exacerbate the volatility of the real and force the central bank to change its tactics to deal with a rising U.S. dollar. The central bank could be forced to increase interest rates later this year or use its international reserves to slow the depreciation. An interest-rate increase coupled with political uncertainty will probably affect economic growth negatively. Global and domestic headwinds could end up slowing the pace of Brazil's economic recovery this year.

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