By Rodrigo Campos
NEW YORK (Reuters) -Argentina will likely shift its foreign exchange policy to allow for a weaker peso after midterm elections this month, with analysts and investors warning that the current trading band is unsustainable and that U.S. support would only buy time for the beleaguered currency.
The U.S. has been buying pesos and is working on a debt facility for Argentina, contingent on a strong performance by President Javier Milei's La Libertad Avanza party in the October 26 vote
and a continuation of his policies of aggressive spending cuts, deregulation and free markets.
That support has lifted the stakes for Argentina's next policy move, and the party will need to strengthen its presence to avoid a legislative override of Milei's vetoes of spending bills and his reliance on governing by decree.
U.S. SUPPORT ONLY PARTIALLY EASED PRESSURE ON PESO
The Argentine central bank has kept the peso in a managed band since April while its interventions, alongside the Argentine treasury, have fended off recent attacks on the band's weak end. But the downward pressure abated only partially after the U.S. Treasury said it purchased pesos in the open market.
"The central bank might need to widen the currency band as it tries to take the training wheels off the currency," said Brian Jacobsen, chief economist at Annex Wealth Management, adding that shock therapy could trigger volatility near-term but was needed for long-term success.
"Widening the trading band for the currency until it stops bumping against the bounds will take a while, but it's probably the direction they need to go."
Argentine Economy Minister Luis Caputo said he hoped to execute a framework very soon with the terms of a $20 billion currency swap the U.S. recently agreed with the central bank.
Caputo has said repeatedly that the band system will not be altered and that U.S. backing will help to support the bank's efforts, while a policy that favors a weak currency would risk a worsening of inflation.
U.S. Treasury Secretary Scott Bessent said Wednesday the U.S. again bought pesos in the open market, after initially announcing an intervention last week.
MARKETS PRICING IN BREACH OF THE PESO'S BAND
Yet the forwards markets are already pricing in a breach of the band's weaker limit, highlighting investors' concerns. The peso ended 1.7% weaker at 1,378 per dollar on Wednesday.
The band replaced more rigid currency controls, as part of Argentina's commitments to the International Monetary Fund when it secured a fresh $20 billion loan program in April. The peso has fallen 22% since then.
Sticking with the band will require a redesign, according to Matthew Graves, portfolio manager in the emerging markets debt team at PPM America.
"At the margin, investors would probably prefer a floating foreign exchange regime," he said. "It's a more straightforward, durable fix to what's essentially an external problem."
This is not the first time that government spending and ballooning trade and fiscal deficits contributed to a currency crisis. In 2001, Argentina defaulted on its sovereign debt, forcing the peso out of its dollar peg. The country has defaulted on its sovereign debt twice since then, in 2014 and 2020.
Capital Economics expects a one-off devaluation of the peso after the midterms, followed shortly thereafter by a new, wider band.
"We think maintaining the status quo is unlikely given the extent of exchange rate misalignment and downward pressure on the peso," it said in a note.
CONTROL OF THE PESO SEEN KEY TO TAMING INFLATION
The base case peso scenario for Morgan Stanley is for a controlled devaluation and wider trading band, designed to shore up reserves and restore some external balance without triggering a spike in inflation.
Keeping control over the peso has been a key tool for the government's main objective of lowering inflation, which has shrunk from more than 200% when Milei took over in late 2023 to 32% in September, on an annualized basis.
"All the efforts made by the Argentina government over the last year have been very important - bringing down inflation, running surpluses. So the most difficult job has already been done," said Inigo Fernandez de Mesa, vice president at CEOE and a member of Rothschild's sovereign advisory team, which has advised Argentina in the past.
"They need to set the right exchange rate of course to raise the support of international financial institutions so that the stability will be long-term."
If President Milei's party underperforms in the midterm elections, the reduced political capital and likely delay in reforms could force a sharper foreign exchange policy adjustment.
(Reporting by Rodrigo Campos in New York; Additional reporting by Karin Strohecker in Washington and Walter Bianchi and Jorge Otaola in Buenos Aires; Editing by Alden Bentley and Edmund Klamann)
