Time and again, Argentina’s economic history has revealed that consumer confidence and capital flight usually move in opposite directions. If one grew, the other would decline, and vice versa. Now, although the government’s approval ratings remain positive and the country’s economy is moving ahead steadily — its GDP is expected to grow by 7% in 2011 compared with 3.5% in Brazil — purchases of American dollars continue to rise.

The paradox is this: Although capital flight has risen to more than $12 billion so far this year, Argentine President Cristina Fernández de Kirchner has the support of more than 50% of voters in primary elections, and her victory in the presidential elections of October 23 is practically a foregone conclusion. How can that be explained?

A good place to begin is to clarify the concept of capital flight. Martin Leal, professor at the UADE Business School’s MBA program, notes that the expression "capital flight" refers "to any movement of financial assets that are held in a local currency into external assets that are denominated in a foreign currency; that is to say, this concept does not necessarily mean that the actual capital has left the country [and moved to a foreign country].”

In his opinion, there are three main reasons for the current situation in Argentina. First of all, the upcoming presidential elections have generated an instinctive shift to the dollar both among individual savers and companies. Second, the international economic crisis has left multinational companies unable to fund themselves at a low cost in their home countries, and they are resorting to financing themselves from their subsidiaries that have surpluses. A final factor, adds Leal, is that “in an effort to diversify their local [Argentine] risks, those economic players that have a long history in Argentina have invested in foreign properties [as majority owners] and in financial assets [as minority owners]."

Eduardo Fracchia, a professor at the IAE business school of Austral University in Buenos Aires, agrees about the impact of multinational firms. “They send money [US dollars] to their headquarters [to compensate for losses in other subsidiaries], and for these same reasons other financial executives have begun to place their funds in secure locations.” He adds that the people who send this sort of cash abroad are big national and multinational companies — “especially the latter, which send cash back to their headquarters without reinvesting it in the country [Argentina].”

Some individuals have also been increasing their purchases of foreign currencies. Dr. Domingo Jose Mazza, director of the economics program at the University of Morón in the province of Buenos Aires, suggests that this is due to the fact that “the average Argentine has increased, if only slightly, his savings capacity over the past eight years of uninterrupted economic growth, and is putting his savings into dollars because it represents a valuable reserve.” Argentina’s history over the past three decades has shown especially that there is “a residual culture of monetary convertibility that implied a de facto bi-monetization,” he notes. That’s what has led to this situation. On the other hand, he adds, “every sort of real estate asset — land, garages, apartments, etc. — is bought and sold in dollars.”

Some experts, such as Federico MacDougall, a professor at the Graduate School of Business at the University of Belgrano (UB), also believe that while President Fernández de Kirchner holds first place in the polls, that does not mean that the people who are responsible for capital flight — businesses, international investors and large private investors — agree with the economic policies of the current administration.

So Fernández de Kirchner's almost certain victory in the presidential elections does not eliminate political uncertainty about what will happen during her next administration, according to MacDougall. “There is a segment of Argentines who hold the view that the current economic policy cannot continue, and that a major change in direction will be needed after the elections." Given this scenario, companies and individuals send their savings outside the country as a way of protecting themselves against uncertainties in the local market.

The Perils of Capital Flight

Given the instability of the international economy and the lack of certainty about what will happen during a possible second administration of Fernández de Kirchner, people are asking all sorts of questions about what could happen over the short and medium term.

At the moment, the most worrisome thing for some analysts seems to be the high level of capital flight. The continued buying of dollars by companies and individuals — now at some $2 billion per month — creates instability in the exchange rate. Thus, the Central Bank goes out into the market to sell foreign currency so that the price of the peso does not shoot up in the market, which would lead to a decline in its reserves. The Central Bank, headed by Mercedes Marcó del Pont, holds reserves of $50.081 billion, which are intended to cover at least the monetary stock that is currently in circulation.

Paula Soledad Luque, assistant researcher in the field of economics at IAE, notes that any decline in the quantity of reserves generates vulnerability in the Argentine economy and creates a vicious circle. Since the economy is more vulnerable, that leads to less confidence, which makes investors take their money to more stable economies. “This vulnerability stems from the fact that it is the Central Bank that has to respond to any eventuality in national or private banks, and so private banks must place an ‘encaje’ [the required minimum of banking reserves] in the Central Bank. But when the ‘encaje’ of these banks is utilized by the Central Bank, that’s where the reserves come into play: The lower those reserves drop, the harder it is [for the Central Bank] to respond to any contingency, which is what happened in 2001," the year of Argentina’s greatest default and the subsequent devaluation of its economy.

MacDougall argues that there is no danger at the moment that the Central Bank could lose a large volume of reserves, “and that if that were to continue, it could erode confidence in the power of the Central Bank and lead to an acceleration in the flight of capital, and a consequent devaluation of the [peso-dollar] exchange rate.”

Until recently, any decline in reserves resulting from capital flight has been totally compensated for by an inflow of dollars from trade, notes Mazza. Nevertheless, in recent months, this has produced a higher trade deficit, and this decline in the inflow of dollars via exports does not satisfy internal demand for U.S. dollars. In fact, the “blue” currency (the parallel dollar), recently reached another record high of 4.43 pesos to the U.S. dollar, compared with the official rate of 4.22 pesos. The “parallel” dollar is the informal rate, which is bought and sold in so-called “cellars” without any sort of official control.

Fears of Depreciation

According to Leal of UADE, since the peso-dollar exchange rate is actually appreciating, and the Argentine trade surplus shows signs of weakness, “beginning in 2012, the challenges will be to slow down the pace of inflation, and combine that with a depreciation of the peso at a similar pace.”

The biggest worry for some sectors of the Argentine economy is a possible devaluation or depreciation of the peso relative to the dollar. (That is to say, that the number of pesos needed for buying each dollar will keep going up.) However, this would not happen in an abrupt way, argue some experts. “Unless international economic conditions change, we can presume that the policy will be to slowly devalue the peso, which will reduce the loss in competitiveness of locally produced goods that is [currently] generating inflation,” MacDougall says.

According to Fracchia, any devaluation in the short- or medium-term would have many implications for the economy. These could include "a greater outflow of foreign exchange, increased country risk, a reduction in foreign credits and new social unrest if the devaluation measures that are applied turn out to resemble those of 2001" — such as the "corralito" of that year, which imposed restrictions on the availability of cash without damaging the assets of depositors, or the "corralon," which was the automatic conversion of peso deposits into dollars at a rate that was well below the market rate.   

Leal also warns people to be careful about such external factors as international prices of major Argentine export products. Meanwhile, the progress of the Brazilian economy, Argentina’s largest trading partner, will also be important. This year, Brazil could grow by only 3.5%, according to some estimates, which is significantly lower than the 7.5% pace of last year. “A deceleration of the Brazilian economy, like depreciation in the value of the [Brazilian] real, would be warning signals for the Argentine economy and for the stability of [Argentina’s] exchange rate,” adds Leal.

Unresolved Issues

If Fernández de Kirchner takes office as president again on December 10, what will be her main economic challenges? Many experts agree that inflation, currently 22% according to unofficial data, will be the most important obstacle to resolve. “The challenge of the next government will be to enact an anti-inflationary program, along with economic policy measures that do not freeze the economy and which guarantee that it will pursue a stable annual growth rate of about 5%,” according to Leal, who also warns about potential structural problems involving the energy sector (Argentina will import $6 billion worth of fuels in 2011); regional integration (roads, cargo transportation and border crossings need to be upgraded); and the diversification of the country’s production profile (i.e., replacing grain exports with exports of higher-value added products).

Luque recalls that since 2007, Argentina’s National Institute of Statistics and the Census has been intervening in policy making, which he says has rendered the country’s statistical reports no longer credible for analysts both within Argentina and abroad. “I believe that the President should no longer delegate this area to others; on the contrary, she should recognize that this policy [of intervention] has been wrong, and that the best thing that can be done is to go back to operating in a transparent way.” Analysts at IAE also propose that greater importance be accorded to regulating illegal and informal employment, which has reached a rate of almost 40% of the Argentine work force.

Tackling these initiatives would leave the Argentine economy with positive prospects for 2012, argues MacDougall, although with less room for maneuvering than in 2009. Some issues would still need to be addressed, he says. “Next year, one key issue will be to limit inflation, which could reach 30%, according to estimates. In addition, the surplus in the [Argentine] trade balance will decline because of increasing internal costs and the depreciation of the peso. Also, rates for some public services have been frozen since 2002” and they may need to be raised.

Adds Mazza, “In the coming years, the economic challenge will be to promote social improvements, control rising prices, maintain the surplus in the big balances of the economy and deepen [Argentina’s] trade relationships with foreign countries, especially with its neighbors.”