The Undervalued Peso

I received a question today about the rumors of the peso being undervalued. Although I've addressed this issue in other posts, I wanted to make a very detailed explanation so that expats can understand what the issues are. The currency issue is an important one for every expat that's living here on a U.S. dollar-based income or pension.

Reader's Question

I keep hearing that the peso is undervalued and that the government is deliberately keeping the exchange rate with the dollar low. Is this true? And if so, how and why are they doing it? I thought now that the 1:1 fixed rate days were over the market is free.

The Peso Market

The days of 1:1 are over and now we're living in the days of 3:1. However, the market is by no means a free one. It is still tightly controlled by the government. The central bank controls all wire transfers going in and out of the country. Anyone wiring money in or out must show the government what they're doing and why.

Like the government of China, the government here allows the peso to float within a certain range with the dollar. Over the last few years that range has been between 2.8 and 3.1. However, many people here believe the true market rate of the peso is between 1.8 and 2.4. So, how does the government keep the peso down, why are they doing it, and can it continue?

Why The Peso Wants To Rise

There are several reasons the peso should be higher these days. First is due to the fact that there's more exports now than imports. When you have everyone selling abroad, the exporters get paid in U.S. dollars. However, they pay their bills in pesos, so they must turn in their dollars for pesos. If you repeat this process thousands of times you'll eventually have more people who want pesos than dollars and this causes the value of the peso to increase.

In addition, there's a lot of people with dollars who are coming here. All these expatriates, foreign investors, and tourists have dollars and they need to exchange them out for pesos to pay for things here. That puts more pressure on the peso. With such a demand for the peso and only a limited supply of pesos out there in the market, the price of the peso should go up.

Market Manipulation

The government, however, is preventing the rise of the peso. It wants to protect the exporters and the national industry. It does this by buying up all the dollars on the market and printing new pesos. By buying up all these dollars and supplying pesos to everyone who wants them, the government can keep the peso from increasing in value.

This strategy does cause some problems, however. Namely, inflation. By flooding the market with all those pesos, the peso's buying power would be reduced -- too much money chasing too few goods. The government knows, this, so they are countering this by borrowing back all the pesos they've just printed. So, the number of pesos in the marketplace remains more or less the same.

Nevertheless, this strategy is not sustainable over the long term. Although the government earns some interest on the U.S. dollars it is storing up, the amount it earns is less than what it has to pay out to borrow all those pesos. Eventually the interest payments on the pesos will blow a hole in the budget and the government will be forced to let the peso rise in value.

Impact for Expatriates

What this means for you is that you can't expect to have a cheap peso forever. While I fully expect that Kirchner will keep the current exchange rate policy when he's reelected next year, if he can't get the inflation problem under control, he may be forced to let the peso rise. Inflation has been the undoing of so many other Argentine presidents, I would expect that Kirchner is more obsessed with keeping inflation low than he is keeping the exchange rate fixed at 3:1. So, just keep an eye out.