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Brazil-Argentina common currency: An idea so bad, why is it being discussed?

  • Common currency benefits: anchor economic policy and reduce barriers to cross-border trade, investment, and travel

  • Common currency pitfalls: unsustainable without fiscal (political) harmonisation, distorts export competitiveness

  • Common currency requirements: apart from political will, similar inflation and interest rates, fiscal balance and debt

Brazil-Argentina common currency: An idea so bad, why is it being discussed?
Hasnain Malik
Hasnain Malik

Strategy & Head of Equity Research

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Tellimer Research
23 January 2023
Published byTellimer Research

Brazil and Argentina are talking publicly about the idea of a common currency. There is no stated timetable at this stage and such discussions have taken place before.

Brazil and Argentina are a long way away from the convergence in economic policy and performance required to launch monetary union, likely lack the political will to enshrine the adherence to this convergence, and such a union may not be suitable for them in any event, given that they are not even each other's largest trading partner, and a unified currency might distort competitiveness in non-commodity exports.

Note that both Brazil and Argentina have a history of managed or fixed exchange rates which did not end well.

If this is such a bad idea that one wonders why it is being discussed at all? A sign of solidarity between two leftist governments, a response to economic policy which, to differing degrees in each country, has lost credibility, a response to last year's US dollar strength – none of these are compelling justifications.

A number of other areas of cooperation were mentioned in the 22nd January op-ed co-authored by presidents Lula and Fernandez, eg climate change, pandemic response, food security, immigration, Mercosur trade, nuclear energy, electric grid interconnection, and space satellites.

For Argentina, in particular, the idea of a currency union should in no way distract investor attention from the actions it needs to take to correct course to tame inflation, fiscal deficit, remove capital controls, and close the gap between the official and parallel exchange rates. Furthermore, tying itself to an economy over three times its size might mean it makes more sense simply to adopt Brazil's currency as its own.

For Brazil, in particular, despite its own policy credibility challenges, why it would wish to tie itself to a smaller neighbour with such a chequered track record on policy credibility is anyone’s guess.

Argentina Peso devaluation of 50% implied by parallel rate

Monetary union is a bad idea

The benefits of monetary union might be the following:

  • Establishment of a policy anchor and

  • Reduction of barriers to trade, investment, and travel.

Policy anchor

The credibility of economic policy in both Brazil and Argentina have been undermined in recent years by, among other factors, loose fiscal policy.

Brazil's deficit cap has been sacrificed at the altars of Covid-era stimulus and former President Bolsonaro's re-election. Argentina's efforts to control fiscal deficit did not survive former President Macri's re-election effort.

Argentina has defaulted for the ninth time on its sovereign debt, is suffering from high inflation, and its ruling Peronist coalition, which faces an election in October 2023, is divided over taking the corrective policy actions required to keep IMF assistance on track.

Both need to re-establish credibility in this regard but a monetary union is much more difficult than, for example, a refreshed debt or deficit ceiling.

Trade and investment barriers

Although significant, Brazil and Argentina are not each other's largest trading partners.

  • For Brazil, Argentina is its 3rd largest source of imports, but China is 4x and the US is 3x bigger, and its 3rd largest destination for exports, but China is 7x and the US is 2.6x bigger.

  • For Argentina, Brazil is its 2nd largest source of imports, about 10% smaller than China and 2x larger than the US, and its largest destination for exports, bigger than China by 2x and the US by 2.4x.

Convergence

The establishment of a monetary union requires, at least, convergence in economic performance and policy – this is far from the case in Brazil and Argentina currently, whether measured by differentials in inflation, fiscal balance, or short-term external debt vulnerability.

Monetary union not appropriate for Brazil and Argentina

Political will

The maintenance of a monetary union requires the political will to establish a lasting commitment to unified monetary policy, eg via an independent and combined central bank, and to harmonised fiscal policy.

Both require constitutional reform, which is likely well beyond congresses in both countries that struggle to establish majorities beyond business-as-usual legislation.

LatAm strategy: Brazil over Argentina, Chile top pick

Overall, we expect domestic political risk to cast a shadow over LatAm equity markets although most, ex-Argentina, are cheap relative to historic average. Chile, where copper export revenues should benefit from China re-opening and Peru protests in the short-term and the renewable energy transition in the long-term, is our top-pick.

LatAm equity market valuation comparison

Between Brazil and Argentina, we regard the former's exchange rate as cheap enough versus historic average to offset risks associated with domestic political polarisation and the latter as untouchable given ongoing capital controls and set up, at best, for a temporary reversion to market-friendly policy in the event of opposition win in this year's election.

LatAm currency valuation comparison

Related reading and data

Brazil riots not a prompt for a coup but a reminder of Lula’s challenges (Jan 2023)

Trade to watch: Argentina, Culverhouse (Dec 2022)

LatAm EM equity strategy: 2023 outlook (Jan 2023)

EM Country Index update (Dec 2022) — a ranking of countries based on short and long-term growth prospects, policy credibility, political risk, legislative mandate, governance factors, geopolitical risk, and ESG factors