Inflation, election weigh on Argentine money market

BUENOS AIRES (Reuters) - Spooked by high inflation and a presidential election, Argentines are moving to the safety of U.S. dollars and testing the Central Bank's ability to tame interest rates.

While the bank is expected to have enough foreign reserves to ease the stresses, policy missteps could ignite the kind of crisis that has plagued the country in past elections. Even in a best case scenario, analysts warn the country is likely to suffer higher inflation, more painful interest rates, or both.

The rates that Argentina's banks charge each other for short-term loans soared in July and August, climbing as high as 20 percent from 8 percent early in the year. The Central Bank has been flooding the banking system with pesos in a bid to restore calm, so far without great success.

"The motive for the higher cost of money is fear, and it's not fear in big companies or corporations, but investors and savers who want to preserve what they have by changing it into hard currency," said Enrique Dentice, chief analyst at San Martin University.

First lady and senator Cristina Fernandez de Kirchner is expected to win an October 28 presidential election. She is expected to continue the economic policies of her husband, whose four years of center-left government have been marked by Latin America's fastest growth, but also by inflation concerns.

Even though foreign reserves are sizable and the possibility of a debt default is remote, election run-ups are traditionally a tense time in Argentine markets, where memories of the severe recession and turmoil of five years ago remains fresh.

ROOM TO MANEUVER

"Some have begun to wonder if this mini-run on the peso will translate into a full run," UBS analyst Javier Kulesz wrote in a report this month. "We doubt it, at least over the near term."

Analysts and traders said the central bank can fall back on reserves -- foreign reserves reached a record him of $44.2 billion in July, to administer the money market as well as regulating through bond auctions.

Despite deterioration in the budget and trade deficits "there is still a way to go before we would become really worried about Argentina. We believe there is still ample room for maneuver," Kulesz wrote.

The Central Bank on Monday stepped up intervention in the money market, boosting sales of repurchase agreements at an 11 percent fixed annual rate to 1 billion pesos ($313.2 million).

Market players in Buenos Aires said the bank was trying to keep banks from having an excuse to pass on higher interest rates to clients, which would put a damper on the country's economic growth as credit became scarcer.

Given the high base of Argentine growth, the fiscal surplus and high prices for its grain exports, economists say that slower growth for Argentina is not cause for alarm and don't anticipate problems meeting payments on debt.

"Given that Argentina has $43 billion in international reserves, we suspect that tighter credit is unlikely to bring a major dislocation to the Argentine economy either in the remainder of this year or in 2008," Morgan Stanley said in a report on Monday.

Some observers say the outflow is mostly short-term investors getting out while institutional investors have maintained their positions in assets throughout Latin America, reflecting confidence.

The rise in Argentina's interbank rates shows investors are adjusting to the reality of inflation, some analysts say.

At the end of August, 12-month inflation was 8.7 percent in Argentina, Latin America's third-biggest economy, and the official end-year target is under 10 percent, but some private surveys say it is more than double that.

Interest rates in pesos were negative a few months ago when adjusted for inflation. The stability of the peso, which the central bank tightly controls, meant investors who turned their local investments into dollars enjoyed high returns compared to rates elsewhere around the world.

"This rise (in interbank rates) reflects the fact that the rates we had in June ... were ridiculously low for the inflation we had," said Camilo Tiscornia, analyst with Castiglioni Tiscornia and Associates consulting firm.

Having lost confidence in a steady peso, investors have started to pay attention to real interest rates.

The peso has weakened 3.6 percent since the start of the year, slipping to 3.21 per dollar in the informal foreign exchange market measured by Reuters ARSB=.

"We've got international turbulence and there are expectations that the peso will depreciate, which logically implies higher interest rates," Tiscornia said.