Argentina is inching closer to a currency crisis that could unleash economic havoc unless the government takes the tough decisions needed to increase confidence in Latin America’s No. 3 economy and stem the outflow of foreign reserves.

Starting in 2003, Argentina’s government began moving away from market-friendly economic policies toward a more populist attitude that grants generous government subsidies on everything from public transport to social programs.

This soon led to a spike in inflation, which private analysts estimate at 25 percent, one of the world’s highest rates. The government, which has been reprimanded by the International Monetary Fund for inaccurate data reporting, says inflation is between 10 and 11 percent.

In an attempt to control prices, President Cristina Fernandez’s government has kept the official exchange rate at artificially strong levels, effectively making imports cheaper but hampering manufacturers’ ability to compete internationally and driving down private investment.

With the country unable to finance imports or debt payments by borrowing from abroad after its 2002 default, Argentina has been forced to rely on foreign exchange reserves, which are mostly generated by grains exports.

Reserves are down by 20 percent this year to $34.4 billion, their lowest level since early 2007.

If this trend continues, the government may find itself without enough foreign currency to honor its debts or pay for its energy needs, eventually leading to economic collapse.

Fernandez’s government has reacted by limiting Argentines’ ability to gain access to dollars, fueling a black market that charges nearly twice the official rate per U.S. dollar.

After mid-term congressional elections later this month, the government may be tempted to take more unpopular steps to clamp down on access to the greenback.

The following are some potential actions the government can take in response to this threat, in order of likelihood:

TIGHTEN CURRENCY CONTROLS

In late 2011 Argentina began prohibiting companies and individuals from purchasing dollars for savings purposes. Businesses in Argentina that need dollars are required to go through multiple layers of bureaucratic hurdles, while Argentine tourists are often denied their requests for foreign currency.

The next year, the government imposed a 20 percent tax on credit card purchases abroad. Those purchases still drain nearly $700 million per month from the central bank’s reserves.

The government could tighten those controls further, raising the rate or imposing a spending limit on foreign purchases. It could also make it tougher to buy dollars for import purposes.

The impact of additional currency controls is likely to be negative in the long term, though. With restricted access to dollars, local firms will be increasingly unable to import the inputs needed for production, causing some to shut down and fire employees. Under this scenario the economy could only go so far before it creaks to a stop.

REMAIN ON COURSE

The government may decide to take no action to address currency concerns, in which case the outcome would likely be a further deterioration of Argentina’s economy.

For now, Argentina’s leaders have their fingers crossed, hoping for a record 2013/14 grains crop. The government could also try to buy time by seeking additional lines of credit from the World Bank, the International Monetary Fund and the People’s Bank of China.

In any case, Argentina will eventually need to attract investment from abroad to get back on its feet, though that may hinge on how investors view the country’s next leader, due to take office at the end of 2015.

“The Argentine government is seen domestically and internationally as a chronic liar,” said Nicolas Cachanosky, an Argentine economist at Metropolitan State University of Denver. “There is a need for an institutional shock, a strong political and institutional signal that things are going to be different.”

FORMALLY ESTABLISH MULTIPLE EXCHANGE RATES

The central bank could set one official exchange rate for capital flows such as tourism spending and another for trade, in a sense carrying out a partial devaluation.

The bank could weaken demand for dollars by offering an official rate for tourism that runs closer to the black market rate, but without the premium charged for engaging in illegal activity. The exchange rate for imports would stay near current levels in order to stem demand and control inflation.

The government could also set different rates for certain industries in a bid to boost the competitiveness of local manufacturers and attract more dollars. This could buy some time, but analysts say it would not solve the problem due to the likely corruption and arbitrage that would take place.

SHARPLY DEVALUE THE PESO

The government could decide to sharply modify the official exchange rate to a level that more closely matches that of the black market in order to boost the competitiveness of local manufacturers and bolster exports.

“The peso needs to weaken, and badly,” said Michael Henderson, Latin America economist with Capital Economics in London. “Argentina is now one of the most expensive places in the world to be a producer.”

Currently, one dollar costs about 9.69 pesos on the black market, a 66 percent premium to the official rate of 5.83 pesos.

One drawback would be a resulting spike in prices, which would erode purchasing power and reduce domestic consumption.

Argentina’s central bank is currently devaluing the peso, but at a pace that has failed to keep up with price levels.

Many analysts see a one-time devaluation as unlikely due to its political cost. Fernandez vows not to devalue, arguing that it would only favor grain exporters, many of which are her political rivals, and hurt the poor, her key support base.

Source: Reuters (UK)