October 4, 2018 / 6:43 PM / 2 months ago

UPDATE 3-Argentina peso snaps three-day rally with more losses expected

(Adds closing peso level, Thursday's sale of short-term central bank notes)

By Hugh Bronstein

BUENOS AIRES, Oct 4 (Reuters) - Argentina's peso fell on Thursday, pressured by the recession-hit country's dismal inflation outlook and higher U.S. interest rates that have pushed capital away from riskier emerging markets and toward the greenback, local traders said.

The peso shed 1.85 percent to close at 38.4 per dollar after having gained 9.58 percent over the previous three days under a freshly-renegotiated International Monetary Fund financing deal that calls for tougher fiscal and monetary policy measures.

Sales of high-interest, short-term debt instruments known as "Leliqs" by Argentina's central bank supported the local currency earlier this week by mopping up excess peso liquidity that might otherwise go toward safe-haven U.S. dollars.

The peso was nonetheless expected to weaken further in the months ahead. The IMF's solid show of support for Argentina is being countered by nagging skepticism among investors over the government's ability to tame consumer price increases and plug its budget deficit, according to a Reuters poll.

With inflation expected by the market to end 2018 at 44.8 percent, the currency is seen plummeting about 19 percent to 47 to the dollar over the next 12 months, according to the median of 13 forecasts from currency strategists and economists.

In the United States, Federal Reserve policymakers have signaled support for gradual interest rate hikes that would likely reroute investment from Argentina and other fragile emerging market economies. The peso has already lost more than half its value against the dollar in 2018.

The newly-renegotiated $57 billion IMF pact with Argentina showed solid IMF support for the free-market policies of President Mauricio Macri ahead of his 2019 re-election bid.

Macri, elected in late 2015, has struggled to stabilize Latin America's No. 3 economy after eight years of heavy-handed foreign exchange controls, generous public utility subsidies and high deficits under previous President Cristina Fernandez.

'CRISIS MODE RATES'

Argentina's central bank issued 97.71 billion pesos ($2.53 billion) in seven-day Leliq notes, at a nose-bleeding interest rate of 72.83 percent, on Thursday. The bank says regular Leliq auctions are part of its anti-inflation plan.

The peso sell-off started in May, driven by doubts about the central bank's ability to roll over its burgeoning stock of another short-term debt instrument known as the "Lebac."

The run on the peso was sparked by jittery foreign investors who dumped Lebac notes in favor of dollar assets. The Argentine economy has since slipped into recession.

The Leliqs now being offered on a daily basis by the central bank are sold only to Argentine financial institutions regulated by government-imposed capital requirements that would block them from selling the notes all at once.

"This level of interest rates is not sustainable forever. These are crisis mode rates," said Gabriel Zelpo, chief economist at local consultancy Elypsis.

The central bank has said it will keep rates above 60 percent until December. "This implies a very tough tightening of monetary policy and it should be successful in keeping the foreign exchange rate under control," Zelpo said.

The currency crisis drove Macri to seek a deal with the IMF. The original $50 billion agreement signed in June was upped to $57 billion last month after being renegotiated to include tougher spending cuts and tax increases aimed at erasing the country's primary fiscal deficit next year.

It was a politically sensitive move as Macri prepares for his re-election campaign. Many voters blame the Fund for the country's 2002 economic crisis, which pushed millions of middle-class Argentines into poverty. With high interest rates choking off credit, the economy is expected to keep shrinking next year.

"The level of rates that the central bank is validating at this time carries a very simple message: the bank is willing to risk a deep recession in order to regain foreign exchange and monetary stability," said Alberto Bernal, chief emerging markets strategist at XP Investments in New York.

"I agree with the policy mix," Bernal added. "Without foreign exchange stability nothing is viable." (Additional reporting by Jorge Otaola, Walter Bianchi, Eliana Raszewski and Scott Squires Editing by Susan Thomas and Tom Brown)

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