Monetary policy: Argentina takes its bitter medicine

Illustration: Jonathan Williams

Gradualism is dead in Argentina. 

In its place a new strategy has been devised to tackle the country’s monetary and fiscal challenges. It has just begun to be implemented. 

But it is going to be a strong, inflation-fighting medicine with many serious and unavoidable side effects and a level of toxicity that may kill the administration’s ability to govern. 

The most obvious side effect will be a deep recession, already underway and that is expected to be lead to a contraction of around -2.5% this year. It will also drag on and likely lead to negative growth in 2019 – a presidential election year. 

Meanwhile the country’s banking sector is back in the survival stance it adopted under the previous president, Cristina Kirchner. 

As the recession hits and interest rates rise above 70%, the demand for credit has evaporated, with the exception of the distressed and the desperate. Everyone is monitoring asset quality, which has begun to deteriorate and carries the threat of much worse. 

The crisis has already begun to bite in the consumer unsecured finance sector, where credit cannot be re-priced without seeing delinquencies spike. The small and medium-sized enterprise sector is also already showing signs of stress. Analysts expect some weak banks to go to the wall and the big banks to suffer.

The country is also effectively locked out of the international capital markets – from the sovereign down. The pipeline of equity and debt transactions that was reportedly very strong coming into this year is now on hold and there is no clarity about when these deals may become viable again. 

Local companies are scrapping investment plans as the economy goes into a deep freeze and international investors have turned their backs on the country.  

Now that gradualism is over, there is a chance that the fiscal and monetary adjustment are so large that they weigh on tax collection and make the financial adjustment untenable 

 – Todd Martinez, Fitch Ratings

In the meantime, IMF money will have to cover the country’s large external financing needs up to, and beyond, those critical elections. There are already plenty of theories about how the economic hardship to come will impact the country’s presidential election in October 2019. 

Success for the ruling Cambiemos, the political party formed by president Mauricio Macri in 2015, should finally see the economy reap the benefits of investment that such continuity and stability would bring. 

Victory for opposition Peronists would threaten that. A victory for Kirchner would almost certainly dismantle it. 

With the fate and control of the enormous oil and gas reserves of Vaca Muerta, which are just beginning to come online, up for grabs, the stakes could hardly be higher.

Time is tight. History tells us little. 

There have been few successful examples of monetary regimes that target the monetary base, which is the anchor that the new central bank president, Guido Sandleris, is using to replace the failed inflation-targeting anchor. And none of those has been implemented with a simultaneous fiscal contraction of the size that is required here. 

More importantly, none of these case studies have been based in Argentina, where the credibility of financial institutions is hard won and easily squandered.

Fiscal bleeding

When Macri swept into power in December 2015 – pushing Kirchner out – he set about transforming the economy. He deliberately set out to achieve a slow, gradual adjustment within the political constraints. His party, Cambiemos, had a minority of seats in both houses of government, which limited his ability to push through radical policies and made him keen to enhance his position following the 2017 mid-term elections.

To help Macri staunch the fiscal bleeding over the four-year life of his administration, the international markets feasted on Argentina’s emerging market yields, convinced that the sovereign was a rare one-way bet on an improving EM credit story. 

All types of investors and all the big names were running overweight exposures. 

The high interest rates that accompanied the new inflation-targeting regime increased these capital inflows as the carry trade glistened, further boosting the currency and helping to anchor inflation as it crawled towards its single-digit targets. 

Progress was slow, but it was coming. And, yes, the expensive currency was exacerbating the country’s current account – imports flooded in and Argentines took their spending power abroad – but for the most part that weakness was greeted with shrugs. You can’t have it all.

Macri’s success in the mid-terms in October 2017 reinforced investors’ belief in their good judgement – the odds of the government being re-elected in 2019 were now surely extremely good. This supplemented the other two main points of Argentina’s investment thesis: that the government would continue to make progress in balancing the fiscal account and would continue to battle inflation, whatever the cost.

In the second half of its term, the government began its agenda of further gradual fiscal reform. First, it tackled pensions – a relatively light change to the complicated and slightly illogical indexing formula for state pensions. Officials briefed that the government would push ahead with confidence; it wouldn’t be looking at poll numbers for a year while it tackled the fiscal challenge. 

That promise lasted roughly 10 days, as a severe pushback on the pensions issue cost the government 10 percentage points in the polls. The government panicked: it saw softening economic growth that would further complicate its fiscal challenge on the revenue side. The currency was strong. It gambled it could ease monetary policy and kill two birds with one stone.

Those tweaks to monetary policy – a new target and a couple of minor cuts – backfired dramatically. Instead of stretching the 2018 GDP outlook to 3% from 2.5%, it unleashed a confidence crisis that surged through those overweight investors. 

A rush to trim positions sent Macri’s government straight to the IMF. Botched communications and a run on the peso saw the first plan (essentially a confidence-boosting backstop facility) turned into actual hard currency financing of its debt commitments into 2020, as both the IMF and Argentina realized the country was frozen out of the international capital markets. 

At some point domestic investors realized what was happening and rushed to convert pesos into dollars. The exchange rate – at Ps18 to the dollar at the end of last year – approached Ps39 by the end of August 2018. Panic wasn’t too strong a word. The IMF sped up its disbursements. The central bank’s president, Luis Caputo, in place for just three months to try to prop up its credibility, walked out. 

“The markets closed for Argentina, but it still had these large fiscal and external financing deficits,” says Itaú’s chief economist in Argentina, Juan Barboza. “The first plan was to get a financial backstop from the IMF on the expectation that Argentina was going to regain access to the markets. The idea wasn’t to withdraw all the IMF proceeds but to put in place a package that would be enough to reduce the country’s risk premia and stabilize the currency.

“That didn’t work, and Argentina had to go back to the IMF to request more money – and not on a precautionary basis. That led to a move from a gradual fiscal adjustment to a sharp adjustment and to a discussion of a replacement of the inflation-targeting regime; the only viable alternative was to control the monetary aggregates.”

With the central bank’s credibility toast and its inflation-targeting policy dead, the government, the IMF and Sandleris reached for a blunt monetary policy instrument: controlling the monetary base aggregate. The central bank pledged to keep the growth of its monetary base (chosen because it is the aggregate it fully controls) at a nominal 0% until June 2019. 

There are some subtleties, but it unarguably will lead to a strong contraction when inflation is heading towards 50% (the government is still unwinding spending subsidies that will lead to higher regulated prices in the coming months). 

By controlling the monetary base, interest rates will be set by the market, but the central bank is also committed to a minimum level of 65% for the coming months. (Interest rates are expected to be volatile and have remained above 70% so far under the new regime).

“The new policy is leading to a tightening in monetary policy that is needed to control inflation,” says Edward Glossop, economist at Capital Economics. “Real rates have risen – all the signs are that it should be successful, but the side effects are very large. It will result in a very deep recession.” 

Most economists predict a contraction of 2.5% GDP this year, with a range of expectations from -1.5% and zero for GDP growth next year.

Foreign exchange

There is also a foreign exchange component to the new monetary strategy. The central bank has created a wide ‘non-intervention’ band that began at between Ps34 and Ps44 against the dollar and which will be adjusted by 3% monthly to reflect the economy’s inflation. The band will end the year at Ps37 to Ps48. 

But rather than thinking of this as a valuation range to be defended, it should be thought of as a range beyond which the government will intervene with limited firepower – $150 million a day – not to defend valuation but to allow some limited money creation, releasing some pressure in the contractionary monetary policy (the central bank is not committed to offset its FX actions).

As well as providing the economy with a heavy anchor, the policy is designed to rebuild central bank credibility, which is sorely lacking. 

“The previous president wasn’t viewed as independent – you need to be able to coordinate monetary and fiscal policy, but you also need autonomy,” says Daniel Marx, executive director of Buenos Aires-based research company Quantum Finanzas. “The new programme is aimed at anchoring expectations, and the big test was to stop dollarization in Argentina. The big complication is that the central bank has very limited credibility and they have to build up a reputation.”

On that test, the policy has been a success; demand for dollars has been falling since the crisis – at the expense of those very high interest rates. Most economists expect those high rates to last as long as it takes to bring down inflation and build credibility. The logic of the brutish plan and the fact that there is no plan ‘B’ tends to suggest the medicine will be forced on the country, whatever the side effects.

But not all are convinced. 

One sceptic is Juan Pazos, head strategist at local investment bank Puente. He has examined the fine print of the new regime and found three potential cheats (he prefers the term ‘escape valves’) that could lead the central bank to be much more expansionary in 2019 than the market is predicting. 

The first is the seasonal adjustment to the monetary base. Pazos points out the policy allows for an upward adjustment of around 10% or Ps100 billion ($2.74 billion) in December 2018 and June 2019 but does not require a similar negative adjustment in the low seasonality months. 

Then there is that commitment to maintaining a 65% floor in interest rates – he argues that seemingly hawkish commitment will, for mathematical reasons, expire as soon as December. If the central bank was truly committed to taming inflation, he argues it would have adopted a much more explicit commitment, for example maintaining those rates until monthly inflation dipped sustainably below 1.5% a month. 

The third is a lack of commitment to adjust broad money creation: with reserve requirements now around 34% (and much higher in certain circumstances), compared with a 10-year average of 15%, the bank has created its rules at a time when the money multiplier is at an historical low. 

The bank could cut non-paying reserve requirements on the back of lower interest rates. Pazos anticipates interest rates of between 45% and 50% as soon as the first quarter, which sounds high in nominal terms but in real terms, given the inertia embedded in Argentinean inflation, could spur credit demand.

Should the economy be in a deep recession and the government’s poll numbers fall much faster than inflation, there will be incentives for the central bank to ease monetary conditions before the inflation fight is won. Sound familiar? 

Does Pazos really think the central bank might make the same mistake again?

“That is of course a possibility,” he says. “The government is banking on next year’s soy bean harvest being so good they will be able to ease monetary policy without having a re-ignition of FX volatility.”

That answer is worrying for two reasons. The first is that Pazos is quick to concede the gamble underlying future policy. The second is his automatic conflation of a question about the central bank’s monetary policy with the government’s future policy.

Hernán García, Banco Galicia

Even those who are inclined to believe that the central bank will avoid repeating the mistakes of the past do not communicate huge confidence. 

“There is always a risk in Argentina because there is not sufficient credibility in the central bank to ensure that it won’t happen,” says Hernán García, Banco Galicia’s chief economist. “But I tend to think that an agreement that is backed by the IMF will help ensure that they don’t relax monetary restrictions too quickly.”

Barboza also points out that even if the government hits its 2019 target of a primary fiscal deficit of 0%, the actual fiscal deficit (combining debt interest payments) will be around 3.3%, which is large for a country without access to international markets and one that is projected to have a debt-to-GDP ratio of between 75% and 83% by the next election.

The projected adjustment is easily criticized as low grade – it relies on temporary tax increases and cuts to government investment – but the concerns are broader. However, Fitch’s Martinez says given the constraints, both financial and political, a zero primary deficit would still be an achievement.

Martinez also says the fact that the opposition will agree to cuts on transportation subsidies is because it is aligned with the opposition’s interests: the pain will be felt most keenly in the province of Buenos Aires and that could damage the state’s governor and the country’s most popular politician, María Eugenia Vidal.

Vidal brings the key issue of next year into focus: the presidential election. While people close to the Macri administration say that the president fully intends to run again, there is a widespread speculation that he may – depending on his personal popularity as the election nears – stand aside for another candidate and Vidal would be his most likely replacement.