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July 22, 2014

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Saturday, February 15, 2014

Adjustment: too late to avoid stagflation

By Miguel Braun
For The Herald

After weeks of macroeconomic volatility, the Argentine government has achieved a certain calm. It did it thanks to a clear orthodox turn. Its summer economic package amounts to a classic stabilization plan — devaluation, interest rate hike, attempts at price-wage moderation and possibly fiscal adjustment.

So is that calm here to stay? Probably not if the administration does not advance on the remaining issues, that is, if it does not decrease a monetary expansion. If it does, the path to 2015 will be reasonably calm (albeit with low if any growth and high inflation). One way or another, it is far from a plan and a vision that could put Argentina on the path of sustainable development. The adjustment came too late to avoid stagnation and high inflation.

Up to now, the underlying economic plan was characterized by a gradual devaluation paired with an ultra-expansive monetary policy that combined an increase in the money supply to fund growing fiscal deficits and negative real interest rates. In that scenario, the profitability of holding dollars or dollar denominated assets was higher than any peso denominated assets; therefore, the result was a growing demand for dollars, expectations of devaluation and a consistent fall in international reserves. The Central Bank’s answer was a turn toward orthodoxy through four main channels: devaluation, (slight) relaxation of restrictions on foreign exchange, higher interest rates, and regulation that forced banks to increase the supply of dollars.

The first measure was a jump in the foreign exchange rate instead of a gradual slide of the dollar. The peso lost 20 percent of its value between July and December 2013, and 22 percent in January 2014. At the same time, the government relaxed restrictions on foreign exchange (the cepo). The idea was to allow small investors to buy dollars at the official rate to reduce pressure on the parallel dollar inasmuch as a bigger gap results in higher expectations of devaluation. This is a double edged weapon, though, as it opens a new channel for the loss of reserves of 500-700 million dollars per month.

The third ingredient in this new economic recipe was a hike of interest rates. NOBAC and LEBAC interest rates were at 17 percent at the end of 2013 and 30 percent at the end of January. The aim is to increase the yield of peso-denominated assets vis a vis the return of dollar-denominated assets. The Central Bank was also able to absorb more pesos, limiting the rate of expansion of the monetary base (26.5 percent per year). The risk, of course, is to limit economic activity, through less consumption and the increase in working capital for small businesses.

Finally, the Central Bank reissued an old regulation (A 5536) that is forcing banks to sell a huge chunk of their dollar-denominated assets, including cash, bonds and dollar futures. The idea is to increase the supply of dollars, lower the expected devaluation (by increasing the supply of futures contracts, thus lowering the future value of the dollar) and stop the rise of both the official and parallel exchange rates. Banks will have to sell around US$4 billion from here to April; thus, in the short term this regulation increases the supply of dollars, in what could be a bridge until the arrival of the proceeds from the soy harvest. This move is, however, a short-term fix: last year alone, the Central Bank lost US$13 billion in foreign reserves.

The new policies have temporarily limited the uncertainty in the foreign exchange market. The Central Bank has been able to defend the peso at and around 8 pesos per dollar; the unofficial dollar has abated and the expected devaluation fell to 30 percent (based on the implicit rate of end-of-year dollar futures). At the same time, the Central Bank has absorbed some excess pesos in circulation and we have been seeing a lower rate of loss of reserves.

On the other hand, there have been two signs of alarm. According to the Congress-CPI, inflation hit 4.6 percent in January. A higher inflation rate will put extra pressure on wage negotiations and on the exchange rate. The other alert was fiscal; the Treasury demanded a record amount of financing through monetary expansion in January (a traditionally slow month in this regard). In other words, the new calm could be only temporary if the underlying macroeconmic issues are not addressed.

Several issues could jeopardize this newfound calm. The first is that there are still too many pesos for too few dollars. Even with the absorption mechanisms, the quantity of pesos increases and reserves fall, and the relation of monetary base to reserves is at around 13 pesos, close to the parallel exchange rate. The second risk is the possible spiral of inflation and devaluation, not negligible in a scenario of close to full employment and absence of a fiscal anchor. This is particularly the case after the 4.6 percent rate of inflation in January, that could quickly erode the competitiveness gained with the devaluation. The third issue lies in wage negotiations: the 25 percent average increase the government is bargaining for could be difficult to achieve, and a bigger hike could put further pressure on prices. Last but not least, as long as the fiscal deficit continues to grow and no financing from abroad is available, monetary expansion will continue to put pressure on the exchange rate and prices.

In any case, economic activity will suffer. A context of still high uncertainty, higher interest rates and probable restrictions to imports will probably mean a cooler economy. Midway through 2013, Latin American Consensus Forecast projected a 3-percent growth in 2014; seven months later the projection was dropped to 1 percent-1.5 percent, and now that looks increasingly difficult to achieve.

Populist rhetoric notwithstanding, it appears that the government will sacrifice growth to avoid a further drain of dollars from the Central Bank, and a coherent, sustainable, long-term development programme is nowhere in sight.

Miguel Braun is the executive director of Fundación Pensar (PRO).

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