BCRA Meets its Monetary Target, but Is Not

UNCLAS BUENOS AIRES 001223

SIPDIS

SENSITIVE
SIPDIS

PASS FED BOARD OF GOVERNORS FOR PATRICE ROBITAILLE
TREASURY FOR DAS LEE, RAMIN TOLOUI AND CHRIS KUSHLIS
NSC FOR SUE CRONIN
AND OCC FOR CARLOS HERNANDEZ
USDOC FOR ALEXANDER PEACHER
USDOL FOR ILAB PAULA CHURCH AND ROBERT WHOLEY
USSOUTHCOM FOR POLAD
OPIC FOR GEORGE SCHULTZ AND RUTH ANN NICASTRI

E.O. 12958: N/A
TAGS: EFIN ECON ELAB ALOW AR
SUBJECT: BCRA Meets its Monetary Target, but Is Not
Fighting Inflation



1. (U) Sensitive but unclassified. Not for internet
distribution.

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Summary
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2. (SBU) The average M2 level during the first quarter
was close to the lower end of the Central Bank's
(BCRA's) Monetary Program target. Still, M2 increased
26 percent y-o-y, and would have increased 28 percent
but for a last-minute transfer of social security
funds to a time deposit in late March. The BCRA
introduced two measures that appeared to signal a
tightening bias in monetary policy, but real interest
rates remain negative and fell even further in the
first quarter, to -6.2 percent on time deposits. The
BCRA's priorities continue to be accumulating reserves
and avoiding peso appreciation, not attacking
inflation. So far, the BCRA has been able to
sterilize its dollar purchases by issuing Lebacs and
Nobacs and encouraging discount window repayments,
while avoiding sharp interest rate increases.
However, in the future the BCRA may have to allow
interest rates to increase further with the downside
of eroding the BCRA's quasi-fiscal surplus. The BCRA
should be able to meet its M2 target this year, but it
will have to ignore M3 growth, which may better
reflect recent growth in the money supply. End
Summary.

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BCRA Meets Monetary Target for the 11th Consecutive
Quarter
-------------- --


3. (U) The Central Bank (BCRA) announced that it
fulfilled its monetary target for the first quarter of

2006. According to BCRA data, the average M2 (cash
plus public and private sector current and saving
accounts) level during the quarter was ARP 106.2
billion, close to the lower end of its Monetary
Program target of ARP 104.4 billion, and well below
the upper limit of ARP 110.9 billion. During the
quarter, M2 increased ARP 2.3 billion (26.5 percent y-
o-y) to ARP 106.2 billion. M2 increased 2.2 percent q-
o-q due to an ARP 1.4 billion increase in public and
private sector sight accounts and an ARP 900 million
increase in cash in circulation.


4. (U) This was the eleventh consecutive quarter in
which the BCRA has met its target. The BCRA shifted
to an M2 target instead of the monetary base because
M2 better reflects monetary conditions due to the
increase in the money multiplier. The 2006 monetary
program envisions a deceleration in M2 growth, which
is expected to increase 21.2 percent in 2006, well
below the 36 percent, 33 percent and 25 percent
increases seen in 2003, 2004 and 2005, respectively.


5. (U) Economic consultant Miguel Angel Broda recently
noted that meeting an M2 target is not exempt from
"creative accounting" by, e.g., asking a public
institution to transfer its transactional deposits
(funds held in savings or checking accounts) to time
deposits. Broda points out that the social security
agency transferred ARP 1.5 billion from its sight
accounts to a time deposit at the end of March.
Without that transfer, M2 would have increased 28
percent y-o-y in the first quarter.

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Monetary Base
--------------


6. (U) The monetary base increased ARP 2.6 billion in
Q1 to ARP 58.5 billion, mainly due to the BCRA's
emission of ARP 7.9 billion to purchase dollars to

rebuild its reserves and avoid peso appreciation, as
well as ARP 2.8 billion in repo transactions. This
increase was partially sterilized by ARP 5.0 billion
in banks' repayments of their discount window lending
to the BCRA, an ARP 1.7 billion GOA repayment to the
BCRA for short-term financing, ARP 994 million in net
issuance of Lebacs and Nobacs, and ARP 300 million of
other factors. (Note: As of the end of March, three
banks -- out of 24 at the beginning of the 2001
financial crisis-- still owed the BCRA a total of ARP
6.2 billion for discount window borrowing. End Note.)

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BCRA Reserves
--------------


7. (U) BCRA reserves decreased 23 percent in the first
quarter, to USD 21.5 billion, mainly due to the GOA's
full prepayment of its USD 9.5 billion IMF debt on
January 2. However, the BCRA's steady intervention in
the foreign exchange market during the remainder of
the quarter allowed the BCRA to add USD 2.3 billion to
its reserves, recovering 24 percent of the IMF payout.
The BCRA's monetary program envisions a complete
recovery of reserves this year back to USD 28.0
billion, their level prior to the IMF payment.

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Time Deposits and Loans
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8. (U) Average total time deposits increased slightly
during the first quarter, from ARP 49.9 billion to ARP
50.7 billion, due to an increase in private sector
deposits that more than offset a fall in public sector
deposits. Loans to the private sector increased 9
percent from ARP 43.7 billion to ARP 47.5 billion
(average of the quarter). At the end of March, loans
to the private sector totaled ARP 48.8 billion with
consumer loans, mortgages and current account advances
representing 30 percent, 18 percent and 40 percent,
respectively.

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Interest Rates
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9. (U) The BCRA increased the 7-day active repo rate
(the rate at which the BCRA offers financing and adds
liquidity to the system) by one percentage point in
the first quarter, to 7 percent. The BCRA maintained
passive repo rates (the rates at which the BCRA
borrows funds and absorbs liquidity) unchanged at 4.5
percent for a 1-day repo and at 5 percent for a 7-day
repo. [Note: repo agreements -- repurchase
transactions -- involve temporary loans of securities
in return for short-term financing. End Note.]


10. (U) In December 2005, the BCRA ended its policy of
shortening Lebac maturities to avoid interest rate
increases. Since the beginning of the year, the BCRA
shifted to issuing longer-term Nobacs, which carry a
variable rate of Badlar (rate for deposits of more
than ARP 1 million) plus a spread (determined at the
BCRA auction). Badlar rates increased from an average
of 6.80 percent in the last quarter of 2005 to an
average of 8.20 percent in first quarter of 2006.
Currently the BCRA is paying interest rates of 12
percent on the 2-year Nobac, roughly equal to expected
inflation.


11. (U) Lebac interest rates remained almost unchanged
at the short end of the curve (less than three months)
at 6.7 percent, 6.8 percent, and 7.2 percent for the 1-
month, 2-month and 3-month instruments, respectively.
However, the interest rate on the 6-month Lebac
increased by 80 basis points to 8.3 percent at the end
of the first quarter.



12. (U) While Lebac rates remained almost unchanged
during the first quarter, it is important to note that
their relative participation in the stock of BCRA
paper outstanding decreased sharply during the first
quarter, from 74 percent to 42 percent at the end of
March, with a stock outstanding of ARP 11.8 billion.
At the same time, Nobacs increased their participation
from 26 percent to 58 percent, with a stock
outstanding of ARP 16.3 billion. Nobacs increased
their participation in tandem with the increase in
Badlar rates. Investors shifted to Nobacs because
they offer better yields and better protection against
inflation than Lebacs.


13. (U) Market rates for time deposits and the call
interest rate -- the inter-banking lending rate --
both increased in the first quarter. The average rate
for time deposits jumped 130 basis points from 4.80
percent to 6.10 percent, while the call rate increased
90 basis points from 6.00 percent to 6.90 percent.

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BCRA Sends Mixed Messages on Monetary Policy
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14. (U) The BCRA introduced two measures in the first
quarter that appear to signal a tightening bias in
monetary policy. First, the BCRA increased bank
liquidity requirements for sight accounts (current and
savings accounts) by 2 percentage points to 17
percent. Second, it eliminated the 2.55 percent
annual rate that the BCRA paid banks for their minimum
reserves. These measures should stimulate a shift
from M2 and into time deposits and may force an
increase in interest rates. However, by themselves,
these measures do not indicate a turning point in BCRA
policy.


15. (SBU) Monetary data indicates that the BCRA's
priorities are accumulating reserves and avoiding the
peso appreciation. So far, the BCRA has been able to
sterilize its dollar purchases by issuing Lebacs and
Nobacs without raising interest rates sharply, aided
by banks repaying their discount lending to the BCRA.
That will not be possible indefinitely, and at some
point, the BCRA may have to allow interest rates to
reach positive levels. That will reduce the BCRA's
quasi-fiscal surplus. Discount loans are the BCRA's
best-performing asset, and the rise in repayments
reduces the BCRA's surplus even further.


16. (U) In a recent interview, BCRA President Martin
Redrado said that the BCRA may sell its holdings of
Boden 2011 bonds to supplement the BCRA's absorption
capabilities. This appears to confirm the concerns of
some analysts that the BCRA will have problems
containing money supply growth while rebuilding
reserves, although Redrado downplayed those concerns.
[Note: The Boden 2011 is a peso-denominated bond
adjusted by CER (CPI-linked index) with a 3.5 percent
coupon. The BCRA holds ARP 6 billion worth of Boden
2011 and is the only owner of this bond, which it
received from the GOA in compensation for the BCRA's
purchase of provincial quasi-monies in 2003. End
Note.]


17. (SBU) At first glance these measures appear to
indicate a turning point in BCRA monetary policy
towards a tightening. However, the current level of
real interest rates suggests a need for a further
tightening. For example, real interest rates (based
on expected inflation as measured by the BCRA
consensus survey in March each year) were lower in the
first quarter, y-o-y. Real interest rates on time
deposits averaged -6.2 percent at the end of the first
quarter, compared to -5.7 percent in the first quarter
of 2005. This is consistent with the Kirchner

Administration's goal of expanding domestic demand, as
lower interest rates generally, and negative interest
rates in particular, give people an incentive to
increase consumption and decrease savings. But this
is not consistent with a monetary tightening to combat
inflation.


18. (SBU) The BCRA's management of the monetary base
is not an objective in itself but helps the BCRA meet
its M2 target, since M2 equals the monetary base times
the money multiplier. The BCRA measure increasing
bank liquidity requirements decreased the money
multiplier, because it requires a higher proportion of
reserves for each peso in the financial system,
reducing secondary money creation. The increase in
reserve requirements for sight accounts should
generate an increase in time deposits (and thus reduce
M2) but this shift may in the end produce an increase
in the money multiplier for M3 (a wider monetary
aggregate equal to M2 plus private sector time
deposits) because reserve requirements for sight
accounts are larger than for time deposits. Thus, the
BCRA will fulfill its M2 monetary target this year,
but it will have to ignore the likely growth in M3,
which may be the most appropriate variable as it
includes private sector time deposits and better
reflects the growth of money supply.