ARGENTINE CENTRAL BANK PRESIDENT PLEAS FOR

C O N F I D E N T I A L BUENOS AIRES 002486

SIPDIS

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E.O. 12958: DECL: 11/02/2016
TAGS: EFIN ECON KTFN AR
SUBJECT: ARGENTINE CENTRAL BANK PRESIDENT PLEAS FOR
PATIENCE WITH GRADUAL REFORM PROGRAM


Classified By: Charge d'Affaires Michael Matera. Reasons 1.4 (b,d)

Summary
--------------

1. (C) Argentine Central Bank (BCRA) President Martin Redrado
urged patience with his sequencing of reforms during an
October 20 meeting with Charge, claiming that a program of
gradual monetary tightening was impacting inflation and some
delay was warranted before Argentina returns to a fully
floating exchange rate. In addition to solid monetary policy
and the BCRA's comfortable reserve position, Redrado
emphasized other positive economic developments: the GoA's
strong fiscal balance, the strengthening financial system,
and falling inflation, with the latter due mainly to sound
macro policies, not price controls. Although he acknowledged
that the primary fiscal surplus had declined 1% per year
since 2003, Redrado argued there was no macroeconomic basis
for spiraling inflation. On Paris Club, Redrado called for
long-term rescheduling and clarified that the GoA would need
to pass a law authorizing the BCRA to use reserves to pay
arrears. Redrado reassured Charge that the GoA would submit
draft counter-terrorism finance (CTF) legislation to Congress
by year-end. End Summary.

Gradual Sequencing of Reforms is Critical
--------------

2. (C) Charge and Econoffs met with BCRA President Redrado
October 20 to discuss BCRA monetary and banking policies,
inquire about his outlook on the broader economy, and get his
assessment of the GoA's ability to submit a draft CTF law to
Congress before the Financial Action Task Force's (FATF)
February 2007 deadline.


3. (C) Meeting alone and speaking perfect English, Redrado
asserted that Argentina's 2001/2 financial crisis was
equivalent to the U.S. depression, especially with regards to
its impact on the poor, and urged patience with Argentina's
sequencing of reforms. He argued that Argentina must first
complete the process of restructuring debt, ensure a healthy
fiscal balance, rebuild the damaged financial sector, and
accumulate adequate official reserves, before eventually
implementing a fully free floating exchange rate regime and
moving towards an inflation targeting monetary policy.
Despite the country's impressive strides in these areas, with
primary fiscal surpluses, a profitable and growing banking
sector, and reserves topping $28 billion (exceeding the level
of reserves prior to the January 2006 payment to the IMF),
Redrado called for restraint, noting that Chile took ten
years to make a similar transition.

Gradual Tightening of Monetary Policy
--------------

4. (C) Redrado noted that real interest rates were now in
positive territory as a result of his gradually contractive
monetary policy. He claimed that BCRA rates on short term
financial instruments (Lebacs and Nobacs) and repos
(overnight lending) had almost doubled in the last year due
to the BCRA's liquidity absorption policies. He admitted to
generous monetary expansion in 2003 and 2004, claiming this
policy was critical to the economy's recovery, but also



asserted that the contractionary impact of the last 18-24
months was measurable. Monetary expansion is currently half
of what it was in 2005 and, consequently, real interest rates
are now positive. (Note: yields on BCRA notes have been
11-12% over the last year, up from 6% in March 2005. End
Note).


5. (C) Redrado refuted criticism of the BCRA's partial
sterilization policy. BCRA intervention in the market has
maintained the peso at an artificially low level, while
allowing the BCRA to accumulate substantial official
reserves. However, critics claim it will be difficult to
continue sterilizing the BCRA's interventions while at the
same time maintaining low interest rates. Redrado denied
that this would be a problem, pointing out that no debt had
matured at the last two auctions, so the BCRA was easily able
to absorb 800 million pesos at each without bumping up Lebac
and Nobac yields. The BCRA is also aggressively using repos
to mop up excess liquidity. (Note: interestingly, repo rates
have increased roughly 20% in 2006, possibly supporting
critics' arguments. End Note). Redrado also dismissed
concerns about the BCRA's quasi fiscal balance, which higher
interest rates would jeopardize. He stated that the BCRA's
profit in 2005 was 2.5 billion pesos, of which he used half
to strengthen the bank's capitalization. He also claimed the
BCRA's total net worth was $7 billion, evidence of sound BCRA
financial management.


6. (C) Redrado argued that the financial system has not
recovered sufficiently for the BCRA to implement an inflation
targeting regimen. In public statements, he has defended
BCRA policy of relying on monetary targets to manage
inflation, arguing that the speed of money circulation is
less volatile than interest rates in Argentina, and the
absence of a reference interest rate (i.e., federal funds
rate) makes it more reasonable for the BCRA to use monetary
targets.

Strengthening Banking System
--------------

7. (C) There have been two important and positive
developments in the financial system, according to Redrado.
First, bank exposure to the public sector has fallen to 27%
of total assets, from a high of over 50% in December 2002 and
over 40% at the beginning of 2006. Redrado took partial
credit for this, following his increase of capital
requirements on public debt (which was zero percent during
the 1990s). Redrado also credited lower GoA borrowing needs
for the shift. For the first time in 13 years, credit to the
private sector surpasses that to the public sector,
"crowding-in" the private sector. The second development is
the elimination of "mis-matched currency exposures on bank
balance sheets," with bank assets and liabilities now both
denominated in pesos and the BCRA serving as lender of last
resort, in pesos.


8. (C) Redrado admitted that the lack of long term debt
instruments in Argentina's still small financial market
remains a concern, one that has led the life insurance
companies and pension funds to invest billions in Brazil and



Asian market long term paper. (Note: banking sector credit
to the private sector is only 10% of GDP, versus 35% in
Brazil and 60% in Chile. End Note). Although the GoA has
developed several lackluster initiatives, such as providing
government support for the development of a secondary
mortgage market (i.e., Fannie-Mae),these have gone nowhere.
Redrado commented that the issue is whether the GoA or the
financial sector will pay the up-front cost for developing a
secondary mortgage market's risk-pooling infrastructure.


9. (C) As a longer term alternative, the BCRA is improving
and adjusting bank regulation to increase banks' incentives
to provide longer-term financing. In terms of bank
supervision, Redrado stated that the BCRA's bank supervision
department is already implementing Basel II risk standards,
and the BCRA Directors' Board approved use of the Basel II
"25 Core Principles" last month. Redrado's goal is to
implement the Basel II "simplified standards" approach by

2010.

Inflation: Impact of Price Controls Overstated
-------------- --

10. (C) Redrado agreed that the primary fiscal surplus had
eroded by one percent per year since 2003 due to increased
public sector spending at the federal and provincial levels,
and also acknowledged that this was pushing aggregate demand.
Nevertheless, he argued that there was no current
macroeconomic basis for spiraling inflation, given the BCRA's
tightened monetary policy and the GoA's continuing primary
fiscal surpluses of 3-4%.


11. (C) Redrado disputed that the GoA's price controls were
the main factor in falling inflation, rather the BCRA's
tightened monetary policies were having an impact. However,
in a contradictory statement, he admitted that lower meat and
dairy prices -- the result of price controls and export bans
-- were responsible for a 2% decline in the 2006 inflation
rate, compared to 2005. Redrado also admitted that these
controls have created distortions and shortages, especially
in the food and beverage markets. However, most areas are
not as negatively affected, and he asserted that no
businesses, in any sector of the economy, were losing money.
He concluded by falling back on the oft-heard GoA complaint
that the inefficient and semi-oligopolistic private sector
was weak at anticipating and reacting to problems, and until
the business class improved its competitiveness, government
intervention was warranted.


12. (C) The price controls have had one positive affect,
according to Redrado: taming salary demands. The major
unions accepted 19% salary increases for 2006 and 11% for
2007, lower than expected because of the unions' faith in the
GoA's ability to control inflation. While conceding that
solid fiscal and monetary policies were the preferred means
to maintain stable prices, he claimed that wage policy was
also a key factor. (Note: in public statements over the
last year, Redrado has defended BCRA policies, arguing that
inflationary pressures are due to expansive fiscal policy,
salary hikes and supply bottlenecks in the manufacturing
industry. End Note).



GoA Goal Should Be Long-Term Paris Club Rescheduling
-------------- --------------

13. (C) Redrado noted that the Argentine Congress would need
to pass a new law to allow the BCRA to use reserves to pay
Argentina's $3.5 billion arrears to Paris Club creditor
nations. The law authorizing the GoA to use official
reserves to prepay Argentina's entire $9.5 billion debt to
the IMF in January 2006 only applied to debts to the
International Financial Institutions. Regardless, Redrado
argued that the GoA should pursue a long-term rescheduling
agreement with the Paris Club that would not include a large
upfront payment.

Draft CTF Law Will Reach Congress by Year-End
--------------

14. (C) Redrado stated that anti-money laundering and
counter-terrorism finance (AML/CTF) were high priorities for
the BCRA, and he is working with the Treasury Department to
develop private-public mechanisms to improve AML/CTF
coordination in the region. While Argentina has improved its
AML legislation and enforcement, Redrado agreed that the top
priority was to submit a draft CTF law to Congress prior to
the February 2007 FATF plenary, as the repercussions of
missing this FATF deadline could be devastating for the
financial system. Redrado said the GoA's "Mixed Commission,"
comprised of law enforcement agencies, BCRA, and the Ministry
of Justice, was working to complete a final draft by
mid-November, and the Justice Minister had recently assured
him that the goal was to deliver it to the President and then
to Congress by year's end.


15. (C) Redrado said the Justice Minister's decision two
months ago to take ownership of the drafting process had
galvanized the GoA's effort. The Justice Ministry had since
developed an adequate definition of "Terrorism" in the draft
law that would exclude "social protest," and thus avoid a
divisive human rights debate in Congress. Redrado admitted
that the process had taken far too long, and had tarnished
the GoA's reputation with other FATF countries, but
emphasized that it was important to deliver a bill that met
FATF standards and could also pass Congress.

Comment
--------------

16. (C) Redrado began his tenure as Central Bank President in
late 2004 with low expectations from the community of
Argentine economists, who considered him a relative
lightweight. The central bank's steady performance to date
has, however, won him increasing respect. While we
appreciate his arguments for gradual reform, he must know
that the current mix of BCRA and GoA policies is probably
untenable in the medium to long run. The imposition of
capital controls in 2005 has helped to alleviate upward
pressure on the peso by diminishing short-term (portfolio)
inflows and limiting the money supply expansion fed by the
central bank's purchase of dollars in the FX market.
Nevertheless, continued strong dollar inflows resulting from
Argentina's high merchandise trade surplus will require
ongoing BCRA intervention and will make it difficult for



Redrado to achieve his goal of restraining money supply
growth and limiting inflation. End Comment.
MATERA