The 2006 Monetary Program Unlikely to Help

UNCLAS BUENOS AIRES 000300 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: The 2006 Monetary Program Unlikely to Help Reduce Inflation ¶1. (U) Sensitive but unclassified. Not for internet distribution. -------------- Summary -------------- ¶2. (SBU) Central Bank (BCRA) President Martin Redrado presented the BCRA's 2006 monetary program on December ¶29. It will maintain a moderately contractive monetary policy, with a small increase in interest rates. Redrado acknowledged that meeting the 8-11 percent inflation target will be a lower priority than recovering the USD 9.5 billion in reserves used to pay off the IMF. Even with GOA help in managing the exchange market, the BCRA will be challenged to rebuild reserves, meet its monetary targets, and keep interest rates low. The BCRA will use M2 as its monetary indicator this year instead of the monetary base. The BCRA does not have direct control over M2 so the M2 target will be harder to reach. Nor, as in 2005, will reaching the target guarantee that inflation will be brought under control. Virtually all economic analysts are forecasting higher 2006 inflation than the BCRA, averaging 12.3 percent, with some forecasting a 15 percent floor. End Summary. -------------- The BCRA Unveils its 2006 Monetary Program -------------- ¶3. (U) The President of the BCRA, Martin Redrado, presented the BCRA's 2006 monetary program to the Senate Treasury and Budget Commission on December 29. During his presentation, Redrado noted that the 2006 monetary program will no longer focus on the monetary base but rather on the performance of M2 (cash plus public and private sector current and saving accounts). The change in the variable is due to the increase in credit and resulting increase in the money multiplier. (Note: Credit expansion increased the money multiplier -- measured as the ratio of M2 over the monetary base -- from 1.8 in January 2005 to 2.0 in December. End note.) ¶4. (U) Redrado argued that the Argentine financial system has not yet recovered enough to properly implement an inflation targeting regimen. He defended the BCRA's policy of relying on monetary targets to manage inflation, saying that the speed of money circulation is less volatile than interest rates in Argentina. Also, the absence of a reference interest rate makes it more reasonable for the BCRA to use monetary targets to control inflation. When questioned about the acceleration of inflation despite the BCRA meeting its 2005 monetary targets, Redrado argued that prices were increasing due to an expansive fiscal policy, salary hikes and supply bottlenecks in the manufacturing industry. (Note: 2005 inflation reached 12.3 percent, compared to 6.1 percent in 2004 and 3.7 percent in 2003. End Note.) ¶5. (U) Highlights and assumptions of the 2006 BCRA Monetary Program include: - Real GDP growth of 6.2 percent, similar to the assumptions in the 2006 Budget. - Average inflation of 8-11 percent, not including any utility tariff increases. This is below the average market forecast of 12.3 percent. - An increase of BCRA reserves to USD 28 billion by the end of 2006. This is the same reserve level as December 2005, before the GOA paid off its USD 9.5 billion debt to the IMF, and indicates that the BCRA will continue its strategy of accumulating reserves through intervention in the foreign exchange market. As of January 19, BCRA reserves stood at USD 18.9 billion. - Exports increase to USD 43.5 billion and imports to USD 32 billion, resulting in a trade surplus of USD 11.5 billion. This is expected to be the main source of foreign currency. - M2 growth of 11.7-21.2 percent, leading M2 to ARP 116-126 billion by the end of December. M2 is currently at ARP 105.3 billion and increased 25 percent in 2005. -------------- -------------- BCRA Monetary Program Targets for M2 (in billions) -------------- -------------- Mar 2006 Jun 2006 Sept 2006 Dec 2006 -------------- -------------- Lower-Band 104.4 107.8 110.7 116.3 Upper-Band 110.9 115.4 119.3 126.2 -------------- -------------- -------------- What to Expect from the BCRA Monetary Policy -------------- ¶6. (U) During his presentation to Congress, Redrado noted that the BCRA would have a moderately contractive monetary policy in 2006, in coordination with GOA fiscal policy, aiming to keep control over the growth of monetary aggregates, and with only slight increases in interest rates that would promote higher savings without jeopardizing economic growth. ¶7. (U) In a press interview on January 17, Redrado argued that the shift to targeting M2 was a signal of a potentially more contractive monetary policy. He further insisted that the shift demonstrated the BCRA's commitment to control inflation. He admitted, however, that targeting M2 would be harder for the BCRA. The desired monetary contraction would likely be achieved through an increase in banks' reserve requirements rather than a direct increase in interest rates, which would have a negative effect on growth. (Comment: However, increasing bank reserve requirements will also result in higher interest rates since it will reduce the amount of funds that banks have to invest. Reserve requirements currently are 15 percent for checking and saving accounts. There is no reserve requirement for time deposits of more than six months. End Comment.) ¶8. (U) Redrado acknowledged that meeting the 8-11 percent inflation target would be a lower priority than rebuilding the BCRA's foreign reserves following the USD 9.5 billion payment to the IMF on January 3. He recognized the need for the BCRA to recoup those reserves to insulate the economy from potential external shocks or financial fluctuations and admitted that a prudent policy of accumulating reserves will indeed impact interest rates and the exchange rate, and may prevent the BCRA from reaching its inflation target. ¶9. (U) In a recent publication dated January 2006, the Exante consulting company argued that the shift to M2 likely was designed to help the BCRA increase its foreign currency reserves. They argue that if reserve requirements are raised, banks will have an incentive to sell their dollar holdings to the BCRA to obtain the pesos they need to meet the higher requirements. -------------- -------------- Embassy Scenarios for the Foreign Exchange Market -------------- -------------- -------------- -------------- ¶A. BCRA Re-purchases USD 6.5 Billion of the Foreign Exchange Surplus -------------- -------------- ¶10. (SBU) The private sector foreign exchange surplus will reach USD 14 billion in 2006, according to a Banco Frances report. In a scenario in which the GOA purchases USD 7.5 billion of foreign exchange, the BCRA would only need to purchase the remaining USD 6.5 billion, well below the BCRA's 2005 purchases of USD 9.4 billion. In this scenario, the BCRA could fulfill its monetary program without the pressure of increasing Lebac issuance and increasing interest rates, since the monetary base expansion of ARP 19.8 billion (USD 9.5 billion times an assumed exchange rate of 3.05 ARP/USD) could be sterilized with a reduced amount of Lebacs and a reasonable level of repo transactions. (Note: in this scenario, the monetary base and M2 grow at the same rate. The BCRA absorbed ARP 10 billion from the money supply by issuing Lebacs in 2005, which were the most contractive factor for the monetary base. End Note.) -------------- -------------- ¶B. BCRA Re-purchases USD 10 Billion of the Foreign Exchange Surplus -------------- -------------- ¶11. (SBU) However, if the BCRA seeks to rebuild its foreign exchange reserves by purchasing USD 10 billion in dollars, the BCRA will be forced to increase its sterilization efforts, increasing its Lebac issuance and raising interest rates. In this scenario, the monetary base (and M2) increase by ARP 28.9 billion. -------------- ¶C. Rebuilding Reserves in Q1 2006 -------------- ¶12. (SBU) If the BCRA wants to recover its reserves while inflation is accelerating, it will have to sterilize large peso emissions to avoid further price acceleration. Analyzing only the first quarter of 2006, and assuming that the BCRA purchases USD 2.4 billion in reserves in the quarter (one-fourth of the USD 9.5 billion paid to the IMF),the monetary base would expand by ARP 7.2 billion (at the exchange rate of 3.05 ARP/USD). Making the further assumption that M2 is allowed to expand to ARP 110.9 billion (the upper limit of the M2 target for March 2006),and given that currently M2 stands at ARP 105.3 billion, the BCRA would only need to sterilize ARP 1.6 billion in the first quarter, which seems manageable at first blush. ¶13. (SBU) However, the BCRA's recent policy of issuing short-term Lebacs will complicate this sterilization. The BCRA will have to roll over all the ARP 10 billion in Lebacs coming due in February and March in addition to sterilizing ARP 1.6 billion issued for reserve repurchases, the BCRA thus will have to increase its Lebacs USD 11.6 billion. To accomplish this, the BCRA likely will have to raise its interest rates, increasing the BCRA's quasi-fiscal costs. During January, the BCRA did not raise rates at its Lebac auctions and managed only to partially refinance its maturities by issuing very short-term (less than 3 months) instruments. (Comment: the above scenarios make a key assumption that the monetary base and M2 grow at the same rate. However, if the money multiplier increases in 2006, the sterilization challenges for the BCRA will become even more complex. End Comment.) ¶14. (SBU) Virtually all domestic and international analysts forecast higher inflation than the 8-11 percent range projected by the BCRA, suggesting that the GOA policy of "voluntary" price restraint agreements will not succeed. The latest BCRA consensus survey (from January 4) forecast 12.3 percent inflation for 2006, and some analysts are projecting a floor of 15 percent inflation for the year. -------------- Comment -------------- ¶15. (SBU) Redrado has signaled very clearly that the BCRA's priority in 2006 will be accumulating reserves rather than keeping interest rates low or inflation under control. It is not yet clear, but is likely, that the GOA will use its fiscal capacity to absorb excess dollars in the foreign exchange market and help the BCRA avoid an appreciation of the peso. Even with GOA help, the BCRA will be challenged to find ways to sterilize a large amount of pesos without raising interest rates while meeting its monetary target and rebuilding reserves. ¶16. (SBU) The BCRA's focus on M2 rather than the monetary base is viewed positively by most analysts because it better reflects the money supply. Credit expansion and stronger financial intermediation have increased the money multiplier and made the monetary base a less reliable target. Also, M2 is more closely aligned with consumer spending and savings patterns, making it a better inflation indicator. However, many variables that make up M2 are out of the BCRA's control, such as the public's willingness to hold pesos or deposit funds in banks. That will make it more difficult for the BCRA to meet its M2 target. ¶17. (SBU) Even if the BCRA meets its M2 target, it in no way guarantees that the BCRA has inflation under control. The BCRA complied with its 2005 monetary targets every quarter, while inflation accelerated. It managed to meet its 2005 targets only by changing the definition of the monetary base and changing regulations to prompt banks to prepay their peso discount borrowing. The M2 target for 2006 also offers opportunities for such creative accounting (although some analysts believe it will be more difficult with an M2 target). For example, given that public deposits are included in M2, GOA deposits could be shifted as necessary to comply with the monetary targets. ¶18. (U) To see more Buenos Aires reporting, visit our classified website at http://www.state.sgov/p/wha/buenosaires GUTIERREZ