ARGENTINE CENTRAL BANK PRESIDENT TELLS FED GOV

C O N F I D E N T I A L BUENOS AIRES 001083 SIPDIS SIPDIS TREASURY FOR CLAY LOWERY, NANCY LEE, AJEWEL, WBLOCK, LTRAN NSC FOR JOSE CARDENAS, ROD HUNTER PASS FED BOARD OF GOVERNORS FOR RANDALL KROSZNER, PATRICE ROBITAILLE PASS EXIM BANK FOR MICHELE WILKINS PASS OPIC FOR JOHN SIMON, GEORGE SCHULTZ, RUTH ANN NICASTRI USDOC FOR 4322/ITA/MAC/OLAC/PEACHER E.O. 12958: DECL: 05/30/2027 TAGS: EFIN ECON EINV AR SUBJECT: ARGENTINE CENTRAL BANK PRESIDENT TELLS FED GOV KROSZNER THAT COORDINATED POLICIES NEEDED TO REDUCE INFLATION AND ENSURE A SOFT LANDING REF: A. BUENOS AIRES 1080 ¶B. BUENOS AIRES 1008 ¶C. BUENOS AIRES 801 Classified By: Charge d'Affaires Michael Matera for Reasons 1.4 (b,d) Summary -------------- ¶1. (C) Argentine Central Bank President Redrado assured Fed Governor Kroszner and Ambassador that the GoA would make it through October elections without a sharp increase in inflation. However, he said post-election adjustments were needed to bring the inflation rate down and ensure a soft landing for the economy. This would require the GoA and BCRA to coordinate wage, monetary, fiscal, and exchange rate policies, which is not currently the case. In public statements during Kroszner's visit to Argentina, Redrado attributed high growth rates in Latin America to ample international liquidity and improved terms of trade, but also argued that prudent monetary and fiscal policies and lower debt levels ensured that Argentina and other LatAm countries were less vulnerable to external shocks. End Summary. GoA And Central Bank Must Unite To Fight Inflation -------------- -------------- ¶2. (C) In private discussions with Federal Reserve Bank Governor Randall Kroszner and Ambassador, during Kroszner's May 15-16 visit to Argentina (see refs A, B),Central Bank President Martin Redrado acknowledged that the GoA's price control policies were losing their effectiveness and controlling inflation was Argentina's primary economic policy challenge going forward. He argued the GoA must use all its policy tools to attack it following the October 2007 Presidential elections, but disagreed when Kroszner speculated on the possibility that inflation might get out of control prior to the elections. ¶3. (C) Redrado attributed inflationary pressures to various factors, but mostly exempted the BCRA's policies from culpability. He said wage increases in 2007 had been higher than he had hoped for, with average increases of about 16.5%, increasing to an all-in 21-22% including the cost of benefit packages. Also, higher GoA expenditures to fund infrastructure development and subsidies to key constituencies had resulted in a two point reduction in the 2006 consolidated primary surplus, compared to 2004. He said this meant that the GoA was pumping an additional seven billion pesos (roughly $2.3 billion) per year into the economy. ¶4. (C) Redrado argued that the combination of higher wages and expenditures (i.e., public sector consumption) was pumping up aggregate demand, overheating the economy, and resulting in inflationary pressures. However, he also argued that Argentina was importing inflation in the form of high world prices for commodities, which contributed to higher local prices, particularly for the food products that Argentina both consumes and exports. He also blamed the delayed pass through of the 2002 devaluation for rising inflationary expectations. Prices for services -- mainly utilities -- were mostly frozen since the 2001/2002 financial crisis and only started to adjust in 2005. Redrado said this transition was ongoing and would continue to impact inflation measurements. ¶5. (C) Redrado estimated 2007 real GDP growth of 7.7 - 8%, and argued that it was time for the GoA and BCRA to coordinate efforts to slow the growth of aggregate demand. He argued that the BCRA was raising some interest rates and was maintaining growth of the monetary base below the growth rate of nominal GDP. However, he argued that the BCRA could not do the job alone, and that better coordination of fiscal, wage, and monetary policy was required to manage the impact of aggregate demand, commodity prices, and service prices, and allow a soft landing for the economy over the next few years. ¶6. (C) Redrado acknowledged that the BCRA must also gradually move away from its policy of maintaining an undervalued (or "competitive") currency in order to bring down inflation. The BCRA would eventually move to a more fully floating exchange rate regime, but this required sequencing of reforms, a stronger financial system, and a return to fiscal virtue in 2008. He noted that Chile had taken years to go through this same process and had also received strong support from the Chilean Treasury, in the form of FX purchases. He said the same was needed in Argentina, and argued that the GoA should begin using up to one point of the primary fiscal surplus (one percent of GDP, or about $2.5 billion in 2007) to buy dollars during the first 100 days following the October election. ¶7. (C) Redrado said he had recently been discussing options with Economic Minister Miceli for ways to build out the peso yield curve, to make for more effective interest rate signaling to markets. However, the Economic Ministry has exclusively issued dollar-denominated bonds over the last few years, and Redrado claimed that Miceli was balking at issuing five-year or longer maturity bonds in pesos. He alleged that Miceli was worried investors would demand a high yield, which would expose her to criticism from within the government. To provide cover (and encourage her to commit to a longer-term issuance),the BCRA issued for the first time a four-year note on May 22. (Comment: The resulting yield of just under 10% was at the low end of market expectations, which Economic Ministry officials likely found encouraging. End Comment) LatAm Less Vulnerable To External Shock -------------- ¶8. (SBU) In public statements during Fed Governor Kroszner's visit, Redrado acknowledged that ample international liquidity and improved terms of trade had contributed to strong growth in Argentina and the rest of Latin America. However, he also attributed it to solid policies, including fiscal surpluses, reduced debt levels, export orientation, prudent and consistent monetary policies, more flexible exchange rates, and stronger financial systems operating in domestic currencies. ¶9. (SBU) Overall, in contrast to past decades, most countries in the region were implementing solid macroeconomic policies. These policies, in conjunction with strong accumulation of official reserves, resulted in lower vulnerability to external shocks. While recognizing that international markets were more cautious about investing in Latin America, due to past turbulence, Redrado argued that the recently improved solvency and predictability in Latin American markets was attracting investment. (Note: Separately, Redrado admitted to Ambassador and Governor Kroszner that the investment rate in Argentina, albeit much improved -- at 22% of GDP up from 12.9% of GDP in 2002 -- was still well below the 25% rate necessary to maintain annual real growth in the 6% range. End Note) ¶10. (SBU) Redrado highlighted that the commodity boom had impacted Latin American countries differently. He noted that petroleum and mineral prices had tripled since 2003, but agricultural commodity prices were only about 30% above the highs in the 1990s. Given that about half of Argentina's exports are related to agriculture (compared to about 12% for petroleum product exports and roughly 4% for mineral exports),the country has not benefited as much relative to others from the commodity price boom. However, Redrado also noted that this also meant that Argentina was less exposed to a fall in commodity prices. Furthermore, since only 9% of Argentina's exports go to the U.S. (in comparison to 40% of Mexico's and 80% of Venezuela's),he noted that Argentina was less exposed to a slowdown in the U.S. economy. ¶11. (C) Possibly in an attempt to highlight to GoA officials the need for tighter fiscal policy, Redrado made a pitch for using the boom periods to implement counter-cyclical policies. Latin America was still highly exposed to either a slowdown in the U.S. economy or falling commodity prices, or both. While maintaining high reserves was a prudent, counter-cyclical policy, he commented that equally important was the maintenance of large fiscal surpluses. (Comment: In an aside with Ambassador and Governor Kroszner, Redrado noted that the Economy Ministry's recent announcement of a $7 billion "counter-cyclical" fund was an exaggeration. GoA officials leaked the story only because they were aware that other countries in the region had such a fund. The reality was, according to Redrado, that GoA Ministries accumulated at any one time up to 26 billion pesos (over $8 billion) in accounts at government-owned Banco La Nacion, but no plan existed to coordinate the use of these funds. End Comment) Comment -------------- ¶12. (C) While Redrado is correct to point out the expansionary impact of current GoA fiscal and wage policies, the BCRA's own policies also contribute to inflation concerns. The cornerstone of GoA economic policy is its so-called "competitive" currency, which the BCRA maintains by buying up FX inflows. In effect, the BCRA is maintaining a fixed nominal exchange rate, albeit significantly undervalued, which restricts the use of monetary policy to fight inflation. Since the BCRA sterilizes only about 70% of its FX purchases, BCRA monetary policy has actually been accommodative if not expansionary for several years, with net negative real interest rates (until just recently) stimulating demand and deterring savings. Because this exchange rate policy is mandated by President Kirchner, Redrado has been limited to making only minor adjustments to brake monetary growth, i.e., by announcing minor increases to repo rates and reserve requirements, and easing controls on capital outflows. ¶13. (C) Redrado has argued in the past (Ref C) that the relatively small size of Argentina's financial system (at only 11% of GDP) limits the effectiveness of monetary policy tools in fighting inflation. Many local analysts -- including the Central Bank's outgoing Chief Economist -- disagree, and argue that the BCRA could at least pursue policies that are not accommodative. However, these analysts tend to agree with Redrado that restraining current pro-cyclical fiscal policy would have more impact on slowing aggregate demand. Redrado's increasingly frequent public hints that fiscal policy needs tightening, along with his efforts to get Miceli to issue longer-term bonds (at higher rates),may be a signal of his frustration at GoA inaction. ¶14. (C) Many of Post's local contacts agree with Redrado that the GoA and BCRA must adjust their policies post-election. However, there also seems to be a consensus that the GoA is wedded to an "if it "ain't broke, don't fix it" mentality that make significant policy changes unlikely anytime soon. End Comment ¶15. (U) Federal Reserve Governor Randall Kroszner did not clear this cable. MATERA