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