CENTRAL BANK GOVERNOR CALLS ARGENTINE ECONOMIC

C O N F I D E N T I A L BUENOS AIRES 001517

SIPDIS

SIPDIS

NSC FOR DAN PRICE, DAN FISK
PASS FED BOARD OF GOVERNORS FOR KROSZNER, 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: 08/02/2027
TAGS: EFIN ECON ETRD AR
SUBJECT: CENTRAL BANK GOVERNOR CALLS ARGENTINE ECONOMIC
POLICIES UNSUSTAINABLE AND AGREES TO WORK TO MODERATE GOA'S
DOHA NEGOTIATING POSITION

REF: BUENOS AIRES 1496

Classified By: Ambassador E.A. Wayne for Reasons 1.4 (b,d)

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

1. (C) The GoA's "fiscal policies are not sustainable past
this year," Central Bank (BCRA) President Martin Redrado
(PROTECT) told Ambassador during their July 31 meeting. He
warned of increasing problems if Argentina maintained its
domestic demand-driven growth policies (he noted the BCRA
estimates inflation at 13%, vs. the 8% official rate).
Nevertheless, he expressed optimism for change during the
first 100 days of a likely Cristina Kirchner administration.
Redrado said the BCRA had passed a "stress test" during the
recent turmoil in world markets, demonstrating that it could
calm markets and also justified the BCRA's reserve
accumulation policy. He acknowledged, however, that the
worldwide repricing of risk (and "flight to quality") over
the last week had significantly increased Argentina's
financing costs. Redrado said WTO Director General Pascal
Lamy had urged him to engage personally on trade issues
within the GoA, and he welcomed USG suggestions on ways to
moderate Argentina's Doha negotiating stance. End Summary.

Time to Move Past Post-Crisis, Keynesian Growth Policies
-------------- --------------

2. (C) During a July 31 meeting with Ambassador, BCRA
President Redrado (STRICTLY PROTECT) stated that the time was
overdue for the GoA to move past the post-crisis phase, where
the GoA had pursued a number of unorthodox economic policies
to stimulate domestic demand and achieve high growth rates.
He argued that Argentina needed to enter a new phase of
pursuing sustainable growth, and this would require
substantial GoA policy changes. Current fiscal policies --
expenditures growing more rapidly than revenues, increasing
subsidies to both agriculture and manufacturing,
election-year tax cuts -- are unsustainable past 2007, in his
opinion. He foresees worsening problems for the economy,
particularly higher inflation, further energy shortages,
rising interest rates, and difficulty in attracting
investment if the GoA insisted on maintaining the current
focus on domestic demand driven growth.


3. (C) While admitting that he had not received any specific
indication that Presidential-front-runner Cristina Fernandez
de Kirchner would, as President, undertake major economic
reforms, he was optimistic with regards to "Cristina's first
100 days." In particular, he noted that Cristina's recently
proposed "social accord" between government, the private
sector, and unions offered a possible means to realign GoA
policies to engender a "soft landing" to a more sustainable
growth rate. He thought that the GoA could use such a broad
dialogue to manage expectations on issues such as wages,
inflation, taxes, and spending. Including labor would be the
key, he thought, as he thought reigning in wage increases (in
the 15-20% per year since 2002) was a key component to
rationalizing macroeconomic policies and controlling
inflation. Redrado estimated current inflation at 13%,
annualized, versus the headline rate of about 8% reported by
the government statistics agency, INDEC (see reftel).


4. (C) Redrado acknowledged that micro-reforms were also



needed if Argentina were to increase investment flows,
particularly the rationalization of utility sector prices
that are limiting investment in the energy sector. He agreed
with the Ambassador's assessment that the GoA has not
internally figured out the role it wants to play in the
energy sector, i.e., whether to just have an unofficial bias
in favor of local investors or to continue GoA accumulation
of direct ownership stakes in energy sector assets via
state-owned ENARSA. Redrado noted that the recently popular
idea of creating a national development bank (similar to
Brazil's BNDES) had lost steam, but argued that the same
could be accomplished by redefining the role of state-owned
Banco Nacion. He claimed Banco Nacion had in the range of 26
billion pesos (over $8 billion) in liquid assets, mostly
deposits from GoA agencies, including the social security
agency (ANSES). Redrado argued that the GoA could use some
portion of these funds for infrastructure investments, and
actually increase the return on the funds.


5. (C) Redrado noted that Cristina's only economic advisor at

the moment was her husband, President Nestor Kirchner, and
the Ambassador was left with the impression that Redrado may
see this as an opportunity to position himself as the go-to
advisor on the economy. He is already widely considered to
be on the short list for Economy Minister in a Cristina
government (reftel).

High Reserves Help BCRA Pass "Stress Test"
--------------

6. (C) Redrado claimed that the BCRA had passed a "stress
test" in the last week during the turmoil in world financial
markets, and had shown that it could use its abundant foreign
exchange reserves to attenuate exchange rate volatility.
Redrado said the BCRA's actions had validated his reserve
accumulation policy, as the BCRA had intervened in FX
markets, selling reserves to control the sharp depreciation
of the Peso (caused by local and international investors'
sudden rush to sell peso-denominated bonds in order to buy
dollars). As a result, after bottoming at about 3.21
Pesos/USD, the Peso has appreciated to about 3.16 and
stabilized.


7. (C) At its most volatile point on July 26, the BCRA
intervened with up to $150-250 million. In Redrado's
opinion, this demonstrated the need for liquid reserves and
undermined the argument put forward by some in the Kirchner
administration that official reserves should be used to fund
investment projects (or pay back Paris Club debt). (Note:
Local analysts argue that last week's gyrations have
established a new 3.12 - 3.20 trading range for the Peso and
have added a degree of volatility into market calculations
that serve BCRA interests in limiting speculative hard
currency short-term capital inflows. End Note).

Argentina: Victim of Worldwide "Flight to Quality"
-------------- --------------

8. (C) Despite the BCRA's success in calming local markets,
Redrado pointed out that the ongoing worldwide reappraisal of
risk had resulted in significantly higher financing costs for
the GoA and BCRA. As investors abandoned Argentina's
relatively risky financial instruments, Argentine bond
spreads increased significantly and above Latin American
comparables:



-- Argentina's short to medium-term peso-denominated bonds
saw their yields increase about 200 basis points (bps) since
mid-July, while short/medium-term, dollar-denominated bond
yields widened about 150 bps.

-- Argentina's country risk, as measured on the JPMorgan EMBI
plus, widened from 320 bps on July 16 to 480 bps on July 27
(versus the historical low of 180 bps in late January).

-- The Argentine 5-year Credit Default Swaps (CDS) spread
widened by 200 bps at one point, and ended last week up 150
bps (versus only a 45 bps increase for Brazil).

-- As a result of the heavy BCRA peso purchases last week,
short-term market liquidity dried up and interbank interest
rates climbed to unprecedented levels of about 28%. Although
subsequent BCRA injections of pesos into the market (through
purchases of short-term BCRA instruments and reverse repo
operations) stabilized the rate at between 12 and 13%, that
is still substantially higher than the 8% interbank rate at
the beginning of July.

-- The BCRA canceled this week's auction of LEBACs and NOBACs
(short-term Central Bank letters and notes),partly to
maintain peso liquidity and control rates, but also to let
the market cool down before issuing new debt. (Note: LEBAC
and NOBAC rates were also in the 7-8% range in early July,
but it is likely that the BCRA would now have to offer rates
approaching the current interbank rate to attract sufficient
bids. End Note)


9. (C) In order to mitigate the adverse impact of the now
much steeper yield curve on GoA finances, Redrado said he had
reversed his campaign to convince the Economy Ministry to
issue longer-term debt, and was now advocating issuance of
shorter-term (3-5 year maturity) debt until the dust settled.



10. (C) Redrado also acknowledged news reports that Argentina
and Venezuela were planning to issue another tranche of the
so-called "Bono del Sur," but denied knowing details. (Note:
septel provides more information about this apparently
imminent deliverable from visiting Venezuelan President
Chavez. End Note)

Perception of Argentina as Obstructing WTO Talks
-------------- ---

11. (C) Redrado said WTO Director General Pascal Lamy had
called him to complain that Argentina had not played a
constructive role during recent Doha round discussions. Lamy
had urged him to engage within the GoA to moderate
Argentina's negotiating stance. (Note: Prior to his
appointment to the BCRA in late 2004, Redrado was the GoA's
lead Foreign Ministry trade negotiator; he also played a key
role in selecting the Foreign Ministry official who succeeded
him in that position: Alfredo Chiaradia, through whom Redrado
claims to have some influence on trade issues. End Note)
Redrado said he had agreed to engage, and also noted that he
was open to U.S. suggestions for new ways to present the
case. However, his preliminary analysis was that
manufacturing sector losses would more than offset
Argentina's gains in agriculture, at least in the short-run.


As an example, he noted that Argentine auto tariffs were 35%
for both applied and bounded rates, and the Argentine auto
manufacturers -- including the U.S. companies -- were adamant
in rejecting the almost 50% proposed cut.


12. (C) The Ambassador responded that the impression in
Washington was that Argentina, particularly in contrast to
Brazil, had aligned itself with the most extreme positions on
NAMA (non-agricultural market access) talks. The Ambassador
speculated that there was likely some position that would
come across as less extreme, but would continue to meet
Argentina's perceived needs to protect certain sectors in the
near-term. He recommended that Redrado consider longer-term
arguments of the benefits of agricultural liberalization and
a gradual lowering of industrial tariffs, especially peak
rates. Redrado said he would welcome any facts, figures, and
arguments from the U.S. to help make a case for a more
flexible GoA position on NAMA.

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

13. (C) The GoA has little incentive this year to alter its
tough negotiating stance in Doha's NAMA talks. The
industrial sector remains vocal in calling for higher
protection, the President just named an openly protectionist
economist as the new Economy Minister (reftel),and this is
an election year. Furthermore, with agricultural commodity
prices so high, the Argentine agricultural sector has less
incentive to advocate for a Doha deal that would include
subsidy cuts. Embassy would welcome detailed arguments to
share with Redrado. End Comment.
WAYNE