ARGENTINA'S CENTRAL BANK PRESIDENT AVERTS

C O N F I D E N T I A L SECTION 01 OF 04 BUENOS AIRES 000712 SIPDIS E.O. 12958: DECL: 05/22/2027 TAGS: EFIN ECON ETRD AR SUBJECT: ARGENTINA'S CENTRAL BANK PRESIDENT AVERTS FINANCIAL CRISIS: "NOW YOU SEE THE POWER OF RESERVES" REF: 2007 BUENOS AIRES 2225 Classified By: Ambassador E.A. Wayne for Reasons 1.4 (b,d) -------------- Summary -------------- ¶1. (C) Argentine Central Bank (BCRA) President Martin Redrado told Ambassador May 19 that the mini-run on Argentine banks and on the peso in early May proved that the "wounds are still open" from the 2001/2002 crisis. Apparently accelerating inflation and the GoA's failure to resolve the now three-month-old agricultural sector conflict sparked the crisis. Redrado claimed, however, that heavy BCRA interventions in currency markets had succeeded in stabilizing the exchange rate and calming markets, which validated his reserves-accumulation policy. President Kirchner reiterated this theme during a May 20 speech, and criticized those predicting a financial meltdown. She again echoed these points in a private meeting with the Ambassador and others on May 21. Redrado argued to Ambassador that Argentina's economic fundamentals remain sound, did not justify current market nervousness and would ultimately prevent inflation from spiraling out of control. He acknowledged, however, that high inflation, the GoA's manipulation of inflation statistics, and the agricultural strike had spooked a population that has come to expect a crisis every 5-7 years. "Inflation fears for Argentines are like the terrorism fears for Americans post 9/11." Redrado speculated that the recent financial market volatility might at least force the country's leadership to acknowledge the inflation problem, "the first step to solving it." Media reports suggest the BCRA continued to be active in currency markets this week. Discussion of USG technical assistance on terrorism finance reported septel. End Summary. -------------- -------------- "Wounds Still Open," Justifying Reserves Accumulation -------------- -------------- ¶2. (C) During a May 19 meeting, BCRA President Redrado told Ambassador that the recent pressure on the Argentine peso and mini-run on Argentine banks showed that the "wounds are still open" from the 2001/2002 crisis. Argentines have still not recovered psychologically from that crisis, which in many respects was comparable to the U.S. depression. They are conditioned "to expect crisis every 5-7 years and rush to protect themselves with dollars at the first sign of economic uncertainty." The fact that they do not flee to other reserve currencies like the Euro, Redrado noted, also shows how isolated from global capital market trends Argentines remain. ¶3. (C) Redrado added that this skittish attitude proves that Argentina is still not a "normal economy," and justifies the "gradual" approach that he has advocated in prior meetings (Reftel). In particular, recent market unrest provided proof that the country is not ready for a fully floating currency. "Now you see the power of reserves," Redrado proudly proclaimed. He asserted that the BCRA's "increasingly sophisticated" interventions in currency markets -- selling spot and forward dollars -- worked to stabilize the exchange rate and calm markets. This showed that the BCRA's managed float policy was the correct one, he remarked, and also validated the BCRA's reserves-accumulation policy. Redrado predicted that Argentine financial sector intermediation would continue to recover and grow and the sector return to a "normal" state, and this would accelerate with any news of progress between the GoA and farmers on ending the agriculture strike. ¶4. (C) During a May 20 speech at the inauguration ceremony of a thermo-electric generator, President Cristina Fernandez de Kirchner (CFK) reiterated the importance of maintaining high reserves. She emphasized that Argentina has never "had the financial backing that it has today, with US$50 billion of reserves. There is no emerging country similar to ours that can....back the money that is on the street (monetary base) and bank deposits, 100%." She then criticized those in the media and private sector that, despite the strong reserves position, had in recent weeks been predicting a financial meltdown and spreading unfounded rumors of runs on banks and GoA plans to restrict deposit withdrawals (the so-called, "corralito," which the GoA used unsuccessfully in 2001 to forestall the financial crash). On the evening of May 21, CFK made a number of the same points to the Ambassador in a private meeting with others at the Casa Rosada (septel). She BUENOS AIR 00000712 002 OF 004 said that Argentina's sizable reserves were far in excess of what the IFI's recommend, but noted that Argentines still tend to be "too creative" when it comes to panicking over the economy. -------------- Crisis of Confidence Causes Flight to Dollars -------------- ¶5. (C) In the May 19 meeting, Redrado acknowledged that the level of uncertainty bordered on panic during the first few weeks of May. The results were falling peso deposits, increased demand for dollars, a weakened peso, and increased capital outflows. After roughly US$2 billion capital outflows -- capital flight -- in April, outflows through mid-May ran at an estimated monthly rate of US$3 billion, according to Embassy contacts at private banks. Furthermore, Argentine bond yields have spiked since mid-March, and sovereign risk measurements are at record levels (with the JPMorgan EMBI plus index near 600 basis points). The leap in dollar demand was exacerbated by the simultaneous decline in dollar inflows, a consequence of the agricultural strike-induced reduction in dollar-earning commodity exports. ¶6. (C) With investors dumping Argentine financial instruments and capital flight accelerating, the nominal peso/dollar exchange rate rapidly depreciated several percent (from about 3.15/3.18 to 3.27 pesos/dollar). Facing rising expectations of an even larger depreciation, the BCRA increasingly intervened in currency markets, selling dollars to keep the peso stable. Redrado did not provide data during the meeting, but according to private sector estimates, after selling US$400 million in April, the BCRA sold between US$1 and 1.5 billion through mid-May to support the peso. (This compares to the US$1.8 billion the BCRA purchased in April 2007, and US$2 billion it purchased in May 2007.) Press reports indicate the BCRA continued its activity in the markets throughout the week. ¶7. (C) Redrado commented that the BCRA's increasing use of the futures markets had been particularly effective in strengthening the peso. (The BCRA has heavily intervened, selling dollars, in Argentina's two futures markets -- in the cities of Buenos Aires and Rosario). Redrado argued that this allowed the BCRA to affect expectations. By stabilizing forward rates, the BCRA lowers expectations of further depreciation, alleviating pressure on the peso to depreciate in the spot market. As of market close on May 23, the BCRA has succeeded in bringing the spot market wholesale exchange rate to 3.14 pesos/US$ from the high of 3.27. (Unsaid, but also a key factor, is that the BCRA can enter into forward contracts without spending reserves. Even so, private sector analysts estimate that reserves have fallen to about $49 billion, from a high of almost $52 billion.) -------------- "Fundamentals Sound"... -------------- ¶8. (C) Redrado argued that the economic fundamentals -- fiscal and trade surpluses, "prudent" monetary policy, and a flexible and stable exchange rate, supported by US$ 50 billion in official reserves and record high commodity prices -- do not justify market players' perception of increasing economic uncertainty in Argentina. In fact, he claimed, the fundamentals are basically unchanged from five months ago, or maybe even a little stronger. Given the country's relatively strong position, Redrado predicted that there was minimal chance of inflation spiraling out of control. He agreed that macro policies could be better, but at least there had been no worsening. ¶9. (C) Redrado gave as an example the reduction in the pace of fiscal spending: following the 2007 election year, during which the GoA ramped up expenditures by around 50%, spending is now growing at roughly a 35% annual pace. Redrado said he would feel more comfortable with 25%, but at least the trend line was moving in the right direction. Similarly, salary increases so far in 2008 are at about 22-23%. Although Redrado would again prefer lower increases, in the range of 19%, at least they are roughly equivalent to 2007 salary raises (despite significantly higher inflation so far in 2008, compared to 2007). ¶10. (C) Redrado called the BCRA's monetary policies "prudent," despite the appearance to many private economists that money supply growth, highly negative real interest rates, and the maintenance of an undervalued (or BUENOS AIR 00000712 003 OF 004 "competitive") peso are at minimum "accommodative." (Comment: Nevertheless, it is true that money supply growth is more restrained so far in 2008, compared to 2007.) Redrado also pointed out that the nominal exchange rate was about the same as it had been 5-6 months ago, aside from the volatility of recent weeks. He admitted that the rapid strengthening of the real exchange rate -- due to high inflation -- would eventually contribute to lowering competitiveness, slowing the economy, and, consequently, dampening inflationary pressures. However, he called this an inexact and limited tool to fight inflation, and one that would soon complicate both the fiscal accounts and trade balance. -------------- ...but Political Crisis Breeding Uncertainty -------------- ¶11. (C) Redrado acknowledged that the real problem was one of expectations, with the growing perception in the public that inflation is getting out of control and the econmy is deteriorating. The Ambassador commented that the mild panic in early May seemed to have been set off by the quasi-political crisis (the ongoing battle between the GoA and farmers -- septel),and quoted an Argentine friend's comment that "Argentina has entered into one of its cycles of self destruction." Redrado agreed. He explained that the roots of the growing uncertainty were clearly high inflation, government manipulation of statistics, and the agricultural strike. However, clearly it was the Kirchner administration's apparent inability or unwillingness to accept and deal with high inflation and resolve the strike that had spooked a population that tends to expect an economic/financial crisis at regular and fairly frequent intervals. Redrado noted that "Inflation fears for us (Argentines) are like the terrorism fears for Americans post 9/11." ¶12. (C) The question now, thought Redrado, is how to deal with worsening perceptions when the "deterioration of national statistics" has removed the anchor on inflation expectations. "There are now 18 million CPIs," with everybody having their own opinion of the real rate of inflation, Redrado noted. Even the BCRA no longer uses official CPI numbers in its reports, preferring to use other indicators, such as the raw materials index or the deflator on private consumption. Nevertheless, he disputed that inflation was still accelerating, commenting "whatever your inflation number was a few months ago, I think the number is in the same range today." -------------- Comment -------------- ¶13. (C) A major reason for the perception of greater uncertainty and higher risk in Argentina's financial sector, particularly from the point of view of foreign investors, is the impression that the Kirchners are unable or unwilling to accept that an overheated economy and inflation needs to be dealt with -- soon -- via tighter macroeconomic policies. This is compounded by the perception that there is a lack of competent economic management in the government, and also by the impression that anything goes in Argentine economic decision-making. The fact that the GoA is working through its fourth Economy Minister since last July is indicative of the broader lack of continuity and good economic management. When the Ambassador noted to Redrado that he had still not been able to meet with new Economy Minister Carlos Fernandez, after three weeks of requesting the meeting, Redrado retorted that "you aren't the only one; not many have." By his tone, Redrado would appear to agree with the general assessment in the markets that the new Minister has limited autonomy and serves mainly as implementer of Nestor Kirchner's economic decisions. ¶14. (C) While arguing that Argentina is not facing circumstances that could provoke hyper-inflation, Redrado made it clear that he is struggling to craft a role for the BCRA to help dampen inflationary pressures and anchor expectations. He admitted that the role is unclear when the current structural pressures are, in his opinion, either non-monetary (exogenous food and energy price pressures) or political (creating uncertainty and pushing expectations). The silver lining, Redrado conceded, was that this crisis of confidence in early May might force the country's leadership to acknowledge the inflation problem, which would be "the first step to solving it." End Comment. BUENOS AIR 00000712 004 OF 004 WAYNE