Milei’s challenge

How to fix the central bank

VICTORY FOR the ultra-libertarian candidate in Argentina, Javier Milei, may at last trigger measures needed to defeat inflation.

After his victory Milei emphasised “fixing problems” at the central bank, an apparent softening of his position to “abolish” Argentina’s central bank (BCRA.) Given the challenge associated with eliminating BCRA, not least the lack of hard currency to replace Pesos in circulation and the likely lack of support from the international community for such a move, this is probably a sensible change of tone.

But what needs to be done? A look back at the last four years of the BCRA balance sheet provides some clues.

A balance sheet snapshot

It’s been a remarkable 4-year journey for Argentina’s central bank (BCRA) as seen through a snapshot of the balance sheet.

The table below reworks into analytical form the BCRA’s weekly financial statement as of 7 Nov. this year, the latest available, and on the same date in 2019, roughly the last change of administration.

The GDP data is taken from the latest World Economic Outlook database, though the dollar GDP value for this year is adjusted for the latest official ARS exchange rate of ARS350 per USD. Even with this adjustment, it is doubtful the dollar value of GDP has increased 11% over the last 4 years, another sign of an overvalued official rate. But this is good enough for our purposes.

Three things stand out:

• First, the past 4 years have seen net foreign asset decline by about USD25bn, by about 6½% of GDP, to reach negative USD5bn, despite restrictions on capital controls. True gross reserves have been run close to zero; only by tapping the PBOC swap line is Argentina able to generate any fx liquidity. Dollar liquidity is nearly non-existent.

• Second, net domestic assets have expanded USD76bn, or 14% of GDP, mainly due to increasing claims on government securities of USD99½bn; the contrary move in net equity reflects the attempt in 2019 to correctly value assets (registering negative net equity for a time), a short-lived effort at accounting transparency that was unwound when assets were over-stated in value once more. For the past 4 years, the Fernandez administration and numerous Finance Ministers, under the wing of an IMF program, have been pressing ahead with a macro policy program based on an insolvent central bank. This has to change.

• Third, BCRA total monetary and near-monetary liabilities have increased about USD52bn, about 7½% of GDP, mainly due to an expansion in bills (LELIQs) to absorb liquidity and provide a vehicle for domestic saving with a half-decent real rate of interest. The total outstanding stock of these liquidity bills is today about USD65bn or about 15% of GDP.

The flow matters

Of course, as with public debt sustainability analysis, it’s not the stocks that really matter—rather, the flows implied and the potential for runaway balance sheets.

All that matters for understanding the BCRA balance sheet is the fact that the interest on BCRA securities now exceed 100% annualised—in fact, 133%.

In other words, the value of LELIQs outstanding, measured in local currency, will more than double over the next 12 months. In fact, these are rolled every one or two weeks, so properly compound the story is even worse. But let’s say it increases by 1.3 times over the next 12 months. Then the BCRA interest bill is nearly 20% of GDP.

How does the central bank service these liabilities?

There are typically four offsets to this, but these have been eroded so that only one is currently available.

First, BRCA could earn interest on domestic securities—but the government has stuffed the central bank with low interest securities, so domestic assets provide limited offset to the cost of sterilisation.

Second, BCRA could earn interest on international reserves. But genuine gross reserves have been dwindled to near zero, and the PBOC swap line is a drain rather than interest earning asset.

Third, until recently the depreciation of the local currency would, at least, revalue BCRA net foreign assets—to increase the local currency value of reserves relative to dx liabilities and increase the available sterilisation-per-dollar of reserves.

Fourth, inflation would increase the demand for currency in circulation for every day transactions, raising demand for zero interest central bank liabilities.

When these sources fall short, BCRA has no choice than to monetise their interest bill—creating yet more units of local currency, requiring even more money to be sterilised, acting like a dog chasing her tail.

Since only the last of out four outlets are currently available to support the central bank’s interest bill, more money printing and accelerating inflation is the only vehicle to overcome the flow imbalance.

No wonder inflation has been accelerating.

But now that BCRA net foreign assets are negative, depreciation makes matters worse—by increasing net foreign liabilities and making matters worse.

If Milei had not been elected, with his determination to fix the central bank balance sheet, it is possible that hyperinflation would have been the next phase of monetary madness.

Can he fix it?

It is hard to be sure that Milei has the correct measure of the challenge. And in any case, domestic politics will make it hard for him to deliver.

How can this be fixed? Well, Argentina’s central bank has been running a hidden deficit of perhaps 10% of GDP over the past 12 months; up from about 3% of GDP at the turn of the last administration.

Investors are stuck in a Ponzi scheme that is about to be unwound.

Of course, a large exchange rate adjustment is necessary to bring the Peso in line with fundamentals—necessary but not sufficient.

For this to succeed, to genuinely “fix” the central bank, Milei has to solve BCRA’s flow problem.

This could be done by converting LELIQs into government securities instead of indirect claims of depositors on the government via banks through claims on the central bank. If this involves converting into longer maturity claims, all the better—though at the expense of savers.

Or it could be done by recapitalising BCRA with an interest bearing government security to de facto sterilise the interest that would otherwise be paid on LELIQs, passing the cost back onto the fiscal authorities. This will preserve the liquidity of claims on the central bank, but contribute initially to substantially worse public debt dynamics.

Moreover, we should not forget that support for BCRA will have to allow for future reserve accumulation which will contribute to negative net income—and so the recap of the central bank has to allow for future balance sheet structure. In other words, it is important to not repeat the mistakes of the Macri administration.

Whatever the solution, the true fiscal deficit in coming weeks should be revealed as substantially worse than than anything acknowledged until now.

But there is more…

Unfortunately, this only goes part way to resolving the overall sustainability problem.

No amount of fiscal adjustment will generate the foreign exchange needed to service external debt; that said, impoverishing the population through fiscal contraction and exchange rate depreciation will by compressing imports to pay external creditors. The latter is unacceptable. External creditors have to accept their responsibility for the mess in Argentina.

A fair solution will therefore require external creditors, including the IMF, to reduce the external flow burden, to free foreign exchange earnings to support a local population already battered by decades of macroeconomic mismanagement and destabilising capital flows.

Now is the time for all sides to support Argentina.

The content in this piece is partly based on proprietary analysis that Exante Data does for institutional clients as part of its full macro strategy and flow analytics services. The content offered here differs significantly from Exante Data’s full service and is less technical as it aims to provide a more medium-term policy relevant perspective. The opinions and analytics expressed in this piece are those of the author alone and may not be those of Exante Data Inc. or Exante Advisors LLC. The content of this piece and the opinions expressed herein are independent of any work Exante Data Inc. or Exante Advisors LLC does and communicates to its clients.

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