global liquidity

Argentina: From the “confidence fairy” to the (still devilish) IMF

Guest post by Pablo Bortz and Nicolás Zeolla, Researchers at the Centre of Studies on Economics and Development, IDAES, National University of San Martín, and CONICET, Argentina.

In recent days, it has become customary to recall the issuance of a USD 2.75 billion 100-year bond in June 2017. This was the most colourful event of the short-lived integration of Argentina into international capital markets, beginning in December 2015. Last week, Argentina returned to the front pages of the financial press when the government requested financial assistance to the IMF amidst capital flight and a run against the peso that authorities were struggling to stop.

This is the most recent episode in the typical cycle of an emerging economy entering financial markets, suffering a balance of payments crisis and adopting an IMF-sponsored stabilization program. It starts with the claim that we are now a respected member of the international community, with presence in the Davos forum, and the promise that this time, finally, the international “confidence fairy” will awaken and investment will flood the country because of all the profit opportunities this forgotten economy has to offer. When the fairy proves to be an hallucination, we find ourselves at the steps of the IMF, facing demands, as always, for fiscal consolidation and structural reform.

When explaining this story, it is important to have some background on the Argentineans’ fascination with the dollar, and on some very recent political history. Because of its history of financial crises and its underdeveloped capital markets, there are very few savings instruments available to the non-sophisticated investor: real estate, term deposits, and dollars. Real estate prices are denominated in dollars, but you need a lot of dollars (relative to income) to buy a house. So buying dollars is pretty much a straightforward investment in uncertain times, i.e. most of the time.

Added to that, Argentina has a higher degree of exchange rate pass-through than other developing countries. The main exporters also dominate the domestic market for cooking oil and flour; oil and energy prices are dollarized; and exchange rate movements are very closely followed at times of wage bargaining. Unlike other emerging countries, and despite the sneering of some government officials, in a semi-dollarized (or bimonetary) economy such as Argentina exchange-rate pass-through is alive and kicking, which discourages large devaluations.

It is important to remember that the previous administration of Cristina Fernandez de Kirchner had implemented pervasive capital and exchange controls, which led to the development of a (relatively small) parallel market, with almost a 60% gap between the official and the parallel exchange rate. As soon as the Macri government took power in December 2015, it lifted all exchange rate controls. The official exchange rate (10 pesos per dollar) moved towards the parallel (16 pesos per dollar), and it is one of the reasons for the increase in the inflation rate, from 24% in 2015 to 41% by the end of 2016.

The new authorities also made two big moves. One was cancelling all the debt with vulture funds with new borrowing. This officially marked the return of Argentina to international capital markets. The second move, by the central bank (now lead by Federico Sturzenegger, an MIT graduate and disciple of Rudi Dornbusch), was the adoption of an inflation-targeting regime, with a mind-set that preferred freely floating exchange rates, and not much concern for current account deficits[1].

But looking at the external front, one may even be forgiven for asking: why did this crisis take so long to burst? Argentina was haemorrhaging dollars for many years, and with no sign of reversal: since 2016 the domestic non-financial sector acquired an accumulated amount of USD 41 billion in external assets. During the same period, the current account deficit totalled another USD 30 billion, in the form of trade deficit, tourism deficit, profit remittances by foreign companies and increasing interest payments.

The well-known factor that allowed all these trends to last until now is the foreign borrowing spree that involved the government, provinces, firms, and the central bank, including the inflow from short-term investors for carry trade operations. In the case of debt issuance, since 2016 the central government, provinces and private companies, have issued a whopping USD 88 billion of new foreign debt (13% of GDP).  In the case of carry trade operations, since 2016 the economy recorded USD 14 billon of short-term capital inflows (2% of GDP). The favourite peso-denominated asset for this operations were the debt liabilities of the central bank called LEBAC (Letters of the Central Bank).  Because of this, the outstanding stock of this instrument has now become the centre of all attention.

It is important to understand the LEBACs. They were originally conceived as an inter-bank and central bank liquidity management instrument. Since the lifting of foreign exchange and capital controls and the adoption of inflation targeting, the stock of LEBACs grew by USD 18 billion. Moreover, the composition of holders has changed significantly since 2015: At that time, domestic banks held 71% of the stock, and other investors held 29%. In 2018 that proportion has reverted to 38% banks/62% to other non-financial institution holders, which includes other non-financial public institutions (such as the social security administration) (17%), domestic mutual investment funds (16%), firms (14%), individuals (9%), and foreign investors (5%). This is shown in Graph 1 and Table 1. That means that a large part of all the new issuance of LEBAC is held by investors outside the regulatory scope of the central bank, especially individuals and foreign investors. This represents a potential source of currency market turbulence because these holdings could easily be converted into foreign currency, causing a large FX depreciation.

LEBACs

Holders of LEBACs, May 2018 %
Financial institutions 39%
Non-financial public sector 17%
Mutual Investment Funds 16%
Firms 14%
Individuals 9%
Foreign investors 5%

Source: Authors’ calculation based on Central Bank of Argentina

What was the trigger of the recent sudden stop and reversal of capital flows? Supporters of the central bank authorities point towards the change in the inflation target last December, when the Chief of Staff Marcos Peña (the most powerful person in cabinet) and the Economy Minister Nicolas Dujovne moved the target from 10% to 15%. In light of the change in the target, the central bank started to gradually lower interest rates from as high as 28,75% to 26.5%, while inflation remained unabated, giving rise to rumours about the government’s internal political disputes. However, inflation remained stubbornly high even before the change in the target; and there were also some minor foreign exchange runs both before and after that announcement. In the meantime, the government did reduce the budget deficit. The problem is not of fiscal origin: one has to look to the external front.

Other analysts point towards the reversal of the global financial cycle of cheap credit, which has led to devaluation of emerging markets’ currencies across the board. The turning point, in this interpretation, was when the 10-year rate on US Treasury bonds reached the 3% threshold. In a similar vein, others highlight a tax on non-residents’ financial profits that was going to come into place on May 1st, that triggered the sell-off by foreign investors. Indeed, the run was primarily driven by foreign hedge funds and big banks (notably, JP Morgan) closing their positions in pesos and acquiring dollars. However, the impact on Argentina dwarfed the devaluations, reserve losses and interest rate increments in other developing countries.

Finally, some blame the patently disastrous response of the central bank to the first indicators of a capital flight. The run accelerated in the last three weeks. The CB initially sold all the dollars that foreign banks demanded, in an attempt to control the exchange rate, without increasing interest rates. Then the devaluation accelerated, and the central bank started to increase the interest rate, to 30, to 33, and finally to 42%. Its intervention in the exchange market was equally erratic.[2]

These points have some validity, but are insufficient to explain the full extent of the run.  The reason is that investors could enter the country and could leave it without no restriction whatsoever. The main problem is the total deregulation of the financial account and the foreign exchange market, for domestic and foreign investors. The government borrowed heavily in international markets and the central bank offered large financial gains, while the external front deteriorated and domestic non-sophisticated investors were demanding dollars at increasing speed. The most infamous and egregious measure of all is the abolition of the requirement that exporters sell their foreign currency in the foreign exchange market. Instead of having an assured supply of dollars, the central bank is now forced to lure them with a high interest rate. In such a context, where capital can move freely, anything and everything is an excuse to cash in and get out. It is therefore a mistake to focus only on individual issues. The problem is the setting – the whole policy framework.  Now, the central bank is caught between only two alternatives when choosing interest rates: either to encourage carry-trade operations, or to suffer steep devaluations.

The decision to ask for an IMF loan was in the offing for some time but was rushed during the run against the peso. The government’s first intention was to obtain a Flexible Credit Line, the best (or the least evil) of all the IMF facilities, because it provides a decent amount of money with few conditionalities, or at least its minor cousin, the Precautionary and Liquidity Line (PLL), with less money but still not many conditionalities. The IMF, instead, told Argentine negotiators that there was no room for the PLL, and they would have to apply instead for the dreaded Stand-By Arrangements. All the international support and “credibility” that the Argentine government claimed to have was of no use when it came to the moment for banking on it.

But resorting to an IMF loan was not an unavoidable decision.[3] There were other ways to obtain dollars and to cap the foreign exchange run. The government could have forced exporters to sell their foreign currencies; they could have negotiated a swap agreement with some major central bank; or they could have erected barriers to capital outflows.

The report also shows what is to be expected from now on. The IMF will ask for tough measures on labour market flexibility (which was already on the government table), further cuts to public employment, wages, transfers and pensions, and lifting of the greatly reduced trade barriers. The devaluation has already happened, but it should be mentioned that previous devaluations failed to encourage exports, while they only fostered inflation.

It is impossible to forecast what will happen in 2019. On the economic front, there are at least four big risks. The first is a recession, because of the negative impact of devaluation on private consumption. The second refers to an acceleration in the inflation rate and its distributive effects. Nobody expects now that the 2018 inflation rate will be below the 2017 number (25%), and with further devaluations, inflation could spiral to new highs. A third risk, which will be persistent throughout the year, is the eventual demand for dollars by the non-bank LEBAC holders. The fourth one is a possible (though not likely) bank run. Banks have USD 22 billion of deposits denominated in dollars. Any bank-run will directly hit reserves.

This very short experience is another example of the typical boom-and-bust cycle of emerging economies borrowing heavily in foreign currency with totally deregulated financial flows and foreign exchange markets, while experiencing growing current account imbalances. If one were to obtain some “new” corollaries, we would have to point to the failure of the inflation-targeting policy framework in a semi-dollarized economy with no capital controls. The IT regime did not reduce contract indexation; exchange rate flexibility did not reduce the pass-through. And relying on the “confidence fairy” is no path to development; it is rather a highway to hellish institutions. We Argentineans thought we had rid ourselves of that devil.

 

[1] The inflation target, however, was set at very optimistic levels, was never achieved in the two years since the adoption of the IT regime, and was changed last December, something that many say had an influence in recent events.

[2] Some say that this behaviour was not a bug but a feature, since it allowed foreign banks to profit in their investments and leave the country at favourable interest rates. Others, in a less conspirative but equally perverse logic of action, say that the erratic initial response was an attempt by the central bank to prove the wrongfulness of the Ministry of Economy’s approach and regain full control of monetary policy. The unfolding of events is consistent with this argument, with the caveat that even after regaining political power, the central bank proved to be still unable of stopping the run for three weeks.

[3] In fact, when the news of the SBA came, the run actually accelerated, because one of the expected IMF conditions was a devaluation of between 10 to 25%, according to the last Article 4 Consultation Report. That might help to explain why the government wasted a loan from the BIS in less than 2 weeks.

 

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MMT meets Rey’s dilemma: a balance sheet view of capital flight (coming soon to an EM country near you)

Recently, a colleague emailed with the following set of questions: ‘a balance sheet approach to defending currencies. Do you know literature that explains in detail the globally interlocking balance sheets between central banks, commercial banks and what happens when a national government has to defend its currency? What is the role of national and foreign reserves and how do they travel these balance sheets in the process of trying to defend a currency? I came back to this question when discussing the Swedish fight to defend the Dollar-pegged Krona in the early 90s and the promise of MMT? Most particularly we wondered to what extent national governments can just issue Krona and use them to buy foreign reserves or what sets the limits exactly to this attempt?’

My MMT friends do have answers to these questions (and they do spend a lot of time defending MMT from critiques that it doesnt consider balance of payment constraints to monetary sovereignty). I thought I would answer these questions a la Minsky, with balance sheets, since that’s how I teach my undegrad students about exchange rate management in emerging/developing countries. I teach by setting those questions within the broader conversations about global liquidity, global financial cycles and Rey’s dilemma – independent monetary policy is only possible if countries manage capital flows (capital controls).

  1. Start with an economy in autarchy: central bank issues reserves to banking sector for settlement purposes (banks pay each other in reserves), banks lend, create bank deposits in the process.

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2a. Commercial bank borrows abroad from parent bank/interbank market (USD/EUR/JPY)

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(this scenario played out in Eastern Europe before Lehman, when foreign-owned banks would borrow from parent/interbank markets – ending up with the Vienna Initiative)

2.b Commercial bank funding via fx swap with non-residents

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Step 1 occurs where local banks are allowed to lend retail in foreign currency. If it looks like MMT 2.0, it is not exactly that – without legal restrictions, the only constraint on banks creating foreign money (eurodollars) is their foreign currency reserves (an exogenous money story a la monetarism).

Even with restrictions on the lending in foreign currency (skipping steps 1&2), banks typically intermediate non-resident demand for local currency bonds via fx swaps (see my paper here on growing appetite for EM securities as part of shadow banking reform agenda). This is big enough that BIS has recently proposed to approach fx swaps as missing debt. Note that this is a global liquidity story:  without capital controls, non-resident demand/bank borrowing abroad reflects funding conditions in US money markets (see Bruno and Shin’s risk taking channel of monetary policy).

3. Rey’s dilemma kicks in: central bank intervenes to stem currency appreciation (for mercantilist or macroprudential reasons)

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For this commercial bank, the central bank’s policy rate is no longer a binding constraint, since it obtains local base money (reserves) by selling its fx liquidity to the central bank, rather than in the local interbank money market. When interest rate differentials are significant, this eases cost of funding (in the macro literature, this is part of the debate on the effect of financial globalisation on the effectiveness of inflation targeting central banks).  It’s global liquidity, not domestic liquidity, that determines short-term money market rates.

4. To regain monetary control, central banks issue own debt.

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This operation is known as sterilisation: that is, ‘sterilising’ the impact of fx market interventions on domestic money market rates. Central bank issues own securities (or sells government bonds, or takes deposits) in order to absorb back the reserves it created when it paid for the fx liquidity it bought from banks. Note here that this does not solve Rey’s dilemma, since banks have full discretion over how much to place in central bank securities. Rather, for banks this is an attractive carry – borrowing cheap abroad, placing it in risk-free local securities (banks can hedge fx risk).

If you think this is a theoretical exercise, think again.

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5. The limits to monetary sovereignty: global liquidity conditions tighten, capital flight ensues.

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In step 1, non-residents sell local securities – potentially triggering liquidity spirals if large, unregulated local repo market exists.  Note that by step 5, local banks with no direct links to global finance also start to suffer as interbank liquidity tightens. Cant the central bank mitigate this by reverse sterilisations, that is, by again insulating fx market interventions from domestic money market dynamics? The lessons from the 1997 Asian crisis, according to the IMF, is to segment domestic money markets, that is, to prevent local banks from lending to (non-resident) speculators:

Because a speculative attack requires the establishment of a net short position in the domestic currency, countries have employed a number of tactics to raise the costs of short positions. When sterilized intervention fails to stem capital outflows, short-term interest rates are allowed to rise, tightening conditions in financial markets and making it more costly for speculators to obtain a net short position by borrowing domestic currency. Frequently, however, an increase in short-term money market rates is transmitted quickly to the rest of the economy; it may therefore be difficult to sustain for an extended period, especially if there are weaknesses in either the financial system or the nonfinancial sector. When high short-term interest rates impose an unacceptable burden on domestic residents, countries may “split” the markets for domestic currency by requesting that domestic financial institutions not lend to speculators. Foreign exchange transactions associated with trade flows, foreign direct investment, and equity investments are usually excluded from such restrictions. In essence, a two-tier system is created that prevents speculators from getting domestic credit while allowing nonspeculative domestic credit demand to be satisfied at normal market rates. (IMF 1997)

Even if the central bank successfully protects local banks  from cross-border volatility triggered by global financial cycles, it can only defend the currency to the extent that it has foreign reserves. It will most likely not wait until it runs out. In the happy scenario, it draws on its swap lines to weather capital flight – but few central banks have that luxury (and ask yourself, how many will actually have it when Donald Trump needs to be consulted on this). The worst case scenario:  IMF/Troika/whoever will lend  – with heavy conditionality.