What’s Wrong With Argentina?

In the last few months, Argentina has seen a series of currency crises as an excessive reaction to international events and changes in market conditions. While to some extent the problem is due to foreign shocks, much of it is also due to Argentina’s own wrongdoing. Argentine monetary policy was a crisis waiting to happen. Why did Argentina have a larger currency crisis than other countries, and how did it get there?

When Mauricio Macri took office in December 2015, he found a challenging economic situation. The previous administration, that of Cristina F. de Kirchner, monetized its large fiscal deficits, producing rates of inflation of 20–30 percent. Macri’s administration and the new central bank authorities tried to reduce the inflation rate faster than the fiscal deficit.

During Macri’s first year in office, government spending and the deficit increased in real terms. Only in the second year did the deficit start to fall. The treasury received less assistance from the central bank and issued more foreign debt instead. However, since the foreign debt was denominated in dollars but spending was in Argentine pesos, the central bank issued pesos to buy the dollars collected from the debt issued by the treasury. Then the central bank sterilized the newly issued pesos by issuing its own short-term bonds, Letras del Banco Central (Lebacs). Both financial institutions and households were allowed to invest in Lebacs.

The Lebacs policy took place in the context of a decade of high inflation rates and lack of confidence in the security of private bank deposits due to a history of expropriations. Households save and invest in dollars, not in pesos. A high interest rate paid on the Lebacs was needed to constrain inflation and further depreciation of the peso. The high interest rate policy built a carry-trade game, where investors would make deposits in pesos that would pay an interest rate above the expected depreciation of the peso against the dollar with the intention of making a profit in dollars. By the end of 2017, the outstanding amount of Lebacs was 1.17 times the amount of base money the central bank had committed itself to issuing at some future date, as Lebacs are not renewed or rolled over anymore. Unless money demand increased at the same rate, the excess of money supply would put pressure on the price level and the exchange rate.

Arguably, three events triggered the series of currency crises in Argentina that started in the first half of 2018. First, the high interest rate policy hampered economic activity. Firms could not pay banks the high interest rates the central bank was offering through Lebacs. So the government decided on December 28 to force the central bank’s arm and make it reduce interest rates. This was seen as a violation of central bank independence. Inflation was mostly flat for most of 2017, but expected inflation in 2018 jumped from 17 to 20.4 percent and reached 31.7 percent with the first currency crisis in April/May. Second, a new law passed by Congress and promoted by the administration  taxed income from Lebacs both domestically and internationally starting in April. Third, an increase in interest rates in the United States and elsewhere made the Argentine debt less attractive to hold.

The lack of confidence in the independence of the central bank, the new tax on Argentine Lebacs income, and higher interest rates in foreign-denominated currencies triggered a sale of Lebacs and the liquidation of the carry-trade position from April to May, when the new tax became effective. The liquidation of the carry-trade position increased the demand for dollars in the foreign-exchange market, triggering the beginning of the currency crisis.

External shocks affected the Argentine exchange rate. But it was Argentina that decided to issue Lebacs paying high interest rates as a way to reduce inflation. Argentina was playing with matches in a distillery. The fact that the government inherited economic problems  from the previous administration does not mean the risks described above did not exist. Still, it is not clear that this was the only policy that the central bank could take.

Starting in 2005, the Kirchner administration gave non-transferable bonds to the central bank in exchange for pesos to monetize the deficit. Because these bonds are non-transferable, they cannot be used in open market operations to increase or decrease the money supply. Because of this legal constraint, the central bank authorities that took office with Macri’s government decided to issue Lebacs as a way to sterilize the new pesos in circulation. No one ever explained, however, why the new administration could not swap the non-transferable bonds for transferable bonds so that the central bank could perform conventional open market operations without the need to issue Lebacs.

Besides the peso depreciation and a spike in inflation rates, the monetary authorities were replaced and the government reached an agreement with the International Monetary Fund. The new economic policy shows improvements, but remains similar to the previous policy. The fiscal deficit is expected to decline faster. The central bank is changing the Lebacs for a new short-term instrument, liquidity letters (Leliqs). The Leliqs have a shorter maturity, as they last only for one week, and can only be held by financial institutions. By the end of November, the amount of Lebacs and Leliqs will be around 1.3 times the amount of base money. Argentine monetary policy still has work to do. Maybe it is not too late to swap the non-transferable treasury bonds for transferable treasury bonds in order to give more flexibility to the monetary authority.

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