Martín Redrado: Overview of monetary and financial policy in Argentina
Speech by Mr Martín Redrado, President of the Central Bank of Argentina, before the Committee on
Treasury and Budget of the National Senate, Buenos Aires, 20 December 2006.
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1. Monetary and financial policy guidelines
In our third year in office, we are laying the foundations and starting points for the monetary and
financial system of the coming decades. This strategy is based on four main pillars - a consistent,
articulate and gradual monetary policy; a foreign reserve accumulation and management policy that
provides a long-term horizon; a system that is independent from public sector needs; and a policy
framework that boosts corporate and household credit.
The economic literature has shown that there is no optimal one-size-fits-all scheme. Worldwide, there
are success stories both of fixed and floating exchange rate regimes, with or without explicit inflation
targets, that use the money supply or the interest rate as an instrumental variable. The important thing
here is not the label of the regime, but the monetary policy internal consistency, designed to ensure a
balanced money market. At this stage in national history, there are no adequate substitutes for a
monetary policy that allows the system to develop while keeping the growth of monetary aggregates in
check and fosters savings without affecting investment. In fact, we carry out a sterilization program
that is unprecedented for Argentina - because of its depth as well as its quality - on the basis of a
public sector that saves, a sound financial system, and a Central Bank with a strengthened balance
sheet.
While we are enjoying a favorable international scenario, believing that this scenario will last forever
would be misleading. In fact, the world today is highly volatile and, as we all know, the challenges we
face are magnified in emerging countries such as Argentina, where transmission mechanisms are still
vague and instruments have a limited power. As a consequence, our risk management approach
entails that monetary and financial policy should help prevent crises and weather uncertain scenarios.
This leads to the development of countercyclical mechanisms to cushion the effects of external
disruptions on the economy. One of them is the prudential policy of international reserve accumulation,
which enables us to hold a stock of over USD 31 billion, an unforeseen level not long ago.
Besides, after decades of financing public spending through various monetary arrangements, we are
designing an independent monetary and financial system. This structural change sets out a substantial
difference from the past: neither the Central Bank nor the financial system are used to finance fiscal
imbalances.
In this sense, the Central Bank has developed market instruments to encourage the revival of private
credit. A series of specific measures from the asset as well as the liability side has led to a new
regulatory framework that widens the base of potential borrowers, eases reporting requirements,
extends the use of collateral and encourages the extension of maturities.
These policies lay the foundations for the Argentine monetary and financial system of the coming
decades as true State policies - independently from any predetermined ideological scheme and
assimilating the opportunities and challenges of today's world - thus contributing to sustained
economic growth.
2. The international scenario
The international scenario still shows sound economic growth, with commodity prices at a record high
and substantial liquidity. Expansion is nowadays more balanced due to lower US growth, that was
offset by a more favorable trend in the euro area, Japan and the emerging countries. In fact, the world
is expected to grow nearly 5 percent by 2007 in a context of subdued inflation. Latin America benefits
from a favorable global framework and is expected to increase 4 percent by next year.
The region shows a sounder expansion than in previous recovery episodes since, in the past years,
macroeconomic discipline has been strengthened. The region is therefore better prepared to face
adverse shocks. Latin American countries are implementing prudent monetary policies, showing
sounder fiscal positions, reducing currency mismatches, holding positive external balances, applying
more flexible exchange regimes, building up reserves as a preventive mechanism, and paying back
debt with international organizations in an effort to improve their liability management.
An example of this enhanced soundness is that the higher financial volatility evidenced worldwide in
May and June had a relatively mild impact on the region's economies as compared with other
emerging economies with a more vulnerable macroeconomic situation. This was mainly reflected in
stocks and foreign exchange rates and, to a lesser extent, in fixed income instruments.
However, the global scenario is not risk-free for Latin America and Argentina. Both the trend of
(financial and real) asset prices and the way in which global imbalances (and, in particular, the effects
of an eventual significant deceleration in the US economy) are gradually corrected, are two factors that
may trigger sudden disruptions in the international economic scenario.
As to the former, today much is debated over the permanent or temporary nature of current commodity
prices.
In my opinion, here the analysis can be split in three:
For metals, the long-term price has risen and current prices seem to exceed such long-term values.
These new long-term prices are due to higher energy costs, while the relatively high current price is
due to rather long production cycles, with significant fixed costs and low marginal costs.
In turn, the prices of agricultural products are relatively high, but long-term prices have not increased.
That is to say, the average is stable and so a reversal to the mean kind of process is expected.
Finally, the price of oil depends on extra-economic factors that are difficult to grasp through a model.
In addition, the oil market is not very competitive, leading the price dynamics to be mainly perceived as
a random walk. In this sense, the recent drop in crude oil prices allowed inflation to decrease and core
inflation indices to relatively stabilize worldwide. Second-round effects seem to be limited, as was the
case when the oil price exceeded USD 75 per barrel.
The end of the housing boom in the US is having a limited impact despite lower prices and sales.
Indicators such as employment growth, high corporate profits and liquidity, and the growth of activity in
the residential segment are quite strong to support consumption. However, the correction of real
estate inflation continues to be a source of uncertainty for the global economy, given the size and
scope of its effects on aggregate spending.
As to the second risk factor - i.e. the correction of global imbalances - the trend in the US external
sector seems to signal a certain degree of stabilization. Anyway, these data do not seem to indicate
that the exchange adjustment has come to an end. Both the current account deficit - around 7 percent
of the Gross Domestic Product (GDP) - and US financial assets held by the rest of the world are high.
This has already resulted in a readjustment of the main currencies that, in my view, is not over yet.
While the euro has significantly appreciated against the dollar, the adjustment has been less
pronounced for the currencies in different Asian countries with a surplus current account.
The pattern of global growth in recent years led to a significantly reduced share of the US in global
output and trade, which may limit the impact of a deceleration in the US economy. Also, the economic
growth of Japan and the euro area is mainly supported by domestic demand, reducing contagion
through trade flows.
Nevertheless, the possibility of the adjustment resulting in financial turbulences, such as the ones in
May and June, should not be ruled out. In those months, there was a strong belief that interest rates
would soar, and this led to a sell-off of emerging market assets with the resulting effects on asset
prices and on most currencies in the world. The Federal Reserve monetary policy - which is today
explicitly data-dependent - has shifted part of the uncertainty within its own monetary policy committee
to the markets, and we, emerging countries, must be alert to any sudden change in global investors'
expectations.
3. Monetary and financial policy in 2006
3.1. Compliance with the Monetary Program
By the end of 2006, the Central Bank has strictly complied with the Monetary Program self-imposed
targets for 14 consecutive quarters, which is a signal of certainty and predictability.
The change in the monetary policy stance begun in 2005 through a strict control over monetary
aggregates deepened in 2006, and was reflected in a sustained deceleration of year-over-year M2
growth (currency in circulation, private and public sector's current accounts in pesos and savings
accounts in pesos), which fell around 6 percentage points.
An indicator used by central banks to measure the monetary policy prudential bias is the comparison
between monetary aggregate growth and nominal GDP. Monetary aggregates in Argentina are
decelerating nowadays, converging to the GDP nominal change, which represents a significant
reduction from the excessive monetization in 2003 and 2004, whose effects are still felt today, given
the lags with which monetary policy works.
The effect of the change in the monetary policy stance was not limited to the M2: the change in
currency in circulation also slowed down markedly, falling nearly 8 percentage points in 2006.
In turn, we continue pursuing our prudential international reserve accumulation policy, which enabled
us to hold a stock of over USD 31 billion in the past few days. This entailed that in only nine months
we have managed to recover the levels reached before the full payment of the debt owed to the
International Monetary Fund. As many emerging market central banks, we are generating an effective
insurance mechanism against crises, which acts as a collateral for the macroeconomic program. This
policy reduces external vulnerability and exchange volatility, fosters the development of domestic
financial markets in local currency and the reduction of the economy's financial cost, and improves our
relative position when competing for investment in the global economy.
The impact of the reserve accumulation strategy on the money supply has been offset by a deep
sterilization policy that allowed us to absorb the excess money supply in the economy. The joint action
of the various absorption factors has led to a monetary contraction of around ARS 27 billion in 2006.
Both the financial system and the public sector have contributed to the absorption of surplus pesos.
Due to the scheme set forth by the BCRA, the early repayment of rediscounts led to a monetary
contraction of around ARS 6.6 billion in 2006, and the number of institutions that are still indebted to
the BCRA was reduced to two. The minimum requirement policy contributed with ARS 4.4 billion, while
the main tool used was the placement of Central Bank securities, which contributed with ARS 10
billion.
Consequently, in early December the stock of Central Bank bills and notes amounted to ARS 41.2
billion (29 percent of LEBACs and 71 percent of NOBACs). Throughout the year, the NOBACs' share
at a floating interest rate has increased (64 percent of the stock in early December), vis-à-vis
CER-indexed instruments (5 percent in that period) and LEBACs in pesos (31 percent). As a result of
this strategy, the Central Bank's debt average term was extended from 260 (at the beginning of the
year) to 360 days (in early December).
Throughout the year, the Central Bank introduced changes to the minimum requirement policy, raising
minimum cash requirements for demand deposits. In particular, in April we eliminated interest paid on
demand deposits and raised the minimum cash requirements from 15 to 17 percent. We also reduced
the maximum interest rate paid on funds held at the Central Bank without full minimum requirements
from 75 to 50 percent of the BADLAR rate for private banks; and reduced the interest rate paid on the
liquidity requirements on money market funds from a nominal year-over-year 2.55 percent rate to a
nominal year-over-year 0.5 percent rate. In August, additional measures were adopted, raising the
minimum requirements for demand deposits in pesos to 19 percent, eliminating the requirements for
time deposits of over 180-day residual maturity, and establishing that only 67 percent of cash held by
banks could be used for minimum requirements purposes. These measures aimed at recovering
prudential liquidity, acting, in turn, indirectly on the means of payment, promoting the extension of the
funding structure, and thus facilitating an increase in credit.
Our aggressive sterilization policy is feasible due to the Central Bank's strengthened balance sheet
and positive quasifiscal result. At present, income from the high level of reserves and from the
payment of illiquidity assistance more than offsets outlays, which are mainly related to payments of
interest on securities issued by the Central Bank and the premia paid on its repo transactions.
In addition, the behavior of the reference interest rate (interest rate on reverse repurchase operations)
in 2006 also reflected the change in the stance of monetary policy, with a 125 bp hike. Market interest
rates followed the reference rate dynamics. Hence, in early December, the BADLAR rate for private
banks rose 240 bp up to a 9.5 percent year-over-year, and the interest rates for 30-to-59-day time
deposits grew 210 bp up to a 7.2 percent year-over-year, thus leading real interest rates to neutral
levels.
In turn, there was a sustained decrease in the inflation rate throughout the year. During the first eleven
months of the year, the consumer price index (CPI) rose 8.8 percent, 2.3 percentage points below
year-over-year. This trend is explained by stabilization of core inflation since May (around 0.7 percent
per month, equivalent to 8.7 percent per annum), which was also accompanied by smaller increases
(the median price rise for the products making up the core inflation index went from 0.9 percent in the
second quarter to 0.5 percent in the last few months), a lesser spreading of rises (from around 85
percent in the first half of the year down to 76 percent), and a lesser persistence of price adjustments
within the various time horizons. The trend was reflected in inflation expectations: according to the
latest measurement, the retail inflation forecast for the next 12 months resulting from the BCRA ́s
Market Expectation Survey (REM) was nearly 3 percentage points down from the beginning of the
year.
Despite these advances, lower inflation for 2006 is concentrated in certain specific sectors, and the
magnitude as well as the spreading and persistence of price rises remain high, reflecting the need to
keep on following this path.
To sum up, in 2006 we have complied with the Monetary Program targets strictly controlling the means
of payment growth, without affecting the Central Bank's balance sheet and actively pursuing our
prudential policy of international reserve accumulation.
3.2. Credit growth
In 2006, the process of rebuilding financial intermediation, which was begun last year, was
consolidated. This year we are able to show not only a deepening of this process, but also an incipient
improvement in terms of its quality as well as of general access conditions.
Our proactive policy, together with the favorable macroeconomic scenario, boosted private credit,
which is growing at rates of over 40 percent year-over-year. All lines have grown, with credit to small
and medium enterprises reaching above-average levels.
Mortgage credit lines began to grow significantly together with their average maturity, boosting
medium- and long-term financing. This positive behavior is being driven by public as well as private
banks, with prudent risk management evidenced by the improved quality of both public and private
sector portfolio. Today, nonperforming loans are hitting record lows and are below the Latin American
average.
The Central Bank went on building a plan of adequate incentives to generate the revival of private
credit in its three basic dimensions: quantity, quality, and access. A set of specific measures on the
asset as well as the liability side has led to a new regulatory framework that widens the base of
potential borrowers. According to the underlying philosophy, adequate conditions need to be created
for financial institutions to assess projects requiring financing with a forward-looking perspective - that
is, favoring prospects over past experience.
On the liabilities' side, we have broadened the range of instruments included in financial institutions'
equity that make it easier to attract resources in the long run. The so-called "hybrid bonds" or
"perpetuities" have become eligible as basic capital. What distinguishes these instruments is their
extended maturity, which we have determined to be no less than 30 years. The possibility of accessing
this type of funding, particularly considering the current context of marked liquidity in the financial
markets, favors long-term financing and fosters productive investment and housing financing and,
simultaneously, the development of the domestic capital market.
One of the features that has historically characterized our system is the low use of banking services.
Although the most economically productive regions in the country enjoy relatively adequate levels of
banking coverage, the distribution nationwide should be improved. That is why in the past year we
authorized the opening of 137 new branches. Opening new branches in geographical areas where
banking services are not so widespread enables these areas. Also, we are working to improve access
of lower socio-economic segments of the population to such services. Our measures include a more
regular payment schedule for credit to microenterprises (on a weekly, bimonthly, or monthly basis),
enabling banks to grant an initial grace period for the payment of capital services. In addition, we
raised the maximum payment amount from ARS 200 to ARS 300 in order to cover a larger population
segment, and extended the maximum financing term from 24 to 36 months, thus increasing the
financing amount available for infrastructure works from ARS 3,000 to ARS 6,000.
In addition, we offer the possibility of setting up a new type of operating house in towns with no
branches already opened to perform various transactions. This enables a more efficient management
of variable costs to reach areas that are farthest away from the major cities and beyond the financial
system's coverage.
During 2006, several changes were introduced to deepen the reversal of the crowding-out of private
credit (the maximum amount allowed for public sector asset holdings will be reduced from 40 to 35
percent of assets as from July 2007). Consequently, in the past two years the share of credit to the
government in total assets decreased 17 percentage points. In fact, financing to households and firms
is today the main component of financial institutions' assets and the focus of their action.
When assessing central bank practical independence both in Argentina and in other emerging
countries, strict compliance with the rules regarding assistance to the Treasury and regulatory
incentives for banks to absorb the public debt are crucial. This contrasts with mistakes made in our
recent history when, under a supposedly independent scheme, the financial system ended up
financing public spending in the framework of banking regulations that not only failed to prevent it but
also fostered it, discouraging private sector financing.
In this context, earnings amounted to 1.7 percent of assets year-over-year. Improved profitability
together with capitalizations (the financial system received capital contributions worth approximately
ARS 2.4 billion throughout 2006) fostered the consolidation of financial system solvency.
3.3 International reserve management
Uncertainty factors worldwide trigger the need to protect ourselves against volatility and to create
mechanisms to ensure liquidity and the value of our financial assets. In this sense, the international
reserve management policy aims at optimizing returns on reserves, seeking the best possible
combination of risk and return through investment in financial assets with high liquidity and with the
lowest credit exposure.
The specific restrictions to Central Bank international reserve management, our country's structural
changes and the current international economic cycle have led to flexibility in the objectives pursued
for reserve management, as well as the maximization of opportunities available.
Today's international reserve management is significantly different from that of the past decade's: in
the past, the monetary system prioritized the immediate availability of investment and a
comprehensive program of external managers was used (supplemented by the in-house management
of a part of the reserves).
The current floating exchange rate system and the policy of foreign reserve accumulation make it
possible to lay less emphasis on very short-term placements.
In the past two years, apart from the "traditional" task of monitoring the international markets and
economies on a daily basis as the starting point for decision-making in international reserve
investment, quantitative analytic models have been developed that have succeeded in improving the
strategic and tactical decision-making processes. Some of these models focus on the fundamentals;
others, on technical indicators of market behavior; yet others combine both elements - but all of them
use advanced financial tools to assist and supplement the traditional qualitative analysis of investment
opportunities.
In turn, the floating system implies that there are no technical reasons to concentrate reserves in a
single currency, which allows for portfolio diversification. Diversification gradually moved from an
"opportunistic" approach (fully based on the expectations regarding exchange rate evolution) to an
approach based on the economy's structure, particularly, on the currency composition of the current
account and the external debt, which allows for tactical deviations to increase returns.
The debt with the IMF was paid with practically all foreign currencies in the portfolio other than the US
dollar. Since then, euros and pounds were gradually purchased, until investment in currencies other
than the US dollar (including gold) reached around 18 percent of reserves. As part of this
diversification policy, the euro and pound positions were set above the neutral levels (resulting from
the current account and public debt currency structure), while the yen position was set below those
levels.
Despite the redefinition of the currency composition after the payment to the IMF, the share of euros is
at its highest (except for the considerable euro purchases in late 2005 to make the payment), while the
share of pounds and yens has been reduced. As to the gold position, derivative instruments started to
be used in order to reduce the impact of market rate volatility, as necessary.
In particular, the great increase in the price of gold during the past two years entailed an additional
source of return for international reserves.
While the rise in the price of gold was mainly due to the strong demand from India and China, this year
in particular there was a very significant increase in speculative positions. In consequence, and in line
with the higher price, there was a significant increase in price volatility. Against that backdrop, we
decided to use a partial hedge strategy, made up of financial derivatives. This has protected us from
an eventual decrease in prices and, in turn, considerably reduced the volatility of reserves resulting
from fluctuating gold prices.
Investment in callable bonds involved the need to resort to "effective duration" (instead of the usual
duration) to measure the average term of placements and the portfolio's exposure to interest rate
changes.
As from this year, a policy of gradual increase in portfolio duration was adopted. This policy is not only
the result of expectations on the US rate cycle, but also a gradual process towards the reintegration of
benchmarks for reserve management. In fact, as has been empirically proven, the discipline derived
from the use of benchmarks, with specific restrictions to deviation, offers tangible results in the
medium-long term and is the policy regularly adopted by most central banks.
As the element agglutinating all of the innovations mentioned above, a full change in investment
policies is being introduced so as to include the basis for investment policies and update the range of
instruments available. At the same time, updating investment policies entails, besides the traditional
restrictions in terms of liquidity and credit risk, precise limits to market risks, such as value at risk
measures, among others.
Despite context-imposed limitations, the outcome has been very positive. It is estimated that, without
taking into account fluctuations in the peso exchange rate, the investment of international reserves in
2006 would yield over USD 1.2 billion (5.6 percent yield per year over the average stock during that
period). This means that there was a 2 percentage point increase during our term in office.
Regardless of the very important benefits for the economy in general (less country risk, less crisis risk)
as a tangible result of a prudential reserve accumulation policy, as our stock grows, its management
becomes increasingly relevant. Therefore, maximizing investment efficiency and effectiveness through
the optimization of the decision-making process impacts on financial performance and is a
fundamental basis for monetary policy.
4. The 2007 Monetary Program
4.1. The macroeconomic scenario
The optimistic scenario for the global and regional economy, together with the pillars of the domestic
economic policy, anticipate a good performance of the Argentine economy for the coming year, with
significant output growth, continuing fiscal and external surplus, favorable financial conditions, and
improved social conditions.
Nevertheless, when designing the Monetary Program, some domestic economic determinants should
be taken into account which in the transition towards the steady state path, influence the behavior of
some variables and restrict the use of certain traditional economic policy tools, available in contexts of
sufficient financial depth.
Firstly, the adjustment of relative prices after the devaluation is not yet over and, therefore, preventing
some goods and factor prices from adjusting, far from being a healthy practice, may threaten the
economic path towards long-term stable equilibrium.
Secondly, although post-crisis financial recovery has been extraordinary, monetary policy transmission
channels are not yet adequately consolidated. In fact, credit barely exceeds 10 percent of GDP, so its
channel is still inadequate to influence the aggregate demand level through monetary policy.
Thirdly, even though uncertainty is external, domestic economic policy and, in particular, domestic
monetary policy should be ready to face unexpected changes in the international scenario. It would be
a mistake to think that the favorable conjuncture for emerging countries will last forever.
In that case, the lack of definition of the new global financial architecture and the absence of a lender
of last resort force us to enhance prudential policies which, for the monetary authority, result in
international reserve accumulation to face external contingencies.
Apart from that, expected 8.5 percent GDP growth for 2006 brings to the coming year a statistical
carry-over of over 3 percent. Thus, output is projected to grow to over 7.4 percent next year, bearing in
mind a quarterly increase that will remain high, though somewhat lower than this year's, leaning
toward levels that are more consistent with long-term sustained growth. Domestic absorption would
continue to lead this process, mainly due to a new expansion of consumption and investment.
Investment is expected to grow again above average, expanding its share in terms of output.
Trade with the rest of the world will continue on the upswing, anticipating additional exports growth
(exports would hit record levels of around USD 50 billion). Exports levels would practically double the
ones recorded before the devaluation and allow the trade surplus to hit high levels again - of around
USD 10 billion, in FOB-CIF terms - in spite of a slight correction. In addition, based on the
aforementioned goods trade balance, which would still be the major foreign exchange earner for the
country, the positive current account balance in 2006 is projected to remain so in 2007, allowing for
the external gap to be slowly bridged. By the end 2007, international reserves are expected to hit a
new record high in the institution's 71 years.
In turn, following budgetary guidelines, fiscal discipline would continue as in recent years, which would
contribute to stabilizing inflationary expectations. More specifically, and according to expectations, the
3.1 percent of GDP primary surplus will be accomplished. It is worth highlighting that in building a
financial system permanently independent from public sector needs, the 2007 Monetary Program
allows for a reduction in public sector assets in the financial system during 2007.
Finally, core inflation forecasts point at a deceleration of end-to-end measurements as compared to
this years' to fall within an 7-11 percent range.
4.2. Monetary guidelines
In 2007, the Central Bank will follow monetary policy guidelines based on the prudential accumulation
of foreign reserves and a strict control of monetary aggregate expansion, through the sterilization of
money supply in excess of demand.
As in 2006, M2 will continue to be targeted because it is the monetary aggregate that better reflects
the demand for means of payment, given its closer long-term relationship with price dynamics.
Thus, we consolidated monetary policy conduct based on the control of M2 growth, while the
institutional and financial infrastructure is being developed, to enable the transition towards an inflation
targeting regime but without completely departing from the quantitative analysis, via the adoption of a
two-pillar approach that draws on the European Central Bank's successful experience.
Among the prerequisites to implement this regime, we have already complied with the following:
(1) institutional commitment with long-term price stability, regardless of the natural and
necessary relative price adjustments related to the transition phase;
(2) fiscal, financial and external stability, evidenced by the consolidation of a positive public
sector balance, a recovered banking sector, and a stable external surplus;
(3) a comprehensive and transparent communication strategy, including a clear explanation by
the monetary authority of its plans, intermediate objectives, and decisions;
(4) autonomy for the monetary authority to manage its instruments and meet the targets set;
(5) the monetary authority's accountability for compliance with disclosed plans.
As I have already mentioned in several opportunities, the main obstacle to implementing inflation
targeting is the small size of the financial system: this does not ensure the adequate functioning of
monetary policy transmission mechanisms and results from the deep shrinkage experienced by our
banking system after the crisis. Based on the current scenario, in an economy that still makes
intensive use of relatively liquid means of payment, with reduced credit and financial depth, it makes
sense to directly control the money supply vis-à-vis the control of aggregate demand through interest
rates. However, the remarkable financial system's recovery points at the prospects for advancing
towards a more sophisticated monetary system in the future.
Consistently with expected macroeconomic and fiscal performance for 2007, means of payment were
estimated on a quarterly basis, both for M2 and for the other monetary aggregates. The need for
monetizing the economy in keeping with the expected trend in output, interest rate and inflation was
calculated with the best econometric techniques available. In addition, intervals were determ