The development of central bank credibility helped slow inflation down and the currency appreciated after an initial overshooting, ultimately allowing Uruguay to enter the single-digit inflation range.
Our view
Overall, the new agreement seems to be backed by a relatively consistent set of policies. First, having monetary and fiscal policies both highly contractionary should help reduce inflation, albeit with a lag. It is also important that the elimination of deficit monetization is also expected to pay off on the disinflation front once the pass through effect of the recent currency devaluation fades. Second, a swifter fiscal consolidation combined with a larger and more front-loaded package should help eliminate markets' concerns over the potential for a default, bearing positive implications for FX stability (see Sovereign Credit Strategy: A More Stable Outlook Ahead ). And third, targeting base money while keeping a relatively high degree of FX flexibility seems the most viable option considering the relatively limited FX intervention power the authorities have (see Local Markets Strategy: Why This Is the Time to Go Long Argentina Local Assets).
We think using monetary targeting could prove successful in reducing inflation, with the typical lags. Although potential further FX volatility remains a concern, the new monetary framework is the best option available, in our view, given scarce FX reserves. Assuming some degree of FX stability, keeping base money growth flat until mid-next year could help tame inflation expectations, although it could be argued that targeting broad base money could prove more powerful to reduce inflation. We agree with the IMF view that this is a simple and easy to track system and the clear communication we have seen from the authorities yesterday is also a plus to gain credibility. After all, keeping a tight grip on base money growth is something the authorities can deliver on, either by letting interest rates (LELIQs) fluctuate or by managing reserve requirement ratios, as seen in recent months.
The new FX policy seems an attempt to reduce currency volatility considering the limited fire power. The no intervention zone seems wide enough to keep some of the positive features of floating FX systems, including limiting the pressure on FX reserves and promoting FX risk management by the private sector. Moreover, limiting the volatility of the FX may help reduce the depth and duration of the ongoing recession by giving an FX-focused set of economic agents some certainty to plan their activities.
Despite the seemingly consistent policies, risks are centered around FX volatility and growth sacrifices. We are concerned that a wide band could lead markets to test the currency and push it to the upper limit of the no intervention zone, even if the ARS has already undergone a significant devaluation. We view the announcement of the eventual intervention policy as a hint that the authorities are not willing to defend the currency at all costs. While consistent, the combination of largely restrictive monetary and fiscal policies should increase the sacrifice ratio in terms of foregone output, with its associated social and political costs. Reopening some of the wage agreements that were signed early in the year, when inflation expectations were much lower, could help reduce social discontent.
The approval of the 2019 budget, Brazil's elections, and higher US Treasury yields remain the three most important developments to watch in the coming weeks. First, we keep thinking that the government has enough support from the broader political class to approve the 2019 budget bill currently in Congress. Having said that, we expect a heated discussion in Congress given the swift fiscal consolidation proposed. Second, we
view the Brazilian election as a key external factor to watch, not only for the obvious FX implications associated with a potential depreciation of the Brazilian currency, but also because of the strong link in the real economy, especially in the manufacturing sector. And third, even under the new policy framework Argentina still remains exposed to broader external market jitters.
While deteriorating sentiment towards EM seems to have caught a break, several risk factors remain for countries like Argentina, such as the perspective of further pressure in US Treasury yields (see: "EM Strategy Update: Closing the Short," September 24, 2018). In the event we see another round of EM volatility hurting the Argentine currency, the effectiveness of the monetary aggregate targeting system would be limited.
Bottom line
We think the new set of macro policies under the new IMF agreement may help restore confidence. A swifter fiscal adjustment and a larger package should reduce concerns about financing needs while having both monetary and fiscal policy in highly contractionary territory should help reduce inflation expectations. Targeting monetary aggregates may be preferred over exchange rate targeting, given the authorities limited FX intervention power. But it is not risk-free: further FX volatility could hamper the effectiveness of using base money targeting as an anchor. Also, the sacrifice ratio in terms of foregone growth could impact social and political dynamics negatively.
Argentina releases an important set of high frequency activity indicators for August and September to help watchers gage the depth of the ongoing recession: the manufacturing and construction reports should keep declining at a moderate clip while the September tax revenues and auto production releases will shed light on whether the economy is facing a hard-landing – incoming data thus far suggests it hasn't. Colombia's central bank hosts a rate decision: watchers widely expect no change as external conditions remain unsupportive for easing despite a benign domestic inflation picture, to be reinforced by the September CPI release. In Chile, the executive will unveil its 2019 budget initiative by the end-of-month deadline; policymakers previewed their plan for only a small increase in spending (3.2% in real terms) which, combined with prospects for above-trend growth next year, seems consistent with the plan to gradually narrow the public sector deficit with an eye on an eventual stabilization in debt ratios.
Argentina: Resetting Monetary and FX Policy by Fernando Sedano and Lucas Almeida
The facts
The new agreement between Argentina and the IMF entails a bigger package (USD 57.1 billion versus USD 50 billion) and a front-loading of disbursements between now and 2019. The pending disbursements this year will reach USD 13.4 billion (up from USD 5.8 billion) and will total USD 22.8 billion in 2019 (up from USD 11.7 billion), further reducing financing needs during this period (see Sovereign Credit Strategy: A More Stable Outlook Ahead ). The agreement also incorporates the recently announced objective to reach a zero primary fiscal deficit in 2019. We keep our view that the 2019 budget bill aimed at institutionalizing this goal should be approved by Congress before year-end, after a likely heated debate.
The new agreement also brought a new monetary policy framework as the anchor to reduce inflation. Specifically, the Central Bank of Argentina announced the implementation of a monetary targeting regime to replace inflation targeting as of October 1, with the goal of restoring credibility. Authorities announced that base money will grow at an average nominal monthly rate of 0% between now and June next year (down from an average monthly rate of 4% since May), hinting an extremely tight monetary policy given the ongoing high inflation (see Exhibit 1). The authorities will use the LELIQ rate – which was the reference interest rate under the inflation targeting framework – to manage base money growth. The LELIQ rate will now fluctuate on a daily basis, although policymakers promise to keep it high (60%) for the time being. Further changes in reserve requirement ratios could also be used to attain base money growth targets, especially as the unwinding of the Lebac stock remains in place. Base money growth could exceed zero in the event the Central Bank intervenes buying dollars in the market, thus increasing FX reserves.
FX policy also has been tweaked, with the exchange rate expected to fluctuate inside a pre-determined wide band. Starting October 1, this band is set between USDARS 34 and 44, adjusting on a daily basis at a 3% monthly pace between now and year-end, before resetting the pace next year (see Exhibit 2). Argentine authorities referred to the wide band as an intervention zone; while the IMF described the system as a floating FX with no intervention, unless extreme overshooting requires limited intervention to prevent disorderly market conditions. At the top of the band, the monetary authorities can intervene with up to USD 150 million per day. Conversely, should the FX undershoot the band the Central bank may purchase FX and beef up reserves – the sole condition under which the monetary base may expand.
