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Summary
- The new Milei administration signalled plans to dollarize the Argentine economy.
- Some think the central bank must accumulate USD to make this happen.
- The solution, however, is just a simple exercise in arithmetic: find the USD/ARS that equates gross foreign exchange reserves to the central bank’s monetary liabilities.
- The calculation comes to 885 Argentine pesos per dollar, exactly where the official rate is now.
- Former Minister Domingo Cavallo under President Carlos Menem took a little over a year to implement the Convertibility Plan in the early 1990s.
- We expect the current Milei administration to take the same amount of time to prepare to dollarize.
Market Implications
- At the current exchange rate, all Argentine domestic assets are cheap, especially real estate.
- Despite the rally in Argentine bonds, we see significant room for further gains.
- We expect further difficulties in Congress and with the courts. However, if the Milei administration continues with persistence and direction, we think better days lie ahead for Argentina.
New President, New System
The new president of Argentina, Javier Milei, ran on a platform of dollarization, eliminating the central bank, and massive fiscal adjustment. Although some claim these policies are inconsistent, they seem highly consistent to me. If you dollarize your economy, you do not need a central bank. And the only way to make such a system work without massive recession is by implementing and maintaining severe fiscal reform.
More interestingly, many economists speculate Argentina lacks enough foreign exchange reserves to implement this scheme. However, Argentina has done this before with the Convertibility Plan of 1991 established by former Economy Minister Domingo Cavallo.
Are the conditions the same now as in 1991? To see if the arithmetic works out, we must first decide what type of reserves to use: gross or net?
Chart 1 shows both measures of reserves through the end of 2023. Both gross and net foreign exchange reserves fell going into the elections, and net reserves dipped into negative territory. However, just as in 1991, the important measure is gross reserves as long as the lenders – namely the International Monetary Fund – to the BCRA do not pull their funding.
We first look at this question in detail.
Net or Gross Foreign Exchange Reserves?
In early 1991, gross foreign exchange reserves stood at USD5.8 billion. Foreign exchange liabilities of the Banco Central da la República Argentina (BCRA) were almost USD10.5 billion, rendering net foreign exchange reserves negative USD4.7 billion (Chart 1). USD inflows were so strong – mostly from a combination of Argentina offshore accounts and other unrecorded USD inflows (under the mattress USDs) – that net for exchange reserves turned strongly positive at USD2.6 billion.
December 2023 gross foreign exchange reserves stood at USD22.5 billion according to the Argentine central bank (BCRA). Yet net reserves were negative USD2 billion. However, USD inflows have resumed in anticipation of economic policies, and risk-hungry investors – mainly from Uruguay and Chile in addition to Argentina – who think they can exit Argentina are buying extremely cheap assets.
At first blush, the worries of many analysts might hold. However, the IMF has stated they will fully back Argentina in its current stabilization efforts. If the IMF will not demand immediate payment or refuses to roll over these loans, net reserves is the appropriate measure for backing the monetary liabilities of the BCRA. Since the IMF has pledged not to call these loans or allow Argentina to roll them over, the correct measure then is gross foreign exchange reserves.
Dollarization Arithmetic
To back all the liabilities of the BCRA, we must choose an USD/ARS exchange rate that makes them equal.
(FX Reserves) *USD/ARS= Monetary Liabilities (Monetary Base + BCRA Bonds)
Then
USD/ARSe = (Monetary Liabilities (Monetary Base + BCRA Bonds[1]))/ (FX Reserves)
FX reserves at USD22.5 billion, while the monetary base stands at ARS9,031 billion, and BCRA bonds – liquidity notes including LELIQ, NOTALILIQ, LELIQ and NOBAC net of repos – stand at USD2.6 billion. If we add in other liabilities such as government deposits and foreign currency deposits at the BCRA, monetary liabilities total ARS15.7 billion. Plugging all this into the equation above:
USD/ARSe = ARS15.7 trillion/ USD12.5 billion = 731
If we add reverse repos, monetary liabilities come to ARS26.3 trillion and the corresponding USD/ARS of 1,219. I think the equilibrium rate from a fiscal point of view is nearer the first estimate than the second. The government seems to have chosen around 813 for now. Certainly, the Milei government can deliver on drastic fiscal adjustment. Moreover, we expect significant USD inflows that have already started, as noted above.
USD/ARS Dynamics: Unifying Official and Black Market
The black-market USD/ARS rate referred to as BLU is named after an arbitrage operation between blue-chip stocks quoted in the Merval with a corresponding ADR traded in New York. The rate was trading above 1000. Yet those familiar with black markets, USD or otherwise, know this is not the equilibrium rate. When a country removes capital controls and allows the official rate to depreciate, the black-market rate appreciates until they are both equal. Chart 2 shows why.
With capital controls, the government rations (through import licenses and such) the amount of foreign exchange at USDO and at the official rate EO. But individuals in the black market are willing to pay EB. The black-market rate is above the equilibrium rate E*. When capital controls are lifted, the official rate rises, and the black-market rate declines as shown by the arrows in the chart below.
This shows the dynamics of the different exchange rates from the rationed equilibrium with capital controls to a floating regime, all else constant. One clear implication of the analysis is that the foreign exchange black market premium should fall.
Market Implications: USD/ARS Dynamics
The BLU exchange rate has evolved in line with the conclusions of Chart 2, with the official rate adjusting to equilibrium (Chart 3). The first thing to notice is the collapse in the premium, but not to zero.
Second, we had an original period of decline in the BLU USD, but this was brief as the new administration is trying to implement reforms at breakneck speed. This explains the continued high uncertainty, and the premium starts to rise again but to nowhere near the levels before the central bank’s accelerated peso depreciation.
The central bank has been buying reserves, meaning the backing of its liabilities is increasing. So, the central bank is in a fight to establish credibility to progress to a second stage where they have promised a full dollarization. Until the government and the central bank can reach this promised credibility, the premium in the BLU market will remain positive.
Many have made comments about the lack of a majority in Congress. However, the Kirschners (Nestor and Cristina) made it much easier to rule by decree by passing a law that made it difficult for Congress to override the decree. The Milei administration has rapidly established reforms that are the executive’s responsibility. These include liberating all controlled prices, liberating the foreign exchange market, reducing subsidies, reducing trade barriers except for a temporary uniform tariff for the transition, and trying to roll over its debt that is coming due, which is no easy task.
Chart 3 follows two ratios – M0/FX reserves and BCRA liabilities/FX reserves, and the informal (BLU) and official exchange rates. In Argentina, one of the best indicators of the nominal USD/ARS is this BCRA/liabilities/FX reserves ratio. It also shows that both nominal exchange rates are above the rates that would allow for dollarization.
Finally, the black-market premium has fallen significantly in the last three months and has almost disappeared (Chart 4). With the official USD/ARS currently at 856.23 (25 March 2024), BLU USD/ARS trades at a premium of 1020.00, or 1.2%. This is massively down from the peak of almost 200% in 3Q 2023.
Large depreciation of the official exchange rate and the freeing of price controls have imposed ‘corrective inflation’ on the economy. With tight monetary and fiscal policies, the surge should prove temporary. However, combined with the litany of reforms Milei is pursuing through executive decrees and ongoing negotiations with Congress, an increase in political resistance came right on cue, from the unions.
The reforms that Milei must put in place are well known. First and foremost, the government must generate primary fiscal surpluses to reduce pressure on the central bank and interest rates by reducing aggregate demand, especially in non-tradable goods.
Fixing Fundamentals: The Main Challenge
No matter the exchange rate regime, for Argentina to return to growth, it must contain inflation and undertake huge fiscal adjustment.
The annualized monthly inflation rate reached 860% in January but has fallen dramatically in February to a still-high 340%. We still have not seen March’s inflation yet, but we expect it to continue to fall. We expect inflation will take several months to recede to a reasonable annualized rate of under 10%.
Chart 6 shows how real GDP growth has suffered during the last 15 years. Before the onset of the pandemic, real GDP growth was trending downward, showing poor performance.
When the pandemic hit, Argentina’s real GDP growth followed the same pattern seen in all countries: a huge initial drop in real GDP then a huge recovery according to the so-called rubber band effect. The harder you pull the rubber band down, the faster it snaps back.
This type of behaviour has nothing to do with forecasts, although we did expect this in all countries including the United States. It is mere arithmetic. Once past the rubber band effect, however, real GDP growth has trended back to poor performance and even negative growth.
To get inflation back to reasonable levels, monetary policy had to tighten. This posed a significant dilemma for the central bank as Argentina’s monetary policy had run loose for the last 15 years (Chart 7).
During the pandemic, Argentina loosened monetary policy even more (Chart 7). Real interest rates fell to very negative levels, pushed there by the high inflation rates. However, interest rates were already negative or near 0% in real terms before the pandemic. The acceleration in inflation at the end of 2023 has made the central bank try to catch up to get real policy rates positive, which it finally did in early 2024.
The dramatic volatility of real interest rates is due to inflation volatility, but we expect this volatility to calm in coming months. The tight monetary stance should continue, but nominal rates should adjust downward as inflation falls to keep this same tight stance. Allowing nominal policy rates to follow inflation downward will avoid added tightening of monetary policy, which has already seen a real interest rate annualized to 80%.
Having mentioned BCRA needing to clean up its balance sheet, we now compare the current experience with that of Argentina adopting the Convertibility Plan in April 1991. It took the government a year to prepare moving to that fixed exchange rate, which was very close to dollarizing.
We expect about the same amount of time for the Argentine government to establish strong stabilization policies and for the initial shocks of those policies to dissipate before they dollarize. Of course, they can opt not to dollarize because the government may achieve all its economic goals by then. The option to dollarize is really to enhance the credibility of the current regime and help the government resist the future temptations to overspend and monetize that overspending.
Any attempt by the central bank to combat inflation in the short term requires very acute physical adjustment. The government went from having large fiscal deficits in the fourth quarter to surpluses in January and February. This is unprecedented.
Chart 8 shows the challenge that the government faces on an annualized basis. The government has run both nominal and primary deficits since 2010. Getting the primary balance into surplus persistently between 4% and 5% of GDP will take huge effort. Nevertheless, the Milei administration has already shown strong signs it will achieve its goal of a 5% primary surplus.
Finally, this fiscal profligacy has weighed on the government through a large accumulation of debt (Chart 9). Despite several restructurings since 2000, public sector debt is hovering around 100% of GDP at $370 billion.
Without going into details, the current fiscal stance is incompatible with this level of debt. If in the medium term, real interest rates on the debt are equal to 6% and real GDP growth is 2%, the primary surplus that brings Argentina back into strict fiscal solvency is at least 3.6%. To regain credibility, the Argentine government will likely have to run primary surpluses of more than 5% of GDP, the Milei administration’s target for the primary public sector fiscal balance.
Market Implications: Assets Are Still Cheap
As I have argued since February, the numbers confirm Argentine assets were and are cheap. Daily 5-year CDs spreads peaked in 2023 at 7503bps over US Treasuries (Chart 10). The current rate is 1,030.95bps. With a 25% recovery rate, the implied probability of default is 49.7% in five years, down from 99.1% in September 2023. Still, an implied probability of default of 49% is high for a country implementing as much reform.
Chart 11 confirms the very large rally in Argentine debt instruments. Weighted by face value the average price has risen by more than 100% since November.
Chart 12 shows the Merval index in nominal and USD terms. The large rise in USD/ARS has masked the Merval performance, but the index has rallied significantly in local currency.
Conclusions
The new Milei administration is implementing drastic market-friendly reforms at breakneck speed. They have hit roadblocks such as labour courts, and Congress has yet to pass the omnibus bill. However, the administration has implemented policies that come under the rubric of the executive and under executive decree, including portions of the omnibus bill. Congress and governors continue to negotiate details of the omnibus bill with the administration, and we expect ultimate passage.
That said, the key macroeconomic policies Argentina needed in place are already there: tight money and fiscal adjustment. The government has secured two consecutive months of nominal and primary surplus fiscal surpluses in addition to a significant fall in the inflation rate. Although Argentina has a long way to go, a sustainable recovery is well on its way to implementation.
Markets are reflecting this already and have significant room to rally further as the prices do not yet reflect the underlying direction. We expect continuous difficulties – after all, this is Argentina. But if the Milei administration continues the persistence and direction it has already shown, we expect continued outperformance of Argentine assets.
[1] LEBAC (Discount Securities) – NOBAC (Capitalization Securities) – LELIQ (Liquidity Bills) – NOCOM (Cash Compensation Notes) – LEMIN (zero-coupon internal bills, paid at the reference exchange rate oriented to the mining sector) – LEGAR (zero-coupon internal bills paid at the reference exchange rate for the constitution of guarantees in markets) – NOTALIQ (Liquidity Notes at variable rate) – LETFCI (Internal Bills of the Central Bank of the Argentine Republic in pesos for FCI) – LEDIV (Internal Bills of the Central Bank of the Argentine Republic in dollars settled in pesos at the Reference Exchange Rate “A” 3500 zero coupon).