Argentina’s central bank (BCRA) has once again surprised markets by substantially hiking their policy rate again. Markets must pay attention to what is really occurring–FX controls that are supporting the currency thus far.
Tighter Monetary Policy, FX Controls
The BCRA is working hard to stop what the government calls the “speculative spiral” in Argentina’s currency. After increasing the policy rate by 600 bps within four days with no relief for the currency, the BCRA decided on May 4 to take it up another 675 bps to set the policy rate (the 7-day repo rate) at 40%, its highest level since Argentina’s inflation-targeting regime was established. The Bank also increased the 7-day lending rate (the rate at which financial institutions get funding) by 850 bps to 47%.
One of the main objectives of these measures is to prevent speculation by financial institutions. By setting the lending rate that high, financial institutions’ incentive to borrow pesos to buy dollars decreases.
On the other hand, by keeping the borrowing rate virtually unchanged, the Bank aims to reduce inflationary pressures by reducing liquidity, Priscila Robledo, junior economist for Latin America with Continuum Economics.”We believe—apparently contrary to the market view—that the most important new BCRA measure is tighter FX controls to financial entities.”
Starting May 7, financial institutions’ daily long positions in foreign currency cannot exceed 10% of the previous month’s total assets. (Previously, financial institutions’ average daily long positions in foreign currency could not exceed 30% of the previous month’s assets.) This new measure is especially restrictive because it not only limits the percentage of foreign currency the institutions can hold, it makes the limit a daily one rather than a monthly average.
The Argentine government, for its part, tried to support the BCRA by lowering the 2018 fiscal deficit target from 3.2% to 2.7% of GDP. The Treasury and Public Finance Ministers gave a press conference aiming to calm market jitters. However, since the government has been able to over-achieve its (rather unambitious) fiscal target in previous years, markets expected the same in 2018. “Therefore, the change of the fiscal target did not manage to calm markets, especially since the market was already expecting a similar number and subsequent years’ targets were not modified,” Robledo explained.
New Measure Likely Only Short-Term
While a number of imbalances make ARS extremely vulnerable to confidence shocks, market analysts widely believe the real trigger of the recent currency selloff was bad policy by the BCRA in a desperate attempt to control inflation. “We suspected the BCRA might consider some alternative measures to stop the devaluation, but we did not envisage FX controls, as they are too costly in terms of credibility,” added Robledo.
The newly-adopted measures have managed to stop the peso selloff so far and FX controls should guarantee less volatility in the short term. As such, “we still expect the BCRA to keep the policy rate unchanged at the next meeting. However, we need to recognize that the BCRA is only buying time, perhaps hoping that external conditions improve so it can withdraw FX controls without much disruption,” said Robledo. “We doubt the Bank is hoping for better domestic conditions especially given Argentina’s extremely restrictive monetary policy and somewhat restrictive fiscal policy.
The risk, she adds, is that these conditions will not improve, and therefore any ARS disruption is just being postponed. In this case, Argentina will inevitably have to face the same FX depreciation (and thus inflation) in the future, but lower economic growth and no credibility for the BCRA. In the best case scenario, the delay will allow a controlled ARS depreciation to match Argentina’s weak external position.