With the debt exchange behind, the focus is now back to macro imbalances. The fiscal deficit is headed towards a record high and the size of the domestic financial market makes it impossible to completely cover Treasury’s needs. This reaffirms the fiscal dominance of monetary policy. Over the last 12 months, central bank financing (profits and advance loans) totaled 7.5% GDP, more than double the numbers seen in late 2014.
In this macro update, we analyze the monetary implications of the central bank accommodating Treasury’s needs. This might be read as an update of Seido Special Report: That 70s’ Show. First, we highlight the basic macro assumptions for 2020-21. Second, we explain fiscal dynamics under our base scenario. Third, we simulate the financial program, considering that the financing needs not covered by the market will be covered by money printing. Finally, we model monetary dynamics combining both fiscal and quasi-fiscal considerations.
Our base scenario involves a continuity of recent trends. If market expectations do not improve now that the debt exchange has concluded, the government will resort to further restrictions and regulations in order to avoid a discrete jump of the official FX rate (due to political, economic, and social reasons). This translates into the following macro assumptions:
(a) Growth: Lockdown effect will prove more permanent and damaging than what could have been expected at the beginning of the Pandemic and import and capital restrictions are likely to increase in order to avoid a BoP crisis. Thus, the recovery may slow down, and even come to a halt. Under this assumption, GDP would end 2020 6% below the pre-pandemic level and next year will increase only 4.1%.
(b) Inflation: Average inflation between 3.0-3.5% per month since Q4 2020 onwards (34% YoY for this year and 47% YoY for the next). Prices are unlikely to lag much behind the official depreciation rate. Additionally, as lockdown conditions relax, relative price adjustments should put pressure on the inflation rate. The government might even approve some increase of regulated prices, stressing even more the inflation rate.
(c) Exchange Rate: We assume that the central bank will keep the crawling peg of the official FX at an average of 2.5% per month, in order to avoid significant real appreciation (though the RER would decrease 11% in 2021). With capital controls in place (and likely to tighten even more to avoid reserve’s drainage), the FX premium would fluctuate around 80%.
(d) Interest rates: Weak activity outlook will prevent BCRA from raising rates, though they might continue using regulations to increase deposit rates and keep dollarization incentives contained. We assume that the reference rate will remain without change at 38%, though the private Badlar rate will gradually increase to 34%.
Under this scenario, we estimate that Fiscal dynamics will improve, but the deficit will remain significant. We maintain our primary deficit forecast at 7.8% GDP but note upside risks (ie: lower deficit) mostly on the expenditure side. July’s data was above expectations and lower transfers from the BCRA in August (ARS 101bn vs ARS 171bn in July and ARS 305bn in June) signal further restraint. For 2021, we estimate that the primary deficit will go down to 5% GDP (overall balance of 6.1%), in line with official estimates. Economic recovery and higher tax pressure will increase real income 5.8%, while the government will unwind part of the “Covid-19 stimulus”, decreasing real expenditures by 5.1%. Political and social reasons will prevent further tightening of fiscal policy.
The financial program of this fiscal scenario is highly demanding. Gross needs for the remainder of 2020 total 7.0% GDP and would climb to 13.1% GDP in 2021 (see table for details). An optimist roll-over scenario (150% of ARS amortizations and 100% of IMF and other IFIs) would leave a financial gap of about 3.4% for this year and 4.0% for the next.
How does this scenario translate to the monetary market? We assume (optimistically) that money aggregates ratios to GDP remain at August’s levels until end-2020. That is, Cash, M2 and M3 will remain at 5.1%, 12.8% and 20% GDP, respectively. The main source of monetary expansion is the financing gap obtained above, followed by the Leliq’s interest bill. On the other hand, we assume the central bank sells the equivalent to ARS 35bn per month until December (zero afterwards) and issues Leliqs to sterilize whatever is needed to maintain consistency with base money growth.
Our simulation shows that the government should worry about the deficit and the quasi-fiscal deficit as well. In our base scenario, interest payments of BCRA’s remunerated liabilities would total 1.2% GDP for the remainder of 2020 and 3.5% next year, increasing financial needs above Treasury’s demands. In order to keep money base growth “contained” at 47% YoY, the Leliq + Repo ratio to GDP would have to increase to 9.4% (+1pp from current level), while the ratio to private deposits would have to increase to 61% (+5pp).
Lower inflation or a fall of money demand would only worsen the situation. Using the same set of basic assumptions but an inflation rate 10pp lower (37%), remunerated liabilities would climb to 3.7% GDP or 70% of private deposits. Alternatively, a fall of 1pp in money demand (cash balances) would make remunerated liabilities to increase to 3.9% GDP or 70% of private deposits. The same reference rate than in our baseline scenario looks questionable, but a lower Leliq rate in the first alternative scenario might destabilize the forex market while a higher one in the second would only increase the Leliq’s interest bill.
his exercise highlights the (undesirable) consequences of fiscal dominance of monetary policy. The central bank accommodates Treasury’s needs, but all that money printing requires additional sterilization to avoid stressing (even more) the forex market. The fiscal problem has become a quasi-fiscal one as well, adding an endogenous source to money growth. Monetary imbalances will keep piling up, and the lockdown exit strategy now requires a solution other than an inflation outburst that “cleans” BCRA’s balance sheet.
The government bets on a recovery that increases money demand. If the economy recovers stronger than we expect and expectations improve, monetary aggregates could (at least) remain at their current levels. For instance, using an average growth rate of 5.6% (consensus view according to REM forecasts), Leliq’s interests would be 0.3pp lower than our baseline and the sterilization efforts could be absorbed without increasing the Leliq + Repo ratios to GDP or deposits. Furthermore, if the government could secure an extra source of USD (maybe extra DEGs distributed by the IMF to all its members?), the central bank could intervene in the market and reduce sterilization requirements. An intervention of USD 3bn would reduce Leliq’s interest bill by an additional 0.1% GDP.
Combined with measures that aim to reduce the FX premium, the government could try to move along the thin path that leads to the “good equilibrium”. Or, at least, postpone the inevitable adjustment until the mid-term elections take place. Political economy considerations should not be overlooked.
Considering the sheer size of economic imbalances, the small margin of error and the occasional unexpected shock, the chances of a disorderly adjustment are important. If the central bank cannot keep the forex market under control, the depreciation of the official FX will wipe out imbalances, at the expense of higher inflation and an economic contraction. In this regard, the sustained loss of international reserves is alarming: net reserves ended August at USD 7.9bn (- USD 1.4bn MoM) and, at this pace, would be depleted in less than six months. The conclusions of our earlier report still look appropriate: the chances of a BoP crisis are high, though they could materialize in 2021 instead of this year.