SUBJECT: The depreciation of the Argentine peso in early January.
SIGNIFICANCE: The recent weakening of the exchange rate is largely due to the Central Bank's need to restore international reserves following the payment of 9.5 billion dollars to the IMF. However, the implicit exchange rate target seems to have risen, in line with the recent surge of inflation and consistent with the government's goal of a high real exchange rate. In the medium term, persistently high inflation could fuel the demand for dollars and lead to a run against the peso.
ANALYSIS: After reaching a minimum of 2.86 pesos to the dollar in August 2005, the exchange rate depreciated by 6% to 3.03 by year-end. The peso has continued to weaken in early 2006, reaching 3.06, the highest level since January 2003. This has been driven by the active intervention of the Central Bank (BCRA) in the foreign exchange market, after the stock of international reserves fell sharply following early repayment of outstanding obligations to the IMF. Reserves fell by 33.8%, from 28.1 billion dollars at the end of 2005 to 18.6 billion at the beginning of 2006.
In the first seven days of 2006, the BCRA purchased a daily average of 35 million dollars, up 133% over January 2005, due to the government's decision rapidly to restore the stock of reserves to pre-payment levels. However, the Bank reduced its intervention thereafter to prevent a major depreciation of the peso. Foreign currency supply has also been constrained by the seasonal contraction observed in exports earnings (due to the agricultural cycle), although exporters may also have postponed sales speculating on a further increase in the exchange rate. By the third week of 2006 international reserves reached nearly 19 billion dollars, while at the end of January the exchange rate has strengthened to 3.04.
Real exchange rate. On December 29, the BCRA presented its monetary programme for 2006. The Bank anticipates a year-end inflation rate of 8.0-11.0% (down from 12.3% in 2005), which is not defined as a target but rather an indicative range. The inflation forecast does not include either an eventual adjustment in public utilities tariffs or a rise in other regulated prices (see ARGENTINA: Anti-inflation measures miss root causes - November 16, 2005). Real output is expected to rise by 6.2%, still above the long-term growth rate, which the government has estimated at 3.0-4.0%. The monetary target will focus on M2, which is expected to increase between 11.7-21.2%, down from 24.0% in 2005. The question is whether this slowdown will be enough to prevent a further acceleration of inflation. BCRA President Martin Redrado's presentation reflected the assumptions of the monetary authority:
Despite the BCRA's autonomy, it will not disregard the government's goals, in particular those related to economic growth and the exchange rate.
The Bank emphasises the role of relative price adjustment in the recent trend of inflation.
The Bank will continue its policy of international reserves accumulation, to act as insurance against external shocks. By the end of 2006, international reserves are expected to reach the level attained prior to the payment to the IMF.
In a context of robust economic growth, the output gap is also closing rapidly, with both employment and capacity utilisation returning to the peak levels reached in 1998.
Public expenditure will be a key variable to monitor in order to achieve the inflation target.
The exchange rate policy will be oriented to reducing exchange rate volatility, preventing a further appreciation of the peso, which is benefiting from a favourable international scenario.
The BCRA appears committed to a high real exchange rate. Although the real exchange rate appreciated by 3.2% in 2005, it is still 92.0% above the average of the convertibility plan in the 1990s. In fact, the BCRA has virtually adopted a crawling peg, where the implicit nominal exchange rate target is periodically revised to maintain a high real exchange rate. This has been key for recovery of the manufacturing sector, and has also contributed to boosting exports, which reached a record of 40 billion dollars in 2005. However, a depreciated peso has also bolstered tax revenues: export taxes, which account for 10% of the total, expanded by 20% in 2005.
Different viewpoints. The strategy of international reserves accumulation is also consistent with this policy, as the BCRA participates actively in the exchange market through the continuing purchase of dollars. However, this policy has resulted in a sustained increase of the monetary base, which in the last three years expanded at an average annual rate of 23%. The expansionary monetary policy (reflected in negative real interest rates) is widely considered to be behind the surge in inflation, which rose from 3.7% in 2003 to 12.3% in 2005. This viewpoint is not shared by the government, which believes that recent inflation rates are largely accounted for by the recovery of non-tradable goods prices (now rising owing to the recovery of domestic consumption), and by firm international commodities prices (which affect the price of some basic goods such as food).
However, the BCRA is emphasising the need to control primary spending, whose rapid growth (21.5% in 2005) has contributed to fuelling domestic consumption and, hence, consumer prices, in a situation where little idle capacity remains. In this respect, the BCRA's analysis differs from that of the Ministry of Economy, which considers that the role of public expenditure growth in the recent surge of inflation is less important. In fact, relatively high inflation rates have contributed to a significant fiscal surplus through increasing tax revenues, while primary spending has risen at a slower pace. However, this is also a risky strategy: once inflation rates persistently exceed 10%, it is difficult to bring them down to one-digit levels, while the risk of a spiral increases -- particularly in a country where the memories of hyperinflation are still fresh (see ARGENTINA: Inflation surge causes concern - September 29, 2005).
Outlook. According to the latest survey of market expectations (REM) conducted by the BCRA, in 2006 year-end inflation will reach 12.3%, with an exchange rate of 3.07. This implies that expectations have worsened in the past six months: in June 2005, the REM was forecasting 8% inflation and an exchange rate of 3.02 in 2006. It also suggests that government expectations may be regarded as over-optimistic, which in turn would explain why it is seeking to combat inflation using a tool -- price freezes -- which, although appreciated by public opinion, has proved ineffective in the past. In this respect, economists stress the need to combat inflation, a macroeconomic problem, through a contractionary monetary policy. However, this is resisted by the government, which relies on strong economic performance to maintain its political support.
CONCLUSION: Rapid economic growth, a stable exchange rate and low inflation have been largely driven by a benign international scenario and a considerable output gap. This gap is now closing and the government's ability to maintain an expansionary economic policy is limited. Persistently high inflation could negatively affect expectations, with the risk of an over-reaction and a currency crisis in the medium term.