Reserves usually end up having costs, but the benefit is that they lower liquidity risk.
Argentina’s central bank recently announced that it will accumulate more international reserves. While it is true that the central bank had already been purchasing dollars directly from the treasury (resources from debt issuance abroad) throughout last year and 1Q17, the monetary authority was largely inactive in the foreign exchange market, while it was publicly defending a clean floating exchange rate regime. In fact, during 2016 and 1Q17, the central bank bought USD 17.4 billion, of which USD 13.5 billion were direct purchases from the treasury and USD 1.3 billion came from direct purchases from the Province of Buenos Aires (also related to bond issuance) and from Banco de la Nación. The central bank purchased only USD 2.6 billion in the exchange rate market, and most of these purchases were in the first half of 2016.
The central bank has set an ambitious target: an international reserves-to-GDP ratio of 15% of GDP within one or two years (a level close to other LatAm countries). Currently, Argentina’s reserves-to-GDP ratio is below 9%, with gross international reserves standing at USD 48.3 billion. To accumulate an additional 6% of GDP would mean purchasing USD 33.5 billion in addition to the hard-currency public sector debt service (which uses international reserves and amounts to USD 10.8 billion through the end of 2018), if 2016 nominal GDP is used as the baseline. If we use as a baseline the nominal GDP we expect for 2018, the amount rises to USD 45.0 billion.
Although the central bank said that the dollars for the buildup of reserves will come mostly from the treasury’s debt issuance, it is unlikely that the government will place that much hard-currency debt in the next two years. We note that Argentina already issued USD 29.2 billion in 2016 and USD 9.2 billion in 2017.
In fact, the central bank has already started to purchase dollars in the exchange rate market. The central bank purchased USD 500 million in five consecutive trading sessions during May. The purchases were implemented by public commercial banks (Banco de la Nación and Banco Ciudad). These dollars were then resold to the central bank.
The monetary-base issuance resulting from the central bank’s dollar purchases will be fully sterilized, increasing the amount of Lebacs in the market. The ex-post cost of accumulating reserves will naturally depend on the evolution of the exchange rate. A depreciation in excess of the interest rate differential with U.S. (which is currently very wide) would improve the central bank’s balance sheet, though it would still lead to a deterioration of the consolidated public sector balance sheet (considering that public sector hard-currency debt stands at USD 217 billion, or 40% of GDP). In the long run, with a stable real exchange rate (that is, the nominal exchange rate depreciating in line with the inflation differential with the U.S.), the cost of carrying reserves will be the real interest rate differential with the U.S. Given the ongoing transformations in the Argentinean economy, it is still too early to forecast the equilibrium real interest rate, but even if it falls to levels similar to those of other LatAm countries (which will be hard, given the inflation risk premium), it will still be higher than in the U.S.
Reserves usually end up having costs, but the benefit is that they lower liquidity risk (and consequently sovereign risk). We estimate that gross external financial requirements (defined as the current account deficit plus amortization of public and private hard-currency debt minus net FDI inflows) stands at USD 80 billion for 2017 and 2018, including the year-to-date payments. Gross reserves cover about 60% of that.
We also note that even if the central bank manages to bring gross reserves to 15% of GDP, net reserves will likely remain below its peers. In fact, reserves excluding reserve requirements on dollar deposits and liabilities with China stand at only USD 18.9 billion (or 3.4% of GDP) currently. In most countries of the region, the difference between gross reserves and net reserves is small, as their central banks do not have meaningful foreign-currency liabilities anymore. One exception is Peru, where the financial system is partially dollarized (like in Argentina), but even there reserves excluding foreign-currency liabilities (other than treasury deposits) amount to USD 44.7 billion (22.9% of GDP), while gross reserves are USD 63 billion.
While the declared purpose of increasing reserves is to lower sovereign risk, concerns over excessive exchange rate appreciation likely played an important role in the central bank’s decision to accumulate dollars. The fact that Argentina recorded a current account deficit of 2.8% of GDP in 2016 (financed mostly by debt), despite a 1.6% decline in internal demand, is a yellow flag. However, considering that the country did not have consistent access to international financing in recent years (on the contrary – Argentines were pulling money out of the country), a scenario in which Argentina lives for many years with a wide current account deficit relative to other emerging markets and a strong real exchange rate is a possible equilibrium.
Besides, fighting exchange-rate appreciation can make it even more challenging to bring inflation down. In our view, given the low credit penetration in Argentina’s economy and the high (albeit falling) pass-through, it is important for the central bank to make use of the exchange-rate channel of monetary policy. As the commitment of the central bank with the inflation target is stronger than the goal of increasing reserves, we think reserve accumulation will only continue if external liquidity continues high, so dollar purchases can go on without leading to an exchange rate depreciation that threatens disinflation.
João Pedro Bumachar Resende
Juan Carlos Barboza