By Diana Mondino, Economist, University of CEMA
As more people try to understand how inflation affects countries and their financial systems, Argentina’s experience may be relevant, revealing some valuable lessons and important pitfalls to avoid. Unfortunately, regulators of OECD (Organisation for Economic Co-operation and Development) countries seem to believe that the Argentine disaster can never happen to them, but we should all understand that crises develop slowly, and then…all of a sudden!
It is well known that Argentina has a rampant inflation rate of close to 100 percent, the local currency (the peso) is under constant pressure, and the government debt is a heavy burden. This shows that even if the country did not have a significant fiscal deficit to monetize, the financial system would be under significant strain, and inflation pressures would be slow to subside.
In this article, I’ll concentrate on the financial system that has to operate under such conditions. As the years have passed, it has developed some odd characteristics that set it apart from other countries’ financial systems. (I will not mention Argentina’s odd fixed-exchange rate regime and its consequences, nor its debt levels and servicing.)
The government needs constant financing for its deficit, as neither current nor interest expenses can be fully covered. Given the default track record, access to markets is close to zero. Therefore, the central bank (BCRA, or Banco Central de la República Argentina) has been financing the deficit over a long period by issuing local currency. It has been printing money or increasing the monetary base (a liability) without a matching asset increase. Although there are all sorts of accounting gimmicks, the gist of the problem is that the monetary base keeps growing while the asset side consists of only scarce reserves and government bonds.
Since the BCRA knows that significant increases in the monetary base and other monetary aggregates spur inflation, it sterilizes these rises through its own bonds. As of the end of 2022, the central bank’s bonds (Leliqs, or Las letras de liquidez) represent 2.5 times the monetary base. The effective interest rate paid on Leliqs is nearly 100 percent per annum. That means that absent any changes in policy and without the motivation to finance fiscal deficits further, we know that next year the BCRA’s liabilities will be the equivalent of five times today’s monetary base.
Let that sink in.
Remember that the total ex-post transaction amount must add up to the total money circulating—at an ever higher velocity—in the economy. Even if a significant increase in transactions happens, there is no escaping further inflation. Avoiding inflation today means higher inflation tomorrow.
A big question is: Who buys the central bank’s bonds, and why? Banks do. Mutual funds do. There are various reasons.
First, the central bank’s bonds have higher creditworthiness than the federal government’s since they can be fully repaid with further monetary printing. The nominal value will be made whole. What purchasing power would be left if that were to happen is unknown. Tellingly, banks consider it irrelevant since the benefits or costs will be transferred to depositors.
As mentioned, the buyers are banks and some mutual funds. The banking system’s depositors expect interest rates that cover most of the anticipated inflation. Therefore, banks’ liabilities are growing at a significant rate. There are few options on the asset side to fund those liabilities. The preferred option is providing credit to the private sector, but very few companies or families dare ask for a loan on which they will have to pay a very high interest rate to cover inflation. On top of that rate, there are at least two taxes: the VAT (value-added tax) at 21 percent and the gross income tax at 8 percent. Few companies can afford such rates, and usually only if their prices were to increase concurrently. That is the second reason to buy central bank bonds.
As a side note, Argentina has significant price controls, at around 4 percent per month, dropping to 3.5 percent in the last few weeks. Companies are suffering cost increases and have little, if any, access to finance; therefore, their working capital is severely strained. Even if the economy stabilizes, that will still be a major concern since, without financing, companies may not be able to increase their production levels, let alone invest.
Since high costs and the lack of credit are significant problems, authorities repeatedly create subsidized loan programs at low interest rates. Even if they are not subsidized, all fixed-rate loans are diluted as time passes and inflation creep up. Debtors benefit. Savers suffer. No wonder there is a lack of investment under such circumstances.
Were it not for these subsidized loans, all credit would go to government agencies and create a relevant crowding-out effect. At the same time, if interest rates do not attempt to cover inflation, depositors will save only in dollar-denominated instruments.
A third reason is the regulation itself. Banks can also buy government bonds, but, of course, their credit quality is very low. Knowing this, the central bank’s regulations mandate banks to partially buy their own Leliq bonds as liquidity reserves and also allow them to hold a significant additional portion of their assets in Leliqs.
From the perspective of the financial system’s soundness, the argument is that the central bank can always print additional currency and, therefore, will not default on its debt. As a regulator, the central bank is in a bind—it cannot forbid a bank from buying its own bonds; instead, it encourages them. On the other hand, the central bank is willing to run the risk of further future inflation since it cannot default on its bonds. Unless, of course, it was willing to force banks to default on their depositors. This is not nonsense: It happened in 1989 and 2002 with disastrous consequences.
This policy has other outcomes. As mentioned, the central bank does not have any other source of revenue, and therefore, newly printed money is a liability that can be matched only on the asset side if there is a significant devaluation of scarce dollar reserves. Devaluation fosters inflation, because imports are mostly intermediate or capital goods. Besides, given inflation’s track record, the lack of other financial instruments and shallow capital markets make the dollar the preferred savings asset. (I know reading about this is exhausting. Imagine living under these circumstances!)
The economy faces a significant challenge: Banks will not be able to pay depositors if the central bank does not pay its debt beforehand. The central bank cannot pay its debt without printing more money, but that newly printed money will spur prices. Since there is no credit, there is almost no economic growth; since there is no growth, government spending cannot be served unless there are significant tax increases, which cripple growth. It is a vicious, unending cycle. The answer to this conundrum is, of course, fiscal policy, not monetary policy.
That is probably the main lesson to which other regulators should pay attention. Although monetary policy is the fastest and easiest to implement—there’s no need for Congressional debates or animal spirits to rise—it rapidly takes on a life of its own. While OECD central banks have bought bonds far more creditworthy than Argentina’s, there are still significant mismatches in returns. Liabilities should grow at the same pace as government bonds held as assets, and interest rates should match. It is not a present-day problem, but if policies of higher interest rates are maintained, slowly but surely, mismatches will grow. It may be irrelevant today, and everybody expects it can be reverted. But can it be easily reverted? Is it the same as expecting to reverse fiscal deficits, which are also said to be easily resolved or, at least, easily financed?
To summarize, under a persistently high inflation rate, there is almost no credit for the private sector—families or companies. Without credit, it is difficult for an economy to grow. If inflation is factored in, it becomes clear that it is almost impossible to increase or even maintain the value of scarce savings. The central bank’s policy of financing the government’s deficit while simultaneously avoiding flooding the market with newly printed bills and coins creates additional inflationary pressures that grow larger as time goes by.
Argentina may be an extreme case, but regulators worldwide would be wise to take heed and try to figure out if there are—hopefully not—any similarities in the underpinnings of their financial sectors. Interest-rate changes affect private-sector growth, credit quality, savings rates and banks’ asset-liability management. Once a central bank’s balance sheet begins to grow, it isn’t easy to scale it back.