News Brief No. 02/80

29 July 2002

Economic and Financial Issues facing Argentina

Report to the Government of Argentina and the International Monetary Fund

by a Panel of Independent Advisers^*

1. Argentina faces a highly complex set of challenges in the economic and financial sphere. Output and employment are depressed, the normal functioning of the banking system has been disrupted, the Government is unable to service its debts, and substitute quasi-currencies are circulating throughout the economy. The crisis has given rise to substantial financial losses, many of which have yet to be recognised and attributed. Confidence is at a low ebb, not only in the economic and financial system, but also in social and political structures more generally. Moreover, the present government is of an interim nature, and will hand over to a new administration following elections now scheduled for March 2003.

2. In these circumstances, the Argentine authorities have set themselves the goal of developing a programme that would enable them to pass on to the next administration an economic and financial situation that has been stabilised. They would like to receive the support of the IMF, both to demonstrate the understanding of the international community, and to enable payments falling due to the Fund to be rolled over.

3. The Panel has attempted to make an objective assessment of the overall financial situation, with the aim of judging whether the authorities' current strategy will enable them to achieve their stated objective of laying a basis for stable sustained growth in the future. In this context, we cannot emphasize enough that measures (such as increasing government obligations through further indexing) that buy short-term stability at the expense of pushing problems into the future are counterproductive.

4. The Panel has been specifically asked to give its opinion on two matters:

(a) the design of a monetary anchor; and

(b) the independence of the central bank.

With regard to these issues, we do not see it as our role to arbitrate any differences of opinion that may exist within the Argentine authorities, or between the authorities and the IMF. Nor does the Panel have the capacity to make specific judgements about quantitative financial forecasts. Rather, we have sought to set forth the broad principles that we believe should govern the approach to the issues at hand.

5. With regard to the choice of a monetary anchor, there is no universally accepted definition of what a "monetary anchor" means. The Panel interprets it to mean a fixed point of reference for Argentina's monetary policy that gives confidence to economic agents as regards monetary values. A monetary anchor is a necessary (though not sufficient) condition for the restoration over time of price stability. In turn, price stability is a necessary, but not sufficient, condition for re-establishing an effectively functioning banking system that can support a revival of economic activity. Other requirements that are needed include: a respect for the rule of law and the sanctity of contracts; a fiscal policy environment that does not overburden the banking system with financing demands; a central bank that has the authority and ability to carry out its designated task; and, more generally, an understanding in society at large that monetary integrity is a national priority.

6. The Argentine authorities have set certain constraints on monetary policy choices. They have ruled out formal dollarisation, and they have declared their firm opposition to policies that would entail a substantial acceleration of inflation. In addition, they have indicated their desire to move to an inflation-targeting framework over time. The Panel can accept these policy choices as a valid point of departure. In any event, neither official dollarisation nor rapid inflation would solve the deep-seated problems facing the economy and economic policy, and would narrow the options facing the next administration. It needs to be recognised, however, that, de facto, the dollar will inevitably play a significant role in the economy for the foreseeable future, and that exchange-rate induced inflation has still to run its full course.

7. The objective of restoring a national financial system based on the peso, and achieving a sustained reduction in inflation imply a demanding regime for monetary and economic policy. In particular, given the extremely narrow margins within which the Argentine monetary authorities currently have to operate, the objective requires a framework (or "anchor") in which the authorities have the clear capacity to limit the creation of peso liquidity in conformity with the demand to hold pesos. At present, the risks of excessive peso liquidity appear to derive from two main sources:

(i) The monetisation of fiscal deficits; and

(ii) the release of assets presently "frozen" under the "Corralito" and "Corralon".

In the short-term, the stability of the monetary anchor depends largely on how the Corralito and Corralon are managed. In the longer-term, as is discussed below, it depends also on a fiscal position that strictly limits the need for monetary financing of the government.

8. The Panel recognises the case for undertaking a gradual release of the liquidity that is currently frozen. This would contribute to a more normal functioning of the banking system, help re-establish confidence, and lay the basis for an improvement in economic activity and employment. However, to achieve the authorities' objective of containing inflation, and to avoid the loss of confidence to which an acceleration of inflation would give rise, any release of liquidity needs to be guided within an appropriate overall monetary framework. Such a framework requires appropriately conservative assumptions about the spontaneous demand for peso-denominated liquidity, and a credible mechanism for rapidly absorbing excess liquidity if the demand to hold pesos in the banking system turns out to be less than expected.

9. In this connection, the Panel wishes to emphasize that an early and durable solution to the problem of "amparos" (judicial injunctions resulting in the immediate release of frozen deposits) is essential. The continuation of amparos is simply not compatible with adequate monetary control. Addressing this problem requires not just a temporary stay on amparos, but a clear strategy for preventing their re-emergence.

10. Provided the question of amparos is dealt with, a variety of strategies can be considered for dealing with the assets remaining in the Corralito and Corralon, and thus moving towards a normalisation of the banking system. The Panel does not consider itself competent to judge which of the various approaches that have been suggested is the most promising. But it believes it is possible to find solutions that:

(i) make a start in the release of frozen assets, especially those of small holders;

(ii) increase the transferability of the claims that remain frozen;

(iii) offer meaningful alternatives to deposit-holders; and

(iv) ensure that the overall release of liquidity is kept to manageable proportions.

11. However, since it is impossible to foretell with accuracy how the demand to hold pesos within the banking system will develop, there is inevitably a risk that less of the liquidity released from previously frozen deposits will be held voluntarily in the banking system than projected. Therefore, the Panel considers it vital that the authorities have a realistic plan that gives credible assurance that the release of liquidity will be tailored to absorptive capacity and that any excess peso liquidity will be reabsorbed in a manner that does not compromise the programme's objectives.

12. A means of absorbing peso liquidity that has been used heavily in the past is the sale of foreign exchange from the official reserves. We do not believe it would be wise or feasible to contemplate this mechanism as suitable in current circumstances, given Argentina's currently low level of international reserves and its very large external debt service obligations. A rising, not a declining, level of reserves would be more conducive to the restoration of confidence. Given Argentina's large trade surplus, this should be a feasible goal.

13. The Panel also wishes to underline that the development of a financial system based on a stable peso is not compatible with the continued existence of alternative currency issues. The faster these alternative currencies are retired, the sooner the basis will be laid for a credible national currency.

14. Although the Government's objective is to foster the development of a strong and stable national currency, the reliquification of bank deposits could put pressure on the exchange rate in the short-term. In addition, it is apparent that the US dollar will continue to be used as a parallel currency for the foreseeable future. Fluctuations in the peso/dollar exchange rate are therefore bound to be a matter of some sensitivity. The Panel has two observations to make about this. First, movements in the exchange rate are an important signal about the sustainability of domestic policies. The authorities should therefore pay close attention to the exchange rate, as a sensitive indicator of an emerging need to adjust macroeconomic policies. It is important, however, that any attempt to manage the medium-term trend in the rate through intervention is avoided. Our second observation is that, for a country like Argentina, with a geographically diversified trade structure, attention should be paid to movements of the local currency against all significant partner currencies, and not just the US dollar.

15. Looking further ahead, the Argentine authorities have, as noted at the outset, stated their intention to lay the basis for the introduction of an inflation-targeting regime. The Panel accepts this aim. Inflation targeting can be a suitable anchor for policy and has been adopted by other Latin American countries, such as Brazil, Chile and Mexico. Certain conditions need to be met, however, for inflation targeting to succeed. These include the emergence of a genuine underlying private sector demand for claims in pesos, the restoration of an effectively functioning banking and financial system, durable fiscal discipline, and the existence of a central bank endowed with the means and capacity to carry out its responsibilities.

16. Not all of these conditions need to be fully met before an inflation-targeting regime is introduced. But each of them needs to be borne in mind. Consider, for example, the need for fiscal discipline. Argentina has no current need to borrow from the banking system to finance a fiscal deficit. But this is only because it has suspended debt service. Moreover, although not borrowing to finance a current deficit, Argentina's debt is growing in nominal terms (and relative to GDP) as a result of indexation. The counterpart private sector claims will constitute liquidity once the temporary recourse to freezing of bank deposits is lifted. All this means that a sustained effort to improve the fiscal position on a durable basis is a priority, if the instruments of monetary policy are not to be overburdened. Argentina will of course need to aim in the years ahead for a fiscal outcome that is substantially better than simply covering expenditures before debt service.

17. The Panel was also asked to advise on central bank independence. We consider an appropriate degree of decision-making autonomy for the Central Bank as essential to the effective working of an inflation-targeting regime. Different models of central bank autonomy exist, and we do not regard it as our comparative advantage to try to provide details of what would be most suitable in the Argentine case. At a more general level, however, it is necessary that a Central Bank should have the authority and powers needed to deliver monetary stability and generate confidence in its maintenance. The legal basis for central bank autonomy must be assured, but the legal basis is not in itself decisive. It is important that the Central Bank become a respected institution in the economic structure, whose opinions are valued, whose top staff have the ability and latitude to make and carry out decisions, and whose commitment to monetary integrity is unquestioned. Central bank staff, like other Government officials, should not be deterred from exercising their best judgement for fear of personal consequences. Obviously such a situation cannot be mandated by fiat or achieved overnight. But it should be the government's objective to develop structures that allow the BCRA to become an institution that has earned a level of respect now enjoyed by its peers in a number of other countries.

18. Our last substantive point concerns a subject which was not mentioned specifically in our terms of reference but is fundamental to the issue of restoring financial stability. It concerns how to revive Argentina's banking system. As noted above, the restoration of an effectively functioning banking system is critical to enabling the Argentine economy to fulfil its potential. It is also, as just noted, an integral component of an inflation-targeting regime. Dealing with this matter is therefore of the utmost priority. Above and beyond the inevitable damage caused by the flight of deposits out of banks located in Argentina and to destinations outside the country, the banking system has been weakened by a number of policy initiatives taken during the crisis, many of which were beyond the control of the banks. The banking system can only attract the capital needed to resume its economic functions and support growth if it can be confident that it will not be subject to arbitrary actions affecting property rights. The government should seek to foster a climate in which the banking system, having accepted a share of the costs of overcoming the crisis, is seen as a full partner in the restoration of Argentina's economic health.

19. The task facing the Argentine government and people is not an easy one. Nor will it be completed quickly or painlessly. Sacrifices will be needed, probably beyond those with which society has already come to terms. But the Panel is convinced that, if the right policies are pursued, now and in the future, the elements of a successful outcome are present. The country is rich in physical and human capital. There is a broad realisation that a decisive break with past practices must take place. On the economic policy front, the government has so far been courageous in holding the line on wages - a necessity if an inflation spiral is to be avoided. The exchange rate is competitive and the requirements for re-establishing financial stability have been identified. Provided policies that restore credibility on a sustainable basis are put in place, there is no objective reason why Argentina should not once again enjoy financial stability and durable economic growth.

ANNEX 1

10 July 2002

IMF Managing Director Horst Köhler announces Advisory Group on Argentina

IMF Managing Director Horst Köhler made the following statement today:

"I am very pleased to announce that, in close collaboration with the Argentine authorities, we have been able to finalize the visit of a high level group of persons to Argentina to advise about important aspects of monetary policy. The members of this panel will be Mr Andrew Crockett, General Manager of the Bank for International Settlements, Mr John Crow, former Governor of the Bank of Canada, Mr Luis Angel Rojo, former Governor of the Bank of Spain, Mr Hans Tietmeyer, former President of the Deutsche Bundesbank. The group is expected to be in Argentina over July 22-24 2002.

"Briefly, we see the panel as advising the Argentine government and ourselves on aspects crucial to the design of a monetary framework. This includes a monetary anchor to control inflation and other institutional aspects, including central bank independence. These are crucial components of a strong and comprehensive stabilization programme for Argentina. We are very grateful that the distinguished members of the panel are able to make themselves available at very short notice for this task."