Draghi’s last stand

THE LAST meaningful monetary policy meeting overseen by outgoing European Central Bank (ECB) President Mario Draghi was not without controversy. Indeed, Draghi seldom disappoints. And once more he delivered an aggressive package of measures designed to achieve the ECB’s price stability target—including a number of fascinating policy innovations. Yet somehow this package is more than simply another set of innovations. This set of measures instead represents Draghi’s last stand—an attempt by the outgoing President to secure his legacy by casting a spell over monetary policy into the distant future, creating new policy tools while tying the hands of successor Governing Council members and his successor.

What was announced?

First, a reduction in deposit rate by 10bps to -50bps—alongside tiering of interest applied to bank deposits with the Eurosystem. As a result of the new two-tier system, up to six times the value of deposits in excess of require reserves will be exempted from the negative deposit rate—while any remaining surplus above this will be charged 50bps. Crucially, the 0% “remuneration rate of the exempt tier and the multiplier can be changed over time,” meaning the quantum and interest rate on this tier are subject to review. Crucially, this was not mechanically tied to the Main Repurchase Operations (MRO) rate—currently also 0%. Rather, it is a distinct—therefore new—Tiered Reserves Rate (TRR). In effect, the ECB created a new interest rate on a variable tier of banking system reserves—and therefore a new policy tool.

Second, recalibration of the third series of Targeted Long Term Repurchase Operations (TLTRO3)—due to be initiated this month—such that the 10bps premium over the main repo rate has been eliminated, the maturity extended from 2- to 3-years, while the interest rate charged could now fall as low as -50bps if bank lending targets are met.

Third, the reintroduction of the Asset Purchase Program (APP) at EUR20 billion per month for an open-ended period—that is, until stringent conditions on inflation are met. In particular, APP will “end shortly before we start raising the key ECB interest rates.” As for these rates they are expected “to remain at their present or lower levels until we have seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2% within our projection horizon, and such convergence has been consistently reflected in underlying inflation dynamics.” In other words, roughly speaking, APP will continue until core inflation reaches near 2% for a sustained period of time.

How can we assess this package of measures?

Let’s start by recalling the previous policy stance and liquidity constellation, before contemplating the impact of the lower deposit rate and the two-tier system. What follows is my understanding—I welcome corrections or clarifications.

Something of a caricature, until Thursday last, the Eurosystem operated roughly as follows. There were two key sources of liquidity—TLTRO2s and past APP purchases. TLTRO2s are negative yielding assets, in that banks would receive the deposit rate of minus 40bps on these if they met lending targets—and roughly 90% of banks reached their lending targets, so de facto these assets tax the system 36bps per year. Against this, excess liquidity across the system—created by both TLTROs and APP purchases—is charged the deposit rate, meaning above reserve requirements banks are essentially taxed to pay TLTROs and create income for the Eurosystem.

With the exception of the coupon on Public Sector Purchase Program (PSPP) holdings—which could soon generate negative income, if not already in some cases—the monetary income across the system is pooled. So whatever is made through the using TLTRO2s and excess liquidity is shared according to capital key.

The distribution of excess liquidity, TLTRO, and APP purchases is shown in Figure 1 below, using data on disaggregated National Central Bank (NCB) balance sheets as of early-August.

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Given we can ignore PSPP coupons, which are returned to the local NCB, we can have a go at calculating the income and outgoings from the policy stance prior to Thursday, and how this will change.

An important caveat is necessary at this point. We cannot back out the sharing of coupons from the various other components of the APP—such as Covered Bond Purchase Program (CBPP), supranationals, etc., as well as outstanding coupons from prior programs such as the Securities Market Program (SMP) etc. So we ignore this flow, which could be important and will depend on the distribution of purchases, including by the ECB itself, on behalf of the Eurosystem. In addition, the precise country-level TLTRO interest cannot be known based on information available, so we assume the lending targets were met equally across countries at 91¼% (see March, 2019).

With this, we narrow in only on the monetary income from TLTROs and excess liquidity alone. In Figure 2 (left side), income due to the negative deposit rate by country or group of countries is shown. In the aggregate, on these monetary policy-related operations, the Eurosystem makes a profit of about EUR4.6 billion. Germany makes income of about EUR2 billion on behalf of the system, while Italy makes negative net income of about EUR0.4 billion. But German profit is only EUR1.2 billion, Italian is EUR0.8 billion.

While Germany, France and other Core countries make some income from what will become “tiered liquidity”—separated out here—Italy and Spain make all of their positive income from this classification of liabilities. Their excess liquidity is below the ceiling of six times required reserves.

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However, due to the sharing of monetary income across the system, some of the income from excess liquidity in the core is de facto transferred from the Core to the Periphery. Recall, aggregate monetary income is shared by capital key.  The income due to the sharing of monetary income is shown as “profit sharing” in the chart; de facto transfers are identified as “profit sharing.”

Indeed, income generated through the implicit tax on the banking systems of France (EUR0.7 billion) and Germany (EUR0.8 billion) and other Core countries such as Luxembourg is in effect transferred to the banks of other Periphery members such as Spain (EUR0.8 billion) and Italy (EUR1.4 billion) and others.

Take the Banca d’Italia (BdI). While they would make a loss on monetary income due to transactions with domestic banks for monetary policy purposes, in fact they will still make a profit of about EUR0.8 billion. This is possible because they receive about EUR1.4 billion in transfers from the rest of the Eurosystem. This covers their “profit” from system-wide monetary policy as well as funding necessary transfers to the Italian banking system of EUR0.6 billion on roughly 36bps TLTRO2 outstanding net of excess liquidity taxed at 40bps.

In other words, until Thursday Core banks were making transfers to those in the Periphery. But NCBs were making positive monetary income, notwithstanding these concealed transfers.

What is the impact of Thursday’s policy announcement? Let’s assume TLTRO2s are rolled over in full into TLTRO3s, and that bank lending targets are met 100%. And let’s assume the current distribution of liquidity is unchanged (i.e., don’t contemplate additional APP purchases for now, or capital flows within the system.) Then the impact on income and transfers across the Eurosystem is shown on the right side of Figure 2. With tiering of six times required reserves—set at 0%–there is no longer any income from this source. Moreover, the cost of TLTROs has increased as the deposit rate has been reduced to minus 50bps.

Crucially, the main impact if that the overall profit in the system is reduced EUR2.7 billion, from EUR4.6 billion to EUR1.9 billion. As such, the resources available for NCB profits, other things equal, is reduced.

Moreover, curiously, the size of the transfers from creditor to debtor within the Eurosystem actually increases. Why? Because Spain and Italy now don’t generate any income on excess liquidity, in fact they need to receive larger transfers from the system in the context of sharing monetary income to fund the payments to their banks from TLTRO3 as well as zero income on excess reserves.

Indeed, Figure 3 shows how Thursday’s announcement, other things equal, benefits banks by country and impacts intra-system transfers relative to the baseline. Banks in Germany benefit about EUR650 million (per year) while Bundesbank profits decrease about EUR700 million. The difference is larger transfers to the system as a whole as additional transfers, mainly from France, are needed to Italy and Spain.

Screen Shot 2019-09-15 at 21.33.29Perhaps the most important point to note here is that the new policy measures mainly act to reduce NCB monetary income. Given many NCBs will soon—if not already—face negative income on holdings and rollover of PSPP portfolios, which will be a drag on profits, this further threatens income and capital in the future.

In other words, the policy change has served to transfer income from Eurosystem income to the banking system.

And most important, since the interest rate on tiering is distinct from the MRO rate, this can be increased in the future to create additional income for banks at the expense of NCB capital—to improve profitability and, hopefully, increase net lending in pursuit of the inflation target. To this end, Figure 4 below provides a number of scenarios, calculating the monetary income for the aggregate Eurosystem as a function of the tiering ratio—starting from 0, i.e., no tiering, to 15, though chosen at 6 last Thursday.

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(As an aside, it seems clear why the initial tiering ratio of 6 was chosen. In my model, this generates savings to banks of EUR3.6 billion, which is almost exactly the same as the rollover of EUR693 billion of TLTROs at -50bps.)

While the current system, without tiering, generates income for the Eurosystem, tiering creates the possibility that the system as a whole receives negative income from monetary policy actions. For example, with a deposit rate of -50bps and tiering rate of +50bps, then a tiering ratio above 10, there would be negative income for the Eurosystem as a whole. In other words, monetary policy would require NCBs to run down capital to transfer to the banking system to encourage lending and meet the inflation target.

(We ought note there are other, non-monetary sources of income—as well as possible coupons on APP purchases. But the trend towards running down NCB capital in pursuit of monetary stability is clear.)

More realistically, at the existing tiering ratio of 6, a TRR of +100bps with deposit rate unchanged would generate negative income for the Eurosystem of about EUR5 billion per year.

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For this case, Figure 5 illustrates the impact on income and transfers across the Eurosystem given the existing distribution of liquidity. Since the system as a whole makes a loss, it is this loss which is now shared across the Eurosystem. However, peripheral banks are still in receipt of income due to both TLTRO3s and that due to tiered reserves. As a result, some of the income on non-tiered reserves from the Core is transferred to the Periphery still—Core banks are still subsidizing their Periphery counterparts.

Meanwhile, there are more extreme outcomes, of course. See Figure 6. Imagine the deposit rate at -100bps with TRR at +100bps. And suppose the Tiering Ratio is increased to 10 times required reserves, with existing liquidity distribution. Then we are again in a world where NCBs make losses on monetary income. But here, for Core central banks, this negative income goes to pay domestic banks for their use of the Tiered Reserves as well as transfer to Peripheral banks for the same purposes. Thus, NCBs are running down their capital to provide income for the domestic banking system—and in the case of the Bundesbank subsidize peripheral central banks’ income and banking systems.

Of course, none of the above reflects on the possibility of a growing balance sheet of the Eurosystem as a whole, or indeed the future distribution of reserves—and TARGET2 balances. Even with TLTRO rollover and repayment on schedule, and with currency in circulation growing at nearly 5% per year, APP purchases of EUR20 billion per month would drive excess liquidity near EUR2.8 trillion by end-2030 (that is, EUR1 trillion above today’s levels.) The distribution of this liquidity, and associated TARGET2 balances, will become increasingly important in determining the relative transfers between NCBs and the overall income of the system.

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Should core inflation continue to fall short of target, this raises the concern that open-ended APP with possible increases in the TRR will create losses for NCBs—eroding capital in pursuit of price stability.

Thus the creation of a new interest rate—the TRR—alongside potentially open-ended APP generates many more possibilities for sharing of income or the erosion of NCB capital.

That Draghi laid down such stringent conditions for the withdrawal of exceptional monetary policy measures last week suggests he is tying the hands of his successors—to make sure they cannot back down from the pursuit of price stability. Doing so, he is not only suggesting to fiscal policymakers it’s time to take up the burden of macroeconomic management—but without this there will be quasi-fiscal losses through NCBs, as well as growing quasi-fiscal transfers across the system. Better to make these fiscal measures explicit and generous than feeble and hidden.

And central bank governors hate making losses. They are political beasts, many with political ambitions. To be reporting losses year-in-year out, and to be seem as part of a hidden transfer union will be uncomfortable for many—or most.

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The fact that, by re-weighted capital key, at least 55.8% of central bank Governors were in some way opposed to the announcement last week (Germany, France, Austria, Netherlands, and Estonia) is suggestive. Add to this two members of the Executive Board, and there is a considerable faction against Draghi’s latest policy wheeze. Is it the open-endedness of proposed APP that matters? Or the new TRR that could generate losses for NCBs in the future? Or the combination of the two? Not clear.

In summary, understanding the quasi-fiscal flows throughout the Eurosystem and the available future policy tools just got much more difficult—and interesting. Bring it on.


Goodbye IMF, hello ECB. But what’s the quid pro quo?


WHEN FRENCH POLICE searched the Paris home of then-International Monetary Fund (IMF) Managing Director Christine Lagarde in March 2013, an undated, handwritten pledge of allegiance from Lagarde to former President Nicolas Sarkozy was uncovered. Later leaked to the press, the letter—presumably written while he was still President—urged Sarkozy to “use me for as long as it suits you and suits your plans and casting call.”

The pretext for the raid on Lagarde’s home was, of course, the investigation into possible misuse of public funds—more than €400 million—in settling a claim on the state by Sarkozy-supporting, French businessman Bernard Tapie. Eventually, Lagarde was found “guilty of negligence in public office” for settling the case, but absent a sentence or formal criminal record from the finding by a special Paris court in December 2016, her position as IMF Managing Director was unthreatened.

When asked in court why she had not read detailed briefing that described the history of the Tapie case alongside a recommendation to rule out arbitration, Lagarde’s reply was that she “received between 8,000 to 9,000 notes per year.” In her overall defense, Lagarde implied she was not on top of her brief, was a mere pawn in the heady world of French politics, and was in any case happy to defer to her chief of staff on this decision—and likewise happy for him to take the blame in court.

What does this glimpse into the world of Madam Lagarde reveal about the person set to become the President of the European Central Bank (ECB)?

LAGARDE ARRIVED at the IMF in July 2011, about a year before the euroarea crisis peaked. Retrospectives on her contribution to the Fund will be cast in terms of charisma and statesmanship, as well as her contributions to the empowerment of women—it’s impossible to scan an IMF document today without stumbling upon measures to improve female labor force participation. However, an honest assessment of her tenure would recall those issues that most define her time at the Fund: austerity in the UK and Brexit; the Greek great depression; the Cyprus deposit insurance debacle; flawed euroarea oversight; and Argentina’s crisis renewed. There is a common denominator in all these cases—deeply flawed analysis driven by, or coupled with, politically-motivated decision-making. In all cases Lagarde was found out of her depth. In most cases, there appears to be a quid pro quo behind decisions. Her appointment to the ECB therefore represents a dangerous, perhaps seminal moment for the euroarea.

WHEN THE time came to nominate a new Managing Director in May 2011, it was not a euroarea member state making the case for Lagarde at the IMF. Rather, it was United Kingdom (UK) Chancellor of the Exchequer and austerity advocate George Osborne who formally nominated Lagarde in May 2011. And when Lagarde was up for a renewed term in 2016 it was Osborne again who quickly advanced re-nomination just months before the UK’s EU Referendum. Why was Lagarde’s candidacy so important to Osborne?

In 2010, as the coalition government in the UK had begun a policy of fiscal consolidation, the IMF under previous Managing Director Struss-Kahn had fallen under the austerity spell. The Fund produced saccharine analysis on the pros and cons of fiscal adjustment in that year’s Article IV consultation—the oversight of the UK economy conducted annually by the IMF. And the IMF was happy to conclude: “After weighing these different arguments [for and against austerity]… a significant fiscal tightening with frontloading in 2011/12 is appropriate to secure confidence in the UK’s debt sustainability” (Box 2, page 27.) This endorsement was exactly what Osborne needed; an IMF challenge to his strategy would be a tough pill to swallow. DSK’s unexpected departure could make the next annual health-check awkward, therefore—unless a suitable replacement could be found.

In throwing his weight behind Lagarde, Osborne was buying continued support for his policies—and would be able to call in any other favors along the way. Following her appointment as Managing Director, Madam Lagarde was duly on hand to add sparkle to the press conference at the end of the next Article IV visit in 2012, offering support to the “Chancellor, dear George.” The stomach turns.

The IMF’s endorsement of austerity in the UK thus continued despite hardships owing to the regressive nature of the adjustment including due to falling public investment—while continuing net inward migration diluted available public services. Moreover, as is now increasingly appreciated, austerity was not necessary at all—it was a political choice.

Spin ahead a few years, and Osborne had a bigger favor to ask. The decision to hold an EU Referendum in June 2016 required “objective” analysis that would point towards the benefits of Remain—Osborne’s position. In a series of clearly political interventions, the Fund’s Article IVconcluding statement in May 2016 was timed to coincide with the final month of the campaign; Lagarde was again on hand to deliver a carefully scripted message that led some to claim the IMF was “bullying” voters; while the publication of the Article IV report itself, just one week before the referendum, was surely timed to grab headlines and impact the vote.

Even if the IMF should to have strong views on these matters—and they should—delivery ought not be staged-managed for political favors. And the analysis itself should not be driven by political considerations. In any case, after the IMF’s wrong-headed support of austerity in the UK, why should anyone believe their analysis? The marginal voter in the EU Referendum, we might speculate, was likely most negatively impacted by the very same austerity the IMF was previously happy to endorse on Osborne’s behalf. Once bitten, twice shy. And when a prominent Leave campaigner suggested the UK public had “had enough of experts,” one wonders if the IMF was one of the targets. Only a few months later, the IMF was said to be “left shamefaced” over their flawed forecasts leading up to the EU Referendum.

THE FAILURE in Greece was a scandal on a different level, of course. The IMF was hardly a deciding factor in the EU Referendum in the United Kingdom. But the Fund was certainly central to the Greek great depression. And the program’s failure was assured before the ink on the document was dry. In short, the May 2010 adjustment assumed with no justification that Greek exports of goods and serviceswouldexpand65% through 2015 (imports would growonly5%)so exports as a share of GDP wouldincrease from 17.8% to 27.7% in six years. This 65% increase in nominal Greek exports over six years, necessary to offset domestic demand compression and retain the illusion of “debt sustainability,”would be achieved through both real exports and the price of the Greek export basket. That is, 39 percentage points of growth was penciled indue to real export growth (Staff Report 10/110, p.10), the remainder due to price increases—roughly a 3% per year average increase in the export price deflator over the period, despite so-called “internal devaluation.”

Moreover, although general government interest expenditure, mainly due to external debt,was expected toincrease from 5% of GDP in 2009 to projected 8.1% in 2015 (10/110, p.13), net interest in the external current account did not involve an equivalent deterioration.

It was later revealed  by veteran IMF-watcher Paul Blustein that a memo from the Research Department before the Greece program was finalized correctly warned that the “program could still go off track (even with full policy compliance)” absent “strong export rebound.” So, some staff warned about the egregious assumptions—beyond the control of the Greek authorities—upon which the program hinged. But the program went ahead regardless.

Yet, taken together, the GDP and external factor income assumptions at the time of the initial program impliedthat, to sustain domestic demandand repay debt, the people of Greece wouldgenerate external income of more than €30 billion per year by 2015, or roughly 13% of initial GDP. This was against a backdrop of substantial, coordinated fiscal tightening across Europe—and growing risk of euroarea disintegration.

To simply assume the Greeks could magic euros from thin air was ridiculous—a scandal seldom been before seen in the history of official action in international monetary affairs except, perhaps, the German reparations imposition. Moreover, the attitude of official creditors was like that of a loan shark—repayment terms were impossible to meet, but if the Greeks failed to deliver they would be punished by ever-greater bullying and onerous impositions.

All this was pre-Lagarde-as-MD, of course—though coincident with her time as French Finance Minister. Upon appointment at the Fund, Lagarde faced a choice. She could have asserted the independence of mind to rethink the Greek situation—and defend the Greeks as Managing Director of the multilateral body inaugurated after the Second World War to lend to countries“by making the general resources of the Fund temporarily available … without resorting to measures destructive of national or international prosperity.” Or she could side with euroarea creditors against the Greeks. And she very publicly chose the latter.

To begin with, when debt restructuring was finally broached in late-2011 and 2012, the IMF capitulated to official creditors and allowed the ECB and national central banks (NCBs) to swap their €56½ billion holdings of Greek government bonds into new titles so they could be exempted from restructuring. This increased possible private sector losses in the restructuring—and later, the quasi-fiscal, thus unseen, transfers from taxpayers through lower interest costs. Doing do, it also reduced the potency of Eurosystem purchases—prior or prospective—in other countries. It hinted at greater private sector losses in future if needed, perhaps contributing to financial instability. It thus later became necessary to clarify that official holdings would be treated the same as private investors later under the ECB’s Asset Purchase Program (APP), underlining the sensitivity of the matter for investors. But when it came to Greece, narrow political constraints overwhelmed decisions needed for system wide stability and recovery of a very depressed economy. Given IMF support was necessary for continued Northern European involvement in the program, there was plenty of leverage to force a better deal for the Greeks.

The problem was, the Fund under Lagarde had chosen to demonize the Greeks rather than rethink the flawed macroeconomic logic that underpinned the so-called adjustment program. Indeed, even after the PSI operation, an investor visiting Athens in summer 2012 was not encouraged to be met by the IMF’s then-Resident Representative—and person responsible as desk economist for the original, incoherent program—explaining that “as long as this place is not burning to the ground, we’ll keep turning the screw,” a sentiment accompanied by a hand gesture to emphasize the point. This would hardly catalyze private investment! This was hardly the spirit of Fund lending without recourse to measures destructive of prosperity!

But the remark made perfect sense in the context of comments only a few months before, shortly after the flawed debt restructuring, when Lagarde herself explained to the Guardian that “she has more sympathy for children deprived of decent schooling in sub-Saharan Africa than for many of those facing poverty in Athens.” This attitude demonstrated a willingness to overlook entirely those analytical flaws in the original Greece program, as well as the IMF’s Purposes, to instead push a message from political masters in Europe. Indeed, this mirrored exactly the attitude later recalled by former Treasury Secretary Timothy Geithner, that the Europeans’ in early-2010 “we’re going to teach the Greeks a lesson.”

A braver, intellectually independent Managing Director would have noted the impossible assumptions upon which the original Greek program was based—and asserted the primacy of the IMF’s own mandate over that of European institutions. A more thoughtful leader would have taken a stand against the Northern European bullying and argued for stronger and more immediate debt relief.

WHEN GREEK debt restructuring finally arrived in 2012, several Cypriot banks were left overexposed, undercapitalized, and essentially bankrupt. By early-2013, a newly elected center-right President Nicos Anastasiades paved the way for a Troika program to restore financial stability after vacillating by his predecessor. By this time, however, the IMF’s involvement in euroarea lending programs had become increasingly controversial amongst non-EU members of the Executive Board. Moreover, unlike in the case of Ireland, there was now pressure from Core euroarea countries to bail-in the private sector to cover banking sector losses. Perhaps most important, Germany did not want to be seen to use taxpayer money to “bailout rich Russian depositors” as veteran IMF reporter Paul Blustein has explained. Indeed, as Blustein continued, German Finance Minister Wolfgang “Schauble insisted on limiting the size of the loan package to €10 billion; the remaining €7 billion [of financing] needed for the banks would have to come from their depositors and other Cypriot sources.” This is even though debt sustainability would have seen Cypriot public debt on a substantially more favorable trajectory than many other euroarea program countries. Crucially, Lagarde aligned once more with European creditors.

Regardless of the merits of the choice between bail-in and bail-out—and there is a case to be made that bail-in should not have been countenanced for financial stability reasons given public debt sustainability was not a major concern, — once that decision was taken what happened next should neverhave been allowed to happen. In short, the IMF’s initial proposal to bring sustainability to Cyprus involved losses for bondholders and large depositors—which would be transferred along with troubled assets to a “bad bank” and face losses of perhaps 40%. But the EU Commission was worried about the spillovers due to such large losses while the Cypriot authorities thought it might undermine their role as offshore financial center. Thus, the Commission, in the form of Olli Rehn, proposed a series of taxes on large-, medium-, and small deposits to fill the gap. The problem being, small deposits included those subject to deposit insurance.

Now, deposit insurance has been sacrosanct for financial stability since the Great Depression in the United States, when the Federal Deposit Insurance Corporation (FDIC) was inaugurated to stop bank runs and stabilize the banking system. Most countries developed their own deposit insurance schemes since, including across the euroarea where deposits under €100,000 were supposed to be insured. But in Brussels, as negotiations over Cyprus continued throughout the night—at the first key meeting chaired by recently appointed Eurogroup President, Jeromin Dijsselbloem—there was no-one apparently willing to speak up against breaking the deposit insurance taboo and associated implications for the rest of the euroarea. By the end of the night, under the strain of deadline, an agreement was reached which would tax deposits below €100,000 at 6.75%. The read-across to the rest of the euroarea was clear—all deposits were fair game to restore sustainability to the fiscal-financial sector. The risk of deposit flight was immediately elevated.

Fortunately, the Cypriot legislature refused to vote through the deal, and the damage was quickly undone. But this was a truly breathtaking failure of global macroeconomic policymaking. Blustein described it thus: “It was one of the starkest examples in financial-crisis history of how highly intelligent people can make decisions under pressure in the middle of the night that look appallingly unwise in the light of day.”

Put another way, it’s an example of how the blinkered objectives of interlocutors—each with their own narrow negotiating brief—can result in a dangerously suboptimal compromise with global implications. In this case, the IMF was more concerned about dotting the i’s and crossing the t’s in a pro formadebt sustainability exercise—which happened to justify the German need for a private bail-in—while reducing the IMF’s reputational risk by putting a lower proportion of the bail-out money forward. In the scrum to achieve these narrow negotiating objectives to please different constituencies, Lagarde took her eye off the big picture.

Any IMF Managing Director who allowed this to pass ought to have been sacked the next morning. But Lagarde could always blame the Europeans—or her staff; the Europeans could always blame the Cypriots; the Cypriots could blame the Greeks; the Greeks could blame financial market ebullience—and before you know it, no one is to blame.

Of course, this was not the first time Lagarde had been close to decisions that jolted financial markets over the course of the euroarea crisis. It is not clear what role Lagarde played in the background to the Deauville declaration in October 2010, while French Finance Minister. But it was in Deauville that Chancellor Merkel and President Sarkozy bilaterally agreed—that is, without consultation with other member states—that future bailouts would involve private sector haircuts, contributing to the intensification of the euroarea crisis. It’s difficult to imagine the two Finance Ministries were not involved.

THERE WERE in fact two periods of coordinated monetary-fiscal tightening in the euroarea over the period 2010-14, which left an imprint globally via the value of the euro. The first was intended, the second due to a bug in emergency monetary measures.

In 2011, under President Trichet, the ECB began tightening monetary policy, raising the main policy rate from 1% to 1.25% in April, and a further 0.25% to 1.5% in August—despite ongoing coordinated fiscal consolidation. And IMF staff were on hand in July, shortly after Lagarde’s arrival at the Fund, to support this egregious policy tightening. “The outlook calls for a gradual withdrawal of monetary stimulus,” the surveillance report insisted.

Within months, of course, this premature policy tightening was withdrawn by incoming President Draghi—while a series of Very Long Term Repo Operations (VLTROs) were implemented in December 2011 and March 2012. Under the pre-text of heading off a bank funding hump, these VLTROs bought some crucial time for euroarea peripheral governments—by loosening the balance of payments contraint temporarily. But it would eventually take Draghi’s “whatever it takes” moment in the summer of 2012 to reserve capital flight related to fears that the euroarea would indeed dissolve.

As capital inflows resumed to the periphery in the second half of 2012, banks were once again able to access private funding. And a key problem with VLTROs was that they allowed early, voluntary repayment. They were not “outside money” to the financial system, as with standard Quantitative Easing, but were “inside money”—simultaneously both an asset and liability of the banking system. So, with enhanced liquidity, euroarea banks—perhaps to signal their access to private funding—began repaying these borrowed reserves. This brought about the endogenous tightening of monetary conditions—as base money and excess liquidity contracted, EONIA increased and the euro appreciated. This monetary tightening was entirely preventable. But it took the associated euro appreciation and disinflation pressure for the ECB to act through a series of exceptional measures in 2014 and 2015—from negative interest rates to APP.

The result of this monetary loosening and endogenous tightening was that the euro depreciated nearly 15% against the dollar between end-2010 and mid-2012 as fears about the euro area emerged. It then appreciated on endogenous tightening through early-2014. This was followed by a sharp depreciation as deflation risk emerged and investors began to factor in exceptional policy support. The euroweaked 15% in real effective terms and 21½%  against the dollar since end-2010.


The Fund was largely a champion of fiscal consolidation throughout this period, only in recent years encouraging fiscal expansion. Still, the impact on the euro of the monetary reaction falls squarely within the IMF’s mandate. How has the Fund throughout Lagarde’s term assessed the euro exchange rate? The table below summarizes the conclusions on the external value of the euro since 2009, taken from the euroarea surveillance report each year, as the euroarea current account went from near balance to about 3% of GDP on peripheral depression and flawed fiscal response.


What is most striking is how difficult it has been for Fund staff to provide a proper assessment of the euro exchange rate. Even in 2015 and 2016, with sharp depreciation as monetary policy strained to offset the distortions imparted by flawed fiscal policies, staff considered the euro as “broadly consistent with medium-term fundamentals.” This policy action impacted the rest of the world largely through the weak euro, of course. And one of the IMF’s core functions under the Second Amendment to the Articles of Agreement is the assessment of policies as they impact others through the exchange rate. This is not to claim that exceptionally loose monetary policy was inappropriate, only that a more thoughtful assessment of deflationary global spillovers through the currency would have helped underline the true cause of this problem in fiscal policy.

MOST RECENT has been the IMF’s intervention in Argentina. Unlike Greece, this is entirely on Lagarde’s watch. But like Greece, it is defined by the primacy of politics over analysis in program design.

For several years prior to the IMF’s latest involvement in Argentina, the government leaned on the central bank (BCRA) to finance growing fiscal deficits. For example, as well as purchasing government debt directly, BCRA was transferring profits to the government throughout. However, the central bank had negative net income throughout. How was BCRA making profits then? Due to Peso depreciation which created paper gains on foreign exchange reserves. And so, as the currency depreciated, BCRA would make paper gains that would serve as the basis for cash transfers to the government. Since 2011, BCRA transferred ARS375 billion in profit to the government, averaging 0.9% of GDP per year all the while BCRA capital was shrinking from 1.4% of GDP in 2011 to 0.7% of GDP in 2017.

In fact, BCRA did not even have income to pay for administration costs and the printing of paper currency, so would create base money for this purpose as well. Overall, to prevent the impact on base money from this and other transfers to the government, BCRA would issue interest bearing securities. But absent the real resources to finance these sterilization operations, the central bank had to resort to either printing more money to pay the interest on these or issue ever greater securities in a monetary policy Ponzi scheme.

The overall fiscal and quasi-fiscal position was much worse than the IMF acknowledged at program outset, therefore. The interest bill on BCRA securities more than 2% of GDP, a hidden fiscal deficit. But the program proceeded as if this was of no importance when assessing fiscal sustainability. The recapitalization of BCRA—a known and possibly substantial fiscal cost—was acknowledged, but was only to be completed by end-2019. Moreover, monetary policy proceeded by increasing interest rates without recognizing that this would either bring future monetization and exchange rate risk, or an additional impact on fiscal sustainability to be later realized. Investors meanwhile proceeded as if these quasi-fiscal risks did not exist.

These challenges were known in advance—or could have been known with the forensic analysis of monetary-fiscal interactions. And addressing them early as prior actions when building the program would have triggered early either debt reprofiling or restructuring. Instead, the Argentine authorities leaned on the Trump administration; the US Treasury leaned on the Fund; Lagarde waved through largest program in IMF history—potentially USD57 billion, of which about USD44 billion has been disbursed—based on a monetary policy Ponzi scheme.

WHAT DO these serious cases have in common? They are all characterized by deeply flawed macroeconomics and political influence on decision-making—and there is typically a quid pro quo involved. For Osborne, Lagarde delivered on austerity and Brexit analysis in the joint pursuit of his political goals and her career ambitions. In Greece and Cyprus, Lagarde sided with Germany throughout—allowing deeply flawed analysis to pass her desk to keep the Greeks under the European thumb and impose costs on the Cypriot taxpayer. In exchange, it was widely rumored Lagarde was under consideration for a European Commission role in 2014—but was ultimately still needed in DC. When it came to analysis of the euroarea, the IMF has been incapable of balanced assessment of fiscal-monetary policies; the assessment of the euro has been stale and thoughtless throughout. But this was necessary so that German fiscal policy would not be under scrutiny, ingratiating herself with Chancellor Merkel. In the case of Argentina, despite being castigated for being under political influence throughout the euroarea crisis, Lagarde was found under the influence of the US Treasury in signing off on a program that hinged on a continuing monetary policy Ponzi scheme.

BEFORE LAGARDE at the IMF there was Dominique Strauss-Kahn (DSK) of course. And DSK perfectly set the tone for Lagarde’s time at the Fund.

Strauss-Kahn was commonly expected to use his time at the Fund as a springboard to the French Presidency, dethroning Sarkozy. Indeed, during his successful bid to become Managing Director in 2008, Strauss-Kahn employed Paris-based public relations firm Euro RSCG (as then called) to manage his image. Then, upon DSK taking the job, the IMF immediately “hired two big-name PR agencies to help spread the Fund’s message” as Reuters explained in August 2008. These two contracts were said to be worth between $1.5 million and $2.0 million—an unusual expenditure at exactly the time the Fund was trying to cut costs by $100 million per year. Though everyone turned a blind eye, one of the firms chosen was the very same Euro RSCG—the company that supported DSK’s campaign, a firm run by friends of Strauss-Kahn, the same friends who were amongst the first to visit him when on bail following allegations of sexual assault.

The awarding of such large contracts strongly hinted at DSK’s desire to use his position at the IMF to forge his image and further his political ambitions in France—a stealth campaign from the relative distance of DC. But it also smelt strongly like misuse of public funds.

How would Sarkozy respond to this growing threat from across the Atlantic? According to the retelling of the circumstances surrounding DSK’s arrest in New York City in May 2011, there are secret recordings of Strauss-Kahn discussing his candidacy with friends just days before his arrest. DSK was perhaps being monitored by the French secret service, his actions potentially relayed directly back to Sarkozy. Moreover, it is possible that DSK’s criminal actions that day were orchestrated at Sarkozy’s request to explicitly disqualify Strauss-Kahn from the French Presidential race—if true, a remarkable intervention in global governance, at a pivotal moment in the euroarea crisis, for purely domestic political reasons by a European sovereign.

Put another way, DSK’s tenure underscored how European politicians have never been interested with what they can do for the IMF, only what the IMF can do for them.

Following in DSK’s footsteps, Lagarde has levered her time at the Fund to promote her career within European institutions. Being asked to replace Draghi as President of the ECB would appear to reward fealty, sycophantism, and analytical incompetence. These are not qualities that the most senior monetary policy position in the euroarea requires.

There are three arguments surrounding Lagarde’s ECB appointment that we might dismiss based on her track record.

First, Lagarde is a continuation of the status quo—and therefore a dovish replacement for the current President. Honestly, this we do not know. She was as supportive of Trichet’s failed policies as she was of Draghi’s enlightened interventions. She has no track record in monetary decision-making, and has shown no command over the intricacies of central bank balance sheet interactions and financial superstructures. And those decisions she has been involved in during the euroarea crisis were often destabilizing.

Second, Lagarde will be able to bring her political gifts to command greater monetary-fiscal coordination. In fact, her record in terms of holding euroarea creditors to account demonstrates nothing but fiscal conservatism. Moreover, her written answers responding to the European Parliament questions before her formal appointment exhibits no appetite to challenge the deflationary fiscal bias in the euroarea—beyond supporting a future centralized fiscal resource.

Third, technical staff will keep Lagarde on the straight and narrow. More likely, she will promote those staff who provide the analysis needed to advance her own personal objectives or help deliver on some political side-deal or other.

Overall, the biggest risk to the euroarea today is the unknown—and unknowable—quid pro quo that might underpin the decision to appoint Lagarde to replace Draghi or might emerge in the future as the new President plans her own future. If Lagarde sees her tenure at the ECB as a stepping stone to something more—she will be in her early-70s by the end of her term, meaning there is still time to become, perhaps, the first euroarea Finance Minister or take another elder statesperson role—then monetary policy over the next 8 years can easily come under political influence. And the assumption that Lagarde is a like-for-like replacement of Draghi is a huge misreading of her track-record.


What to expect from Argentina’s 5th Review debt sustainability analysis

What can we expect of Argentina’s 5th program review? We are told the IMF team arrived in Buenos Areas on Saturday. Presumably the objective is to complete this review by end-September—as this review will be judged against the end-June program targets, already passed. IMF funds can be released before the election, therefore. The implications of the election can be dealt with later. This is the right decision, in my view—despite the challenges facing Argentina. The global community owes Argentina some forbearance.

Still, what might be the new path for public debt-to-GDP in the 5thReview? This depends on the politics driving the optics of requiring debt-to-GDP at 60% by the end-forecast horizon. The table below summarizes assumptions that underpinned the 4thReview. The IMF already implicitly assumed ARS would reach 49.4 by year-end, so had factored in some depreciation. Then again, even at ARS55 we are 10% weaker still. The recent exchange rate move with large liability dollarization throws the previous DSA out the window. The Fund also assumed an increasing share of ARS denominated debt over the forecast horizon and low effective interest rates on Federal debt—with negative real yields driving down debt-to-GDP.


How might these assumptions change? Let’s knock out our own projections and see where this takes us. Let’s assume ARS sits at 55 through September, depreciates 2% a month through end-2020, 1% a month through 2022, and ½% a month thereafter. This gives us a new path for end-year ARS as shown in the table below. These new assumptions see ARS reach 99.8 by end-2024, compared with 79.5 implicit in the IMF’s 4thReview.


How might this translate into GDP deflator? The chart below demonstrates congruence between exchange rate depreciations in Argentina and changes in the GDP deflator—and the lag is slight. It also shows a projection for the GDP deflator which assumes a generous spread for the GDP deflator relative to ARS depreciation ahead.


This translates into a secular increase in the ratio of the GDP deflator-to-ARS, returning to levels seen in 2017 by 2025, as shown below—arguably a period of overvaluation, but let’s ignore that.


In addition, let’s assume 1% contraction in GDP for this quarter and the next, 0% growth each quarter next year, and 1% quarterly growth thereafter (more generous than the IMF’s 4thReview in later years, perhaps too generous compared to reality near-term).

How does this convert into a revised path for nominal GDP? This is shown in the table below. Two things are worth emphasizing. First, nominal GDP in ARS is barely changed in 2020 despite the additional ARS depreciation here. This is because the IMF are far too generous in their GDP deflator assumptions—driving down debt-to-GDP. This alternative GDP is roughly unchanged relative to the 4thReview for 2020 despite sharper ARS depreciation. That said, in later years GDP in local currency increases above the 4threview assumptions—though not in USD. According to this new projection, USD value of GDP fails to surpass 2017 levels by 2024.


This takes us some way to generating a revised debt path. We need to address the issues of interest and the primary balance.

On the interest bill, it’s anyone’s guess at this point. For example, between the 3rd and 4th Review, the expected interest bill for the first 6 months of 2019 in the fiscal financing tables was substantially reduced. At the time of the 3rdReview, the 2019H1 interest bill was projected at USD10bn. By the 4thReview this had been reduced to USD7.3bn, with the financial and nonfinancial public sector contributing 90% of this lower interest burden. At the same time, there was an increase in projected amortization over the same period of USD1.6bn—of which public sector amortisation contributed 84% of this increase. It’s as if public sector bodies had been asked to reduce recorded interest paid by the Federal government and roll this into amortization—certainly this is how the BCRA “profit transfer” of end-May was treated. This presumably allows the Federal government to show a lower fiscal deficit for the year due to a lower interest bill, contributing to favourable debt dynamics. Note also, the 4thReview effective interest paid in 2019 was expected to be 5.5%—ridiculously low for one of the world’s least creditworthy governments—increasing to only 10.9% by 2022.

If the authorities, with IMF consent, are willing to play such games with the fiscal numbers, it’s difficult to pre-empt what they might cook up for optical purposes. Instead, let’s call bullshit and simply add 200bps to the 4thReview interest rate assumptions throughout—this being still incredibly generous in my view given ongoing institutional malaise and necessary monetisation. There is a case to increase the interest bill further, but let’s overlook this.

As to the primary balance, let’s assume a deficit this year of 1%, 0% next year, and 1% surplus thereafter. Perhaps.

Anyway, the final assumption necessary is the currency composition of debt. Let’s assume local currency debt stays constant in % of GDP, with FX issuances making up the rest.

With these assumptions—not, admittedly, a true bottom up DSA, rather top-down—where do we end up? The chart below contrasts the 4thReview with these revised assumptions. While the 4thReview could show a monotonic reduction in the debt-to-GDP from 2018, our alternative sees debt increase near-term, beyond which it falls. But debt-to-GDP still sits above 75% by 2024.

ARS6The key reasons for the less favourable debt dynamics are the less ebullient GDP deflator, the higher interest rate, and the larger share of fx denominated debt. It’s worth emphasizing again this is more back-of-the-envelope than bottom up analysis. But sometimes simplicity delivers clarity.

That said, I would expect the IMF to continue to use the GDP deflator and interest rate assumptions to deliver a more favourable debt path to the above—coming in closer to 70% of GDP by 2024, perhaps.

Regardless, none of this addresses the need for BCRA recapitalization. Absent this institutional imperative there will be continued monetary instability. This will be addressed after the election, should the program continue. And it will add materially to the ratio of public debt-to-GDP. Given the implied interest on BCRA liabilities of more than 2% of GDP currently, once this is dealt with public debt will look even less favourable, and the prospects for sustainability eroded further—sensible restructuring will have to factor this in.

Finally, this does not factor in the challenge of rebuilding international reserves. Sustainability for Argentina should consolidate the Federal government with BCRA, not only to deliver sustainable monetary policy, but as corollary to uncover a path for balance of payments that might—at last—bring about fiscal-financial stability. This ought to be an explicit concern in program design, but remains elusive. This underscores the inadequacy of the IMF’s debt sustainability framework, and the risks investors in Argentina continue to take.

But even the above would allow the IMF to continue to engage with Argentina until the election is over.


Argentina’s monetary meltdown: What policy reaction function?

BCRA meltdown pdf.

The Central Bank of the Argentine Republic (BCRA) provides, with a short lag, updates on daily contributions to the change in Peso (ARS) base money. With this, BCRA on Thursday offered a glimpse into their reaction function in response to the acute market pressures that followed the primary election outcome. What can be learnt from this experience?

First, local LELIQ claims on BCRA are flighty. In short, ARS257bn of LELIQs were maturing on Monday 12th August; together with interest (annualized at 62.6%) of roughly ARS3bn this provided a rollover need of perhaps ARS260bn to neutralize the impact on base money. However, they were only able to rollover ARS100bn in LELIQ (at 74.8%.) And so, they replaced less than 40% of the LELIQs falling due. Most (but not all) of the rest contributed to the expansion of base money from ARS1,345bn outstanding as of Friday to ARS1,487bn on Monday.

Second, BCRA is willing to intervene on the spot market. For the first time under the latest monetary leg of the program, BCRA engaged in spot market intervention…

Third, that said, BCRA is very reluctant to run down gross reserves to protect ARS. Total spot intervention on Monday amounted to USD105mn. Let’s guess at an average intra-day exchange rate on Monday of, say, ARS55—doesn’t matter much in the grand scheme of things. That amounts to roughly ARS6 billion sterilization. And so, of the ARS160bn of LELIQs not rolled over—most of which presumably sought refuge in foreign exchange—less than than 4% was sterilized through intervention.

What sterilization was permitted under the IMF program? Some intra-marginal spot market intervention was allowed, but never acted upon. Most important, once the upper band of ARS51.5 was reached, BCRA might “be prepared to sell up to US$250 million (an increase from the previously announced US$150 daily limit) and may undertake additional interventions to counteract episodes of excessive volatility.”

If last Monday does not meet the definition of excessive volatility, then nothing does.

Thus, despite extraordinary market volatility, BCRA remained largely passive—utilizing less than 50% of the permitted intervention margin under the program. Why? Let’s imagine BCRA were to choose to defend the upper band supposed under the program and sterilize all the LELIQs that failed to rollover. At the upper bound of ARS51.5, this would imply running down about USD3.1bn of gross international reserves to defend the currency. What does BCRA’s external position look like? Figure 1 provides the answer, plotting Gross International Reserves (GIR) since end-March 2018. GIR was USD61.5bn before pressures began in April 2018. Today’s GIR is barely changed at about USD65bn. On the face it, BCRA has a war chest to defend ARS. However, this overlooks the massive official support that has been provided over this period. Figure 1 also shows cumulative IMF (USD44bn) and China swap line (USD8.5bn) support over this period as well as GIR net of this support. This net reserve measure reached USD12.5bn as of Tuesday. In addition, there is a legacy swap line from China believed to be around USD12bn, meaning that the true net reserves figure is roughly zero. (Note, BCRA external loans were reported at USD21.8bn as of end-2019Q1, which is mostly these PBOC swap lines.)

Screen Shot 2019-08-17 at 14.13.19


This helps frame BCRA reluctance to make use of gross reserves to defend the currency—even if USD3bn seems small in relation to their reported gross reserves, the true external position is much weaker than this. And USD3 billion would have driven the net reserves position so measured negative.

As a caveat, the true consolidated government external position should allow for Federal debt as well as external assets. External assets are minimal, while non-IMF external debt was about USD130bn as of end-2019Q1.So the consolidated State net external position is likely around minus USD130bn.

Finally, we should note that BCRA also intervened on Tuesday last week in the amount of USD150mn—so more than during Monday’s meltdown, and USD255mn in two days. Meanwhile, LELIQ rollovers were resumed at reasonable levels, but at an interest rate of about 75% annualized.


Recalibrating Argentina’s Ponzi Program

Restoring stability Argentina pdf plus technical annex.

TODAY’S SHARP ARS adjustment from 45.3 per USD on Friday to about 53.0—a depreciation of 14½%—comes as no surprise to anyone who has been studying Argentina’s macro-financial policies in recent years.

The catalyst for the sell-off in Argentine assets, of course, was the outcome of yesterday’s primary election—where the opposition Fernandez-Kirchner ticket defeated the so-called market-friendly incumbent, President Macri, by 15½ percentage points. A return of populism to Buenos Aries can be expected.

However, as so often the case, while politics will be seen as the turning point for Argentina’s program, a further sharp adjustment of ARS was already baked in the cake—only the timing was uncertain. Rather, failed macroeconomic policies are to blame. Why?

To understand Argentina’s inevitable demise, it is necessary to recognize that the monetary-fiscal program currently in place—including as part of the IMF’s largest ever program—is a Ponzi scheme. And as with all Ponzi schemes, it’s demise is inevitable. In short, Argentina’s central bank (BCRA) has very few interest-earning assets, but pays a large interest on its sterilization operations—currently Leliqs, previously Lebacs and various other instruments. Without the real resources needed to fund its operations, BCRA has no choice but to monetize the cost of its operations. But to prevent the impact of this on base money, with associated pressure on the exchange rate, BCRA must issue ever greater sterilization instruments as an offset. However, over a long enough horizon, this policy implies BCRA’s monetary plus sterilization liabilities will grow exponentially relative to reserves assets. Inevitably, this must at some point unravel—all that was needed is a catalyst. Yesterday’s election duly delivered.

Understanding Argentina’s Ponzi program with the IMF, therefore, is a prerequisite for beginning to sketch how things will unfold from here—the true implications for sustainability and necessary and sufficient debt restructuring under any new administration. The mistake investors have been making until now is to believe there is a positive “market friendly” outcome, whereas under any administration the true challenge of restoring fiscal sustainability brought only downside for Argentine assets. Today’s adjustment represents a belated imposition of fundamentals.

The evolution of BCRA balance sheet

To appreciate Argentina’s monetary-fiscal dilemma, we need to dig deep into the BCRA balance sheet—and monetary-fiscal interactions in particular. Every year, around July, BCRA produces an annual financial statementfor the previous calendar year. By piecing the information together from these statements, we can build links between BCRA and the fiscal authorities since 2011.

Table 1 shows the net interest income received by BCRA between 2011 and 2017, capturing the end of the previous Kirchner administration and the first part of Macri’s term. In 2011 BCRA was running a deficit of 0.4% of GDP in terms if net interest income. Interest received of ARS3.8 billion, mainly on government securities and international reserves, was more than offset by interest paid of ARS12.9 billion, mainly on BCRA securities. This deficit was roughly unchanged (in % of GDP) through 2013, but increased every year since to reach deficit of 1.9% of GDP in 2017. Interest received increased to ARS29 billion in 2017 while interest paid reached ARS233 billion. Interest received increased 8-fold on a lower base, interest paid increased 18-fold.


Not shown in Table 1, the 2018 financial statement reveals the interest paid on BCRA securities increased to reach ARS383 billion in 2018, from ARS210 billion in 2017—despite a sharp fall in outstanding absorption instruments (more on which shortly.)

And so, while not counted in the fiscal position of the Federal government, BCRA has been running a growing deficit in recent years—to reach 2.2% of GDP in 2018. This hidden deficit is the essential challenge for restoring macro-financial sustainability in Argentina, as we discuss. But first, where has it come from?

            Since at least 2011, BCRA has been a source of finance for the Federal government in various ways. One of the several ways has been through the transfer of BCRA net income (including valuation adjustment) to the Federal government.

Table 2 shows the stock of BCRA capital, reserves, and retained earnings, as well as the contribution to the change in BCRA capital due to net income. Note, this net income measure includes valuation adjustments. Since BCRA has a positive net open position in foreign currency, owing to holdings of international reserves, whenever ARS depreciates this creates positive valuation gains. And ARS was on a secular depreciation path over the period—something continued today—meaning there were positive valuation gains throughout. However, this did not result in large upward valuation of BCRA capital and reserves. Why not?


The Federal government implemented a profit sharing rule whereby net income from the previous year—including these valuation gains—was transferred to the Federal government as income. This was not quite 100% in the final years shown, but exactly true for the first 5 years. Consider how net income including valuation gains of ARS78 billion in 2014 was transferred in full in 2015 to the Federal government. Thus, even though there as negative net income cash flows throughout the period, the valuation adjustment was to more than enough to offset this. And so, despite negative realized cash income, BCRA was continuing to transfer profits to the Federal government throughout. Over the 7 years covered, BCRA transferred ARS375 billion to the government, averaging 0.9% of GDP per year. Crucially, it was valuation gains that were being transferred, even if these valuation gains were yet to be realized and all the while BCRA capital was shrinking from 1.4% of GDP in 2011 to 0.7% of GDP in 2017.

But this wasn’t the only source of financing between BCRA and Federal government over the period. 

            Table 3 provides the best decomposition of contributions to changes in base money in Argentina possible (by me at least) from the varying annual financial statements. The change in base money of ARS840 billion cumulative, averaged about 2.4% of GDP, whereas the change in contributions owing to transactions with the government of various kinds summed to ARS1279 billion, averaging about 3% of GDP. These transactions on behalf of the government include the purchase of FX in later years (when international markets were open for borrowing), the drawdown of deposits, temporary advances to the government, and transfer of BCRA earnings noted above. With respect to the latter, there is a difference between the flows reported in BCRA income statement (Table 2) and the smaller implied cash flow (Table 3) which is assumed without investigation an accrual versus cash distinction.


In any case, the decomposition shown in Table 3 reveals fiscal dominance in Argentina over the period 2011-17. Most important, to contain the creation of base money, BCRA expanded the total stock of outstanding securities—sterilization instruments—by about ARS380 billion (or 3.5% of 2017 GDP.) Crucially, this is a net figure, meaning the interest on outstanding BCRA securities which would otherwise contribute to greater base money creation is being mopped up here; the total increase is considerably larger.

In fact, the total stock of BCRA securities increased from ARS89 billion end-2010 to ARS1,160 billion end-2017 (Figure 1). This exponential increase in BCRA securities, later rolled off somewhat in the crisis of 2018, is a pictorial representation of the challenge of monetary stability with inadequate central bank resources. In effect, to achieve monetary stability BCRA was issuing its own securities in lieu of government debt. This quasi-fiscal debt sits on BCRA balance sheet instead of government. This ought not be overlooked in assessing overall macro-financial sustainability, however.


To assess overall sustainability, of course, requires consolidating the Federal government with BCRA to produce a true assessment of overall State position. But to do so would have stretched to breaking point the intellectual capacity of the Fund—their debt sustainability framework has no meaningful role for consolidated public sector assessment—while working against the political imperative to be seen to support Argentina’s efforts to reintegrate into the international community. And so the IMF’s program was fudged.

The IMF program: death foretold

In brief, the IMF program—amounting so far to a prospective USD56 billion, of which about USD50 billion is a done deal, the largest in Fund history—took note up front of the lack of BCRA capital and the need for action in the future on this, but decided not to deal with this as a prior action. For example, the staff reportat program initiation notes the need to update accounting standards at BCRA while setting as a “structural benchmark” for end-2019 the need to “Recapitalize the central bank to ensure it has the adequate level of capital as percent of the monetary base plus the outstanding stock of LEBACs.”

But such measures, which would have clear fiscal implications, including for sustainability assessments, were illogically postponed. As a result, staff could present a more favourable picture of Federal debt sustainability. However, this overlooked a fundamental inconsistency within the program. While Federal government sustainability requires secular real appreciation, BCRA sustainability in contrast requires secular real exchange rate depreciation to continually revalue foreign assets relative to local currency liabilities.

Absent real depreciation, the BCRA’s monetary policy would be exposed as a Ponzi game in which the value of liabilities would grow exponentially larger than net foreign assets (at any prevailing exchange rate.)

This inherent contradiction sits at the heart of the Argentina program today—as it has from the start. Thus, BCRA securities and overall liabilities (including base money)—despite the apparently tight monetary stance—would far exceed the local currency value of net foreign assets in finite time. The latest IMF 4thReview forecast of this is shown in Figure 2. The only way to correct the imbalance of growing local currency liabilities is through discrete ARS depreciation, to revalue international reserves relative to local currency liabilities. With substantial dollarization of Federal government liabilities, however, this will reveal Federal government debt to be larger relative to GDP than previously thought—as in 2018. Thus, the quasi-fiscal debt of the government imposed on BCRA will show up when BCRA resolves her own unsustainable position.


All this has made ARS adjustment inevitable at some point. For example, the average Leliq interest rate—the interest rate on 7-day absorption instruments—during January through July this year was 61%. The stock of Leliqs was less than ARS500 billion in October 2018, but was on track to exceed ARS1,800 billion by end-2019. BCRA Leliqs were destined in a few weeks from now to exceed base money in size once again. By end-2020, the IMF was forecasting M0 plus Leliqs in Argentina to be nearly double net foreign assets—despite expected exchange rate weakness. Roughly speaking, in the past few weeks, BCRA has been rolling over into 7-day liquidity absorbing instruments about ARS250 billion per day—that’s about 20% of base money each working day. On each occasion, the holders of these claims on BCRA have to ask whether the reward of a 60%-70% annualized interest rate on this one week lending to the central bank is worth the risk that on one of the next 4 days other holders will decide to liquidate the claims and try to purchase USD. If on any day there is a reason to fear rollover in the next week, there is an incentive to run for the exits—precipitating a currency crisis. This is due to the lack of BCRA capital and resources to fund monetary stability, and the ultimate need to monetize the cost of monetary policy.

Ultimately, the need to recap BCRA by end-2019 will have an impact on the fiscal position of the Federal government that has so far been swept under the carpet. The precise size of the recap is impossible to say, but it’s easy to generate (that is, simulate) steady states with an increase of Federal government debt of between 10% and 30% of GDP; with assumed 5% coupon on this debt transferred to the government, this could create an additional interest cost of 2% of GDP per year. This implies the fiscal adjustment in the program would require further painful future efforts to restore monetary sustainability. Alternatively, given the monetary-fiscal adjustment so far has taken a huge toll on the population, fiscal adjustment will likely be paused in favour of substantial debt restructuring. This will be the case regardless of who wins the election in October. It’s time to restore macro-financial stability to Argentina. I believe the existing fiscal DSA ought to add around 20% of GDP in debt in perpetuity to do so, which upends all existing assumptions about fiscal sustainability and the need for restructuring.


A note on debt sustainability in Argentina

THE LATEST International Monetary Fund (IMF) program document for Argentina—the 3rdReview—was published earlier this month. This document sheds light on the drivers of the public debt sustainability analysis (DSA) that underpin the program.

Since the issue of debt sustainability in Argentina will recur after the upcoming Presidential elections, it’s worth asking: What are the assumptions that underpin the latest IMF document? Do they make sense? And what does this imply for investors?

Let’s start with the evolution of projected public debt since program initiation in June 2018. At the time of program initiation in June 2018, debt-to-GDP was expected to peak below 65% in 2018 before falling below 55% in 2o23. The latest review has debt-to-GDP peaking above 85% in 2018 though falling to below 60% in 2024. The convenience of extending the forecast horizon a year allows the economically meaningless though apparently optically necessary 60% debt-threshold to be met by 2024. (When will the IMF disabuse us of this meaningless number?)


What has changed over these different reviews? The most important recent driver of the debt stock relative to GDP is the valuation adjustment of foreign currency-denominated debt given nominal exchange rate depreciation. As of end-2017, 68% of public debt was denominated in foreign currencies (largely dollars); by end-2018, with program borrowing and another dollar bond issued in 2018Q1, 76% of public debt was fx denominated.

It’s useful therefore to review the exchange rate assumptions that underpinned the respective documents. Now, the precise exchange rate assumptions are hidden deep within the documents. But we can back out the implied USDARS exchange rate from the national income (period average) and monetary account tables (end of period). The left side in the chart below shows the expected year average exchange rates implicit at program initiation, where ARS was expected to depreciate only 56½% against USD from 2016 through 2023, with most of this deprecation happening by 2019. Instead, the nominal exchange rate adjustment was much sharper, with USDARS reaching 38 by end-2018, well above that initially expected for 2023; the valuation adjustment on the stock of fx denominated debt therefore drove up the stock of public debt up by about 30 percentage points of GDP, considerably above that anticipated only last June.

Perhaps most interesting, the latest review further revises the exchange rate over the forecast horizon. Instead of ARS reaching 46 in 2023 as at the 1stand 2nd Reviews, it is now expected to depreciate to touch 63 on average that year and 67 by end-2024. Thus, from ARS depreciation of 15% from 2019 to 2023, the latest review builds in a 33% depreciation over this period against USD. This is a substantial revision to the projected nominal exchange rate path, especially given the high share of fx-denominated debt and the extraordinarily tight monetary policy that has been initiated under the program— including zero base money growth, substantially negative in real terms.


The assumed nominal exchange rate depreciation means the large share of USD-denominated public debt will continue to increase over the forecast horizon when measured in local currency, contributing to deteriorating debt dynamics. How then is the program document able to show a declining stock of public debt when measured relative to GDP? The answer is in large upward revisions to nominal GDP in local currency—mostly coming from upward revisions to expected inflation as measured by the GDP-deflator. Again, while the original program assumed NGDP to grow 17% on average per year from 2016 to 2023, the latest program has growth of 26%—given the lower path of real GDP since initiation, the program now implies much higher average inflation rate. The compounding of higher nominal GDP growth therefore drives GDP to above ARS44 trillion by 2024, though in USD terms only slightly higher than the 2017 flow of USD650 billion.


Again, in contrast to the extraordinarily tight monetary policy agreed for 2019 under the program, the Fund now assumes continued nominal exchange rate depreciation as well as large GDP-deflator inflation over the forecast horizon. The expected higher inflation and exchange rate weakness also coincides with base money growth picking after 2019—so recent control of base money is apparently not expected to last.

To assess the two factors side-by-side, the next chart shows the cumulative growth in nominal GDP, GDP deflator, and ARSUSD from 2016. Note, the latter measures the percent change in the number of local currency units that can be bought with 1 dollar; this represents a 77% depreciation properly measured against USD over the horizon.

Crucially, while the nominal exchange rate has “overshot” through 2019, the program has NGDP growth racing ahead of the weaker exchange rate to bring down the stock of debt-to-GDP—with about ¼ of this is due to the GDP deflator. For this reason, the program document emphasizes “projected real peso appreciation in 2019 will improve debt dynamics.” The 3rd Review does not reveal that this is not expected to materialize alongside continued nominal peso depreciation, with inflation catch up and surge ahead of the exchange rate adjustment. Of course, the real exchange rate proper will be impacted in addition by the average inflation rate amongst trading partners, so these comments leave out this important aspect. But it demonstrates the key contributors to falling debt-to-GDP—namely cumulative NGDP growth, including due to the GDP deflator, running ahead of the weaker exchange rate from 2018.


Put another way, the IMF’s DSA hinges on “financial repression”—or, negative real interest rates for investors in both local and foreign currency debt when measured with respect to the local GDP.

How realistic is that local investors will continue to finance the rollover of domestic debt at substantially negative real yields? Given the risk of default, will non-residents continue to fund Argentina—including the roll-off of IMF funding—at manageable rates? Is the implied nominal interest over the forecast horizon reasonable?

Here’s where the challenge of interpreting debt sustainability gets messy for Argentina. It crucially hinges on the definition of Federal government and the portfolio choices of non-Federal-government public sector. In short, there’s a lot hanging on the definition of government. The original program document focussed on “gross federal government debt, which includes intra-public-sector debt” including debt owed to the central bank (BCRA, apparently at effectively zero interest), social security (ANSES), and other public sector entities (including provinces). As of end-2017, 48% of Federal debt was owed to other public sector bodies; as of the latest program “About 35 percent of the federal government’s debt is held by other public-sector entities and provinces. Nearly 70 percent of this intra-public-sector debt is denominated in US$, and within this, the majority are low-interest Letras Intransferiblesheld by the BCRA.”

Against this, when it comes to presenting the Federal government fiscal balance, the interest paid to other public sector entities is removed—see footnote 4 of Table 4 on page 32, where the interest paid “excludes all interest paid to other public sector entities, in line with authorities’ definition.”

So, the Federal debt stock includes intra-public sector holdings, while the Federal fiscal balance strips out public sector interest flows—so the interest flows in the DSA have to add back the interest paid to other public sector entities. Fortunately, the DSA template includes the effective interest rate paid on Federal debt, including to other public sector bodies, as shown in the chart below (page 50).


The effective interest rate, “defined as interest payments divided by debt stock (excluding guarantees) at the end of previous year,” dips to 5.1% in 2019, before increasing to 8.2% at the end of the forecast horizon. It is not clear why the effective nominal interest rate dips this year. At program initiation, the effective interest rate for 2019 was pencilled in at 8.6%, though admittedly with lower expected IMF purchases. Regardless, using the debt stock anticipated over the program (Table 7, page 40) we can back out the implied interest paid on Federal debt, including that to other public-sector entities. And the effective interest rate paid increases to ARS2.0 trillion in 2024 (8.2% of ARS24.7 trillion debt as of end-2023) which compares to interest of only ARS0.9 trillion according to the fiscal balance. The document therefore appears to imply an ever-greater share of interest on Federal debt will be paid to other public sector bodies, including the central bank and social security fund. Indeed, by 2024 it seems to imply about 2% of GDP in interest will be paid to other public sector bodies. Regardless, since the program assumes non-Federal public sector rollover of debt—including capitalization of interest by non-financial public sector bodies—sustainability hinges on a high inflation and therefore a negative real effective interest, much to other public sector bodies, through 2024.


There is much more that can be said about Argentina’s program—looking at the balance of payments, monetary accounts, and likely future path of GDP. But narrowing in on the DSA is enough to get a smell-check as to the realism of the program. And there are substantial problems with the sustainability analysis. But future adjustment will likely take a different form—with larger compression of domestic demand, greater current account adjustment, and a surplus of domestic saving that can be used to finance public sector in outer years as the economy stabilises.

But it is most likely that nominal and real interest rates will be higher, and the stock of debt stuck at a higher level for longer—but the economy will stabilise and inflation moderate. This will raise the prospect of debt restructuring after the elections in October, once the IMF narrows in on more sensible macroeconomics. In the meantime, the greater damage to real incomes that will be materialise creates the possibility of a less outward-looking and more populist government. Will the IMF agree to rollover the program with a permanently higher stock of debt under a Macri government? Or will the IMF look to restructure debt in an orderly way? Or will Cristina decide to turn away from financial markets, creating a disorderly resolution to Argentina’s external debt challenge once more? A sensible view of the DSA suggests any of these outcomes could materialise.


Is euroarea monetary control now in the hands of official reserve managers?

Euroarea monetary control pdf version.

It’s remarkable how the euroarea crisis elevated arcane relations between central banks within the Eurosystem to dinner table talk for households across Europe. After decades of disregard, central bank balance sheets and liquidity management are fashionable once more.

Largely unnoticed, however, a more recent set of connections between central banks of potentially greater significance has emerged. This time, the links are not withinthe Eurosytem but external—between euroarea national central banks (NCBs) and non-euroarea central banks (NEACBs) and their reserve asset managers. That is, growing deposits by NEACBs with NCBs since the European Central Bank’s (ECB) asset purchase program (APP) have the potential to distort future liquidity control—indeed, they are now crucial for projecting Eurosystem liquidity, the yield on euroarea safe assets, and the euro itself.

Let’s take a step back. Since June-2015, the share of “currency and deposits” in total reserve assets held by NEACBs, as reported to the IMF, increased from roughly 3% to 8% (Figure 1). That is, reserve managers rotated assets from global coupon-bearing securities towards deposits with other central banks. Of a stock of reserve assets of near €9½ trillion, the increase was about €400 billion.

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What does this have to do with the Eurosystem? Well, over the course of APP roughly €600bn of euros that would otherwise sit as excess liquidity at domestic banks were “sterilized” due to: larger cash buffers held by resident governments on increased bond issuance (€150bn); financial intermediaries not subject to reserve requirements selling into APP and deposited with NCBs (€100bn); and, most importantly, growing non-euroarea resident deposits (largely NEACBs, €350bn).

Indeed, as of December, non-resident euro deposits at NCBs exceeded €400bn. Two forces appear to have driven these growing claims. First, as reserve managers sold bonds into APP, or saw claims mature, they recycled into euro cash at NCBs rather than securities. This accounts for the secular increase (perhaps €300bn). Second, quarter-end shortages of dollars amongst private banks in core countries, subject to new regulatory requirements, evolved a reliance on NEACBs providing dollar securities to pad their balance sheets. Euros posted as collateral in these repo operations wash from banks into reserve manager accounts, mainly at the Bundesbank—imprinted also in quarterly TARGET2 moves.

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Why does this matter? Five reasons:

First, Eurosystem excess liquidity is now closely linked to official reserve manager portfolio allocation, not fully within the ECB’s control (something not factored into Praet’s projections). Indeed, if NEACB claims on NCBs remained unchanged since 2014, excess liquidity today would be above €2.1trn instead of €1.8trn. And these reserves—larger than total APP purchases in 2018—are waiting to be redeployed as yields normalize. Alternatively, should yields remain compressed, growing NEACB claims couldsqueeze excess liquidity further.

Second, it challenges the narrative that an important part of the global impact on the ECB’s APP has been through the recycling of non-resident portfolio claims to the outside world (see Coeure). Not so. Rather, given asset prices, perhaps half net non-resident portfolio sales during APP instead rotated into euro deposits. Isolating portfolio flows in the balance of payments without looking at other investment is distorting. And perhaps the biggest global impact of APP, therefore, has been on reserve manager portfolio allocations.

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Third, the yield on euroarea safe assets is now determined by the marginal interest rate available to NEACBs (Figure 2). The Bundesbankreveals an interest on the unspecified excess float held by reserve managers at the deposit rate minus15bps—thus currently -55bps. As a result, absent alternate safe assets, NEACB claims on the Eurosystem increased most when the yield on short-end bunds fell below -55bps. This provides a cap on short-end yields, therefore.

Fourth, quarter-end shortages increase the links between NEACBs and the Eurosystem, providing for the former an opportunity to offset some of the cost of negative yielding euro assets. However, these flows challenge any interpretation of quarterly changes in IMF reserve asset allocation data: how should these repo operations between NEACBs and euroarea banks be unpacked? For example, using the IMF’s CPIS and allocation of international reserves data, as well as ECB NCB balance sheet data, it is apparent a growing share of reserve manager claims on the euroarea is now in the form of deposits with NCBs (Figure 3 provides an estimate for end-2017). The increasing dollar-liquidity provision needs to be factored in when estimating quarter-end euro allocations.

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Fifth, interlocking global central bank balance sheets are now of greater interest than intra-system TARGET2 balances. Indeed, the fact that numerous central banks today likely hold more than one-third of their reserve assets in the form of negative yielding deposits at the Eurosystem (e.g., perhaps Australia, Czech Republic, Denmark, Turkey) is remarkable (Figures 4 and 5). This is a tax on non-euroarea residents.

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In summary, the legacy of the ECB’s APP is more nuanced than often supposed. Growing links between the Eurosystem and national central banks outside the Eurosystem have the potential to challenge liquidity management in the future. This also represents postponed APP purchases, since these deposits can be recycled back into euroarea assets raising liquidity once more. For example, over the past 4 weeks, non-euroarea euro deposits have declined €27 billion, defying the seasonal pattern of accumulating deposits in 2017 and 2018 (Figure 6). This suggests anticipation of today’s dovish ECB meeting caused reserve managers were rotating into euroarea fixed income assets to benefit from the rally in asset prices. This is as large a flow as APP purchases each month during 2018H1.

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But all this is just another way of underlining the flaws in euroarea fiscal policy—and the shortage of global safe assets. Should euroarea fiscal failings, alongside reserve manager portfolio choices, eventually hinder euroarea liquidity management, then flaws in euroarea macro-financial design will once more be laid bare for all to see.