| SEIDO Macro Update: How does an FX shock look? The government seems to be following the Rocky Balboa FX strategy (“It’s not about how hard you hit. It’s about how hard you can get hit and keep moving forward”). The official stance is to wait for the pandemic to recede and the agro-export dollars to start flowing in again. However, without major changes in economic policy, doubts are less about what will happen and more about when and how. In this macro update, we ask ourselves: how may a shock scenario look like? Three considerations are in order. -First, the timing of a crisis can not be forecasted. For the sake of our simulation, we date the beginning of the crisis in January 2021, broadly resembling what happened in 2014. -Second, we “reverse engineer” macro dynamics: we simulate how much the official FX needs to increase in order to generate an inflation outburst that eliminates the monetary overhang. -This leads us to our third consideration: We assume that policy response is appropriate to avoid an overshooting of nominal variables and second-round explosive dynamics. How are the mechanics of our simulation for 2021? We define the monetary overhang as the difference between the end-2020 and the pre-pandemic (February) level of monetary aggregates in terms of GDP. We then estimate how much inflation is required from January to April in order to decrease aggregates to that level and, assuming a pass-through coefficient of 0.65, calculate the required increase of the official FX rate for the same period Our simulation shows that the official exchange rate should increase by 53% to eliminate the monetary overhang and Inflation would spike to 12% MoM in February and 10% MoM in March, only to decrease to 5% MoM by June and 3% MoM by December (almost 80% YoY). This steep FX depreciation would derail the economic recovery. With the crisis occurring so early in 2021, the activity would suffer yet another decline. GDP would fall an average of -1.8%, ending the year at -4% YoY and almost 10% below pre-pandemic levels. |
Selected Macro Variables: Continuity vs Shock scenarios |
| SEIDO Macro Update: How does an FX shock look like? General economic dynamics are moving in line with our expectations. Activity is modestly recovering, with GDP increasing +1.1% MoM s.a. in August (vs 1.7% in July and 7.6% in June) but still 10% below its pre-pandemic level. Meanwhile, inflation is high and converging to the official FX depreciation rate (2.8% vs 2.6% MoM in September) despite price controls, depressed demand, and frozen regulated prices. After two months of positive surprises, fiscal accounts deteriorated again in September, with accelerating expenditure growth (33% YoY in real terms, against 18% YoY in August) and a primary deficit that totals 4.8% GDP in so far 2020. |
Monthly GDP (Seasonally adjusted)
However, mounting imbalances reflect themselves in the never-ending widening of FX premiums, which have proved immune to the erratic regulatory changes, while Central Bank’s international reserves are touching critical lows. The monetary overhang continues, despite BCRA’s efforts to reduce money printing (base money changed -0.1% MoM and +65% YoY as of October 16th, against +1.5% and +80.3% in September and +0.9% and 83.5% in August). Broad reserves are at USD 40.8bn, though the net stock is of USD 4.5bn, and net liquid totals USD -0.8bn. This means that the BCRA can intervene in the market, but not with its own money.
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The government seems to be following the Rocky Balboa strategy (“It’s not about how hard you hit. It’s about how hard you can get hit and keep moving forward”). The official stance is to wait: (a) until the pandemic recedes and the economic recovery picks up the pace; (b) until agro export dollars start flowing in and forex market supply increases; (c) until ARS bonds’ offshore holders can withdraw from the local market and the BCS premium subsidies; and (d) until they can negotiate a deal with the IMF that shores up confidence. The problem with this strategy is that the government looks less like Rocky and more like Homer Simpson before Drederick Tatum’s (a cartoon version of Mike Tyson) final punch.
International Reserves (USD bn)
As the government moves along the continuity path and “gambles for redemption”, the chances of a disorderly adjustment increase. With a central-bank-controlled FX rate, the monetary financing of the fiscal deficit translates into an almost continuous decrease of international reserves. A speculative attack on reserves is discarded due to capital controls, but, absent important changes, the BCRA will eventually lose the capacity to intervene in the forex market and the FX will have to float more freely. Regulations and restrictions can only postpone the inevitable, at a cost: increasing depreciation expectations and limiting any possible economic recovery.
Fiscal Deficit and Central Bank transfers to the Treasury (% of GDP)
Without major changes in economic policy, doubts are less about what will happen and more about when and how. Precisely, in this macro update, we ask ourselves how a shock looks like. Three considerations are in order. First, the timing of a crisis is practically impossible to forecast accurately. For the sake of our simulation, we date the beginning of the crisis in January 2021, broadly resembling what happened in 2014. Second, we “reverse engineer” macro dynamics: we simulate how much the official FX needs to increase in order to generate an inflation outburst that eliminates the monetary overhang. This leads us to our third consideration: we assume that policy response is appropriate to avoid an overshooting of nominal variables.
Money Aggregates (% of GDP)
Our simulated scenario assumes that current policy and economic dynamics continue unchanged until year-end. This means that 2020 would end with an inflation rate of 33% YoY, an average growth rate of -11.5% (-7% YoY by end-December), an exchange rate of ARS 82.3 (BCS FX rate at about 170), a policy interest rate of 34% and a primary deficit of 7.4% GDP (overall deficit of 9.4%). Monetary aggregates, our key variables, would end as follows: base money at 9.5% GDP, private M2 at 14.7% GDP, and private M3 at 23.2% GDP.
Exchange rate dynamics: Continuity vs Shock
How are the mechanics of our simulation for 2021? We define the monetary overhang as the difference between the end-2020 and the pre-pandemic (February) level of monetary aggregates (in terms of GDP). We then estimate how much inflation is required from January to April in order to decrease aggregates to that level and, assuming a pass-through coefficient of 0.65, calculate the required increase of the official FX rate for the same period. We also estimate the impact of the FX depreciation on growth, fiscal accounts, financial needs, and interest rates, assuming that the government will try to contain the shock with monetary policy (ie: higher interest rates) and will not loosen fiscal policy, so as to avoid a depreciation-inflation spiral. In our simulation, any damage control policies to minimize the social impact of the crisis imply a rearrangement of spending items.
Inflation dynamics: Continuity vs Shock
Our simulation shows that the exchange rate should increase by 53% to eliminate the monetary overhang. A discrete jump of 40% in January, followed by a 3% monthly increase afterward, would take the official FX rate to ARS 126 by end-April and almost ARS 160 by end-December. Inflation would spike to 12% MoM in February and 10% MoM in March, only to decrease to 5% MoM by June and 3% MoM by December (almost 80% YoY). The central bank would be forced to increase the reference rate (we estimate up to 45%) to contain an overshooting of the FX rate and would only decrease it gradually, to minimize inflationary pressures and try to jump-start activity in an election year.
Monthly GDP (sa): Continuity vs Shock
The steep FX depreciation would derail the economic recovery. With the crisis occurring so early in 2021, the activity would suffer yet another decline. GDP would fall an average of -1.8%, ending the year at -4% YoY and almost 10% below pre-pandemic levels. Worse activity dynamic translates into lower tax collection, but fiscal accounts would “benefit” from higher inflation (80% YoY by end-December) and spending restraint. As a result, the primary deficit would decrease from 7.4% to 3.3% GDP (overall deficit of 4.3%). It is debatable whether the government deploys income support policies or not after the FX shock, but doing so increases the risk of further depreciation and uncontrolled nominality. We assume that policy makers will choose the “lesser evil” option.