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Redrado is Right: Fernandez’ Actions Will Do Lasting Damage March 9, 2010

Posted by Afflatus in Economics, Politics, World Affairs.
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On December 14, 2009, President Cristina Fernandez de Kirchner of Argentina issued a presidential decree of necessity and urgency to establish a bicentennial fund for debt service, which would be stocked with $6.569 billion of the central bank’s foreign currency reserves. Martin Redrado, the president of the central bank challenged the decree and refused to transfer his bank’s reserves into the bicentennial fund. After Redrado refused to resign, President Fernandez issued a second decree ordering the removal of Redrado. A political scandal ensued, the judiciary stepped in and ruled that the Senate must approve of President Fernandez’ proposed use of the reserves. Feeling he had sufficiently stood up for his economic principles, Mr. Redrado agreed to resign in late January.

Mr. Redrado defended two fundamental economic principles concerning the central bank. The first was that a central bank must remain independent; the second that reserves should be used strictly to ensure monetary and financial stability. He was right to do this and it is unfortunate he lost his job. President Fernandez’ attempted seizure of the central bank’s reserves will likely produce grave consequences for Argentina’s economy. President Fernandez has substantially weakened the central bank’s balance sheet. She has established two harmful institutional precedents: compromising the central banks’ independence and encouraging fiscal irresponsibility. President Fernandez’ ultimate goal of repaying government debt is commendable, however her means for achieving that goal are illegitimate. Rather than slashing spending before looming elections, the President has chosen to indulge her political base, and reject sound economic policies. Mr. Redrado did the right thing.

One of the key principles that Martin Redrado defended was the importance of maintaining an independent central bank. This principle is founded on the economic axiom that in the short-term there is a trade-off between inflation and growth. If politicians control monetary policy, they will likely pursue an expansionary monetary policy, particularly in the run up to elections; typically in a politically sensitive time, governments prefer more employment over less inflation. If non-politicized figures control monetary policy over the long-term, this trade-off need not occur. For this reason Mr. Redrado and most other economists believe a central bank’s independence to be sacrosanct. President Fernandez has breached this inviolable divide.

The second belief that Mr. Redrado upheld was that central bank reserves should be used strictly to ensure monetary and financial stability. Mr. Redrado believes that central banks should serve as an independent institution striving to manage inflationary pressures, maintain a stable currency, and promote a healthy economic environment. Mr. Redrado believes that without these reserves, the central bank’s ability to defend its currency is considerably handicapped. A corollary to this argument is that government debts must instead be paid through instruments within the government’s prerogative such as solid fiscal surpluses.

President Fernandez’ attempt to gain access to Argentina’s foreign currency reserves in order to retire government debt presents severe problems in both the short- and long-term. Most immediately, Fernandez’ actions significantly weaken the central bank’s balance sheet. In exchange for its international currency reserves, which are liquid and high-quality assets, the bank will receive a highly illiquid asset (a non-transferable government bond) and it must absorb a considerable loss to its reserves. As Mr. Redrado has stated, this weakens the central bank’s ability to defend its currency.

The central bank of Argentina currently has $47.8 billion in foreign currency reserves; so the $6.6 billion the President is taking is 14% of the bank’s reserves (Benson, 2009). President Fernandez argues that the reserves she will acquire are “excess” reserves, because the central bank currently holds more reserves than the monetary base. This is the same argument Hugo Chavez used to take more than $20 billion from the central bank of Venezuela since 2005. Economists disagree over the necessary amount of reserves. Many, like Redrado, believe that in a highly dollarized emerging economy like Argentina’s, it is important to have an abundance of U.S. Treasury bonds.

The correct level of “excess” reserves is debatable, but larger, more serious, concerns trump this issue. More significantly, the precedents President Fernandez’ actions set, the likely degradation of Argentina’s financial and governmental institutions, and the illegitimate manner President Fernandez attempted to seize the bank’s currency reserves will be long lasting.

In addition to weakening the bank’s balance sheet, President Fernandez’ actions cause other, more serious long-term problems for Argentina’s political economy. First, President Fernandez has set a precedent which compromises the central bank’s independence from the government. President Fernandez has made clear that the executive branch can remove a central banker who opposes the government’s wishes. “The bank’s independence has disappeared,” Abel Viglione, an economist with the Foundation for Latin American Economic Research (FIEL), told BusinessWeek (Raszewski, 2010). In the future, the President of the central bank will understand this precedent and may consider the political and personal implications of monetary policy (i.e. losing one’s job, as Redrado did). A central banker that weighs political ramifications in his or her decision-making process is less likely to produce sound monetary policy. Or, on the flip side, a president who directly influences the central bank’s monetary policy is less likely to attract international investments.

Second, President Fernandez has weakened the incentive for future fiscal responsibility. Anytime a government is in a budgetary bind, it will now be easier for that government to dip into the central bank to stay afloat. This possibility will lead governments to put off tough decisions like cutting expensive, but politically popular programs. Indeed, the postponement of politically thorny decisions is one reason many analysts believe President Fernandez has made this decision. In this way, President Fernandez can pay back maturing bonds, while maintaining her unsustainable spending and indulging her political base.

Third, the manner in which President Fernandez has attempted to seize the central bank’s reserves is dubious and arguably unconstitutional. The central bank’s charter stipulates that if the President wishes to remove a central bank chief, he or she must ask lawmakers for a prior, non-binding recommendation. Ms. Fernandez ignored this specification, and instead tried to fire Mr. Redrado by decree of necessity and urgency. Not only did President Fernandez disregard the central bank’s charter, but also it is unclear if this moment truly merits a decree of necessity and urgency. In fact, Judge María José Sarmiento, the initial appeals judge to hear the dispute, determined in her ruling that it was neither necessary nor urgent to create the Bicentennial Fund with central bank reserves. Moreover, some opposition parties have filed injunctions requesting the courts to rule that President Fernandez’ actions were unconstitutional (Haskel, 2010). To say the least, the legitimacy of President Fernandez’ two decrees are in serious question. While her ostensible goal of paying back bond debts is laudable, her methods are dubious. The end does not justify the means.

Veto player theory applies to President Fernandez’ recent actions as well. Veto player theory argues,  “a higher number of veto players lowers the likelihood of change” (Scartascini, 2008). In the case of Argentina’s central bank dispute, Mr. Redrado acted as a veto player: his consent was necessary in order for the government to access the central bank’s reserves. Now that the main veto player, Mr. Redrado, has been removed, it is significantly more likely President Fernandez will be able to use the central bank’s reserves to pay down its debt to bondholders. Congress, consisting of some veto players itself, must still approve President Fernandez’ proposal in a debate next month.

With a key veto player in Mr. Redrado eliminated, President Fernandez has named Mercedes Marcó del Ponte to be his replacement. She is a staunch supporter of the Kirchners, and certainly would not act as a veto player on this issue. As a lawmaker in 2007, Ms. Marcó del Ponte sponsored a bill to change the central bank’s charter. Though her bill failed, the proposed changes would have expanded the central bank’s prerogative to help facilitate growth and job creation (Weber, 2010). This philosophy indicates that Ms. Marcó del Ponte would likely acquiesce to further incursions into the central bank’s reserves. The elimination of veto players regarding monetary policy makes those policies less resolute. This change sends bad signals to investors looking for a stable financial climate.

It appears that President Fernandez has chosen to sacrifice sound economic policy for political gain. It is quite possible that President Fernandez has established control over the central bank in order to monetize her budget deficits, and fund a spending spree before presidential elections in 2011 (Weber, 2010). Luis María Corsiglia, a former director at the central bank of Argentina, also speculated that President Fernandez wants to use the reserves for current spending (Weber, 2010). The problems with this policy are profound; it will weaken the central bank, weaken the Argentine peso, and lead to a spike in inflation. In fact, official inflation in January reached a 22-month high of 1.1%; however private estimates believe the real number is 2% (Brandimarte, 2010). According to the Financial Times, many economists expect inflation to reach 20% this year (Weber, 2010). With the new central bank president a loyal political ally, it seems unlikely that the central bank will raise interest rates in order to combat inflation. This all will have severely detrimental effects on the economy.

Mr. Redrado rightly defended the importance of an independent central bank. He also championed the idea that central bank reserves should be used strictly for maintaining monetary and financial stability. President Fernandez’ actions weaken the central bank’s balance sheet, decreasing its ability to defend its currency. In the long-term, the independence of Argentina’s central bank has been reduced, and will remain a concern for investors. President Fernandez’ actions also weaken the incentive for her and her successors to maintain a balanced budget; the reserves will be there to bail them out. The method which President Fernandez has pursued to repay debt and regain access to international capital markets will likely backfire. Investors’ anxiety will likely continue due to three factors: improvident spending, a compromised central bank, and high inflation. President Fernandez would be more likely to gain investors’ confidence (as well as voters) if she were to restore the bank’s independence, respect Argentine institutions, and repay debt through fiscal surpluses.