How do you free the FX market without reserves?

Miguel Braun · Jul 16, 2024 · 9 min read

Also: where is Milei's government heading with the new measures taken?

With the latest resolution, the government decided that starting this week the last tap of monetary issuance for buying USD would be closed. Let's remember the three taps of monetary issuance were:

This is hugely important. When Milei took office in December 2023, the BCRA was printing an entire monetary base every less than 2 months just to pay the interest on the remunerated liabilities. This was obviously fuel for inflation. Milei wasn't exaggerating when he said we were heading straight for hyperinflation, because on top of that were the other two sources of issuance and the demand for pesos was getting lower and lower, which was going to lead to a hyperinflationary blowup. Besides, they had left all the Central's remunerated debt in overnight pases, with negative net reserves and wholesale inflation running at 17,000% in December. Real criminals... What they did was epic. They not only lowered the Treasury deficit to a fiscal surplus in the first month, but are also taking on the interest on the BCRA's debt, whose origin is also the fiscal deficit. This is impressive: for the first time in my memory, a government commits to paying the interest on the Central Bank's debt with surplus and not with monetary issuance. They were able to do this after making the largest adjustment in the history of humanity, of about 17 points of GDP.

The merit is doubled if we consider that neither Milei nor anyone in his administration was responsible for this deficit or for the issuance of the remunerated liabilities and the time bomb that represented. That is, Milei is taking responsibility for all the previous imbalances they left him, when he could well wash his hands and say "it wasn't me" or "I didn't take on that debt, I have no reason to pay it", as all previous administrations did for as long as I can remember.

What is being done is simply a change of debtor: from being the Central Bank it will become the Treasury. I think this is fantastic. The BCRA is a parasitic entity, that doesn't produce profits like any other commercial bank because it has no cards, no commercial accounts, doesn't grant loans, nor does it have many reserves it could invest to earn interest. So the only way it had to pay the interest was by printing pesos. This ends.

When they finish migrating the BCRA's debt to the Treasury, the Treasury will take charge of the interest with the fiscal surplus they generate. In the worst case they will have to roll over debt (take on new debt to pay the old) but the latest Treasury auctions show they have more than enough capacity to do so. Every time they hold an auction, they are offered far more pesos than they end up taking (awarding — issuing in debt).

But it is not just that; the scam is double: the BCRA prints the pesos it gives exporters in exchange for their USD. For example, a farmer who breaks his back producing in order to sell his products has to swap with the BCRA the USD his products generate for little pieces of paper the BCRA prints without any effort or added value.

Milei knows this is a scam. He has said over and over that monetary issuance is a scam, and issuance to buy USD is not too different. It is the same concept. The most serious thing seems to be that in the May Pact the first clause says "private property is inviolable" and yet today, during Milei's government, exporters are forced to liquidate their USD against pesos at a fictitious exchange rate. So I ask: isn't this a violation of private property? Does the May Pact have no value? It is a strange attitude on the part of the new government.

Where are we now?

The government came up with the idea that, from now on, what they will do is sell the USD they buy from exporters in the MEP / CCL market, so as to absorb the same amount of pesos they issued when buying the USD. This way, they would close the third tap of monetary issuance.

Since the BCRA buys at the official dollar and resells the USD afterward at the MEP / CCL, they keep the net difference in USD, taking advantage of the spread between these dollars. This way, they don't issue more pesos and keep accumulating some reserves (the net USD they keep, thanks to the difference between the purchase and sale price = the spread).

What is the problem?

That the BCRA is doing this arbitrage at the cost of exporters' effort, who they keep hurting by forcing them to liquidate their exports at a fictitious exchange rate.

What do they want to do? Lower the dollar price, generating supply in the MEP/CCL dollar market.

Obviously the market didn't like this. The BCRA is literally doing an arbitrage at the cost of exporters. But they were already doing this before... now at least they will withdraw the same amount of pesos they issue when they buy USD from exporters.

Is it the final solution? No. With this measure the government aims to lower the spread, but once they lower the spread they will stop accumulating reserves through this mechanism, since everything they buy from exporters they will have to liquidate at the MEP/CCL.

What does this tell us? That the freeing of the FX market is right around the corner!!

Neither Milei nor Caputo now set the accumulation of reserves as a condition to "lift the controls", because they know they will never gather reserves again.

Instead, what I think they will do is free the FX market. That is: exporters keep the USD they generate and importers buy their USD in the MEP / CCL market. Exporters will still have to liquidate part of their USD to cover peso expenses, and besides, if the dollar rises a lot they will be tempted to earn a rate in pesos. This means in the end the market balances itself.

This way the BCRA no longer loses reserves, nor does it have to issue to buy USD from exporters (which closes the third tap of monetary issuance). But besides, it is a measure that will hugely encourage exports, which will make them increase and therefore increase the export taxes the government collects, which in turn will allow it to pay USD debt more easily.

So, the only thing left to free the FX market is:

Those are the two conditions Milei said he needed to lift the controls, but in my humble opinion they aren't even necessary, because if you free the FX market:

The government had about 14 trillion pesos as a cushion, which it could have used if needed to pay the puts, but they preferred to buy USD and send them to the United States to guarantee payment of the hard-dollar sovereign bond maturities in January. It is not bad, because it is a sign of credibility and confidence, but they could have held onto those pesos to use in case a bank decided to exercise a put, thus solving the problem of having to issue pesos to pay the puts.

What are they waiting for? What they are waiting for, I think, is for the spread to finish falling, or at least narrow a bit. Remember: once the spread falls, the government automatically stops accumulating reserves, because there would no longer be a difference between the official and the MEP. So, the USD they buy from exporters they would then sell at the same price in the MEP/CCL market.

So if this happens, what would be the reason for the government to keep making exporters liquidate their exports against pesos?

The best thing they can do is get out of the way and that's it. The freeing of the FX market is THE driver the market is waiting for. Once that happens, Argentine assets should rise very sharply. The important thing is to get the Central Bank out of the middle. The BCRA will never gather reserves if it forces exporters to liquidate at the official dollar minus export taxes, and on top of that has to sell to importers at a subsidized exchange rate vs the market (MEP or CCL). That is: there are far more incentives to import than to export. As long as this continues, the BCRA will never be able to gather enough reserves to "lift the controls".

I put that last part in quotes because in reality "lifting the controls" implies you will be able to buy USD from the BCRA again at the price they tell you. For me, what has to be done and what Milei aims at is to "free the FX market", which is not the same as lifting the controls.

If the BCRA has no USD then it will never be able to lift the controls, because it will never have enough USD to cover whatever demand there is. What has to be done is allow people to buy elsewhere, and not force exporters to liquidate their USD against pesos, much less at a fictitious exchange rate. This way Argentina dollarizes on its own.

Once the three sources of monetary issuance — to finance the deficit, to pay interest on the BCRA's debt and to buy USD — are eliminated, the monetary base will be fixed and the peso will have a fiscal and monetary anchor. That is: there will be neither deficit nor issuance. This is what guarantees the dollar won't go to the moon once they free the FX market.

On the contrary, if the amount of pesos stays fixed and more USD start coming into the economy, the peso could in fact strengthen. So gradually they will also lower the peso interest rate as they get results.

The Treasury will be able to keep collecting export taxes in USD, and with that it can pay the BCRA's USD debt (the famous debt to importers — today BOPREALES). The day they finish paying that debt, they will finally be able to eliminate the export taxes. If we add a tax simplification and reduction to that, Argentina will take off like never before.

This way:

Milei would thus fulfill his promise to dollarize the country, in an endogenous and natural way. The official dollar can keep being devalued at 2% monthly, in order to meet the USD-linked debt commitments the government and private parties have. Once it reaches the same level as the MEP/CCL, the official USD simply floats just like these other dollars, at exactly the same value. In the meantime, simply no one else is obliged to liquidate their exports at the official USD and no one else can access the official USD to pay for their imports. USD have to be traded freely in the market, without BCRA intervention.

Let's hope the government takes note of the market's reaction and frees the FX market as soon as possible. I think we are much closer to that than several analysts believe. It is just a matter of daring.

For those worried about the drops in Argentine assets, I remind you of something Templeton said:

"To buy when others are desperately trying to sell and to sell when others are buying with too much enthusiasm is the hardest thing. But it pays the greatest rewards."

And remember, the fact that stocks trade every day doesn't mean the VALUE of companies changes every day! My optimism is intact.

That's all for today, I hope you enjoyed it.

MB – 07/16/2024