How credit expansion led to contraction due to high interest rates and rising reserve requirements

Starting from a country that had broken its currency and credit system, consolidating public accounts was a necessary condition to turn off the tap of monetary financing of the deficit and begin to straighten out the bankrupt Central Bank's balance sheet , after years of abusing monetary financing.

However, given the inherited debt stock (that of the Central Bank and that of the Treasury), fiscal consolidation is not sufficient to ensure the disappearance of fiscal dominance (which occurs when the government's fiscal policy regarding public spending or debt limits or determines the Central Bank's monetary policy decisions).

Transferring the debt from the Central Bank to the Treasury is useless if country risk doesn't plummet and the Treasury can't put together a financial program to refinance principal and interest maturities (which, remember, aren't recorded in the statistics) at interest rates that don't ultimately derail the economy.

The decision to lift the currency controls in mid-April 2025, as part of the agreement with the IMF, complicated the government's strategy of remonetizing (paying in cash with the issuance of pesos) part of the interest.

What the economic team called the ANKER point , or the influx of pesos into the market due to debt renewal below maturity , was what financed the strong expansion of credit to the private sector when the Central Bank stopped buying dollars.

This was financed with the pesos the Treasury obtained from the "cleanup" of the Central Bank's interest-bearing liabilities. The same pesos the Central Bank had withdrawn from the economy in an attempt to limit inflationary pressures resulting from monetary financing of the deficit became the Treasury's (along with the debt). The Treasury conveniently used them to pay part of the interest due on the peso-denominated debt in cash and, in the process, prevent the debt, measured in dollars, from rising with interest rates that exceeded the dollar's rise.

Although the currency controls were lifted only for individuals and not for businesses, the economy is strictly operating without an exchange rate gap due to the arbitrage (rulo) between the official dollar and the Contado Con Liquidación (Contact with Settlement). This arbitrage is financed by an external asset formation (FAE) that accumulated US$9.6 billion as of June, of which only 18% remained in the financial system. All this in an economy where the current account deficit was projected to close 2025 at 2% of GDP, or US$14 billion.

Without the currency controls, the adjustment valve shifted from the exchange rate gap to the official dollar; while the decoupling between domestic rates and global bond rates disappeared, with country risk remaining unchanged and currently at 711 basis points.

The decision to dismantle the Lefis, announced on June 9 and implemented on July 10, sent shockwaves through domestic interest rates. Eliminating the banks' liquidity instrument added volatility to a system that was already beginning to operate with positive real interest rates and coordinated a change in the composition of Treasury debt (due to the dismantling of the Lefis), a new spike in interest rates , and a dangerous concentration of maturities that the economic team (Treasury and BCRA) is still trying to address with a very different logic than the prevailing one.

It's no longer celebrating the ANKER point: now it's raising reserves , seeking to prevent free pesos from flowing into the dollar and pushing it closer to the band's ceiling.

In Thursday's auction, the Treasury refinanced only 61% of the 15 trillion pesos that were due, so when the auction is held next Monday, 6 trillion pesos would be released into the economy.

The Central Bank has already announced that it will withdraw these reserves from the economy via a new increase in reserve requirements , although this time they will be remunerated. It announced that these can be integrated with bonds, those from the last auction and/or those arising from a new off-calendar auction that it announced via X. At the time of this report, the Monetary Base stood at $42.7 trillion , of which $18.8 trillion are reserve requirements. 30 days ago, the Monetary Base stood at $33.1 trillion and reserve requirements at $9.4 trillion ; practically the entire dismantling of the Lefi ended in reserve requirements.

With the monetary squeeze from the increase in reserve requirements, equivalent to 8% of deposits, liquidity disappeared , and bank rates that averaged 30% before the dismantling of the LEFIs jumped to nearly 70% during the week.

Overreaction and rate volatility have at least three effects on the scheme:

Without de facto restrictions, the economic framework is more similar to that of the second agreement with the IMF, which began in August 2018 , where fiscal and monetary policy were both very contractionary in a context of enormous external asset formation: "Zero deficit, zero growth of the monetary base."

There was then one year left until the 2019 presidential PASO elections, the exchange rate was 30% higher, the Lebacs had been encapsulated in the Leliqs held only by banks, the current account deficit was beginning to adjust at an accelerated pace even with the drought, and US$42 billion was still pending from the agreement signed with the IMF (of which only US$30 billion actually came in).

It is true that today's primary fiscal surplus of 1.6% of GDP contrasts with a deficit of 2.3% of GDP in 2018 (1.5 percentage points lower than in 2017), and the focus, as then, is on reopening the capital account after the election results.

The end is then known.

For this to be different this time, even with a good election result, the economic program will require a new reset with a dollar-interest rate balance that doesn't end up crippling economic activity. However, the immediate question is how we approach the September 7 elections in the province of Buenos Aires and the October 26 elections nationwide.