Domingo Cavallo anticipated the future of the dollar in 2025 and what will happen after the exit from the clamps

In his personal blog, the former Minister of Economy assured that the exit from the clamp will imply a jump in the dollar, but "it does not have to be inflationary"

In his personal blog, the former Minister of Economy said that its elimination could consolidate monetary and exchange rate stability in Argentina

Former Economy Minister Domingo Cavallo once again analyzed the situation of the dollar in Argentina and anticipated a possible exchange rate jump in 2025.

His statements, published on his blog in an article entitled "Getting out of the stocks does not have to be inflationary", generated a stir in the economic and political sphere.

Leaving the Stocks does not have to be inflationary

The government has been winning the battle against inflation. The challenge is to win the war.  The government's success in the fight against inflation has its fundamental origin in fiscal adjustment and the elimination of monetary issuance that was due to the fiscal deficit, but control of the exchange rate and the reduction of the gap also played and will continue to play a fundamental role. Both the president and the economy minister suggest that the pace of the crawl can be reduced to 1% per month and finally to 0%, that is, converge to a fixed exchange rate that would lead to the total elimination of what they call inflation induced by the exchange rate adjustment.

Those who bet on the final success of this stabilization strategy and rule out a future devaluation jump are confident that in the medium term the increase in hydrocarbon and mining exports, as well as the productive results of the investments induced by the RIGI will make the exchange rate at the end of the stabilization process sustainable and will not need additional adjustments and that,  as a bridge to reach this situation, there will be the eventual resources provided by the IMF in a future program and eventual access to the capital market when the country risk rate pierces the barrier of 400 basis points.

I argued in January 2024, as soon as the initial measures of President Milei's government were announced, that 'to eliminate inflation, the most important thing will be to avoid a new jump in the price of the dollar before it is in a position to fully unify and liberalize the foreign exchange market'.  The government is cautious about the possibility of eliminating the clamp precisely for fear of an exchange rate jump and its impact on inflation.

In this post I argue that when the complete elimination of the clamp is decided, there will surely be a jump in the exchange rate, but this does not mean that the disinflation process will be interrupted but, on the contrary, it may mean the consolidation of monetary and exchange rate stability.

As a counterweight to a possible exchange rate jump, the complete elimination of the clamp would lead to a greater reduction in country risk, facilitating access to financing to face the principal maturities of the debt in dollars. At the same time, it will help to ensure that there are favorable balances in the trade balance to facilitate the Treasury's access to buy, with the pesos of its primary fiscal surplus, the dollars it needs to meet the payment of the interest on that debt.

The government, instead of postponing the elimination of the clamp until after the elections, in my opinion should seriously consider its elimination in the first months of next year, to reach the election with the economy stabilized and reactivated and in a clear process of growth through investment and increased productivity.

What is the role of the exchange clamp in the disinflation process?

The so-called exchange clamp is made up of many restrictions on the legal purchase and sale of foreign currencies (for simplicity we are going to refer to one currency, the dollar). The restrictions of the traditional exchange control, which have been applied in many economies at different stages of their economic history, are: a) those that oblige exporters to sell to the Central Bank, within maximum periods defined by the regulations, the dollars that these operations generate and b) those that limit importers' access to the dollars that they must disburse,  both in quantity and in the minimum payment deferral period Theoretically, these controls allow the Central Bank to determine the exchange rate (fix or adjust it at will) and, with certain limitations, achieve quantitative targets for the accumulation of reserves. In essence, it is about the control of price and quantity in the foreign exchange market, something that is not easy to maintain for long periods of time without generating evasion mechanisms that feed a parallel market, black, blue or whatever you want to call it.

As a palliative, in order to also control the gap between the parallel market and the exchange rate managed by the Central Bank, operations for the purchase and sale of financial dollars are allowed, but they are also subject to interventions and regulation by the Central Bank that restrict their operation and affect their price. Those who can open an account in dollars within the Argentine financial system and have the necessary pesos to pay them, can buy the stock exchange dollar (MEP) which, except for cash withdrawal, for payments abroad are subject to all exchange control restrictions. Cash settlement operations (CCL) in the bond market allow payments and collections abroad. But those who, due to their export and import activities, or even financial operations, need access to the official exchange market managed by the Central Bank are not allowed to operate in the CCL.

In short, all these restrictions and exchange controls allow the government to manage the exchange rate and the gap with pseudo-free markets. This leads Central Bank officials and, for the moment, most private sector financial operators, to believe that a devaluation jump can be avoided, even if the private sector operating in the real economy complains about the so-called "exchange rate delay" and the increase in costs in dollars.

The dynamics of inflation

The inflation rate published by INDEC for the month of October was 2.7%, a significant drop in relation to the 3.5% of the month of September and just over the 4% average for the months of May to August, but the early data for the month of November anticipate that the monthly inflation rate will probably return to above 3% per month. This can be seen in Table 1, which compares the rates published by INDEC and the trend marked by the data prepared by Alberto Cavallo based on online observations.

The average rate of online prices, which was 2.2% in October, is climbing to 2.9% in November. If the same increase were to occur for the inflation rate measured by INDEC, it would have to increase from 2.7% in October to 3.4% in November. Some indications from the last days of November (for example, the increase in the price of meat), anticipate that there will also be a trend of increase in December.

This persistence of the inflation rate in the range of 3 to 4% per month should not be surprising when the monetary aggregates M2 and bank credit to the private sector have been increasing at rates of 7% and 14% per month respectively since May.

For the moment, the future dollar market seems to validate expectations that the government will succeed in controlling the exchange rate during 2025 with the crawl at the pace it has been announcing. The reduction of the gap between the CCL and the exchange rate set by the Central Bank helps to consolidate this expectation. The key to success is to prevent financial operators from beginning to anticipate a post-election exchange rate jump. To do this, contrary to what some believe, it is important to eliminate the clamp as soon as possible.  The sooner the clamp is eliminated, the better the monetary system will work with currency competition because the dollar will be able to fulfill not only the role of currency for commercial transactions but also as a vehicle for savings to finance the investment of all types of companies. In particular, those that cannot benefit from the RIGI regime.

Arguments that feed the expectation of an exchange rate jump at the time of market unification and liberalization

It is likely that by eliminating the clamps, the exchange rate will increase. In addition to the argument about the appreciation of the peso in the official market (exchange rate delay), which can be aggravated by the devaluation of the Brazilian real and the strengthening of the dollar due to measures adopted by the Trump administration, there are other arguments to predict an exchange rate jump at the time of market unification and liberalization. The main argument is that the gap between the price in the MEP and CCL markets and the price set by the Central Bank is not realistic, because the regulations do not allow dividends and royalties to be remitted to companies that must necessarily operate in the MULC and the access of individuals and companies to the MEP is also severely restricted. It is argued that the unification of the foreign exchange market should be done while maintaining restrictions on the remittance of dividends and payment of royalties, but if this happens, capital inflows will be discouraged.

Exchange rate stability after reunification can only be maintained if the supervening exchange rate stabilizes without the Central Bank selling reserves. On the contrary, stability will be consolidated if the Central Bank accumulates reserves without causing additional depreciation of the peso. For this to happen, capital inflows need to be encouraged. If capital inflows are vigorous, the Central Bank will be able to buy reserves and allow the appreciation of the peso that will automatically reverse any increase in the inflation rate that follows an exchange rate jump. This is the typical phenomenon of stabilization plans with free movement of capital.

That there is no restriction on the purchase and sale of foreign currencies is an essential requirement for the economy to function with competition from Peruvian-style currencies. This is the monetary system that President Milei has been talking about. On the other hand, if exchange rate stability is achieved with competition from Peruvian-style currencies, the economy will be able to function with less rigidity than with complete dollarization or convertibility with a fixed exchange rate.

How would the exchange and monetary system of currency competition (Peruvian-style) work?

Banks will receive deposits in all types of accounts in both pesos and dollars and the Central Bank will control the expansion of bank credit in each of the two currencies with the same instruments: mandatory legal reserve requirements (which may be different) and open market operations with bonds in pesos and dollars to regulate the interest rate in the two currencies.

The stability of prices in the economy will require that the peso does not tend to depreciate, even if it suffers transitory fluctuations. When external shocks demand depreciation of the peso, the Central Bank may limit that depreciation not only by selling reserves but also by increasing the legal reserve requirement for deposits in pesos, decreasing the reserve requirement for deposits in dollars, and conducting open market operations that increase interest rates in pesos and lower rates in dollars.

The management of reserve requirements and open market operations will allow the sale of reserves necessary to stabilize the peso to be limited. When external shocks lead to the appreciation of the peso, the Central Bank will be able to take advantage of it to increase its level of reserves. It will also be able to handle reserve requirements and open market operations in the opposite direction to the aforementioned to curb the depreciation of the peso.

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