Central bank governor of the year 2004: Alfonso Prat-Gay

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By:
Felix Salmon
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In 20 months as governor, Alfonso Prat-Gay built a credible central bank from almost nothing, managed the money supply brilliantly, oversaw currency stability, kept rates low and even began whipping the banking sector into shape. For these achievements, he is Euromoney's central bank governor of the year. But he also strove for greater independence for the central bank. Now, on the eve of the country's crucial bond exchange, president Nestor Kirchner has chosen to dispense with Argentina's most internationally respected policymaker.

Argentina ditches its respected central bank governor on eve of crucial bond exchange


THIS YEAR, FOR the first time ever, Euromoney will present its award for central bank governor of the year to someone who isn't a central bank governor. At the end of September, just two weeks before the IMF/World Bank meetings, the mandate of Argentina's Alfonso Prat-Gay came to an end and president Nestor Kirchner did not renew it.

By Argentine standards, Prat-Gay had a good term at the central bank. As he himself notes: "Twenty months in the job puts me in the top 13 in terms of duration. Thirty-five of my predecessors didn't make it this far."

Nevertheless, the abrupt decision not to reappoint him for a second term came as a complete surprise. There was certainly no hint that he was doing a bad job: his peers have nothing but praise for him, and there was no scandal associated with his departure. "It violates the spirit of the charter," says Siobhan Manning, Latin America strategist at Caboto. "You're supposed to reappoint these guys unless there's some egregious defect."

There was no egregious defect. Euromoney outlines the many successes of Prat-Gay's tenure below. Analysts say that if Prat-Gay had any defect at all, it was to refuse to sign on to the unorthodox economic plan of the Argentine government. It was well known that Prat-Gay cherished his independence, and was demanding some say in the composition of the bank's board of directors.

"Alfonso felt that to build the credibility of the institution, he needed a more independent board, while the government wanted to stress the commonalities with the finance ministry," says David Sekiguchi, chief emerging markets economist at Deutsche Bank.

Kirchner "preserving policies"

Prat-Gay, it is generally understood, has serious misgivings about the way that the government is approaching its crucial debt restructuring, and wanted to ensure that the central bank was as far removed as possible from the policies of Kirchner and his finance minister, Roberto Lavagna.

Kirchner, on the other hand, might have become frustrated that the head of his central bank was widely known to oppose central tenets of his administration's economic philosophy. When Prat-Gay's mandate came to an end, Kirchner replaced him with Martin Redrado, the deputy foreign minister, a man most analysts consider unlikely to assert much in the way of independence.

President Kirchner is understandably keen to play down any notion of profound disagreements over policy. He told a lunch gathering of the Council of the Americas in New York on September 22: "The change at the central bank is because the term of the current officials and governor of the central bank is ending on September 23. We are fully supporting Argentina's institutional development. All we have done is to change an official in order to preserve policies, because the current governor didn't want to stay on. We hope that Dr Redrado will act along the same lines."

"The government wanted to have more of a party line," says Jennifer Satz, Argentina analyst at the Eurasia Group. "Kirchner doesn't like to be contradicted."

Prat-Gay himself, choosing his words carefully, says that "basically the president and I have different views of what the role of the central bank should be".

The disagreement was not about monetary policy: there is every expectation that Redrado will pick up where Prat-Gay left off, and continue to follow a path of low inflation with a weak peso.

Rather, the difference was more philosophical, about the degree of independence that a central bank should have. Mohamed El-Erian, emerging market fund manager at Pimco, sees two systems emerging in Latin America. In countries like Mexico and Chile the governments take pains to strengthen and respect institutions in general, continually increasing central bank autonomy specifically. In countries like Venezuela, on the other hand, "institutions become part of the political process", he says. "In Argentina, there is a conflict between economic necessities and political realities."

Consolidating political power

Kirchner is certainly at a point in his administration where he is feeling it necessary to consolidate political power. Railing at foreign creditors and the IMF can't keep his popularity at high levels for ever, especially when the economic rebound starts, as is inevitable, to slow down a little.

Recently, Kirchner has been patching up his relationship with Peronist party heavyweight and former president Eduardo Duhalde. Finance minister Lavagna is a hold-over from the Duhalde administration, and, says Satz, "Redrado is a Duhalde man and will play by their rules". Expect many fewer objections from Redrado than from Prat-Gay, for instance, to Lavagna's plan to pay down Argentina's IMF debts out of central bank reserves rather than tax revenues.

If there is any upside to this, at least in the short term, it is in having the central bank governor and finance minister clearly singing from the same songbook during what is likely to be one of the most crucial episodes in Argentine economic history – the debt exchange offer.

In the medium term, however, says Lacey Gallagher, Latin America analyst at Credit Suisse First Boston, "this solidifies the prospect that the central bank will remain under the control of the ministry of economy and Kirchner". She adds: "Prat-Gay got fired because he was trying to be independent."

Yet Prat-Gay did achieve a lot in his short time in office: to see that, one has only to look at the reaction of the markets to his removal.

Market reaction

The peso and the bond markets sold off when the news was announced on Friday September 17, but by Monday afternoon they were basically back to where they started. In a mere 20 months, Prat-Gay had evidently succeeded in building an institution that was stronger than himself personally, and in which the markets had a large degree of faith. That's unprecedented in recent Argentine history, and only serves to confirm Euromoney's decision to give Prat-Gay the central banker of the year award.

There was even a short handover period, in which Prat-Gay held meetings with his successor – something that would be a matter of course in most economies but which has never, to Prat-Gay's knowledge, happened at Argentina's central bank.

Yet for all that markets have remained stable and the central bank remains a solid institution thanks to Prat-Gay's hard work over the past 20 months, the outlook is not entirely rosy. Prat-Gay, a universally admired technocrat and economist, is being replaced by Redrado, a politician whose MA is in public administration. "Redrado is not a hardcore economist," says Deutsche's Sekiguchi. "He's an able professional, but Alfonso was very strong in terms of macroeconomic policy. Redrado's strengths are more as a politician."

Argentina has a fair number of well-known good economists, but with the departure of Prat-Gay, none of them, any longer, are in the public sector – maybe it's simply unfortunate that none seems to have the political skills to survive in it.

"What Prat-Gay did was beneficial to the financial system, and he was the one who had gained the most respect in terms of Argentina's standing in the outside world. He would have been very useful in terms of helping Argentina normalize its financial relationships," says El-Erian. "Is this a setback for Argentina as a whole? Yes, it is."

There is no doubt, however, that what Prat-Gay has already achieved has been wonderful for Argentina. "It feels awkward, but I'm in peace," he says. "I know the machinery is geared in the right direction."

Award winner

The Euromoney award for central bank governor of the year is prestigious precisely because it is an apples-to-apples comparison. No matter where in the world, the central bank controls monetary policy, manages the currency, and regulates the banking system, and whoever does that best gets the award.

This year, however, is a little bit different. Alfonso Prat-Gay, the departing 38-year-old governor of Argentina's central bank, has overseen a banking system that is barely profitable and is, to boot, insolvent. Monetary policy, too, is a work in progress: Argentina's central bank has only recently begun to develop the tools needed to even measure how the economy is doing, let alone actually influence growth and inflation through setting benchmark interest rates.

To be sure, insofar as Prat-Gay did these things, he did them extremely well. At the beginning of 2003, early on in his tenure at the central bank, he stood up to the IMF, which was telling him that Argentina had a monetary overhang. Well, we might, he replied diplomatically; on the other hand, we might not – no-one really knows for sure. Let's wait a few months to find out before embarking on a series of actions that could seriously damage the nascent economic recovery.

Prat-Gay took the view that Argentina is unique, and indicators such as the sheer amount of liquidity in the system did not necessarily mean the same thing there as they would anywhere else. "My example was Japan," he says: "Argentina knew deflation, and Japan's monetary base was growing 30% a year with deflation."

Normally, in a recovery, the monetary base grows quite quickly of its own accord: the central bank's job is to manage the expansion of liquidity that comes along with a rise in credit. In Argentina, by contrast, the banks were still a long way from lending money again, and any increase in the money supply would probably have to come from the central bank directly.

So Prat-Gay kept the monetary reins loose. You go with your conviction, he told the IMF, I'll go with my pragmatism. Inflation continued its precipitous decline, and, he says, "after three or four months, as reality proved us right, the IMF was eager to let us run the show".

It was not the first time that Prat-Gay had found himself running against textbook economics. "He was quite heterodox for a mainstream economist, even though he knew orthodox economics very, very well," says a former colleague at JP Morgan, where he was an economist covering Argentina from 1994 to 1998.

Prat-Gay took that job as Argentina was entering a recession, and differed from most of Wall Street in not considering the country's fiscal situation to be much of a problem. "When it comes to Argentina, there has been a significant misunderstanding of what happened and why it happened," he says. "The main problem in the 1990s was that the currency regime was unsustainable. My view was that the time to worry about the deficit was in '96-97, when the economy was firing on all cylinders. In the middle of the recession, I would have loosened the fiscal screws."

Dream-team policy mix

He hasn't changed his tune. He still thinks that emerging-market economies should have exactly the same toolbox available to them as developed countries. "The primary surplus right now is higher than it should be," he says. "More is not necessarily better."

Nevertheless, Prat Gay is intensely proud of where Argentina is right now. "We've got fiscal discipline like we've never had it, we've got the lowest interest rates ever, and we've got a competitive, floating currency. It's the 'dream team' policy mix," he says.

Argentina, of course, had none of these things for most of the past few decades. When Domingo Cavallo and Carlos Menem finally dragged the country out of its hyperinflationary death-spiral, they did so only by implementing a suicidal currency-board regime. The peso was pegged one-to-one to the dollar, the country became a capital-markets darling, and the government continued to borrow heavily even during periods of strong economic growth.

So when the currency board finally collapsed at the end of 2001, Argentina had a history of nightmarish fiscal policy, and no recent history of any monetary or exchange-rate policy at all. The central bank still physically existed but had barely a trace of an institutional memory of how to do its job. Moreover, even back in the days when it was doing a job, it did it extremely badly. Argentina had never in living memory had both monetary policy and low inflation. It had monetary policy during hyperinflation, and when it had low inflation it was dollarized, so monetary policy was set by the US Federal Reserve.

Prat-Gay became central bank governor at the end of 2002. Many people tried their hands at the job before him and also found it to be a poisoned chalice. After just over a year and a half in the job, Prat-Gay was surprisingly dropped. But by then he had already outlasted 35 of his predecessors. "Lasting 20 months into the job puts me in the top 13 central bank governors in terms of longevity," he notes.

Dropping him may suit the short-term political requirement for unity but still prove to be a mistake. Even Argentina's most adamant foes respected him. Hans Humes, co-chair of the Global Committee of Argentina Bondholders, considered him a responsible person, doing a good job at the central bank, and "one of the stronger members of the Kirchner administration".

More important, he produced extremely impressive results. The currency is stable, the banking system is profitable, and interest rates are now even lower than they were when they were essentially being set by the Fed. For the first time in living memory, the Argentine central bank is a strong, internationally respected institution.

The contrast is striking: when Prat-Gay arrived, along with trusted lieutenant Pedro Lacoste as vice-president, there was almost nothing to the central bank – it didn't even have a research department.

"Someone was asking me recently how do you compare your job with that of your colleagues in other central banks," Prat-Gay recalls. "And you can't really compare it, because in most places you start off at a particular level, while in our case you start off from scratch. Which made it really exciting."

Prat-Gay, then, had any number of demanding jobs to do simultaneously. He had to build and staff the central bank itself while managing Argentina's money supply, keeping an eye on its currency, and trying to whip its banking sector into shape.

Prat-Gay had a more or less impossible task on his hands when he inherited the disaster zone that was Argentina's banking system. The banks, of course, had been asymmetrically pesified: their dollar-denominated assets had been converted to pesos at a much lower rate than their dollar-denominated liabilities, and they were all insolvent.

Normally, after such an intense crisis, the IMF will step in to help out, or the government will help pay for the central bank to close or take over failing banks. In this case, however, the Fund had finally closed the taps, and there was simply no way that Argentina could afford to take on the banking system's enormous liabilities.

"The central bank's role has been very important, and they have been professional," says David Sekiguchi, global head of emerging markets strategy at Deutsche Bank. "The question is whether they could have done more, and closed more banks. That would have been good if there were the conditions for a sustainable financial industry from now on. But given the macro framework, they did the only thing they could have done."

Prat-Gay's approach to the banking sector was both optimistic and realistic. First of all, he decided, contrary to initial appearances, that Argentina was not overbanked. "This was more about creating more businesses, rather than closing more banks," he says. "It was not that we had too many banks, rather too few businesses." If Argentina's 100 banks could adapt to Prat-Gay's new rulebook, they would stay alive. (Prat-Gay notes that although 100 banks seems to be a lot, in fact it's only half the number of banks that Argentina had in 1995.)

Recapitalizing banks with retained earnings

Given the fact that neither the international financial institutions nor the Argentine government showed any inclination towards funding a bank bailout, the only way that Argentina's banks could be recapitalized would be slowly, over time, through retained earnings. Then, if profits started picking up, new or existing shareholders might be persuaded to add some more capital of their own.

Profits have, indeed, appeared: an impressive feat considering that the banking system as a whole posted an astonishing –11% return on assets in the first half of 2002, and a –7% return on assets in the second half. Now, however, those numbers have turned positive.

Already, says Prat-Gay, "a number of provincial governments are keen on recapitalizing their banks", and shareholders' equity in Argentine banks has been rising. It now stands at about Ps22 billion ($7.3 billion), of which about Ps8 billion entered the system after the 2001 crisis, through new investment or debt-for-equity swaps.

It will be a long time before it's clear whether the plan has really worked but in many ways Prat-Gay didn't have much of a choice. The banks are still insolvent but for most of his tenure they have been awash in liquidity, and they are even, slowly, starting to move into profitability. Certainly the stock market has given him its vote of confidence: Prat-Gay notes that "most analysts in early 2003 were competing to give the biggest negative net worth numbers for the financial system, but the market was going in a different direction, with bank stocks up two or three times last year".

Prat-Gay's key aim was to persuade banks to start lending again. The old rules that made extending credit nightmarishly difficult were abolished, and he implemented a flat 8% capital adequacy ratio target for banks to meet. No longer would government debt be zero risk weighted: the banks could and should make their own decisions about whom to lend to.

Lending revives

Most banks still have capital adequacy ratios below 8%, and have exposure to the public sector above what the central bank is asking for. But so long as they can keep to a certain rate of improvement, Prat-Gay would be happy to let them continue operating.

And results are slowly trickling in, not just in terms of profits but, more important, in increased new lending.

Credit is growing, albeit from a very low base, at more than 35% a year, and there is really no ceiling to how far it can go: private-sector debt accounts for just 8% of GDP in Argentina, compared with 23% before the crisis, and 50% in Chile.

Total private-sector lending was Ps70 billion in 1998 ($70 billion at the time, or $23 billion at today's exchange rate), fell to a low of Ps26.5 billion in July 2003, and has now risen back to Ps31 billion.

And new credit is rising much more quickly than those numbers would indicate, since Argentines have been much keener than anybody expected to pay down their pre-crisis debts. Total mortgage debt, for instance, is still decreasing, despite the fact that banks are now offering 10-year peso-denominated mortgages at 10% interest – something that never existed pre-crisis.

Falling interest rates, more than rising credit, are the signal achievement of Prat-Gay's central bank. When he took office, the longest tenor debt that the central bank could issue was six months, and that only at a rate of 52%. Today, the central bank issues out as far as three years, and the last time that six-month paper was issued, it yielded just 2.5%.

Prat-Gay recalls that when he arrived "we did not have monetary policy instruments, we did not have credibility, and we had competition, in the form of quasi-legal tender issued by many provinces: we didn't even have a monopoly on money creation."

In the wake of the crisis, cash-strapped provinces – and even the central government – took to paying their bills by issuing quasi-currencies, or scrip, with names like patacones. Some Ps7.5 billion-worth of this paper was in circulation when Prat-Gay took office, compared with Ps20 billion in official pesos: all of it had to be bought back before the central bank had real control over the money supply.

Even after that, however, Prat-Gay's job was hardly easy. "How do we run monetary policy with inflation expectations at 40% and the IMF telling the world we had a monetary overhang – with no instruments and no policy?" he asks.

Prat-Gay needed an anchor of some description, and he was determined not to follow the disastrous precedent of the previous decade and give that role to the peso. Moreover, there was so little credit in the economy that trying to set interest rates would have had very little effect. Instead, after he had unfrozen the deposits in the banking system, he came up with a series of targets for the monetary base – all of which he met.

One year later, in mid-2004, he says: "We have made progress on inflation expectations and interest rates; we've gained credibility. It's time to move to an interest-rate benchmark."

The central bank has now opened a repo window in the money market, where it absorbs the liquidity in the financial markets at a set interest rate of 2.5%. In repoing its own paper, the bank helps establish Lebacs – central bank notes – as a short-term benchmark. The move seems to be working: "Rates have now converged to that floor rate," says Prat-Gay, "and it is now gradually becoming a reference for the rest of the system."

In other words, Prat-Gay created an institution that is capable of doing the things that all other central banks have been able to do for years. "We still have a long way to go," he says, "and we don't believe in short cuts any more." The next big task, he says, is to dedollarize Argentina: "We have to go step by step in re-establishing the peso as the unit of account and store of value. That will take a long, long time."

Asked whether any country has ever successfully dedollarized, Prat-Gay pauses. "That's a good question," he says, eventually offering up the example of the US itself moving off the gold standard in the 1930s.

There are certainly large tasks ahead for the Argentine central bank and its new incoming governor Martin Redrado. Prat-Gay admits, he had the wind of larger macroeconomic forces behind him: high commodity prices, low global interest rates, and a strong cyclical rebound in the Argentine economy. From here on in, things could get a lot tougher – but at least Argentina will have stronger institutions with which to deal with any problems.

For that, Prat-Gay deserves a lot of credit. "He's done the absolutely right thing," says Mohamed El-Erian, who runs the emerging-market portfolio at Pimco. "He's run the interest-rate/exchange-rate nexus very well, he's slowly made progress on banking, and he's brought to the post an enormous amount of experience and prestige."

El-Erian is echoed by William Rhodes, vice-chairman of Citigroup. "Prat-Gay is a very intelligent and able person," he says. "He's well regarded both by the domestic financial community in Argentina and the international financial community. He presents a very positive face of Argentina to the world."

It remains to be seen whether the new governor can build on Prat-Gay's foundations and earn the same level of respect.