The Argentina Cudgel of the Chilean Right – and the Banco Central de Chile

There exists a version of Goodwin’s law in Chile, which I have noticed in the national press and even in day to day conversations. The longer the conversation proceeds, and the more political it gets, someone will invariably invoke Argentina or Venezuela to argue against your point. This is done in the same manner and for the same reason employed by religious people when they bring god into an argument; it is a blunt force instrument to attempt to destroy the other side without really engaging with the argument itself.  For example, when you argue that the level of redistribution is low for a country with Chile’s GDP per capita, invariably you will be faced with having to respond to the Argentina/Venezuela accusation. This is not to say that Chilean politics, such as they are, entirely exclude the possibility of the Argentina/Venezuela outcome. It surely is possible. However, not all measures to reduce inequality and respond to the issues that Chile faces are a step in that direction. The right in Chile tries to use this argument whenever something that disturbs the status quo is proposed. By doing this, it weakens its own position, by overusing a rhetorical tool that should only be used when it is appropriate. You cry wolf enough times, you will be eaten by one! I dislike generalities, so here I will concentrate on one example; the current proposals, by the finance ministry, to allow the central bank the purchase of government debt from the secondary market. This is a reaction to two pieces of news I have seen circulating in Chilean media (here and the article below)

The central bank holds assets in its balance sheet. These assets mainly comprise government debt, foreign reserves and loans to private banks (good summary here). What assets does BCCH hold? Well, they are pretty transparent and good at their job, so you can find their numbers online. Here is a snapshot of their balance sheet. It seems like they mostly hold international reserves, I am not sure if this is intentional or they are constrained by law, although I suspect it is the latter. So I looked around and tried to see how this composition compares to a country like Canada. Why Canada? Well because Canada is also a small open economy that is very sensitive to its exchange rate, just like Chile. Here are the Canadian numbers. As you can see, the Bank of Canada holds a lot more government bonds as a percentage of its total assets (in fact it is their largest holding). It also holds US Treasuries for the same reason BCCH holds foreign reserves, as an insurance against big fluctuations in the exchange rate. Why does the Bank of Canada hold Canadian government bonds? Well it allows it to manage its Open Market Operations (OMO), which is to say it allows it to increase/decrease the money supply when it wants to. This leaves me with two questions; 1. How does the BCCH manage its OMO and 2. where does it purchase the government bonds from

The answer to the first question may be a bit complicated, but it seems to me that BCCH issues debt to do this. If you look under the liabilities, you will see that BCCH has a lot of debt outstanding. So the BCCH performs its OMO using either foreign currency reserves or by issuing its own debt. (see here for an old comparison with other emerging markets). Again, I am not sure why this is so in Chile. My suspicion is that given we’re in LATAM, people are afraid of central banks becoming reckless, so they put restrictions on what they can use as assets. A central bank can behave recklessly by directly purchasing government debt, thus financing government spending by printing money. This is dangerous (and has happened before in  - you guessed it – Argentina and Venezuela). If central banks are run by political hacks rather than people who want to keep prices stable, they can go berserk and ruin an entire country in a couple of years. This is why Argentines are so good at calculating exchange rates in their head, it is a survival skill, a silver lining to an otherwise destructive phenomenon.

So the BCCH is limited in the range of instruments it uses as assets to manage OMO. Maybe someone more versed in Chilean law can tell me exactly what the law prohibits. In Canada, for example, as the link cited above illustrates, the central bank (the Bank of Canada) holds a lot of Canadian government bonds. Reading the article cited above, it is difficult to understand what exactly is supposed to make Chile like Argentina. Is it that the central bank is buying government bonds? Well, that is common practice for most central banks around the world, and not only the FED as the author claims. Is it that the central bank is buying them in the secondary market? Well, that too seems to be a pretty common response to the Covid crisis. Canada, NZ, Australia all have announced bond purchases in the secondary market. Let’s explore this a bit further.

The question that I had prior to writing this post was; where does the BCCH buy the (few) government bonds that it holds as assets? This is not a simple question to answer in the case of Chile, but, for the FED for example, they seem to purchase them from primary dealers. See here for a nice historical perspective. So why did central banks announce they will purchase directly from the secondary market? Most probably because the current crisis requires them to hold a LOT of assets on their balance sheet, in order to counterbalance all of that money they’re about to print. This is one of those crises where the central bank will have to play a very central role in the provision of liquidity and monetary stimulus. Primary dealers probably do not have the capacity to satisfy this buying binge, so the central banks are going directly to the secondary market (not buying them directly from the government).

Can the BCCH do this through buying the assets it usually buys (dollar reserves and issuing debt)? Well, purchasing dollar reserves when the dollar is at the highest it has been in a long time seems difficult given that everyone is trying to do the same thing (although they are probably doing some of that), repurchasing its own debt (to increase money supply) also seems like a bad idea given that a lot of the financial actors probably use those in lieu of cash and retiring them from the market would reduce rather than increase liquidity. So the BCCH has to purchase government bonds to confront the unprecedented crisis that it faces. Where should it buy those bonds? Well, it decided, just like in the case of Canada, Australia and NZ, to buy them from the open (secondary) market, which is where those bonds are sold by people who already have purchased them (from the government or some other entity). This is a reasonable move, the BCCH is NOT monetizing debt directly, it is just beefing up its assets so that it can do the monetary policy it has to do in these difficult times.

Is there a risk of coordination between the government and the BCCH so that the latter ends up monetizing debt? Well, this is always a risk, in any country. In some future with a more populist government, they can install political “advisors” on the board and thus push the BCCH to coordinate secondary market purchases with government debt issues. This is always a risk, not just in Chile. There are voices in Chile that want to “democratize” the central bank (whatever that gobbledigook means). But so far, there seems to be no indication that this is a real risk in Chile. Any country that gives more freedom to its central bank takes these risks, but a central bank that is not allowed enough freedom to perform its duties is a crippled central bank. And the BCCH has been a responsible and serious institution so far. It hires well, it is run by people who understand their role and fanatically guard its independence. In fact, if most Chileans agree on anything, it is that the BCCH is the most trusted institution the country has to offer. So what exactly is the path to Argentina that we are being scared with? It seems like a knee jerk reaction from an old guard that thinks the BCCH is an immature child, when there is zero evidence to suggest that, and plenty of evidence to suggest the opposite. Furthermore, if the scenario described above ever happens, and political hacks take over the CB, it can do the same amount of damage without resorting to directly purchasing government debt (see for example this sneaky monetization in Argentina). The perceived costs of this move are low, its benefits are large. In the end, making these arguments is a bit retrograde and alarmist, and really serves no purpose but to argue against an institution that has done and continues to do its job well. I would suggest leaving the BCCH alone, it may be the only adult in the room in this country.

PS: I am not an expert on this, and I am willing to be corrected on most of the details of what I have discussed. I am new to the details of central banking so this is a learning process for me as well. There are people in Chile who know much more about this than I do. I just wanted to make the point that the latest move is only trying to bring the BCCH in line with the rest, and the alarmism I see seems over the top.