Argentina: economic transition full speed ahead
Opposition victory in the November 2015 Argentinian elections ended twelve years of Kirchnerism and set the stage for reforms to liberalize and open up the economy. The economic transition bodes well for economic growth in the longer term, but is mired with risks in the short term.
Strengths (+) and weaknesses (-)
(+) Competitive agricultural sector
Argentina has a well-developed and dynamic agricultural sector. The sector benefits from the good quality of the Argentine soil, a favourable climate and good access to sea transport.
(-) Large macroeconomic imbalances
Ultra-loose monetary and fiscal policies have caused huge macroeconomic distortions. Double digit inflation has led to a deterioration of the current account balance, which has eroded FX reserves.
(-) Volatile policy track record
Executive power is vested in the president and that has resulted in a history of volatile policy. The interventionist and erratic measures of the previous government have hurt investor confidence.
(-) Lack of access to external financing
Following the still disputed default of 2001, Argentina lacks good access to external financing. The technical default of 2014 restricts the sovereign’s use of international markets.
1. Opposition victory in the presidential elections bodes well for the business environment
Argentinians voted for change at the end of 2015 and that bodes well for the business environment, though there are implementation risks. The opposition victory in the presidential elections of November 2015 marked the end of 12 years of Kirchnerism. Mauricio Macri’s agenda for change bodes well for the business environment. Benefitting from the sweeping powers vested in the Argentinian presidency, including the ability to rule by decree, Mr Macri has taken bold steps to turn the corner on past political and economic policy. The new government seems to be frontloading reforms in order to benefit from the political capital gained during the elections and the political room available by congress being in recess. However, though Macri’s centre-right coalition Cambiemos consolidated its Congress representation during the elections, the peronist FPV still holds a simple majority in the chamber of deputies and absolute majority in the senate. That may hinder and even paralyse policy implementation once the Congress reconvenes in March. However, several factors reduce this risk: 1) President Macri’s collaborative approach and divisions within the FPV should increase his political leeway 2) provinces depend on federal finance and that creates scope for political negotiation with the senate and 3) the appointment of two Supreme Court judges through presidential decree reduces the risk of policy paralysis, though it also increases tensions with the FPV. In the longer term, Argentina’s trajectory could become less volatile if the current government succeeds in putting the basis for a more balanced executive power. Strengthening congress representation in the 2017 elections is an important milestone in that sense.
2. Normalizing the economy is a tough balancing act and not without risks
The new government has embarked on a bold reform agenda that should boost Argentina’s economic perspectives in the medium term, but the transition period is not without risks. Years of loose fiscal and monetary policies and heavy state intervention have left the economy in disarray. The macroeconomic imbalances that need to be corrected are huge: a stagflationary economy, a large budget deficit reliant on monetary financing, precarious levels of FX reserves, no access to international financing and unreliable statistics. Since taking office on 10 December the new government has taken resolute steps on the external, fiscal and monetary front to normalize and liberalize the economy. Given Argentina’s abundant agricultural and energy resources and a well-educated workforce, the investor confidence derived from this policy shift should lock in private investment that boosts economic growth in the medium term. However, given the magnitude of the adjustments we cannot exclude a disorderly economic transition. We find comfort in the fact that the government is proactively taking measures to reduce this tail risk.
One of the main risks is a balance of payments crisis, given the fact that FX reserves are at very low levels of USD 28bn or 4 month import cover in January 2016. Besides, imports are expected to soar as FX and import controls were lifted after roughly four years of suppression, and that will weigh on the import cover. Besides, public and private external debt due in 2016 is estimated at USD 13bn. However, measures taken by the government to protect and even bolster FX reserves provide some mitigation. First, they removed the currency peg so that a free floating peso can act as a first line of defence. The peso depreciated by 26% (figure 1) and should stimulate the sale of USD 4bn of soybeans hoarded by producers in anticipation of the depreciation, especially as the government also reduced export taxes on soy by 5ppts to 30% and agreed with producers to frontload sales. FX reserves have increased by USD6.53n since the implementation of these measures on 17 December, though the lion share of the increase was accounted by a USD 5bn one year loan the government closed with international banks on 29 January. Besides, the government has made an offer to litigating debtors from the 2001 default, also known as the holdouts. An agreement is crucial for reducing Argentina’s external balances risk, as it would resume the sovereign’s access to international markets. However, an agreement is uncertain as it requires congress approval, though it is positive that support for a resolution is reportedly high among legislators.
3. Policy correction full speed ahead, but social headwinds expected
High inflation and austerity measures inherent to government’s reform agenda could trigger social unrest. The government is planning to reduce the primary budget deficit to 4.8% of GDP, after it had deteriorated by almost 7ppts in the past five years to around 7.1% of GDP in 2015 (figure 2). Envisaged austerity measures are likely to increase discontent amongst the population. Against that background, spiralling inflation could spark widespread social backlash. Thus, it will be crucial for the government to contain salary increases during the upcoming negotiations. It is positive that the government has already taken steps to manage inflation and inflation expectations: tightening monetary policy, setting an inflation target of 30% for 2016, reaching tacit agreements with business to temper price increases in the short term and working with unions to manage expectations. Nevertheless, the risk persists as inflationary pressures will remain high on the back of the peso depreciation and a still expansionary and largely monetarily financed fiscal stance.
Argentina has experienced many political and macroeconomic crises. From the mid-1970s to the early 1980s, the country was under military rule, which ended when Argentina lost the Falklands war. In the 1980s, high inflation turned into hyperinflation. With a tight dollar peg introduced in 1991, the Menem government managed to bring inflation under control. However, in the late 1990s this peg left Argentina unable to deal with the combined impact of low commodity prices, an appreciating USD, substantial dollarization and pro-cyclical fiscal policies; the country was heading for a big economic, political and social crisis. In 2001/2002, Argentina had to abandon the peg and at the same time declared the biggest sovereign default in history. Argentina has been largely excluded from international financial markets ever since. Afterwards, the country managed to recover quickly and benefitted from the commodity boom. However, increasingly interventionist, ad-hoc and unsustainable policies during twelve years of Kirchnerism have led to large macroeconomic imbalances that the previous government contained by means of import, currency and capital controls. A new government took office in December 2015 and is trying to open up and normalize the economy but the transition is not without risks. Argentina’s institutions have remained weak and its politics are centred on persons, with party loyalty and, in particular, ideology playing a much smaller role. The country has a very dynamic and advanced agricultural sector, which accounts for 55% of total exports. Soybeans and soybean products are the most important agricultural export commodity and account for roughly one-third of Argentina’s exports. Manufacturing, largely accounted for by the automotive sector, is another important pillar of the economy. The most important export market for Argentina’s products is Brazil. With a nominal GDP of USD 13,874 per capita in 2015, Argentina remains one of the richest countries of Latin America.
Annex – main risks to Argentina’s smooth transition
A main scenario assumes a smooth economic transition away from the heavy state intervention, erratic policies and large macroeconomic imbalances as a result of loose macroeconomic policy seen in the past. Nevertheless there is a chance the following risks could materialize, so we summarise the main concerns (-) and mitigating factors (+).
1. Political gridlock that makes the country ungovernable
- (-) The Peronist FPV holds a simple majority in the chamber of deputies (117 out of 257 seats) and an absolute majority in the senate (42 out of 72 seats).
- (+/-) President Macri appointed 2 judges in the supreme court by presidential decree (de facto a reversal of a previous move by Christina), so the Supreme Court is now unlikely to sabotage the government economic policies. However, this move was rather controversial and it could strain the relationship with FPV members.
- (+/-) If the economic transition leads to high social discontent on the back of austerity measures and spiralling inflation, political capital is also likely to wane. A smooth economic transition could create leeway for the administration.
- (+) The FPV’s representation was diluted during the elections of October 2015. Reportedly more moderate FPV are questioning the course taken by Kristina Kirchners and might be willing to collaborate with the government on some issue. Support is said to be higher when it comes to resolving the technical default of 2014 by reaching an agreement with the holdouts.
- (+) FPV holds the governorship of a majority of provinces. However most provinces rely on federal income, and that creates scope for negotiating with the governors and implicit with the senate members. It is positive that the opposition got hold of the governorship of the Province of Buenos Aires for the first time in a long time. Macri has already been reaching out to governors and the government is reported to have plans to aid the various provinces with economic development.
- (+) Divisions within the FPV could bolster Macri’s political leeway. There have already been some FPV defections in the lower house. As the opposition is regrouping and in search of new leadership after last year’s elections, similar divisions could follow.
2. Social unrest
- (-) Argentina has a protest culture (and powerful unions) and a history of social unrest and even presidential resignations as a result of economic recession and high inflation. The current environment of high inflation and recession is thus conducive to social backlash
- (-) The government plans to reduce the budget deficit by roughly 2ppts. So far they have announced the intention to cut energy subsidy costs by introducing targeted subsidies and started restructuring the public sector. Such measures are likely to increase discontent.
- (-) Wage indexation following upcoming negotiations could spiral inflation. It is therefore very important for the government to manage inflation expectations ahead of March when the negotiations start.
- (-) Kristina Kirchner had high approval rates of 40% when she stepped down. Thus, it could turn easy for the FPV and/ or unions to mobilize the population against the government.
- (+/-) Inflation is likely to increase on the back of the peso depreciation and, despite consolidation, still expansionary fiscal policy. Besides the government will still rely heavily on monetary finance (they plan to finance roughly 50% of expenses through monetary financing). On the positive side, the government has agreed with companies to contain price increases as a result of depreciation until at least after the wage negotiations. Monetary policy tightening is also poised to reduce inflationary pressures.
- (+/-) The government has realigned monetary policy by shifting priority from the exchange rate to containing inflation. They have also announced they intend to reduce inflation to 3.5-6.5% in 2019. The target for 2016 (30%, compared to almost 30% last year) however seems fairly optimistic because of the pressures mentioned above.
- (+) Mari has a good track record with unions as he managed to avoid conflicts while heading the city of Buenos Aires.
3. Balance of payments crisis
- (-) FX reserves are very low, at USD 28bn excluding gold. Import cover is 4-5 months, but imports have been supressed through controls for the past 4 years. Thus, imports are likely to soar, though there will be a lag in this increase.
- (-) Argentina has restrictions (de facto prohibition) on issuing international debt as a result of a 2014 NY court ruling related to the 2001 default. Argentina needs to reach an agreement with the litigating debtors, the holdouts, to resolve the situation and regain access to international markets. An agreement with the holdouts requires Congress approval once the parliament reconvenes in March. The president could also make the necessary legislative changes by presidential decree. However, as that would increase tensions with congress and could be altered by Congress later, it is questionable whether the holdouts would accept that or whether the government want that. Especially as the holdouts issue has been highly politicised by Christina.
- (+) Due debt is USD 9.3bn (public) and USD 3.5bn(private), so there are enough reserves to meet these obligations.
- (+) The government has abolished the currency peg and will only intervene to reduce high volatility. The currency will now act as a first line of defence and help the current account adjust. Thus it should also temper import growth.
- (+) swap with China- the government has increased USD liquidity by drawing USD on their FX swap facility with China. This does not increase the FX reserves, but it increases the shares of USD.
- (+) FX swap the previous government carried out in the last weeks in office to reduce depreciation pressures. As the swap is in peso’s (only linked to the USD value), it will not affect FX reserves. It will cost the government money as they have to issue peso’s to pay.
- (+) Soy and taxes. The government has agreed with soy producers to frontload around USD 4bn of soy hoarded in anticipation of a depreciation.
- (+) USD deposits. Following the depreciation USD deposits picked up. And as the reserve requirement is 100%, that also contributed to higher FX reserves. Besides, this is also a sign of confidence in the measures adopted. A previous devaluation in 2014 led to significant capital flight.
- (+) Arrears to importers. The government is estimated to owe USD 5-10bn to importers for recent imports. The government offered the importers to pay them by issuing USD bonds which will be paid gradually as of May. It seems that will be the arrangement for the payment.
- (+) Holdouts. The government has started talks with the holdouts (litigating debtors from the 2011 default) and made a first offer to them on % February. Bondholders with a pari passu (equal treatment) injunction were offered a 30% haircut on their claims (principal and compensation for foregone coupon payment). Bondholders lacking a pari passu injunction were offered 150% of the original principal amount (excluding compensation for foregone coupon payments). Argentina will pay in cash and will finance it through new debt issue amounting up to USD 11bn. So far only few holdouts have accepted and these are not the largest ones.
- (+) Loan from international banks. The government signed a USD 5bn one year loan with international banks that bolstered reserves. The facility is backed by treasury bonds and that is a weakness as it could be contested by the holdout judge.
- (+) Multilateral finance. The government confirmed a loan with the IDB of USD 5bn over 3 years. The money is meant for infrastructure finance. The government is also talking to the IMF, though not for a loan but for article IV consultations. The fact that the US has recently withdrew its objection to loans by multilaterals indicates the relations between the two countries could improve though.
- (+) Soy harvest. The soya harvesting season will start in March and that should boost exports by the time imports also pick up. The questions is whether the one will still match the other.
- (+) Bonex clause. This is a clause that is included by Argentinians in their contracts with foreigners which allows Argentinians to buy USD denominated bonds in peso’s in Buenos Aires and sell them in NY for USD. The receipts can be used to meet external obligations. Originally it was only government bonds, but it now also includes other bonds. This provides a relief for the FX reserves and the exchange rate.
The three risks aggravate one another. Given all the mitigants the risk of a balance of payments crisis is fairly small. However, confidence in policy and the outlook are important, as negative sentiment could keep foreign investors away and even lead to capital flight. Thus, the political and social risks could precipitate a balance of payments crisis.