Argentina: normalizing the economy, a tough balancing act
The Argentinian government is sustaining efforts to open up and normalize the economy, but it is shifting to a more gradual approach given social and political constraints. Important successes have already been booked on the external front.
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.
(-) Unsustainable fiscal burden
Argentina is recording large budget deficits and the partial monetary financing thereof feeds through to inflation. The high share of subsidies and social benefits makes a fast fiscal adjustment difficult.
1. So far, smooth adjustment on the external front
The main successes of President Macri’s cabinet have been on the external front, namely a smooth shift to a floating exchange rate after 5 years of heavy capital and import restrictions and solving a 15 year old debt conflict related to the 2001 sovereign default and thereby regaining access to international capital markets. These developments have reduced pressures on the FX reserves, which have stabilized. At the end of August they stood at USD 29bn, equal to 4.5 months of import cover, 30% higher than at the beginning of the year. We do note that in 16H1 one-off USD inflows, such as due to the liquidation of hoarded soy and international debt issued by the central government and provinces, helped to alleviate these pressures. Moving forward we expect pressures on the FX reserves to remain modest, as on the one hand USD inflows are poised to benefit from higher agricultural exports in 17H1n and the implementation of a tax amnesty law on 1 August 2015. The law allows Argentinians to report undeclared foreign assets held abroad and either pay a 10% tax or repatriate and invest domestically. Estimates place declarations in the USD 40-60bn range. Weak domestic activity is poised to contain import growth on the other hand. With Argentina in economic transition, there is a risk of events (e.g. political gridlock and policy paralysis) that could trigger capital outflows and increase pressure on the FX reserves, in which case their current level might prove precarious.
2. The economic adjustment: a tough balancing act
Tackling the macroeconomic imbalances on the domestic front is proving more challenging and the outlook looks uncertain. On the domestic front, President Macri’s cabinet has inherited two main large macroeconomic imbalances: a large and partially monetarily financed budget deficit and resulting an annual inflation of almost 30%. The government took bold measures to tackle both in 16H1. To tackle inflation the government chose for a fast adjustment: 1) the Central Bank increased the policy rate by 8ppts to 38% in March, 2) it announced a clear inflation target for 2017-2019 in April, 3) it increased bank reserve requirements in May and 4) it has been sterilizing liquidity by issuing notes, reducing the broad monetary base (M3) growth from 37% in December 2015 to 31% in June 2016. So far, the monetary authority has been successful as m-o-m inflation has fallen from a peak of 5.2% in April to 2% in July and y-o-y inflation may fall to around 36% by the end of the year (the impact of the annulment of gas tariff increases by a court ruling in August and their possible reinstatement in October is yet uncertain). However, meeting the inflation target of 12-17% y-o-y by the end of 2017 will prove more challenging as the budget deficit remains sizeable and continues to be partially monetarily financed.
Progress on fiscal consolidation has been less straightforward. First, the most important structural austerity measure that was implemented has been an increase of utility tariffs to reduce energy subsidies (that totaled 3-5% of GDP in 2015). However, against the backdrop of a very cold winter, the high utility bills led to widespread social discontent and an August court ruling suspended the gas tariff increases until the government holds public hearings, planned for 16 September. This illustrates the difficult social environment in which the government has to operate. Consequently, further fiscal consolidation efforts are likely to take a more gradual approach, especially with the October 2017 mid-term elections nearing. Second, lacking a majority in Congress, the government has made various concessions to garner political support for envisaged measures. That has had a fiscal cost. For example, to get the amnesty bill approved, the government linked it to a bill that increases pension benefits and pays debt owed to retirees and to an agreement with governors to restitute them 15% of the income in the country’s revenue sharing agreement. Most concessions are pending claims backed by court rulings, some of which had been ignored by the previous government. Thus, Macri was in fact skillful in gaining support for his own measures while setting public records straight at the same time. Third, while the budget deficit in 2016 is expected to be close to target (4.8% of GDP primary deficit and 6.4% of GDP budget deficit), one off amnesty-related income contributes to this realization. The real test of fiscal consolidation, however, will be whether the government will manage to structurally and significantly reduce the shortfall in 2017 while avoiding social backlash and maintaining political support; a difficult balancing act.
3. Economic activity is getting worse before it will get better
The normalization of macroeconomic policy has an economic cost. The sustained efforts to improve the business climate should pay out eventually, but the high inflation and interest rates are currently hurting economic activity. Moving forward, the agriculture sector is expected to begin the recovery as the reduction of export taxes boosts the 2016/2017 production. The disinflation process, the accompanying monetary easing and infrastructure plans will also help. Consequently, we expect economic activity to grow by 2.7% y-o-y in 2017, after a 1.2% y-o-y contraction in 2016.
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, losing access to international financial markets. 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 through tight controls and high state intervention. A new government took office in December 2015 and is opening up and normalizing 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 14,658 per capita in 2015, Argentina remains one of the richest countries of Latin America.