Argentina’s revival?

When Mauricio Macri took over as the president of Argentina, he vowed to revive an economy that after 12 years of populist-left rule was stagnating with double-digit inflation and widening current and fiscal deficits.

His goal is to achieve sustainable economic growth and public finances, including by working with the opposition.

“For us to make the changes that we have promised, we must put together diverse teams, bring on visions that are different from our reality,” Macri said in his Dec. 10 inaugural speech after winning the election for Cambiemos (Let’s Change), a coalition of center-right parties. “We must be united in a country of diversity.”

The 57-year-old civil engineer’s strategy is an about-face to his predecessors Cristina Fernandez de Kirchner and her late husband Nestor Kirchner. Their style divided society, such as with the phrase often used by the party: “You’re either with us or against us.” And their interventionism drove away investment. Currency controls, price caps and protectionist trade policies slimmed profit potential and made it harder to do business.

The Kirchners had early success to build a following. They rebuilt the economy after it shrank 11 percent in 2002, when unemployment surged to 25 percent and the poverty rate to 54 percent.

The recovery came thanks in part to a policy of keeping a lid on utility rates to promote consumer spending. But it was surging international commodity demand and prices during the 2000s that really fueled the rebound. Nestor Kirchner sustained a weak exchange rate to increase exports of beef, corn and soybeans, the latter becoming the country’s biggest export. This fattened foreign reserves and turned the fiscal and trade accounts to surpluses. The economy averaged 8 percent annual growth between 2003 and 2011, and the central bank’s dollar reserves expanded to a record $53 billion in 2011.

The Kirchners, however, failed to fully settle a $100 billion default from 2001. In 2005 and 2010 restructurings of the defaulted bonds, they got a total of 93 percent acceptance for offers of 30 cents on the dollar. But the rest of the creditors sought to collect in full, including by seizing Argentine assets abroad. A group of hedge funds, among them NML Capital, a unit of U.S. billionaire Paul Singer’s Elliott Management, went on to win a lawsuit in U.S. courts for a settlement at full face value plus past-due interest. The 7 percent of these so-called holdout creditors stand to collect a total of more than $10 billion in claims.

Without a full settlement, Argentina couldn’t borrow abroad at a time of globally low interest rates from the early 2000s. This left the Kirchners with few options to finance rising utility subsidies and social welfare programs, and to pay the national debt.

Indeed, after a failure to get congressional approval in 2008 to hike taxes on agriculture exports, the government renationalized the private pension funds, securing nearly $30 billion. It went on to change the central bank charter so it would become a primary lender for growth, development and paying the national debt, not to defend the value of the currency, as was its historical mandate.

Tax pressure was increased to a high of 36.6 percent in 2015, according to the Argentine Institute of Fiscal Analysis, a think-tank. Access to dollars was restricted, including via a ban on companies sending profits abroad. It became harder to import goods. The government hoarded dollars for essential imports, in particular energy supplies to make up for dwindling domestic energy supplies. The low natural gas a power pricing – as well as on diesel and gasoline – discouraged investment to sustain energy production and infrastructure capacity. In 2004, the country lost the energy self-sufficiency it had gained in the late 1990s, causing imports to surge and the fiscal and trade accounts to fall into deficit. Dollar reserves shrank to a nine-year low of $24 billion at the end of 2015.

With dollars tight, the Kirchners ramped up the printing of pesos, and inflation accelerated to a peak of 40 percent in 2014 before receding to 26 percent in 2015. Infrastructure sagged and energy shortages hit. This year, the economy is poised to contract by 1 percent and is not on track to recover until 2017, according to the International Monetary Fund.

The challenge

argentina-flagMacri faces the challenge of turning this around, and to do so he is focusing on cutting inflation, narrowing the fiscal deficit and reeling back foreign investment.

In his first three months in office, the son of a multi-millionaire has made a quick start in setting up the economy for sustainable growth.

Days after swearing in, his finance minister, Alfonso Prat-Gay, eliminated the 15 percent to 23 percent export taxes on beef, corn and wheat, and cut them to 30 percent from 35 percent for soybeans. The former central bank chief and JPMorgan Chase banker subsequently lifted currency controls in place since 2011, and allowed the peso to float freely. The peso immediately depreciated 40 percent to 13.76 per dollar from 9.83, and has since weakened by more than 50 percent since then to nearly 16 per dollar.

The tax cut and devaluation has helped to bring in what’s needed most: dollars.

Farmers stepped up exports to repatriate $5.3 billion in the two months after the Dec. 16 devaluation, according to the Argentine Oilseed Industry Chamber and the Cereals Exporters Center, industry groups. That’s about a quarter of the $20 billion in their repatriations during all of 2015.

The inflow helped to refill foreign currency reserves to nearly $30 billion at the end of February.

Macri’s targets are to steadily boost dollar reserves and financing to slash inflation to between 3.5 percent and 6.5 percent in 2019 from 30 percent this year, and to cut the fiscal deficit to 0.3 percent of GDP in 2019 from 7.5 percent in 2015.

“We cannot continue living with inflation if we want to grow,” Macri said in February. “We’ve had inflation for years, and it is going to take us a while to reduce it.”

The main driver of this high inflation was an expansionary monetary policy pursued by Cristina Fernandez de Kirchner to fuel economic growth and fund swelling expenditures, including on a renationalized state airline, popular television rights for football and a bulging public payroll.

To contain monetary expansion, Macri is trimming the public payroll and subsidies for electricity and other utilities, as well as raising interest rates.

Macri’s production minister, Francisco Cabrera, estimates that the cuts in utility subsidies alone will reduce public spending by about 80 billion pesos ($5.1 billion). Transport and utility subsidies reached 4.1 percent of GDP in 2014, up from 0.4 percent in 2004, according to the Argentine Association of Budget and Public Financial Management, an NGO.

At the same time, the central bank has jacked up interest rates to encourage savings in pesos to reduce the amount of circulating cash and stem a chronic flight to dollars. After the devaluation, the benchmark interest rate for 35-day central bank notes was increased to 38 percent, and then gradually cut it to 30 percent in mid-February. The bank then increased the rate again to 30.5 percent as inflation remained stubbornly high. This was designed to provide more incentive to save in pesos, helping to ease pressure on the exchange rate to depreciate.

Cabrera said he expects these measures to start slowing inflation in the second half of 2016.

There is optimism that this may happen.

“We are celebrating because we’re not in a crisis,” said Martin Polo, an economist at Analytica Consultora, a consulting firm in Buenos Aires. “If the currency controls had continued, then Argentina would be heading toward in a balance of payments crisis.”

Reserves fell by $10 billion in the second half of 2015.

With an overvalued exchange rate, exports were in decline, a situation worsened by falling global commodity prices since mid-2014 as well as a surge in energy imports. The current account deficit reached 3 percent of GDP in 2015, as the value of imports exceeded the value of exports. Argentina couldn’t borrow abroad to reduce monetary expansion, and foreign investment wasn’t coming because of the currency controls, high borrowing rates and interventionism. This left the previous government with little room to depreciate the peso.

“The only alternative to avoid a devaluation was to burn through foreign reserves,” Polo said.

But as the reserves dwindled, “the Macri government had to let the exchange rate go,” he added.

Wage demands

argentina1By keeping the exchange rate stable with higher interest rates and a reduction in monetary expansion, this will help with the next challenge of containing wage demands and the impact on inflation, said Federico MacDougall, an economist at the University of Belgrano in Buenos Aires.

Most of the unions have come out to ask for more than 30 percent salary hikes this year to keep pace with inflation.

But to contain inflation, MacDougall said the government must moderate wage increases to 26 percent, as anything much higher would reduce exports by hurting industrial competitiveness. Keeping a lid on wage hikes, in turn, would help the central bank to cut interest rates to a more attractive 12 percent to 14 percent for companies to ramp up investment to help prevent a prolonged economic contraction.

“In the short term, if interest rates continue at this level, the economy is unviable,” MacDougall said. “Salaries must be cut in dollar terms so that the country is competitive and so that companies are more profitable and can grow and sustain employment.”

Borrowing abroad

The next big challenge is to regain access again to global financial markets, something that is on track after three months of negotiations with holders of bonds from the 2001 default.

The first agreement came in early February, when a group of 50,000 Italians holding $900 million in defaulted bonds agreed to a $1.35 billion cash settlement with past-due interest. Argentina subsequently offered to pay the rest of the holdouts $6.5 billion for about $9 billion in claims, or an average of 75 cents on the dollar.

After reaching a preliminary settlement deal on February 28 with NML Capital and three other hedge funds, Prat-Gay said the country is poised to emerge from default after 15 years.

“This puts us at the starting line for growth,” he said.

The resolution of the holdout issue will allow the country to borrow again, so too companies, said Eduardo Levy Yeyati, an economist at Elypsis, an economic consulting firm in Buenos Aires. “This will pave the way for much needed foreign direct investment.”

Even so, he warned that perhaps a larger challenge is “to rekindle growth and preserve employment after four years of stagnation and against global headwinds.” The world economy is sluggish and commodities prices are in decline, which likely will slow Argentina’s recovery.

But, Levy Yeyati said, it won’t tip the country into a fiscal or balance of payments crisis.

“I see no meaningful risk of a crisis, unless it is a global one,” he said. “Argentina is solvent and does not face currency mismatches or a severe current account deficit. The fiscal adjustment, though, should take longer, particularly if the government prioritizes economic activity and employment in the short run. I think fiscal balance at the end of its four-year period is a feasible but not necessarily optimal goal.”

After so many years as a pariah in the global financial markets, Argentina could stand out as a new attraction at a time when China, Brazil and other emerging markets are now struggling.

Argentina captured a third of the foreign direct investment it could have between 2003 and 2015, whereas it was the No. 2 destination in Latin America in the 1990s. “Now we are the seventh,” noted Polo. “Argentina has huge potential to capture FDI and this will help with infrastructure projects.”

If the investment comes, this will put the country on track to containing inflation and mending public finances.

“The strategy this year is to gain time via the capital markets to resolve the current and fiscal deficits that Macri inherited from the previous government,” said Esteban Fernandez Medrano, an economist at MacroVision Consulting in Buenos Aires.

With improved economic policies and a downturn in other emerging markets, Argentina could attract foreign investors looking for higher returns. Fernandez Medrano estimates that this would put the economy on track to grow at a sustainable 4 percent over the long term, not the unsustainable 8 percent per year of the first eight years of Kirchnerism.

“The market is taking Macri’s first measures positively,” Medrano said. “But there is still a lot to do.”