We introduce this article with a little puzzle. Here is a country that enjoys:
- Fairly low public debt, 43.2% of GDP.
- Low external debt in foreign currency, just 8.3% of GDP.
- Only a small trade deficit.
- Fairly low public deficit (2013 estimates vary from 2.5-4% of GDP).
- Low private debt and low financial leverage as the inhabitants of this country don't trust banks.
Presented like this, we're sure very few people would have argued that such a country will be in deep economic trouble. The characteristics above aren't typical of an emerging market crisis economy at all and would normally be the characteristics of a well-managed economy. Yet the country is anything but well managed, or normal.
The country is squarely on the chart below with misbehaving currencies from emerging markets, in January:
The country in question is Argentina and its currency was the worst emerging market performer, as you can see above. The curious thing is, its economic problems are both entirely manageable (as the above characteristics suggest) and threatening to evolve into a full-blown crisis at the same time.
Public policy is resorting to ever more interventionist and desperate measures to salvage what it can, but we'll argue that its public policy that is the problem in the first place. This is a case of Keynesianism gone wild, then followed by market interventions that have nothing to do with Keynesianism but only distort and made matters worse.
To realize that, we have to go back a decade or so, to what was then the 'mother of all financial crisis,' when Argentina devalued its currency from 1:1 to the dollar to almost 1:4, reneged on its debt, and went through five presidents in a couple of weeks. You would normally think that this sounds like the most bleakest of starts for the next decade, yet this is Argentina we're talking about, the land of economic paradoxes.
The truth of the matter was that while the crisis was undoubtedly extremely severe, conditions for an economic take-off could hardly be better, yet another of those Argentinean paradoxes:
- With a stroke of a pen, much of its external debt had been abolished.
- A commodities boom started which increased both the prices and volumes for important Argentinean commodity exports, like soya.
- After several 'lost' decades, much of the region started to experience much better growth.
- The large fall of the peso (from 1:1 to the dollar to almost 4:1).
- The deep crisis left ample spare capacity, which the economy could grow into without needing much new investment or creating bottlenecks that could fuel inflationary pressures.
- For the first time, the country generated plenty of internal savings.
The large reduction of the external debt and the commodities boom largely removed the 'external constraint' that had plagued the Argentine economy so often in the past, when growth policies sooner or later hit a brick wall of external constraints in the form of a rapidly deteriorating balance of payments and the pursuit of full employment resulted in being incompatible with external balance.
As a result, helped by the steep devaluation , the economy recovered with remarkable speed from the deep crisis (we offered this as a model to Greece a few years ago). The rampant growth also fueled tax revenues while the commodities boom produced a large trade surplus, so Argentina experienced an unusual period of (really substantial) twin surpluses.
It is no wonder, then that the economy really took off from the depth of the crisis, spurred by a large devaluation, very favorable circumstances and (at the time) some sensible policies. Despite the favorable circumstances it would not last. As so often in the past, Argentina showed itself unable to put the brakes on when required.
Always the same problem
In fact, the government did just the opposite. Despite record growth and record tax receipts, public expenditures took off even more, increasing by almost 15 percentage points(!) of GDP between 2003 and 2013.
Increased salaries for public sector workers and a raft of social policies and subsidies were the main beneficiaries, that is, it was mostly consumption, rather than investment (while the latter is really needed as much of the infrastructure is decaying). The fiscal surplus steadily declined and became a deficit.
Between 2005 and 2012 there was a whopping 8% point worsening in the public sector finances (according to the Instituro de Economía Aplicada y Sociedad). Since Argentina didn't have access to international capital markets it was increasingly difficult to finance the public sector (refinancing of existing debt and in the latter years the deficit).
Something of a vicious cycle (one of many) ensued as the authorities resorted to financing this through raiding (nationalized) pension funds (through bonds with negative real yields, creating increasing liabilities in the future) and outright monetary financing by the central bank resulting in ever increasing inflation (roughly $25 billion up until 2012). Below a figure of monetary financing of the deficit in the last two years (and January 2014).
The increasing inflation, distortion of the inflationary figures (from 2007 onwards), worsening public finances and negative real rates made private finance sources increasingly scarce, reinforcing the tendency to monetary financing and even higher inflation. Today, almost 90% of the public sector borrowing requirement is met through the central bank.
This produced other problems. The inflationary statistics were grossly underestimating the inflationary problem from 2007 onwards, together with negative real rates left few domestic destinations for savings. This led to an increasing desire to move out of the peso, capital flight became a torrent in earnest the last three years.
The authorities decided to combat this symptom and not address the problem (the public finances and inflation) with a raft of ever increasing restrictions to buying foreign currencies. A parallel dollar market ('dolar blue') ensued and ambulant money changers reappeared on Florida Street (the 'arbolitos').
The doctoring of the official inflation figures and these market interventions increased the country risk and made foreign capital even more inaccessible, another vicious cycle. It also left the country, once again, without a viable metric for longer-term contracts, hence reducing investment and shortening time horizons of economic agents.
The irony is that these efforts to keep the economy going (or the inability to change course) nevertheless produced a slow deterioration anyway:
- As inflation started to take off, which increased the real exchange rate, reducing competitiveness and the trade surplus.
- A steep rise in the tax burden on domestic business.
- Increasing uncertainty, produced by a raft of market interventions and rising inflation, leading to an ever shorter time horizon of economic agents.
- Importers and the real estate market became the last victims of the scarcity of domestic dollars and uncertainty over the exchange rate. Traditionally, most transactions are in dollars and cash, as a domestic mortgage market is underdeveloped.
Because of the rise in the real exchange rate, trade in industrial products turned sharply negative, followed by the energy balance, although the latter was the victim of what's perhaps the worst policy of the government, the freezing of energy prices and ever increasing subsidies for consumers.
Argentina imports $12B of energy per year. The model of fixed tariffs and subsidies is hugely counterproductive:
- Demand rises inexorably whilst incentives to increase supply are very weak. This results in power cuts (eroding political support and producing a bottleneck for business) and an ever increasing import bill (the energy balance has moved into deficit) and hence more pressure on foreign currency reserves: "According to the Argentine Institute on Fiscal Analysis, energy imports this year will demand from Argentina 13.28bn dollars which is equivalent to 46% of all agriculture exports. This compares with 6% in 2003 and 21% in 2010." [MercoPress]
- The subsidies require ever increasing public spending (they're roughly equal to the deficit at present), fueling the deficit and the monetary financing of the deficit, thereby increasing, rather than moderating inflation, although there will be a big but one-off push to inflation when the prices are adjusted.
- The subsidies are strongly regressive as they benefit higher incomes, who use more energy, much more than they benefit lower incomes, defeating (or even contradicting) their purpose.
- The energy and transport subsidies amounted to 140 billion peso in 2013, or 5% of GDP, which is more than the tax receipts on the exports of agricultural commodities.
Something of a vicious cycle ensues: the policy cut domestic supplies, need ever more import, which needs ever more dollars so reserves dwindle and the dollar keeps rising, which makes the imported energy more expensive, which increases the subsidies, worsens the trade balance and public finances further, and reduces CB reserves. Etc.
These negative incentives on producers led to a steady decline in oil and gas production and reserves, due to a lack of exploration activity to half that of previous decades. Between 2003 and 2011, proven oil reserves declined by 9.2%, proven gas reserves by a whopping 46% (according to Alberto Devoto in Roberto Lavanga "Un Futuro Possible").
Instead of cutting the subsidies, the government with emergency measures (like buying expensive LNG cargos on the spot market) and nationalized YPF. Supposedly because under the ownership of Repsol, it wasn't producing enough, which was hardly a surprise given the disincentives to produce and explore.
Nationalizing energy companies isn't exactly an encouragement for foreign investment and knowledge, sourly needed, to boost Argentina's promising energy fields, although one has to admit there is still a good deal of interest from foreign companies (like Chevron, although seemingly with some controversial guarantees) to help develop its giant Vaca Muerta shale discovery, although this will take years and tens of billions of dollars.
For us, Argentina's energy policy is largely counterproductive, in the most literal sense of the word, whilst producing a raft of negative side effects. Big reductions in the subsidies could almost eliminate the budget deficit, thereby reducing the need to print money to finance the deficit, which would reduce inflation despite the one-off jump that would result from increasing energy prices.
It would also reduce the trade deficit and thereby moderate the bleeding of foreign currency reserves. By restoring incentives for domestic production and exploration, it would reduce (or even eliminate) the energy deficit, reduce (or eliminate) blackouts and it would stem the reserves decline.
Instead, the government did something else.
Will the devaluation work?
After a couple of years of 'crawling peg' in which the peso was allowed to drop a few points a month to keep some semblance of competitiveness, this situation was clearly untenable as the central bank kept on bleeding foreign currency reserves (to the tune of $2B per month) and the real exchange rate kept on rising.
The authorities tried to solve this last month by stopping interventions in the foreign currency market temporarily and try to set a new anchor value at 8 pesos to the dollar. The objectives are clear, to close the gap with the unofficial ('blue') exchange rate and to stem the alarming decline in the foreign currency reserves.
In the week after the devaluation the central bank lost even more reserves, now well below $30B, so the authorities started to twist the arms of financial institutions and exporters to sell dollars at the new rate. Some success was achieved by administrative means, forcing banks to sell $1B, and some of the exporters were indeed induced to liquidate some of their dollars (to the tune of $2B).
But this can only be a temporary respite as the underlying problem, inflation, isn't being addressed at all, quite the contrary. The accelerated devaluation will only spur inflation, now expected to reach 40% this year. Sooner rather than later, exporters will start to wait converting their dollars into pesos (some argue this is a more profitable business than their core business) and the flight to the dollar and the bleeding of foreign currency reserves will resume.
For the reserves to stop falling, other parties, like exporters, must need to see the dollar as attractively valued, but as long as inflation isn't tamed, these moments can only be temporary and brief. In short, any devaluation in order to establish a viable anchor can only be temporary as long as there is an inflation problem, which has just gotten worse, not better.
Apart from arm-twisting exporters and changing the amount of foreign currencies financial institutions can hold, authorities are resorting to ever desperate rhetoric and measures:
- Blaming Shell (and others) for speculating against the peso and rising the price of petrol and other stuff.
- Stopping providing dollars to importers (especially white goods and electronics) as a retribution for price hikes.
- Forcing exporters to change their dollars.
- 'Voluntary' price controls for supermarkets.
- Threatening people who buy dollars to cut gas and electricity subsidies
More importantly, the central bank raised interest rates, this actually is a necessary step, but it needs to be accompanied by a reduction in public spending, and the rise (to roughly 26%) isn't nearly enough:
With estimated 28 percent inflation, rates would have to rise to about 40 percent to lure investors to the peso, according to Bank of America Merrill Lynch. [Bloomberg]
There is a favorable element of the devaluation. Brazil, Argentina's most important trade partner by far, is also embroiled in the emerging markets turmoil. Unlike Argentina, Brazil is defending its currency vigorously with interest rate hikes and sterilization operations. As a result, the peso declined sharply against Brazil's real.
Colin Docherty argues in this respect:
But the most overlooked and arguably the prime motivation: Brazil is Argentina's biggest trading partner. For Brazil, it's the US. Argentina can take advantage of Brazil's costly currency "sterilization" by devaluing the peso against the USD, which keeps Brazilian import costs steady while improving the bottom line for its export markets.
We fail to see this logic. Argentina is gaining competitiveness versus Brazil, but Argentina cannot keep Brazilian import prices steady (as Colin has it) while simultaneously gaining competitiveness (that is, reducing Argentinean export prices versus Brazil). Currency moves have effects on all tradables, not just export prices. So there is nothing "brilliant" about this move (as the author has it).
In fact, Brazil's currency defense has another negative consequence, it also cools off the Brazilian economy, with adverse effects for Argentinean exports to that country, so it remains to be seen whether all this will actually improve Argentina's (negative) trade balance with Brazil.
Counterproductive macro policies
Unable and/or unwilling to restore some semblance of macroeconomic stability, the authorities keep on pushing the gas and deal with the fallout in an ad-hoc manner that is increasingly counterproductive:
- Refusing to slow the economy is producing ever increasing inflation, a real exchange rate appreciation, uncertainty and a raft of interventions that produced a slow down anyway.
- The policies don't smooth business cycles, they exacerbate these. At every downturn, invariably the less well off are suffering much more. This creates steadily bigger demands for immediate retribution when the economy picks up, making short-termism and distributional concerns ever larger obstacles to sensible macro policies.
- Despite a really favorable international environment, policy once again hit the external constraint, producing capital flight and a bleeding of foreign currency reserves.
- The government has low credibility, which makes fighting inflation rather costly, perhaps that's why they seem to leave it to the next government. A good place to start would be to publish real inflation figures and reform the statistical bureau INDEC.
- Subsidies on transport and energy aiming to support the less well off produce budget deficits and inflation, hurting the less well off disproportionately anyway.
Since there is something of an emerging market crisis ongoing, should international investors be worried about Argentina's economic situation could further ignite this situation? Well, we don't have to be worried of another Argentine debt crisis:
between 2003 and 2012 Argentina met debt service payments totaling USD173.7 billion, of which 81.5 billion was collected by bondholders, 51.2 billion by multilateral lenders such as the IMF and World Bank, and 41 billion by Argentine government agencies. Public external debt denominated in foreign currencies (mainly in dollars and euros) accordingly fell from 150% of GDP in 2002 to 8.3% in 2013. [Infonews]
This debt repayment is almost entirely due to the fact that Argentina hasn't been able to tap the international capital markets as there are still outstanding legal issues with the 'holdouts,' 7% of the investors (holding just $4B of bonds) that suffered from the December 2001 default that haven't accepted the restructuring of the outstanding debt (in 2005 and 2010).
Perhaps the major contagion risk runs through Spanish companies like Telefonica (NYSE:TEF), BBVA (NYSE:BBVA) and Banco Santander (NYSE:SAN), which have substantial activities in Argentina. Spain is economically still very weak, and has some $22B in direct investment in Argentina. But the two banks' exposure is minimal, only Telefonica has a 5.3% exposure, hardly earth shocking.
This isn't a typical emerging market crisis caused by a sudden reverse of capital as there wasn't much capital inflow to begin with. It's the domestic capital flight that's causing the problems, and this is because of distrust in the peso, which is caused by the authorities. So domestic investors play no stabilizing role here.
Instead of trying to lock domestic investors in, Argentina should embark on policies that are less stick, and more carrot. Restoring macroeconomic balance, that is, reducing the deficit, monetary finance, and hence inflation, would go a long way in restoring confidence so domestic investors do not have to protect their capital by moving into the dollar.
So there is little contagion danger, in fact, since Argentina's problems are entirely of its own making and its fundamental economic position (see the beginning of the article) is still relatively benign, we don't even think that Argentina itself will necessarily face an imminent crisis. This does depend greatly on what the authorities do next though.
Argentina doesn't have a problem in producing high growth, it has done so the last decade, and it has done so before. What Argentina seems unable to do is to manage that growth well, as these periods invariably end in a bust one way or another, hurting the most vulnerable the most, which intensifies their demand for retribution during the next uptick and the associated distributive policies and shortened time-horizons that lay at the root of the inability to manage economic booms.
The circumstances are actually still quite benign. Most Argentine growth spurts used to end in large trade deficits, for lack of domestic savings and the reliance on foreign capital used to produce sudden capital flight in these circumstances. However, the external constraint has greatly diminished in the last decade because of reduced debt payments and the commodities boom, and the availability of plenty of domestic savings for capital formation.
So there is plenty of capital to be invested, but inadequate policies make these go abroad rather than to be invested in Argentina itself. It's still not too late to correct these policies. Abolishing (or at least greatly diminishing) energy subsidies would go a long way establishing order in public finances, reduce money printing, provide incentives for increased energy supply, save foreign currency reserves and restore some confidence.
While initially producing a one-off bump in inflation, these effects will moderate inflation in the medium turn, if the government can be more disciplined in spending, if necessary the central bank should increase interest rates further to cool off the economy. The economy is cooling off anyway.
Cooling it off in the way we suggest, restoring macroeconomic balance, would temper inflation, which can be followed by dismantling of the import and currency restrictions. Producing better inflation statistics is also a must. We keep on saying that Argentina's economic situation isn't actually that bad, with sound policies, it could be much better.
While this is easy in theory, in practice, it would need social parties to come together in joint action, rather than engage in protracted distributive battles that are so characteristic of the country (between unions, the state, and employers, the Federal state and the provinces, and the countryside and the urban centers).
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.