A Promising Start

ARGENTINA - Forecast 26 Jan 2016 by Domingo Cavallo

The newborn administration has taken the right steps in its first weeks in office with major announcements: first, the removal of FX controls; second, the elimination of export taxes in all agriculture and industrial exports, with the reduction from 35% to 30% in the case of soybean products; third, the elimination of price controls, with the exception of a short list of basic consumption products; and fourth, the announcement by the Minister of Energy of the gradual dismantling of energy subsidies and the unfreezing of public utilities tariffs from next February. In addition, the government started a new round of negotiations to solve the holdouts problem.

The presentation made by the Finance Minister last week showed that there would be no shock on the fiscal front, unlike the shock therapy seen in the dismantling of FX controls. According to the Minister of Finance, the primary deficit (excluding Central Bank and ANSES) reached 5.8% of GDP in 2015, including close to 1% of GDP of “floating debt” with suppliers. After interest payments, the fiscal deficit reached close to 8% of GDP. This is the highest deficit in the last 30 years despite record-high tax collection. The goal is to reduce the fiscal deficit to 6.1% of GDP in 2016, 3.3% in 2017, 1.8% in 2018 and 0.3% in 2019.

Prat Gay also announced that the Central Bank would continue financing the fiscal imbalance in a manner consistent with the announced inflation targets: 20-25% in 2016, 12-17% in 2017, 8-12% in 2018, 3.5-6% in 2019. In 2016, Minister Prat Gay reported that the Treasury expects to receive about AR$ 160bn (25% of the money base) from the Central Bank.

One reason for the gradualist approach in terms of disinflation is that reducing the fiscal deficit and public spending in an inflationary environment is much easier than under a stable environment. Another reason is the dynamics of inflationary expectations after ten years of double-digit inflation. Finally, closing the fiscal gap will require tapping financial markets aggressively: without Central Bank financial assistance, the Treasury would have to issue more than USD 30bn (gross) debt by in 2016.

A gradualist disinflation approach will also imply a gradual recovery of the economy. The reliance on Central Bank financing will increase the difficulty of addressing a combination of expansionary fiscal policy (based not on expanding public spending but on reducing taxes) and restrictive monetary policy, the only recipe to pull an economy out of stagflation. If fiscal dominance continues, and the Central Bank forces a more rapid disinflation, it will have to expand CB notes to control the monetary supply at the cost of very high interest rates. This could bring inflation below official targets but it would also cool the economic recovery.

We continue to be optimistic. We believe ongoing economic reforms (including FX liberalization, external trade openness, relative price realignment, ongoing negotiations to resolve the holdouts litigation, and an improved business climate) will support growth this year and next, despite the recessionary effect of tariff adjustments, interest rate hikes and Brazil’s recession. We project GDP to grow 1% in 2016 and 4% in 2017. We expect inflation to reach 25% in 2016 and decline to 7.5% in 2017.

The new Argentine government has taken the right steps to dismantle the old-fashioned macroeconomics of populism established in the last 10 years. It has also shown a remarkable political ability to deliver the reforms without creating social unrest and excessive political tension. It’s a promising start.

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