The Economy After the Holdouts Solution

ARGENTINA - Report 31 Mar 2016 by Domingo Cavallo

The government delivered quite positively the first phase of its program of “economic normalization”. A key step was the progress in resolving the long-standing litigation with the holdouts. This includes the constructive negotiations and agreements already signed with nearly 90% of the holdouts with judicial claims in the US Courts, and the recently approved law aimed to abolish the “Locke Law” and the “Sovereign Payments Law”.

In the very short run, the economy is facing the classical trade-off between unemployment and inflation. Here, two opposing forces are colliding. On one hand, the recently implemented structural reforms and the exchange rate depreciation will increase productivity and restore profitability and competitiveness in many sectors. This will encourage investment and exports, and support economic recovery. There is anecdotal evidence of "green shoots" in some sectors of the economy, in particular, producers of internationally traded goods benefitting from devaluation. On the other hand, the government is applying a full-fledged anti-inflationary policy, combining monetary and fiscal tightening.

After the resolution of the holdouts problem, we believe the government will gradually turn towards a macro policy mix of tight monetary policy and looser fiscal policy (driven by tax reductions and a recovery of capital spending). The government will increase debt issuance to finance the fiscal deficit in order to reduce the Central Bank’s monetary issuance to finance the Treasury.

In the short term, this is the correct policy mix to leave behind a long-lasting stagflation scenario.

The tight-money/easy-fiscal policy mix will result in an appreciation of the real exchange rate. If the government allows the real exchange rate to appreciate through the nominal exchange rate rather than through prices, FX dynamics could be good news at this juncture. The real appreciation will improve real wages and, hence, will strengthen domestic consumption. The stability (or the appreciation) of the nominal exchange rate will keep inflation expectations subdued and will reduce inflation in tradable goods.

In the future, the government should gradually fine-tune the macro policy mix. Once inflation converges to the targets, the Central Bank reduces the need to sterilize monetary expansion to finance the Treasury, and the economy recovers, the government should gradually modify the macro-policy mix by relaxing monetary policy (reducing short-term interest rates) and tightening fiscal policy (ideally by the recovery of tax collection and by restraining spending and borrowing by the provinces).

This shift in the macro-policy mix will be necessary to prevent the quasi-fiscal deficit from becoming a headache for the Central Bank, and also to avoid crowding-out by the federal government of the private sector, and to prevent an excessive appreciation of the real exchange rate.

We continue to be optimistic about the ability of the economic team to manage a difficult economic transition and the ability of President Macri to assure governability to push the reforms.

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