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Global Economic Outlook
Argentina: Q3 2010 Outlook
By Bertrand Delgado
- Strong demand from Brazil and loose domestic macroeconomic conditions are driving Argentina’s economy; meanwhile, inflation is above 30% y/y.
- The Kirchner administration’s popularity is improving and regaining lost political capital in the provinces, while the opposition remains fragmented.
- A worse-than-expected deceleration in the global economy and a sharp worsening of the inflation outlook are the main risks to our scenario.
Outlook Update: Stronger GDP Growth and Rising Presidential Popularity
We expect Argentina’s economy to expand 6.5% y/y in 2010 (range of 6- 7%) benefiting from robust growth in Brazil, exceptionally loose macroeconomic conditions and a strong rebound in agricultural output. Previously, we forecast a 4.4% y/y expansion; however, better-than-expected growth in domestic and external demand made us revise our forecast up. Overall, the export-oriented industrial sector grew 10.3% YTD to May, mainly driven by strong growth in Brazil, which is Argentina’s largest trading partner and accounts for 34% of total exports. Meanwhile, strong fiscal spending (34% YTD to May), highly accommodating monetary policy (-20% real interest rates) and substantial wage increases (30% average)—together with some improvement in domestic confidence—are pushing consumption and investment higher. In effect, the construction and retail sectors, as well as public services and the automobile sector, have shown positive dynamics into May, while solid recovery in the agricultural output and a low base are adding support to overall economic activity.
Figure 1: GDP and Domestic Demand (y/y %)
Source: INDEC and RGE
In H2 2010, however, we expect growth to lose steam, as Brazil’s economic performance becomes less buoyant and the global economy decelerates. Net exports will remain a drag on growth as domestic demand outpaces external demand. However, we point out that continuing protectionist measures that affected trade with China, together with the eurozone crisis, will worsen the effect of net exports on growth. For 2011, we continue to expect economic activity to increase 3.7% y/y (range 3.5-4.5%) benefiting from strong domestic demand, which in turn will be driven by loose macroeconomic policies as the government looks to the presidential elections in October 2011. However, external demand growth will likely be sluggish, while the agricultural sector will face a high base next year.
Non-official inflation is likely running over 25% y/y, the second highest in the region next to Venezuela. Meanwhile, reports from reliable local think tanks suggest that one-year-ahead non-official inflation expectations are between 30- 35%. In RGE’s view, strong domestic demand, a weak currency—in real terms—and loose fiscal and monetary policies are responsible for high inflation and should keep inflation pressures elevated. Moreover, a high and unanchored inflation outlook and sharp increases in nominal wages of around 25- 35%—and in some cases 40%— should keep inflation dynamics on a persistent deteriorating trend. Unfortunately, these dynamics are unlikely to change much next year because of the electoral cycle and unwillingness on the part of the government to tackle the problem. In the eyes of the administration, the inflation problem is related to structural bottlenecks rather than unsustainable macroeconomic policy.
Figure 2: Official Inflation versus Non-Official Inflation Expectations
Source: CB, UTDT and RGE, Forecast in Box
After a tense political climate at the beginning of the year, relations between the government and the opposition have settled down, and President Cristina Fernandez de Kirchner’s popularity is increasing amid strong economic growth, sharp increases in nominal wages and large transfers to the provinces to ease provincial political discontent. Meanwhile, former President Nestor Kirchner’s popularity might depend on the government improving the economic situation, as he will probably run for president next year, representing a threat to a fragmented opposition and to the economy’s well being. Needles to say, political volatility should emerge in the upcoming quarters as presidential elections approach in October 2011 and political parties narrow their potential candidate lists.
Figure 3: Current Outlay Dynamics (y/y 3MMA)
Source: MECON and RGE
Given that the government would prefer to keep a relatively weak peso in place to maintain competitiveness (especially since inflation is surging) and to boost fiscal income (export revenues and central bank transfers in domestic currency), RGE maintains the view that the local currency will likely experience a 10% y/y nominal depreciation to ARS4.2 per USD by the end of 2010. In real terms, however, the currency has been appreciating mildly, in large part because of inflation differentials. A further deterioration in the external backdrop and in the domestic political environment would exacerbate weakening pressures not only via higher risk aversion but also through increasing capital flight. By the end of 2011, we expect the local currency to be at about ARS4.6, given that domestic political jitters will add to the mix. However, if in fact a change in regime becomes the most likely scenario, we would expect the ARS to appreciate drastically, though the central bank would also intensify its interventionist stance.
Figure 4: Real Effective Exchange Rate versus Nominal (USD/ARS Inverted)
Source: BIS, Bloomberg and RGE
How Do We Differ from Consensus: Above the Average Survey
According to the June Consensus Economics survey, Argentina will likely expand 5.5% y/y on average in 2010 with a range of 4.4- 7%, and 3.4% y/y in 2011 with a range of 2.5-5.4%. RGE’s 6.5% GDP growth projection for 2010 is above the survey’s average; however, we see those results moving higher, as they were taken before better-than-expected data were released. For 2010, our 3.7% growth forecast is broadly in line with the consensus.
Risks to Our Forecast: Political and External Deterioration
Another sharp deterioration in the political scene and further worsening of the inflation outlook remain the main risks to benign domestic demand dynamics, while a worse-than-expected deceleration in the eurozone and China would hurt overall growth and increase capital outflows. On the positive side, this might create or cement the conditions for a regime change. Europe and China account for about 18% and 8.5% of Argentina’s total exports, respectively, while Europe is responsible for 50% of total FDI, with Spain accounting for 20%. European banks represent over 23% of Argentina’s financial system, with troubled Spanish banks accounting for 14%. However, the loan-to-deposit ratio is slightly over 70%, meaning that direct financial contagion effects are relatively contained. Needless to say, a more broad deterioration in global economic and financial conditions would badly hurt Argentina’s situation, given its uncertain macroeconomic management and limited access to international funding.
Policy Implications: A Small Fiscal Surplus and Loose Monetary Policy
Monetary policy will remain loose as the central bank management and the executive branch prioritize growth over fighting inflation. The government and the central bank consider inflation problems in Argentina to be based on structural bottlenecks that limit supply of goods, so their solution is to keep credit and monetary conditions loose to support investment. Moreover, the central bank continues to intervene heavily in the FX spot market to defuse strong appreciating pressures on the currency stemming from strong export proceeds, while non-sterilized intervention is fueling inflation. Moreover, the central bank will keep financing the Treasury to support the government’s spending spree.
For fiscal policy, the government’s still-low but raising popularity and the pre-electoral cycle are keeping spending high while revenues are benefiting from the economic recovery, a strong external sector and high inflation. During the January-May period, tax revenues increased 32.6% y/y, though in Q1 2010 they were boosted by extraordinary transfers from the central bank. However, spending grew above 34% y/y, thus shrinking the fiscal surplus to 1.5% of GDP from 2.1% in the same period a year ago. We anticipate this dynamic will persist in 2010 and 2011, with the risk that even higher spending growth in H2 2010 and especially in H1 2011, given the October 2011 presidential elections. Therefore, RGE maintains its primary fiscal surplus forecast at about 1.1% of GDP for 2010, which accounts for a total of ARS25 billion in transfers from the central bank during the year. RGE foresees a 0.5% of GDP primary surplus for 2011. The government expects a 2.3% of GDP primary surplus in 2010.
Meanwhile, the Kirchner administration will likely continue to use central bank transfers and borrowing from international financial institutions and local entities—such as the pension system agency (ANSES) among others—to finance its needs for the rest of 2010 and in 2011. Given that the less-than-encouraging debt swap results (66% tendered), daunting global financial conditions and an uncertain domestic policy mix, it would be very difficult for Argentina to issue new external debt at single digits. Moreover, there is still the risk that holdouts will go after bond proceedings, if issued, given the existence of lawsuits. Finally, we think that initiating negotiations with the IMF for an Article IV consultation will be difficult in the short term as the government enters the electoral period in full.