Argentina’s inflation is now approaching the 20% range, as it has recently accelerated from the mid-teens levels. There is now a heated debated about its causes, the possible paths that inflation can take in the future and the key variables that one needs to monitor in order to try to predict where it can go.

In contrast to previous episodes, this inflation process, which started towards the middle of the decade, was not driven by the needs to print money to finance the fiscal deficit. Instead it was a result of a combination of factors.  On one side, the economy started to reach full capacity in many sectors and there was starting to appear a large number of bottlenecks.

Despite the need to slowdown the growth in aggregate demand, macroeconomic policies continued to have an expansionary bias. On the fiscal side, nominal expenditures where growing at annual rates above 20%, which meant that there was a clear fiscal impulse despite the fiscal surpluses that the Government maintained during those years.

The Central Bank did not take upon itself the task of fighting inflation, as monetary growth accompanied the evolution of nominal GDP and in this sense it followed an accommodating monetary policy while providing an expansionary bias by keeping nominal interest rates well below inflation.

As a result macroeconomic policies were aiming at lower rates of inflation, but instead they maintained sustained growth in nominal aggregate demand. While there was ample excess capacity (as in the 2002 to 2004 or 2005), this increase in demand was satisfied through a rise in aggregate supply, but once this excess capacity started to disappear most of the pressures fell on inflation.

To make matters worse the Government granted large wage increases (of around 20% per annum), as the unions became stronger once the rate of unemployment fell to one digit.  Besides, it was a way to show gratitude to the union leaders that were key supporters of the Government.

Inflation receded in the second half of 2008, after reaching 25%, thanks to the international financial crisis that affected aggregate demand and caused the first recession in the Kirchner era and the fall in commodity prices that removed some of the pressure on food prices.  However, this was a short pause, as inflation started to accelerate again since the last quarter of last year and is now becoming a monster that is difficult to tame.

In summary, during these years there has not been an anti-inflation policy. Perhaps the only exception has been Secretary Moreno, who single handed tried through the use of price controls and guidelines to keep a lid on price increases.  

But the policy inconsistency of the past implied that these attempts to rely on controls and intimidation were short lived and inflation is again on the rise, and this time the risks are higher.  The main problems are now the Government needs to resort to the Central Bank to meet the financial requirements and the fiscal deficit as it has no access to the markets, unions remain strong and monetary policy still has a clear expansionary bias.

These expansionary policies are in place after four years of double digit rates of inflation and when workers and firms have already incorporated expectations that in the best case scenario inflation will remain at 20%.  Inflation inertia is dominating the process, and experience shows that once this type of process starts it is difficult to reverse it.

In the meantime the Government is making two big mistakes in its analysis of the causes of the inflation process. First, it argues that this is a realignment of relative prices (namely meat and wheat) instead of realizing that this is a generalized and persistent increase in the price level.  What they don’t see (or don’t want to admit) is that most wage and price adjustments are staggered over time and hence there is always one price that explains inflation in a given month. The fact is that all prices and wages are moving upwards, though not all simultaneously.

The second and certainly more risky mistake is that the Government has been arguing that “supply constraints” are the main reason for the recent acceleration of inflation, so-called as “relative price adjustments” by the Government. Indeed, there are some “supply constraints” in some durable and non-durable final consumption products, as some food products. Specifically, the indexes of capacity utilization in the durable and non-durable final consumption products have remained in the last two months in the maximum levels of at least the last ten years, suggesting that there is excess demand in those sectors, despite the 2009 recession, in part as a result of a relatively lower investment. This result may not be a surprise, since several of those sectors in last years have been under Government intervention and regulation, such as several food sectors (meat, milk, wheat, etc.) or public utilities (electricity, natural gas, etc.), with regulated prices and exports quotas. Due to the lack of investment incentives, output and installed capacity in those sectors remained relatively stagnant in past years, and even decreased in several cases.

While the supply constraints have been a factor affecting inflation, though it is wrong to conclude from this evidence that the Government will be able to deal with this issue through increases in supply. Here, there and everywhere when there are generalized pressures by aggregate demand excesses in the short run the only solution is to restrain demand or to increase imports.  Argentina is not likely to follow neither recipe so the effects should be very clear.

Aggregate demand is now growing at around 20/25% per year in nominal terms. The Government believes that the answer is to increase supply, and hence it is meeting with producers to diagnose where the bottlenecks are and to try to provide credit lines to get them to invest and increase production.  The argument does not take into account that investment takes time to mature and to have effects on production, nor does it calculate how much investment needs to increase to generate real growth of around 8 percent (certainly much more that the current 22% of GDP).

All the risks appear to be on the upside, as the Central Bank seems ready and able to maintain large rates of monetary and credit growth and interest rates that remain negative in real terms, while the Government plans to keep the current high rates of growth in nominal expenditures and to resort to the Central Bank to obtain the necessary financing.  This is an explosive mix. 

Despite all these concerns there is a caveat. It would be prudent for our readers to disregard the uneasiness about inflation presented in this analysis as it was done by a so called neoliberal, orthodox economist, who does not fully understand the virtues of supply side economics, nor Say’s Law in reverse (that demand creates its own supply). 

Brazil:

The central bank increased reserve requirements (RR) on bank time deposits by BRL 34 billions, to be effective on April 9, and on additional requirements on time deposits and on demand deposits by BRL 37 billions, to be effective on March 22.   The actions will withdraw a total BRL 71 billion in liquidity from the system.  The RRs were lowered by Q4 2008 in order to provide liquidity to the financial system (BRL 100 billion) during the crisis; however, the central bank considers that the financial system is very liquid and that those measures are no longer necessary. 

Brazil:

The Central Bank Weekly Focus Survey released on February 19 showed that inflation expectations for year end 2010 continued to move away from the mid-point of the central bank target range of 4.5% (+ -2%), while the monetary policy rate (SELIC) stayed unchanged.  Moreover, GDP growth expectations for 2010 were revised marginally up and the real (BRL) for year-end 2010 stayed unchanged.

There is never a quiet time in Argentina, even in a year in which the conditions were ripe for smooth sailing. Back in December all the evidence was indicating that Argentina was going to grow, that it would enjoy a significant reduction in country risk with the prospects of regaining access to the international financial markets, that it would accumulate international reserves and that the only dark cloud in the horizon was the risk of a small rise in inflation.

Brazil:

The Central Bank Weekly Focus Survey released on February 17 indicated that inflation expectations for 2010 continued to deteriorate, though marginally, while economic growth forecasts increased rapidly, as expected.  Inflation forecasts moved slightly up to 4.8% from 4.78% for year-end 2010; however, inflation expectations for 12 months in advance and for year-end 2011 stayed well anchored at around 4.5%.  Meanwhile, IGP-M forecast for 2010 moved sharply up to 5.26% from 4.84% the previous week and 4.55% by mid January.  Here too, however, inflation expectations for 2010 stayed at 4.5%.  The central bank target is 4.5% (+- 2%).  Average GDP forecasts were revised up to 5.47% from 5.35% for 2010 and remained stable at 4.5% for 2011.

Brazil

Last Friday, IGP-10 inflation came at 1.08% m/m in February (Bloomberg consensus 0.98% m/m).  Wholesale prices (60% of the index) jumped to 1.15% m/m from 0.07% m/m in January driven by final (1.63% m/m) and intermediate goods prices (1.36% m/m), as well as industrial costs (1.5% m/m).  Agricultural prices increased to 0.08% m/m from -0.85% m/m in January. Meanwhile, consumer prices (30% of the index) increased less dramatically to 4.45% m/m from 3.99% m/m in January, lifted by higher transportation (6.49% m/m) and food and beverages prices (3.42% mm/).  Housing stayed stable at 4.52%. 

In a way, Brazil is a jail. Fortunately, it is a beautiful prison, with glittering beaches, exotic flowers and wonderful food. However, it has 190 million Brazilians locked in a closed economy—forced to accept whatever quality of goods and services, at whatever price and quantity. Despite all of the BRIC hype, Brazil remains one of the most closed economies in the world. Brazil’s exports and imports, as a percentage of GDP, should be 16% in 2010. Argentina’s trade as a percentage of GDP will be more than twice as much, and Chile’s trade will be 56% of GDP. To put things in perspective, Singapore’s is more than 150% of GDP. The country’s closed economy is the reason why Brazilian firms can charge exorbitant prices for basic goods and services. Automobile prices, for example, are multiples of what they are in other countries. Brazil’s cellular services are the second most expensive on the planet, next to South Africa. Air fares are ridiculous, and the cost of consumer credit is among the highest in the world. The lack of competition gives Brazilian producers monopoly-like powers that result in very attractive business models. Just a few nights in Rio confirms this, where the absence of world-class hotels allows local institutions to charge deliriously high rates for lackluster services. While this may be an annoyance for tourists and business travellers, the real victims of the closed economy are the country’s 190 million inmates. They are the ones who have to constantly bear the burden. Yet, one of the beneficial side-effects of the closed economy was the creation of Brazil, Inc.—a commercial and industrial behemoth that allowed it to take on a dominant role on the global stage.

The same kind of macroeconomic irresponsibility that was typical of Latin America (including Brazil) in the second half of the last century is becoming a major characteristic of the following 20 countries: Iceland, Greece, Portugal, Spain, Latvia, Ireland, Ukraine, Romania, Lithuania, Turkey, Bulgaria, United States (yes, USA), Australia, Japan (yes, Japan), United Kingdom (yes, UK), South Africa, France (yes, France), Russia, New Zealand, and Italy.

After riding the global credit boom for the past decade, fate finally caught up with Jamaica. A prolonged process of deindustrialization and the shift to a services-based economic model led to a persistent series of current account and fiscal deficits that were financed by the debt markets. In two years, the country’s external debt to GDP ratio jumped to 105%, from 76% in 2008. At the same time, Jamaica’s central government debt, which includes all domestic obligations, reached 120% of GDP this year. Debt service was consuming 55% of the country’s fiscal revenues. The current account deficit is more than 10% of GDP, despite a sharp slowdown in economic activity. The Jamaican economy contracted 3.5% y/y in 2009. It was clear that the country’s economy was wrong footed and its debt load was unsustainable. This was the reason why Jamaican bond prices plunged during the end of last year. Still, there is a great deal of international support for the country. Jamaica is the third largest economy in the Caribbean, and closely aligned with the U.S. and Europe. Although the country was under a great deal of stress, the multilateral community was not going to allow it to collapse in disarray. Therefore, something was going to be done to get the country through a tough patch.

Overview

Between May 16th and July 4th, there will be elections to renew 12 governorships, 15 state legislatures via 309 seats, and 1,533 mayorships. The elections will be a testing ground for the country’s largest political forces as they try to reposition themselves ahead of the 2012 Presidential elections. For the PRI the upcoming elections are strategically important as these will define the party’s prospects to recapture the Presidency. For the PAN and the PRD the upcoming elections are vital as a matter of survival. Ahead of the elections, the most glaring issue is the intention of the PAN and the PRD to form alliances to face the PRI and curtail this party’s prospects in the ballot of several states.

The upcoming elections are highly relevant in a number of ways:

The elections will bring to the polls 40% of the country’s voters—that is 31.2 million out of 77.7 million who are registered to vote. Naturally, parties will concentrate their efforts on those states with the highest number of voters and economic development.

Nine of the 12 states that are participating in gubernatorial elections are currently governed by the PRI: Chihuahua, Durango, Hidalgo, Oaxaca, Puebla, Quintana Roo, Sinaloa, Tamaulipas, and Veracruz. But there are two governed by the PAN (Aguascalientes and Tlaxcala) and only one by the PRD (Zacatecas).

In a scenario where the PRI maintains the states that it currently governs and increases its number of seats in state legislatures as well as in some key municipalities, this would suffice to consolidate its political strength nationwide and greatly improve its prospects of winning the 2012 Presidential race.

The Big Picture

The PRI is currently the dominant political force at the state and local levels with leadership in 19 out of 32 states. In contrast, the PAN only holds seven gubernatorial chairs, while the PRD governs six states including the Federal District. The current distribution gives the PRI an important advantage over its adversaries.

Considering the results of past elections for governorships and state legislatures, the PRI seems poised to obtain great victories in the following states: Tamaulipas, Puebla, Durango, Chihuahua, Quintana Roo, and Hidalgo. The PAN is favored in Aguascalientes. Electoral preferences in other states are not so clearly defined at this point.

In 2009, parties had electoral races for six governorships of which the PRI won five by retaining Nuevo Leon, Colima, and Campeche, and by taking San Luis Potosi and Queretaro from the PAN. The PAN only won the governorship of Sonora which it took away from the PRI.

Short-term ramifications

Aside from the mid- to long-term implications of the upcoming elections, results will have significant ramifications in the short-term. As we advanced in our report “Five Key Political Risks,” a landslide victory of the PRI over the PAN would strip President Calderon of important political capital thereby impairing his ability to negotiate balanced deals with the PRI and operate effectively at the local level.

Unholy Alliance

The PAN and the PRD are currently discussing the possibility of running together to compete against the PRI in several states. As of now, alliances for a common gubernatorial candidate have only been approved in Durango, but it is very likely that similar alliances could be announced in the next few weeks for Puebla, Oaxaca, and Hidalgo.

Without entering into much detail regarding these alliances, as each one would require a separate analysis, this unexpected decision should be merely regarded as a political calculus to counter what otherwise would be a near certain defeat for both of these parties.

This decision by the national leadership of the PAN and the PRD has been subject of widespread criticism, and it has already created internal conflicts that relate to ideological considerations. Outside the parties, the bulk of criticism both from the media and academia revolves around the difficulty to unite the interests of a right wing, conservative party with those of a leftist, liberal party which is antagonistic in many cases. Nevertheless, these alliances have also caused a great deal of anxiety among some of the PRI leaders, who in response have threatened to block initiatives in Congress.

Upcoming Battles

The successful completion of electoral alliances between the PAN and the PRD almost certainly will increase competition in several states, but also rivalry between the governing party and the PRI at the national level. Given the PAN’s poor prospects and lack of options, it is likely that the party will once again confront the PRI over the latter’s corrupt past in hopes of differentiating itself. This strategy could potentially polarize the political environment and negatively affect deals in Congress between both parties at a crucial time to advance the reform agenda.

Cartels Meddling in Elections

Ahead of the elections, electoral officials have expressed fears that the country’s drug cartels will try to influence the elections via campaign resources, corruption, or even intimidation and extortion. Given the PRD’s recent experience in Michoacan, where one of its candidates who won a seat in federal Congress was accused of having ties with the cartel La Familia Michoacana, it is foreseeable that party committees as well as electoral authorities will place renewed emphasis on investigating prospective candidates.

Final Thoughts

A number of critics of the Mexican political system often refer to an incomplete democratic transition whereby the power of the Mexican Presidency has been reduced while governors have acquired near feudal powers along with great discretion in the use of resources. At the same time, given the strong correlation between states dominated by a particular party and electoral victories at the federal level, state elections have become all the more important.

Thus winning a state election not only implies budgetary resources and logistical advantages, but also improves the outlook for a party to do well in the upcoming Presidential and federal Congressional elections in 2012.