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The economist of the month: the discal situation is more precarious that is believed
Ambito Financiero
July 22, 2008

In the traditional report of the Economist of the Month, the analysis was in the hands of Manuel Solanet, who warns about the precariousness of the fiscal situation and the need to eliminate doubts about a future default. He is part of the Academic Council of FIEL, and warns also about the exhaustion of the model propped up by a maze of subsidies. He says that the government is mistaking the fight against inflation as attacking its consequences and not the causes.

1 The Argentine economy faces an exhausted model

The air of change that was pronounced in the political events in the Senate on July 17th should be carried to a reorientation of economic policy before a model that has shown itself to be worn out. There are many economic issues that are occupying attention and today are generating worry. Inflation is the most notorious problem and it is worsening from the absence of rational policies to deal with it. There have been attempts to work on its consequences and not on its causes. Price controls led to inefficiencies, as expected, and also harm.

For 18 months he have had too much control over the indexes. This manipulation has come to be not only an institutional offense, but also a legal kind of default. But in a scheme of frozen rates and repressed inflation, with a real revaluation of the peso, the fiscal deterioration is, in the end, the main threat. If there isn't a fiscal margin to sustain the rise in subsidies, the model will crumble on itself. The main reason for this fiscal deterioration is the strong rise in subsidies for energy, transportation and the food industry, as well as the permissive rise in public employment.

There is a risk of fiscal exhaustion making inevitable the straightening out of delayed prices and that would produce an inflation shock, generating a sudden drop in confidence and setting off a very well-known flight of money. It already exists as a worrying question, a trend toward demonetization and the rise in interest rates over the last two months. The growth in productive activity, which until shortly ago appeared to be a positive characteristic of our economy, has given a pass and now there are clear signs of a slowdown. Expectations have deteriorated due to the conflict with the farm sector, and the rise in interest rates and its negative impact on credit.

The insufficiency of investment in the past few years is another problem. It's seen most intensely in energy. There is a shortage of fuel and electricity within the framework of a fall in production of oil and gas. We are going from being exporters to becoming importers just as international prices are in the clouds. At the best market moments for our main products, the trade balance is deteriorating. The twin surpluses are at risk. Both of them.

2 There are signs of a slowdown

The most recent macroeconomic data clearly shows a reduction in the level of activity, as much in consumer sectors as in investment. The estimates for GDP growth in 2008 are being revised down. It's so with a statistical drag on the order of 4%, there is a warning over the difficulty of projecting more than 6% for the whole year.

The data on sales and consumer credit show leveling off or decreases. It's also perceived in the demand for labor. In the interior, the adjustment is more notorious and that is due to the more direct relationship with the farm sector. In June, for example, the tax collection on gross incomes in the provinces declined.

The slowdown will surely reduce the demand pressures on sectors that have hit their maximum productive capacity and will also relieve imports which have to pay higher prices for consumer goods.

It could also reduce demand on public services and that could hold back some growth in subsidies. Nevertheless, this would not be sufficient to avoid the growth in public spending, which is one of the causes of inflation. But when we speak of inflation, we can't fail to think of the enormous accumulated distortion in relative prices, which appears to be a latent and growing threat.

The rates on gas and electricity will have to be increased various times. Diesel and gasoline will have to double in price or still more if crude oil is paid for at international prices. With those adjustments and without subsidies, public transportation will have to triple its rates. If all this occurs, there will be demands for salary increases and a real and psychological propagation of inflation.

The government knows it and for that it never considered arriving at the moment of squaring prices and the distortions are growing. The limit could be the capacity of the public coffers to cover the subsidies. It would be desirable that the squaring of prices would be produced within a framework of confidence, with a rational and well-structured economic program. On the other hand, if it imposes fiscal insufficiency outside a rational and credible programmatic framework, it could provoke a spiral.

3 The public accounts show weakness

The fiscal situation is precarious while the opposite is reported. In the first half, spending went up at a faster rate than revenues. The government, which without a doubt sees the problem, decided to raise export taxes in November 2007 and again in March of this year. The official data that speaks of sustaining the primary surplus calculates only what is paid and not what is owed, and there is evidence of heavy delays in subsidies and public works.

This last bit is clearly a sign of weakness in the public coffers. The well-calculated result, in the best of cases, barely covers interest without contributing anything towards reducing the debt. The maturities on the principals will have to be paid off with new debt at increasing interest rates.

The government remains in default with the Paris Club and with the holdouts and still has no access to the markets. Ch vez is collecting high interest rates from us and there are no alternatives. Our government has already sufficiently spoiled the AFJP portfolio by placing titles that have lost value. Our poor BB rating now has added a "negative trend" and country-risk is close to 700 basis points. It's essential to act on spending to seek a genuine fiscal solvency, but as we've been saying, the day is not arriving to square public rates nor to speak of administrative reform and rationalization.

Worse yet, they are re-nationalizing businesses. The fiscal rebellion by the farm sector over the abusive rise in export taxes put in evidence that there is little or nothing that can be done on the resources side other than raising taxes.

4 One still can't talk about an exchange rate run, but the real demand for money is being reduced

People's behavior has changed since the crisis with the farm sector. It had already been insinuated last year with an extreme sensitivity that led to a reverse in currency flow when the financial crisis in the United States was set off. In the past four months, the Central Bank has lost US$2.9 billion in reserves. It's estimated that in the last 12 months the flight of capital was close to US$20 billion. Monetization has shrunk and interest rates have increased.

The M2/GDP ratio was 18.8% at the end of 2005, dropped to 16.5% at the end of 2007 and currently is estimated around 14%. The main cause of this gradual diminution is without a doubt the perception of economic agents that inflation could not be reduced. They only see the government acting on its consequences and not its causes and the public is not aware that there are growing tensions in the system of prices and that they have multiplied the demands for salary increases.

On the other hand, the process of de-monetization is gradual and a run cannot be spoken about; nevertheless, these are warning signs that demand measures and changes to recover confidence.

5 The energy crisis

The energy crisis is already here and it's punishing industry that is submitting to official requests almost daily to reduce electricity and gas consumption. There is also a lack of diesel for transport and for agriculture. There is no mystery around the causes of this situation. The freezing and controls on prices and the rupture in concession contracting rules have discouraged investment and restrained supply, while demand has been exacerbated by low prices.

The production of oil and gas is declining and electrical generation doesn't yet allow for counting on technical reserve nor supplying peak periods. This has occurred in Argentina at the same time that international energy prices are multiplying various times over. The decoupling of internal prices has brought incredibly elevated export taxes in the case of oil, or subsidies in the case of electricity, gas and diesel.

Getting over this crisis will not be immediate, while the price structure is being mended and regulatory and concession rules are normalized. A period of stability and confidence is needed to gain investments and then they will require quite a prolonged time to be executed and become productive.