16 April 2007

Economic divination for Argentina

I promised I'd make a guess about Argentina's economy in the near future. So here it is...

The Argentine government is making considerable effort to maintain the peso-dollar exchange rate high. It does this by restricting short-term incoming flows of dollars (typically speculative investments), by appropriating part of the dollars brought in by exports using retenciones (export taxes), and by increasing demand for the dollar in the local currency markets. The latter is the most significant part of the strategy, and it involves the Central Bank and the Treasury.

The Central Bank buys dollars in the free market using pesos it emits (yes, there's a little machine that spits out Argentine peso bills). In order to prevent all these pesos from reaching the public, increasing liquidity and "heating" the economy (which involves inflation), the Central Bank subsequently sterilizes these emissions by emitting debt letters. These are like bonds or stocks; they represent an obligation for the Central Bank to regularly pay interest to the holder. The public, seduced by the advantageous rates offered by the Central Bank, buys those letters, and the Central Bank gets back the pesos it just emitted.

The Treasury cannot emit pesos, so it uses its own funds, gathered through taxes. The Treasury cannot buy dollars if it doesn't have pesos to spend, so keeping a sizable fiscal surplus is a must.

Now the guessing begins. First, suppose the fiscal surplus decreases. This would leave the Central Bank in charge of buying dollars without help from the Treasury. This is indeed happening now. What about the Central Bank? The present strategy looks nice, but the bank is actually indebting itself to buy dollars. As it tries to get investors to buy more and more of its debt, it needs to offer them higher and higher interest rates. This influences all rates — including the rate that banks charge you when you go asking for a loan. In short, this makes (borrowed) money more expensive, and discourages private investment (you need credit to start a new business or to get those shiny, new, efficient machines to upgrade your industry).

Now, lack of investment is cited as one of the causes of inflation. If industries don't invest, they don't produce enough; offer lags behind demand, and prices rise. Industries recovered fast after the collapse because they'd been using only a fraction of their productive capacity since the 1990s. They simply got the engines started; but now they need more and bigger engines, and it may be too expensive to get them, especially when you have to get them from abroad (remember a key part of the economic policy of this administration is keeping imports expensive!).

At some point, the Central Bank will have to stop emitting pesos and buying dollars. What will happen then? As millions of dollars enter the country (through exports, tourism and investment), the exchange rate will fall. This will make it easier for everybody to import goods, and may bring down the prices of many products which have an imported component, but it will also make our exports less competitive, and will expose our local industries to competition from foreign producers. The export taxes, which comprise a large portion of the fiscal surplus, will yield less and less, so the state will have less money to spend.

As the dollar locally decreases in value, business will have to make some choices. Those who sell only to the local market will face competition from abroad. If the government doesn't block imports using tariffs, you'll lose, unless you become more productive. You can get your employees to work more hours for equal or less pay, or you can fire employees and use more efficient machines. If you're like many, many Argentine businessmen, you'll do this for a while, then sell everything overnight for a bunch of cheap dollars, file a fake bankruptcy, pack your gear and head for Miami.

Those who depend on exporting their production or who won't flee the country will try to ask for subsidies from the government "to preserve the national industry", but remember, the government doesn't have money to spend on you. It will, maybe, if you have contacts in the high spheres — there's always money to cut from welfare, education and public health, in order to help the local industry barons.

Unless something really amazing happens, the surplus of the trade balance will decrease and the fiscal surplus will follow, as the export taxes gather less and less. This will cool down the economy, since the state will be forced to cut spending and the big exporter conglomerates will see their profits reduced. This should bring down prices of certain products that currently have inflated local prices (but don't bet on it!).

The crux of the matter is what the state will do to finance itself. It's already apparent that the national government is interested in fueling consumption, but doesn't intend to do it through a progressive tax scheme. The IVA (i.e. VAT) is 21% for most types of goods, ridiculously high and regressive. A truly progressive government would increase the taxes that apply only to the rich, and decrease the IVA, which applies to everything from bread, beef and lettuce to plasma TVs and luxury cars. Tax evasion is rampant in Argentina, but it should be easier to cash in a tax that applies to only a tiny fraction of the population — the couple of thousands of individuals and companies that make tens of millions each month. As it is now, IVA is automatically added to all goods and services sold legally, which means everything you buy in the supermarket is one-fifth more expensive than it should, and many goods and services are exchanged outside the legal channels, thus depriving the state of funds.

The state is highly indebted in both pesos and dollars. If I were in charge, I'd start paying right now. There's no need to have more reserves. One of the reasons why it's difficult for the Central Bank to keep the exchange rate high is because it has $37 thousand million in stock and everybody knows, so nobody buys dollars (except importers and tourists). The Central Bank and the government should coordinate efforts to pay off dollar-denominated debt. With reserves going down, the dollar will become attractive and demand will increase, thus pushing the exchange rate up without the need for state intervention. It's a bit stupid, IMHO, to have a massive external debt and yet keep it unpaid while you hoard surplus money with no end in sight.

So this is how I see it, in short: a cheaper dollar, a good deal of inflation due to lack of offer, a state with funding problems, spending cuts, lower investment, less liquidity. Stagflation? I might be off the mark by a large degree (you never know in today's world, or ever, in Argentina). Only time will tell...


  1. The machine that spits out Argentine peso bills is in...Chile...!

    Good analysis that i agree with completely. About 4 months ago i wrote the following to someone who asked me what i thought would happen to the argentine economy and property market in the near-middle future (in my former life in BA i helped other foreigners buy property before having to come over to chile at short-notice for personal reasons). They wrote back shocked that i could possibly have such a terrible opinion...as you say about your views: Only time will tell...Looking at things now i'd say i was probably 6 months or so early with my outlook (as in the economy will last a few months longer than i thought a little while ago)

    "My personal view of the market is that Argentina has suffered extremely regular 10 year boom and bust cycles for the past 80 years. There is absolutely nothing to suggest that the government has taken or will bother to take the steps required to haul the country out of this cycle. As such, we're now 5 years into the current cycle. There's probably room for another year maybe year and half for capital growth but beyond that i firmly believe you'll have to wait around 10 years from now to see your money in full again.

    Argentina is not a stable country, economically or policitally, despite how it looks on the surface. I'd compare it to investing in high risk tech stocks. Gains can be big, if you get in at the right time, but losses can be crippling if you need to access your money while the market is down.

    It all depends on your financial state. If you invest now you'll be investing towards the top of the market. If you are financially stable enough and can wait out the downturn/crash then you will see your money again in around 10 years. If not, then i wouldn't invest in Argentina at this point. In 5-7 years the market will have bottomed out again and the hard-nosed businessman will be back in for cheap property, again.

    The fact is that buying a property is out of reach for the vast majority of Argentines. Mortgages are nigh on impossible to obtain so the 'middle class' (those earning between us$700 and $1200/month) cannot afford to buy a property. This is obviously unsustainable in the long run and prices will have to fall.

    Of course, all this is simply conjecture. It's my opinion and i could be entirely wrong. There are many foreigners who don't believe this doomsday view of the country. Most Argentines i talk to do though and part of the problem here is that if enough of the locals truly believe it will happen then it generally will. Lack of consumer confidence can destroy an economy and if, in 2-3 years time, Argentines believe another crash is coming then they'll simply stop spending and get their money out of the country (as happened just before the last crash. And the one before. And the one before etc). Coupled with external economic factors (for example a price drop in currently sky-high agricultural produce) and the country will plunge head first into recession. Again. And i haven't even mentioned the rate of inflation or the 'floating fixed' exchange rate which sees the government keeping the peso artificially undervalued by roughly 30% (meaning that at some point the country is going to get 30% more expensive for foreigners almost overnight) and inflation steaming along at a supposed 12%/annum...

    This probably isn't the reply you were expecting (!) but i'd rather be honest and express my true opinion then tell you everything is rosy. This country is an amazing place to visit as a tourist or as somewhere to live for a few months on foreign currency. It's one of the great tourist destinations and i love it here. But investing here is another matter. The bargains have gone and i don't think there's much left in in the engine unless the government dramatically changes the entire economic system and culture of the country (social and business). I can guarantee if you write to other foreigners offering real estate services that they'll tell you the exact opposite of what i've written. i am always up front about the prospects here. Some believe us and decide not to invest here (as in we lose them as a client) but some don't or don't care and we work with them. Have a think about what i've said and feel free to ask any other questions you might have."

  2. Pablo, I hope you won't mind - this is rather relevant to your post: http://www.wrighton.com.ar/?p=598

  3. Since it’s crystal ball gazing time …

    I admit that it’s getting more difficult to surprise me about the machinations of K’s economic policies. I suspect that the current administration will do anything and everything to prevent a crisis before the next election, no matter what it takes. It’s fortunate that there are few government assets left to sell, as previous administrations have been able to do to support their economic goals.

    I think that no matter what, prices for imported goods won’t fall, and that restrictive tariffs and price gouging will keep foreign-made goods expensive. The government will pass this off as a measure to protect local industry (rather than as a revenue source). I know that you’ve mentioned the high cost of electronic goods before, but if Argentines only knew the magnitude of import taxes and profit margins, they would be truly horrified. Some of the high-end goods I see for sale at mind-boggling prices are out-of-date merchandise that is already heavily discounted in the world market.

    Given the current economic instability, it’s difficult to predict where the dollar/peso may end up. The Central Bank has been controlling the exchange rate very closely in the last few months, but should there be a major economic upheaval for whatever reason, forces outside Argentina will surely value the peso pessimistically, and the Central Bank will be unable to shore up the currency.

    If the peso does strengthen dramatically, I expect that tourism will plummet. Although that would only affect BsAs and a few other tourist destinations, the perception would be very negative. Long gone are the days when BsAs was one of the most expensive cities to visit (and then probably only once). If the dollar also strengthens against the euro, many from the US will choose Europe as a vacation destination- not only for economic, but for practical reasons. There is still very poor infrastructure for tourism in Argentina, particularly for English (or more generally, non-Spanish) speakers. I don’t fault Argentines for being mainly monolingual, but the reality of the marketplace determines people’s choices of where to spend their tourist dollars.

    I’ve always thought that the regressive IVA was in part due to the difficulty (or perhaps unwillingness) of administrations to tax the business oligarchy. Both governmental and non-governmental studies indicate that about only 50-60% of workers are paid en blanco, and from personal experience, all real estate deals are falsified to avoid tax. Because of the cash nature of so many transactions (and thus a way to avoid detection), I doubt anybody has the faintest idea of what many people’s income is. Affluent Argentines have never trusted the government, and have kept their capital offshore in dollars/euros, or in real estate (both local and foreign), and moving funds outside the Central Bank’s gaze.

    Sadly, I believe that it will be every man for himself in the not too distant future. There will be another net transference of money to the wealthy, and the poor will sink further into poverty.


  4. Anonymous18:06

    Excellent essay and comments.

    It is really fascinating to read about the economy in Argentina and compare it to the way things are here (USA) and in other countries. No doubt there is corruption in every country in one form or another. Certainly there is no shortage of it here.

  5. Thank you all for your comments. Yes, Matt, at least the machine that makes coins is in Chile, but I don't know about the bills.

    The key to stabilizing Argentina is confidence, or self-esteem, or whatever you want to call it. Confidence that we can change our own culture, confidence that we can overturn a government if it does the wrong things and something will have to change eventually, and confidence that Argentina is not doomed to failure every time.

  6. Another great post.

    Reading "And the Money Kept Rolling In (and Out)", you realize how many chances there were to prevent a total collapse before the last crisis. Yes, those opportunities would have caused pain, but they would have almost certainly caused less pain overall than the devaluation, corralito, etc. did when they finally hit.

    We are rapidly approaching a turning point. Kirchner of course wants to win the election so we're not going to see any tough decisions made before then. But after he wins another term, he's got to start making some changes -- changes that might well be unpopular and tough in some respects. If not, it's hard to see how Argentina wouldn't be heading for another one of its busts.

    I'm not wildly optimistic about Kirchner's courage to make these changes, but I do think there's at least a chance he will. If he doesn't, the unraveling might begin on his watch.

  7. Pablo, you make a good point about confidence...argentines are so accustomed to these 10 year cycles that after 7-8 they understandably start to worry. To put it very, very basically, they lose confidence, stop spending and send all their money overseas. Coupled with an unfavourable external jolt (eg a fall in agricultural prices which will probably happen this time) and it rapidly spirals into deep recession and crisis. It's partly a self-fulfilling prophecy but i imagine it's difficult to believe anything else when you've been kicked in the nuts so many times.

    I agree with Dan that major changes, and most likely extremely painful ones, will have to be made to haul the country out of these cycles. The question is: Will K be the one to do it? Personally, i doubt it-K is a populist and he likes to be popular...

    As a comparison, Chile is only now reaping the benefits of thr structural changes brought in by pinochet. But the country had to go through almost 20 years of economic hell and a further 10-15 years of adjustment to get to the point whereby the changes actually had a positive effect. And the only way the people accepted this was because they had a brutal dictator breathing down their necks for 17 years-dissent wasn't really an option.

    If those kinds of structural changes were put in place in the current, democratic argentina there would be chaos and bloodshed. 20 years of economic uncertainty and crisis? No one in the world would accept that as their fate, not just Argentines. That kind of change wouldn't be possible or tolerated in any democratic country.

    I'm not even suggesting that the changes need be as drastic and sudden as they were in chile, just a gradual introduction of new policies and a tightening of the laws and particularly tax controls but i can't see it happening; it's not really in the ruling elite's interest to share the spoils, is it?

    I really hope that we'll look back in 5 years and be proved wrong. I hope argentines start to believe in their future and stop being so fatalistic. It can happen...but it's a long, hard road...

  8. Great post Pablo. I'm thinking you did study economy at University yes?

  9. I had some Economy in highschool and some more at the university, but I studied Systems Engineering (~Computer Science). It's really simple; it's the pro economists that make it sound complicated. :)

  10. So, according to Pablonomics, the best currency strategy would be to convert dollars (and dollar-denominated assets such as real estate) into pesos … and wait for the peso to strengthen. I’m not sure that even the most ardent believer would however be prepared to take the risk. It would be interesting to know how the oligarchy is hedging its bets as to the direction of the economy (and economic policy).


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