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Thursday, November 01, 2007

Time To Cry For Argentina?

Two issues - apart from the exceptionally high levels of recent economic growth which have been achieved recently - seem to have dominated the economic landscape which formed the backdrop to Argentina's latest election: the price of tomatoes and the availability of energy.

In many ways this preoccupation with tomatoes seems to be a good example of one of the defining features of Argentine social and political life, an obsession with detail - and the more exotic the detail the better - and in particular with detail over and above the big picture story. And while having a regular and reliable energy supply is far from being a mere detail, the price of tomatoes might well seem to be one.

The devil, however, is always, or at least nearly always, in the details, and the devil, in one form or another, is never, it seems, very far away when it comes to Argentine politics. As outgoing President Néstor Kirchner is quoted as saying at one point "It's not easy work helping Argentina find it's way out of hell, but in these past four years we've shown that it's absolutely possible to do so". The moral is, it seems, that the devil makes hard work out of life, but he doesn't always win, unlike those who "adjust" the inflation numbers, who seem to do so eternally.

In fact the really big, big news which lies behind the recent electoral triumph of Cristina Fernandez isn't the technique which has been so delicately refined in order to prune the inflation data, nor is it even to be found in the fact that earlier in the year many of the country's factories were brought to a virtual standstill by the need to maintain supplies to Argentina's domestic consumers (and of course voters) in the face of growing shortages. No, the principal "big picture event" which has marked this years electoral process is the fact that Argentina's economy has been expanding at a sustained annual pace of around 8% per annum over the last four years, and is, if anything, accelerating at the present time, since the Argentine economy reportedly expanded at the fastest pace in three months in August and was growing at an annual rate of 9.2%. Obviously the "China phenomenon" - if we can use the expression to characterise those emerging economies which now seem able to sustain very high levels of annual GDP growth (Turkey, India etc) - is something which now extends way beyond China. And the mention of China is not altogether incidental here, since it was by linking-in to China's growing need for agricultural products (and in particular for Soya) that Argentina first began to put the turn of the century crisis behind it. The question which we will ask in this post is whether or not recent growth in Argentina is sustainable, and whether in fact it is now something more than a derivative consequence of the China phenomenon itself.

Of course the big issue here is just how significant and sustainable all this is. In the first place, and looking briefly at the GDP chart above, it is clear that the recent boom years have followed in the wake of a couple of very strong "bust" ones, so to some extent above-par growth was to be expected. So will the Argentine economy continue on its present stellar path or is the present inflation upsurge, as some would have it, a warning signal that Argentina lies on the verge of yet another of those hyper-inflationary spirals? This is the question we will attempt to investigate here, in order to ask ourselves whether or not, and despite the fact that Argentina just clocked in at 85th place in the World Economic Forum's Global Competitiveness Index, there something different about Argentina's evolution this time round? And if - to anticipate a little - there are reasons for thinking that this time it may be different, what exactly those reasons are, since as I note, the World Economic Forum could find little to be happy with.

The Steadily Disappearing Inflation Trick

Certainly reasons why Argentina's "growth miracle" should not continue are hardly hard to come by. The first of these is the incipient rising inflation, and the government shenanigans in trying to hide it. The issue of food prices hit the headlines in grand style earlier this month when Argentine consumer groups launched a week-long boycott of tomatoes after prices reached almost $6 a kilo, making the salad vegatable which garnishes the nation’s dinner plates effectively more expensive than the meat it normally accompanies. The boycott itself took place amidst growing concerns about galloping food inflation and widespread criticism that the official inflation figures presented by the government were being manipulated as part of the run-up to this weeks elections.

Food prices are now widely estimated to be rising at an annual rate of around 22.5 percent - or more than double the inflation rate which is to found in other sectors like clothing, or domestic appliances. The "say no to the tomato” campaigners handed shoppers a tomato in a bag marked "officially priced at 3.99 pesos ($1.30), don’t overpay”, an ironic reference to the official price recorded by Argentina’s much-questioned National Statistics Institute (Indec). Incumbent President Néstor Kirchner has defended Indec’s figures, most notably by describing them as "perfect”, but after months of apparent government manipulation of official data there are few who are still willing to swallow this. Independent economists expect inflation to end the year somewhere in the 15 to 20 percent region, or at double the rate which is to be found in the official government’s forecast. At the present time inflation is estimated by Goldman Sachs to be about double the official 8.6 percent rate, and the blame is put firmly on a 35 percent jump in government spending this year.

To back their inflation claims Kirchner's critics have been pointing to a breakdown in the traditional relationship between price rises in Buenos Aires, the province that the government uses to gauge nationwide consumer prices, and prices in Mendoza province. In the 10 years up to 2006, annual inflation in Mendoza, a wine-producing region located in the foothills of the Andes, was on average 0.4 percent higher than in Buenos Aires. That gap however swelled to 9.2 percentage in the first seven months of 2007.

Indeed in August Patricia Gimenez, the head of statistics for Mendoza province, initially reported inflation as running at 3.1%, more than double the official 1.5 per cent month-on-month rate, but the figures were later modified by the National Statistics Institute to show the lower rate 1.5% rate, according to the newspaper Clarin, and the earlier figure was attributed to an administrative error.

As can be seen below, according to the government prepared Indec data, inflation would actually seem to have been slowing in Argentina so far this year.

Perhaps looking at the above chart we can see why Néstor Kirchner recently described Argentina's inflation data as "perfect". As he said "We don't say there's no inflation", we just say that it is coming down when it is in fact going up. The perfection here obviously lies not in the accuracy of the data, but in the fact that it is hard to observe the hand moving behind the screen.

Argentine Factories Running on Empty?

The second issue which has been bobbing steadily up and down in the background, and which has given lots of fuel to the Argentina "recovery" sceptics, is the state of Argentina's infrastructure, and in particular the preparedness of its energy sector. Last July, and for the first time, even Néstor Kirchner himself was forced to concede that a major problem existed to the extent that he actually used the term “crisis” to describe the severe energy shortages that Argentinians had been experiencing, shortages which in fact forced the government to ration gas supplies to the very factories which had been fuelling all that recent GDP growth in order to try to ensure that there was enough available for heating voters' homes.

One of the complex threads which weaves its way through Argentina's current energy woes is, of course, the issue of climatic change. Lower than traditional rainfall has increasingly been causing problems for hydro-electric dams, and both Argentina and Chile have relied to some considerable extent on hydroelectric power to meet their energy needs.

There are, however, other issues, among them the relatively high level of energy interdependence among Latin American countries, and the relatively high level of political instability which characterizes some of the countries concerned, most notably Bolivia and Venezuela. What all the interlocking and interdependence effectively means is that problems in one country are rapidly transmitted to another. At the end of June, for example, Argentina was only receiving 4.6 million cubic meters of the 7.7 million cubic meters of natural gas it needs daily from Bolivia.

Argentina is not the only country affected by this situation. Whenever Bolivia cuts exports because of internal chaos (which is a not infrequent event), or because of technical problems caused by an investment deficiency (which are ongoing), then it is contractually obliged to service its Brazilian export contracts before it services Argentina. The resulting shortages then prompt Argentina to reduce its exports of Bolivian natural gas to Chile. Chile also is facing natural gas shortages, but cannot purchase directly from Bolivia because of the ongoing feud between the two countries over access to the ocean, which Chile took from Bolivia in 1884. Chile will soon construct liquefied natural gas ports to overcome its energy problems.

Within both Chile and Argentina, residential consumption of natural gas (which in Argentina increased by a staggering 30 percent in May because of an early winter cold snap) is given priority over industrial use. This has led to shortages for power plants and factories in both countries, and also to the use of diesel and other petroleum-based fuels as a substitute for natural gas in those facilities capable of using multiple fuel types. That, in turn, has led to tremendous pollution problems, particularly in Santiago, and to diesel shortages that are affecting Argentine farmers during harvest (though the country's main crop, soy, has not been affected).

But is ever the case with Argentine economics, domestic political questions are never far away in the background, in this case in the form of Argentina’s ultra-cheap energy tariffs, which have helped fuel the increase in demand at the same time as they have helped the economy bounce back from virtual ruin in 2002. After four years of pretty spectacular GDP growth - averaging over 8 per cent per annum - Néstor Kirchner is now prepared to admits the dramatic economic growth has created "bottlenecks", but he has largely attempted to shift the blame onto energy companies for failing to invest enough to boost gas production, and transport companies for failing to deliver enough energy.

From a more conventional economic point of view, of course, the issue of the government regulated tariffs lies behind the issue of the lack of investment. So while external factors undoubtedly played some part in the recent energy trauma which has shaken Argentina, to some considerable extent the problems have "made in Buenos Aires" written all over them. Since coming to office four years ago, President Nestor Kirchner has refused to lift price controls on utilities. These controls were originally imposed during the financial crisis of 2001-2002 to avoid social unrest, and afterward they were continued in order to give the appearance of controlling inflation. However, these fixed prices have discouraged new investment in the country's ample natural gas fields, leaving Argentina cripplingly dependent upon Bolivian imports, even as economic (and hence industrial) growth in the region exacerbates energy shortages. Although Argentina's natural gas production has increased over the past few years, it has not increased enough -- and most of the increases have not come from the opening of new fields, but from existing ones that are rapidly maturing and will soon "top out".

The Electoral Dynamics of Inflation Linked Bonds

On another front, the widespread suspicion that the government of Néstor Kirchner has been manipulating the inflation data and the likelihood that his wife Cristina Fernandez would succeed him have been steadily transforming the Argentine bond market. Argentina's benchmark inflation-linked bonds have fallen 24 percent in the course of this year, making the country's debt market the worst performer among any of the emerging economies, according to data compiled by JPMorgan Chase, and this has converted Argentine inflation-linked debt into the single worst long-term asset to be found in any of the emerging-markets. Yields on Argentina's 5.83 percent inflation-linked peso bonds due December 2033 have soared to 7.7 percent from 5.3 percent on Feb. 1, in other words since just after Néstor Kirchner started making those personnel changes in the statistics office in a drive to "perfect" the statistics.

Now about 40 percent of Argentina's $136 billion debt is in inflation-based securities, and the value of their their principal rises and falls along with the consumer price index, so we can see here an immediate possible and plausible explanation for the growing obsession with inflation data. Merill Lynch estimates that the statistical "perfections" mean that Argentine bondholders may well have lost out on around $250 million in interest payments this year alone, and by steadily reducing the official rate the Argentine government stands to save something in the region of $5 billion in principal payments at maturity.

Of course in electoral terms tampering with an index which should reflect the price of tomatoes is one thing, and tampering with it in order to reduce the size of overseas debt quite another. So whilst the polls show that most Argentines feel that consumer price increases are accelerating, and this obviously is a matter of concern for people who have lived through inflation which skyrocketed up towards the 20,000 percent level in the early 1990s, there are also other items on the household balance sheet which help to some extent to explain Cristina Fernandez's popularity. Reducing the level of debt payments abroad would be one of them. The level of unemployment, which has fallen steadily in recent years, would be another.

Surviving The Emerging Markets Storm?

In fact, despite the numerous tricky issues which arise in association with Argentina's sovereign bonds, the country itself, and its financial markets, have largely been spared the kind of problems which have been experienced in some of the other emerging markets like South Africa, Hungary or Turkey. One of the principal reasons for this is that now – and in stark contrast to the situation which characterized much of the 1990s – Argentina's economy is largely protected against external financial pressures by the presence of budget and current account surpluses, and with these surpluses has come a steady increase in the country's foreign exchange reserves and a reduction in its external financing needs. Rather ironically, the poor reputation which Argentine national debt and institutional quality enjoy may have been more of an advantage than an impediment in recent years, since they have meant that the peso, rather than appreciating against the dollar as many emerging currencies have found themselves doing (the Brazilian Real for example), has in fact been trending slowly down. This situation is rather like running the late 1990s in reverse and has made it comparatively easy for the Argentine administration to maintain competitiveness and a trade surplus in the face of strong internal inflationary pressure.

Put another way, the Argentina administration has not found it necessary to follow in the footsteps of some other (and currently rather more notorious) emerging market countries by adopting a currency peg (something which in any event would be unthinkable in Argentina following the experience of the late 1990s), since market sentiment has done effectively done the work of weakening the peso for it. In fact the peso has fallen steadily against the dollar during the course of the last two years, at a rate which has to some extent been eating up inflation just as fast as the Argentine administration has been meticulously creating it, and all of this without causing any form of major financial disruption. Over at the IMF I can almost see the staff economists in tears at this point. And perhaps this is really why Kirchner describes the inflation data as "perfect", since such manipulation would seem to allow this process to go on and on, in a virtually painless fashion, while at the same time reducing the real value of the outstanding external debt . Or does it?

It would on the face of it seem that Argentina’s real economy is much less vulnerable to external shocks than it used to be, and while it was affected - as can be seen in the above currency chart - by the last August's market turmoil, it has hardly been knocked off its orbit by it. One part of the explanation for this is that the 2001 crisis had the consequence that there have been relatively few capital inflows into Argentina since the turn of the century, and indeed there have been net capital outflows in recent years, a situation which stands in stark contrast with the high levels of foreign capital penetration which existed in the late 1990s. The result is, naturally, that the level of external debt has been falling steadily.

The level of outstanding public debt has also been steadily reduced, and the recent increases in government expenditure in the run up to the election have largely been financed out of revenue. In fact Argentina's tax revenue was up 37.4 percent in August 2007 when compared with August 2006, largely as a result of the fact that wages have been rising strongly (around 20% a year in nominal terms) and this has given a sustained impetus to consumer demand.

Thus tax income in the year up to August 2007 rose to 17.9 billion pesos ($5.7 billion), up from 13 billion pesos a year earlier. Revenue from value-added taxes rose 43.3 percent to 1.8 billion pesos and income tax revenue grew 33.4 percent to 960 million pesos. So while government spending has increased significantly in this election year, the strong revenue inflows have enabled the administration to service the spending without increasing the level of public indebtedness.

And unlike the situation in say, Eastern Europe, the boom in Argentina is hardly a credit driven one. Argentine banks only lend the equivalent of about 40 percent of their deposit base, a figure which is only around half the average rate now prevalent across Latin America. At the present time loans by banks equal about 11 percent of gross domestic product, and again this is down from the level of around 30 percent which prevailed before the financial crisis.

This apparent prudence on the part of the Argentine banking sector recently lead Nestor Kirchner to chide the banks, whose average credit card interest rate is roughly double that which is current in the United States, for example, by urging them to cut finance charges and lend more, vaguely threatening - in traditional Peronist theatrical fashion - that if they didn't act on his advice, then he and his government might be "forced" to consider introducing rules which ensured that they did.

"Banks are too liquid, and have lots of money saved. I'm glad they are solvent,'' Néstor Kirchner said recently in a speech at the presidential palace, "but you have to give loans at low rates, otherwise I'll have to take some measures.''
However, if we take the trouble to look at Argentine overnight interest rates, then we find that they are hardly high in comparison with those prevailing in some emerging markets, and indeed given the level of inflation which prevails (even on the official version) you might think there was some good justification for raising them (in Turkey, for example, the overnight borrowing rate is currently 17.25%, and in neighbouring Brazil where inflation is normally considered to be running at a little over 4%, central bank interest rates are currently at 11.25%). But the bigger point is that - no matter how much you "massage" the official numbers - it is evidently totally unrealistic to imagine that a commercial banking sector can offer rates of interest which fail to cover them for the real inflation rate which prevails.

So while the central bank administered overnight rates are far from high, annual credit card interest rates, in comparison, rose to 26.85 percent on average in July, up from 25.93 percent last December. Rates for personal loans rose to 24.74 percent from 24.56 percent over the same period. By way of comparison we could note that the average fixed rate for credit cards in the United States is currently in the region of 13.5 percent.

Well then, if Argentina is so badly governed, and infrastructurally and institutionally so far from being a shining example to others, what exactly is going on? Why should Argentina have done so badly at the end of the 1990s, when it was being a model student, and why should it be doing so notably well today, when on many counts it is doing exactly the opposite of what the textbook recommends.

It's the Demography Silly!

Well undoubtedly there are many reasons for this, and China's rapid growth and consequent demand for Argentina's agricultural products would be high on the list of triggers which set the party in motion, but if I could single out one factor which I think stands out above all the others it would come in a single word: demographics. So let's take a quick look at why.

First off, and as is evident, Argentina's fertility rate has been falling for many years, and is now about to go below replacement level.

This fall in the fertility rate has lead to a steady easing off in the rate of increase in the number of children born, and since 2000 the number has leveled off, and even begun to decline slightly.

At the same time life expectancy has been improving, and most notably life expectancy among the young and poor, where we can note the steady decline in infant mortality which has again been taking place.

As a result of these processes Argentina's population is still increasing, but again at a much slower rate than hitherto.

One consequence of all of this is that the percentage of the population in the 0 to 14 age group has been declining steadily from the high point reached at the end of the 1980s.

All of this is producing profound changes in Argentina's age structure, changes which are associated with what is known in an economic context as the demographic dividend. These changes can be seen reasonably clearly in the following population pyramids which are for 1990, 2000 and 2010 respectively. Looking at the pyramids we can see how their shape begins to change, and particularly in the third pyramid we should note how the steady stabilization, and then subsequent decrease, in the number of children born means that the generation size starts to shrink. It is the appearance of this change at the base of the pyramid which is the most typical indicator of the presence of the demographic dividend.

There are a number of reasons why changes in age structure affect economic performance, but one of the most important of these in the context of a developing economy like Argentina is the impact it has on saving and investment. Basically the relative decline in the proportion of young children frees off a greater proportion of national resources for saving and investment, and it is this process which means that the dependence on external funding begins to decline. A similar process has been observed in China since the late 1990s, and is now being observed in India.

Also we can note a slight but perceptible decrease in the consumption share in GDP in Argentina in recent years from 78.5% in 2004 to 76,6% in Q2 2007, and a steady increase in the investment share from 17.8% in 2004 to 21.1 in Q2 2007. These are again features that tend to be noted as the demographic dividend works its way through and the declining pressure of immediate consumption which comes from a lower proportion of under 15 year olds frees off more national resources for saving and thus for investment.

To Cry.... or To Laugh?

So to end where I started, with the question - should we be crying for Argentina? My answer would be most definitely that we should not. There may be a lot - a hell of a lot - wrong with the way Argentina is being run, and some of the issues arising have been adressed in this post. But the underlying situation in Argentina is far from being a tragic one this time round. History it sometimes seems is condemned to eternally repeat itself in Argentina, sometimes as tragi-comedy, and others as surreal farce, but there does seem to be a line of advance there, and this time round the line of advance might just lead to real economic development.

Clearly Argentina needs to move away from such 'old-school' practices as manipulating the statistical system. And clearly Argentina also needs to move forward and attract Foreign Direct Investment in a greater quantity than hitherto in order to modernise its energy sector and indeed its infrastructure generally. But the present situation is far from being a hopeless one, and reform is not only possible but probable. Not only that, more by accident than design Argentina may go into the next global growth slowdown better equipped to be able to withstand the pressure than many others. If so this will also be a test, a test for the relative importance of institutional quality when measured against the driving force of demographic tailwinds. The outcome of this test promises to be interesting, most interesting, and for all of us.