Publish in Perspectives - Wednesday, January 24, 2018
President Mauricio Macri has gone to great lengths to regain access to international capital markets, but key challenges persist, the author argues. (Photo: Argentine Government).
Macri government is prioritizing GDP growth over inflation fight.
BY WALTER T. MOLANO
The Argentine central bank’s decision to raise its inflation target for 2018 was a clear signal that the government is prioritizing GDP growth over inflation. This is great news for investors exposed to assets that will benefit from higher levels of economic activity, such as corporate bonds, GDP warrants and equities. However, it is not good news for those exposed to local rates and the currency.
The Macri Administration has been dealing with the long list of problems that were left by the previous government. A large fiscal deficit, an over-valued currency, a broken national statistics agency, distorted public-sector tariffs and no access to the international capital markets were some of the major legacies of the Kirchner Administration. Others include a highly polarized society, very little foreign direct investment (FDI) and crumbling infrastructure.
President Mauricio Macri acknowledged many of the problems and addressed some of the most important issues. However, his rhetoric focused more on the future, rather than the past. This is something that has been the topic of some criticism. While he has gone to great lengths to regain access to international capital markets, remove some of the public-sector tariffs and resurrect the national statistics agency (INDEC), the currency remains grossly over-valued and the fiscal deficit is still very high. We estimate the Argentine peso to be overvalued by more than 30 percent, making it the most over-valued currency of the major emerging market countries. This is, in spite, of the large devaluation that was registered at the end of last year. The fiscal situation is even more worrisome. The government estimated the primary fiscal deficit for 2017 to be 4.2 percent of GDP. However, the IMF, which published its Article IV consultation at the end of 2017, estimated the shortfall to be 4.7 percent of GDP. The government hopes to reduce the primary funding gap to 3.2 percent of GDP in 2018. However, the IMF estimates that the deficit will narrow to 3.7 percent of GDP in 2018. It will be difficult to significantly improve the fiscal accounts without further reductions in subsidies and public assistance programs.
The problems on the exchange rate and fiscal fronts lead to serious problems in the external accounts. The loss of competitiveness and the lack of domestic savings are the reasons why the current account deficit has reached 4.3 percent of GDP. The government has been able to keep its external accounts in balance thanks to an aggressive borrowing program. Argentina’s external debt to GDP ratio remains a healthy 36 percent, but unabated bingeing in the international capital markets will eventually create another debt crisis. This is the reason why the government must take further measures to rein in the fiscal deficit and devalue the currency.
In the meantime, the government is turning its attention to stirring GDP growth. The monthly index of manufacturing activity (EMI) increased 3.3 percent y/y in November. This was slightly down from previous month, when it posted an expansion of 4.4 percent y/y. Manufacturers reported that exports to Mercosur were expected to be stable in the near future, reflecting the recovery of the Brazilian economy. However, they also reported that sales to non-Mercosur markets would decline. This mirrors the over-valuation of the Argentine peso. Fortunately, construction is the sector that is driving the Argentine recovery. The ISAC construction index jumped 21.6 percent y/y in November. Regulatory changes, facilitating access to mortgages, is pushing up the demand for homes. Likewise, large infrastructure programs, particularly a network of new highways, are boosting the level of construction activity. This helps explain why the Argentine economy expanded 4.2 percent y/y during the third quarter of 2017 and 5.2 percent y/y during October.
As a result of these macroeconomic trends, we believe that assets that are geared towards the level of economic performance, such as Argentine corporate bonds, GDP Warrants and equities, should perform better than those linked to the currency and rates. It is important to note that the government still needs to define what will be the base year that will be used to calculate the GDP Warrants. The variance in the different base years will make an enormous difference in the valuation of these instruments. Unfortunately, it has not given any indication on how it will decide. One last point, the government’s shift in priorities, by putting more emphasis on the level of activity rather than restoring price stability, is clearly politically motivated.
With elections looming on the horizon, the government already knows that there is no point catering to the people who will benefit from lower inflation. They are already in the opposition. Yet, by boosting the level of economic activity, the Administration is helping the middle and upper classes, thus reinvigorating its political base.
Walter Molano is head of research at BCP Securities and the author of In the Land of Silver: 200 Years of Argentine Political-Economic Development.