Saturday, October 20, 2007

Time To Cry For Argentina?

Two issues - apart from the exceptionally high levels of recent economic growth - 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 is somehow typical of Argentine social and political life, the devil is always, or nearly always in the details, and the devil, in one form or another, is never, it seems, far away. 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". So the moral is, it seems, that the devil makes hard work of life, but doesn't always win, unlike those who "adjust" the inflation numbers, who see 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 in pruning inflation data, it is the fact that Argentina's economy has been expanding at a sustained annual pace of 5 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 (growing at annual rate of 9.2%), leading it onward and upwards toward a fifth straight year of 8% plusgrowth.

Of course the big issue here is just how sustainable all this is. Is the Argentine economy, as some would have it, on the verge of yet another of those hyper-inflationary spirals, or is there something different about Argentina's evolution, this time round?

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.

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 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 even to the extent of using the term “crisis” to describe the severe energy shortages that Argentinians had been experiencing, shortages which in fact forced the government to ration gas to thevery factories which have been fuelling all that recent GDP growth in an attempt to ensure that there was enough available for heating homes.

One of the threads which runs through Argentina's current energy woes is, of course, the issue of climatic change. Lower than traditional rainfall has increasingly been causeing 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 characterises 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 becuase 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 tarrifs 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 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, which is just shortly after Kirchner began making the personnel changes in the statistics office.

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. Merill Lynch estimates 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 the index for the price of tomatoes is one thing, and tampering with it to reduce the size of overseas debt quite another. 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. Like unemployment, which has fallen steadily in recent years.

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 characterised 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 a steady increase in foreign exchange reserves as well as a reduction in financing needs. In addition the rather poor reputation which Argentine national debt and institutional quality enjoy have meant that the peso, rather than appreciating against the dollar as many emerging currencies have found themselves doing, has in fact been trending slowly down. This has made it comparatively easy for the Argentine administration to maintain competitiveness and a trade surplus in the face of strong internal inflationary pressure.

In other word, the Argentina administration hasn't found it necessary to follow in the footsteps of some of the other emerging market countries and adopt 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 steadily eaten up inflation but without causing any form of major financial disruption.

Moreover, Argentina’s real economy is much less vulnerable to external shocks than it used to be, and while it was affected by the market turmoil of last August, it has hardly been knocked off its orbit by it. Part of the explanation for this is that one of the consequences of the 2001 crisis has been that there have been few capital inflows into Argentina, 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 consequence of this is, naturally, that the level of external debt has fallen steadily.

At the same time the level of public debt has been steadily reduced. Argentina's tax revenue was up 37.4 percent in August 2007 in comparison with August 2006, on the back of strongly rising wages and sustained consumer demand, and rose to 17.9 billion pesos ($5.7 billion) 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 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 roughly half the average rate 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.

Indeed all of this recently lead Nestor Kirchner to chide Argentina's banks, who charge an average credit card interest rate which is roughly double that which is current in the United States, for example, urging them to cut finance charges and lend more, even vaguely threatening that if they didn't act, then the government would consider introducing rules to force them to do so.

``Banks are too liquid, have lots of money saved, I'm glad they are solvent,'' he 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 look at Argentine overnight interest rates, they are hardly high in comparison with those prevailing in some emerging markets given the level of inflation which prevails (even on the official version), and clearly it is totally unrealistic to imagine that the banking sector can offer rates of interest which fail to cover them for inflation.

But while the central bank administered overnight rates are far from high, annual credit card interest rates, in comparison, rosen 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.

So if Argentina is badly governed, and infrastructurally and institutionally is 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 rpaid growth and demand for Argentina's agricultural products would be high on the list, 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 levelled 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 hanges can be seen reasonably clearly in the following population pyramides for 1990, 2000 and 2010. We can see how the shape of the pyramid begins to change, and particularly in the third pyramid how the steady stabilisation, and then 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.

One of the reasons why this moment is so favourably in economic terms is the impact it has on saving and investment. Basically the relative decline in the proportions 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 can be observed in China, and is now being observed in India.

So to end where I started, with the question - should we be crying for Argentina? My answer would be most definitely no. There may be a lot, a hell of a lot, wrong with the way Argentina is being run, and some of the issues have been adressed in this post. But the underlying situation in Argentina is far from being a tragic one this time round. Clearly Argentina needs to move away from these 'old practices' of manipulating the statistical system. Clearly Argentina needs to attract Foreging Direct Investment in order to modernise the energy sector and its infrastructure generally. But the 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 promises of this testto be interesting, very interesting for all of us.