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Cablegate: Argentina Economic and Financial Review, May 6 -

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PP RUEHCD RUEHGA RUEHGD RUEHHA RUEHHO RUEHMC RUEHQU RUEHTM RUEHVC
DE RUEHBU #0753/01 1512125
ZNR UUUUU ZZH
P 302125Z MAY 08
FM AMEMBASSY BUENOS AIRES
TO RUEHC/SECSTATE WASHDC PRIORITY 1221
INFO RUCNMRC/WESTERN HEMISPHERIC AFFAIRS DIPL POSTS PRIORITY
RUEAIIA/CIA WASHINGTON DC PRIORITY
RUEATRS/DEPT OF TREASURY WASHINGTON DC PRIORITY
RHEHAAA/NATIONAL SECURITY COUNCIL WASHINGTON DC PRIORITY
RUCPDOC/USDOC WASHINGTON DC PRIORITY

UNCLAS SECTION 01 OF 05 BUENOS AIRES 000753

SENSITIVE
SIPDIS

E.O. 12958: N/A
TAGS: EFIN ECON EINV ETRD ELAB EAIR AR
SUBJECT: ARGENTINA ECONOMIC AND FINANCIAL REVIEW, MAY 6 -
23, 2008

REF: BUENOS AIRES 622

1. (U) Provided below is Embassy Buenos Aires' Economic and
Financial Review covering the period May 6 - 23, 2008. The
unclassified email version of this report includes tables and
charts tracking Argentine economic developments. Contact
Econoff Chris Landberg at landbergca@state.gov to be included
on the email distribution list. This document is sensitive
but unclassified. It should not be disseminated outside of
USG channels or in any public forum without the written
concurrence of the originator. It should not be posted on
the internet.

----------
Highlights
----------

-- Capital flight accelerates due to increasing political
uncertainty
-- Who are the "Holdouts"?
-- Debate over poverty statistics
-- INDEC seminar and announcement of new CPI
-- FIEL raises concerns about taxes, expenditures, revenues,
and salaries

Capital flight accelerates in first quarter due to increasing
political uncertainty
--------------------------------------------- -----
2. (SBU) Capital flows out of Argentina's financial system
(by the non-financial private sector) reached $2.2 billion in
the first quarter of 2008, according to the BCRA's quarterly
foreign exchange report (published April 25). Following a
neutral balance in the first quarter of 2007, there is a
clear trend in the non-financial private sector towards
taking hard currency out of the financial system, with
outflows of $5.2 billion in QIII 2007 and $3.4 billion in QIV
2007. Capital outflows have been more than compensated for
by the strong trade surplus, which reached a record $4.0
billion in QI 2008, compared to a $3.3 billion surplus in QI
2007. Embassy banking sector contacts confirm that the
tendency so far in 2008 in both the retail market and with
companies is to dollarize peso portfolios.

3. (SBU) The move into dollars is partly a reaction to the Ag
sector conflict, which began March 11 when the GoA imposed a
sliding scale export tax on agriculture exports, and it has
been exacerbated by the GoA and Ag sector's apparent
inability to resolve it. However, Post's banking sector
contacts emphasize that the mini-run on the peso began in
early March, with the recognition that inflation was
accelerating. The combination of high and accelerating
inflation and the continuing strike is stoking rumors and
fears of a peso devaluation. The Ag strike also aggravated
the deteriorating situation in the FX market, since lower Ag
commodity exports reduced the supply (inflow) of hard
currency at the same time that demand was increasing. (Ag
exports, mainly wheat, corn and soy and soy sub-products,
provide 35% of the dollar supply from exports.)

4. (SBU) Highlights of the Foreign Exchange Balance report:

-- A surplus of $3.6 billion for the current account of the
Foreign Exchange Market for the first quarter, compared to
$2.6 billion the same period last year. (This is the net
inflow of FX from all trade transactions, including
merchandise, services, and investment income.);

-- A deficit of $96 million for the capital account in QI
2008, compared to a surplus of $2 billion in QI 2007. The
deficit in the capital account was generated by the $2.2
billion capital outflow from the non-financial private
sector, which was partially compensated by $1.2 billion
inflows from foreign direct investments (mainly for oil,
agriculture, car, steel and mining sector) and $720 million
inflows from loans and credit lines to the private sector.

-- BCRA reserves reached a record of $50.6 billion at the end
of QI as a result of the BCRA net purchases of foreign
exchange of $2.6 billion.

-- In order to pay foreign currency debts, the Treasury
purchased $1.5 billion in QI 2008, compared to $619 million
in QI 2006 and $400 million in QI 2007.

-- (Note: the Foreign Exchange Balance (FEB) and the Balance
of Payments (BOP) report have a similar format. However, the
former reports purchase and sales of foreign currency without

BUENOS AIR 00000753 002 OF 005


considering the residency of the parties, while the latter
reports economic transactions focusing on the residency of
the intervening parties. Also, the FEB uses a cash-basis
methodology, while the BOP uses accrual accounting.)

5. (SBU) So far in the second quarter, the unresolved Ag
conflict, accelerating inflation, and the President's
plummeting approval rating have increased the level of
pessimism about the future of the Argentine economy, spurring
greater dollar outflows. However, the BCRA's heavy
interventions in May, selling dollars in both the spot and
futures markets, succeeded in bringing the nominal exchange
rate down to a trading range of 3.14-3.16 ARP/USD (wholesale)
by May 23. This proved to the market that for the time being
the BCRA has sufficient firepower to keep the exchange rate
at whatever level it desires. Due to the 7-10 delay in the
release of BCRA data, it is still unclear how deep the BCRA
has had to dip into reserves to date, but as of May 16 the
BCRA had sold $1.2 billion, and reserves had fallen to $49.1
billion, below the psychologically important $50 billion
level.

Who are the "Holdouts"?
-----------------------
6. (SBU) There has been a lot of reporting about the
so-called "holdouts" -- holders of GoA defaulted debt not
tendered in the 2005 GoA debt restructuring -- but not much
is known about who they are. Determining who holds the $28.8
billion amount outstanding (as of December 2007, according to
GoA debt statistics) -- and roughly $3 billion held by U.S.
investors -- is more art than science, since defaulted debt
is still being traded (currently at about 32-34 cents).
However, it is possible to identify those holdouts that have
engaged in legal actions to recover the whole value of their
defaulted bonds. These holdout bondholders cannot sell the
bonds as they need to show ownership of the bonds when going
forward with legal proceedings.

7. (SBU) Holdouts have not succeeded in their efforts to
recover investments, but they have caused major difficulties
for both the GoA and BCRA: 1) holdout lawsuits delayed the
2005 GoA settlement by almost three months; 2) $105 million
of BCRA reserves held at the Federal Reserve Bank of New York
(FRBNY) are frozen on account of a holdout lawsuit; 3) a
recent holdout lawsuit resulted in the freezing of $2 billion
of Global bonds held at the Depository Trust Company (DTC)
and backing Guaranteed Loans (GLs); this lawsuit has
effectively blocked the GoA's plan to conduct a debt swap of
the GLs and smooth out the 2009-2011 debt amortization
schedule (see May 5 Econ/Fin report); 4) the GoA must resort
to complex legal structures every time it makes an off-shore
payment; and 5) the threat of holdout lawsuits has virtually
eliminated the GoA's ability to raise fund through bond
issuances under international law, raising financing costs by
an estimate 50 to 100 basis points.

8. (SBU) Based on a detailed analysis of the public
information available in Lexis-Nexus database:

-- There are 70 bondholder cases filed against the GoA in
U.S. courts, all of which are in the court of Judge Thomas
Griesa, U.S. District Court for the Southern District of New
York.

-- These 70 cases are claiming a total face value of almost
$2 billion, without considering past due interest, penalties,
or other compensation for delay in payment.

-- Many of the cases where filed by multiple bondholders
(including both physical persons and companies), so the total
number of investors involved exceeds 70.

-- The average claim is almost $30 million. The smallest
claim is for $133,000, whereas the largest is for $595
million. Only five cases comprise almost 70% (or $1.3
billion) of the total claimed. These five plaintiffs are: EM
Ltd, Greylock, GMO, NML Ltd, and BNP Paribas. These
plaintiffs (and their lawyers) are also the most vocal of all
outstanding U.S. holdouts.

-- In two out of the 70 cases, the lawsuits are against both
the GoA and the Province of Buenos Aires.

-- The status of most of the cases is that the Judge granted
the plaintiff motion for summary judgment. (Note: There are
possibly many other cases in the pipeline, for which a Judge
has not issued a ruling. It is also possible that some of

BUENOS AIR 00000753 003 OF 005


the 70 cases have had partial advances -- such as beginning
the assets discovery process, in order to identify attachable
GoA assets -- but Judge Griesa has not made a final public
ruling.)

9. (SBU) Economy Ministry contacts confirmed the freeze on
BCRA reserves is still in place. The two plaintiffs in this
case are E.M. Ltd, covering defaulted bonds with a face value
of $595 million, and NML Ltd, with a face value of $142
million. The plaintiffs argued for attaching the BCRA's $105
million reserves held in its FRBNY account, following two GoA
decrees allowed the use of BCRA funds for repayment of
Argentina's debt to the IMF. The plaintiffs and the GoA are
currently debating the definition of reserves and whether
BCRA reserves have been used for commercial purposes (as
defined under the Foreign Sovereign Immunities Act of 1976)
and are, consequently, attachable. (The USG submitted a
Statement of Interest in 2004 and an Amicus Curiae brief in
2006, related to the attempts to attach BCRA assets.)

10. (SBU) ICSID Holdout cases: Apart from cases filed in
U.S. Courts, other investors (mainly Italian) have filed two
claims before the World Bank's International Centre for
Settlement of Investment Disputes (ICSID). According to the
ICSID website:

-- The first case was filed under the name Giovanna a Beccara
in February 2007, and ICSID accepted the case and constituted
a "Tribunal" in February 2008;

-- The second case was filed under the name Giovanna Alemanni
in March 2007, and ICSID has not yet constituted a Tribunal.
ICSID has not released details on the amounts involved.
However, according to Argentine media, the first case was
filed by Task Force Argentina (TFA), a bondholder group that
claims to represents 195,000 Italian bondholders holding
about $4.4 billion (face value) of GoA defaulted bonds.
(Note: The majority of the Italian bondholders are retirees
who lost significant portions of their savings in the
December 2001 default.)

Debate over poverty statistics
------------------------------
11. (SBU) President Cristina Fernandez de Kirchner (CFK)
announced May 12 a decline in Argentine poverty levels to the
20.7% level, down from roughly 23% in late 2007 and down 33
percentage points from its post-crisis peak of 54% in 2003.
CFK said this drop should be a source of national pride for
all Argentines. Her statements provoked a passionate debate
over the real level of poverty in the country, with many
analysts arguing that poverty is expanding rather than
declining.

12. (SBU) Many independent economists put current poverty
levels at a significantly higher 30%, and estimate that
poverty rolls increased by 1.3 million citizens in 2007
alone. These economists blame rising inflation --
particularly increases in the costs of food and basic
services -- for the increasing poverty. They attribute the
substantial difference in independent vs. GoA poverty
measures to the GoA's manipulation of inflation statistics
since February 2007. Local analysts predict that the
political fallout on the CFK government of this rise in
poverty will be significant. They argue that this is the
reason why the Kirchners have in recent weeks switched from
denying that inflation is a serious problem to blaming it on
the "socially irresponsible" striking rural agricultural
sector.

INDEC seminar and announcement of new CPI
-----------------------------------------
13. (SBU) Argentina's National Statistics Agency (INDEC)
hosted an international seminar on the CPI May 7 on
"International Experiences with the CPI: Certainties and
Challenges." INDEC invited experts from Spain and France, as
well as Walter Lane, Chief of the Branch of Consumer Prices
in the Office of Prices and Living Conditions at the U.S.
Bureau of Labor Statistics. Lane and other foreign
representatives participated during the first session,
focusing mainly on methodological aspects of the CPI. INDEC
staff members and union leaders also spoke during the first
session, all making the same call for a CPI that supports the
"local economic model for development" (meaning, growth with
income redistribution). INDEC used the second session to
announce features of the new Argentine CPI:

-- INDEC will frequently rebalance products in the new CPI,

BUENOS AIR 00000753 004 OF 005


and criteria for rebalancing will be based on: i)
seasonality; ii) points of sales; iii) quality changes; and
iv) patterns of consumption. (Comment: This turns the CPI
into a cost-of-living index, rather than a means to measure
inflation; this will not facilitate private indexation
decisions, such as salary increases.)

-- The new CPI will only cover the second and third quintiles
of the income distribution (lower-middle-class), which means
that the CPI will be biased to lower income patterns of
consumption (and will, therefore, under-weight areas of high
recent price increases, e.g., private schools, private
medicine).

-- INDEC will incorporate consistency analysis and data
filtering, to avoid the inclusion of outliers.

-- The new index will see a reduction in the number of
varieties included.

14. (SBU) In a private note for clients, HSBC analysts
pointed out that bondholders should keep in mind that this
new methodology will consistently result in lower consumer
price inflation than the methodology used prior to 2007, even
with the same inputs. These analysts say it is impossible
to know at this stage how much lower inflation will be, and
that it will depend on the government commitment to a
credible index. Their base scenario is that the new index
will report around 8% - 9% annual inflation until further
evidence is available. The fact that the government is
institutionalizing a method that reports lower inflation than
a conventional CPI is bad news for the bond market, though
markets have most likely fully priced this news into current
prices.

FIEL raises concerns about taxes, expenditures, quality of
revenues, and salaries
--------------------------------------------- -------
15. (SBU) Renowned Buenos Aires-based Latin American Economic
Foundation -- FIEL -- raised the following concerns during a
May 21 Seminar. (FIEL is a highly regarded, independent
Argentine think-tank devoted to economic and social research
on Argentina and Latin America.)

-- Argentina's fiscal burden is much higher than in the
past. It has increased in each of the last six years, and is
currently at about 33% of GDP when including federal,
provincial, and municipal taxes. This is higher than during
the 1990s, when it averaged 21-22%, and much higher than
during the 1980s, when it was below 20%. Argentina's fiscal
burden is now comparable to Brazil's, which is the highest in
the region (followed by Uruguay at 30%). The agricultural
sector conflict is the first tax rebellion, and FIEL believes
others could follow.

-- GoA expenditures: April primary expenditure increased 52%
y-o-y, compared to an increase of 38% y-o-y for the first
quarter. However, FIEL argues that the GoA under-reported
March's expenditures. In order to reduce the average of the
quarter, the GoA pushed forward some expenditures due in
March to April. In this way, the GoA avoiding showing a low
primary fiscal surplus in March, since March revenues were
weak. Elasticity of expenditures: per every increase of 1%
of GDP in expenditures, the primary surplus falls 0.9% of
GDP.

-- GoA Revenues- extra help from BCRA: In March and April,
the BCRA transferred earnings of ARP 1.4 billion (the total
budgeted for the year) to the GoA, which helped improve the
GoA's reported revenues and primary fiscal surplus for the
first quarter. The BCRA transferred ARP 1 billion in March
and the remaining ARP 400 million in April.

-- Salaries: March 2008 formal-sector salaries measured in
dollar terms (considering only salaries and not other
benefits) are higher in nominal terms than salaries from
October 2001 for many sectors of the economy. However, when
including benefits and the salary increases granted in
negotiations so far this year, 2008 salaries in dollars are
higher in nominal terms than the ones from 2001 for all
sectors. (2008 salaries are still lower in real terms than
equivalent salaries in 2001.)

-- Increase in Argentine risk (as measured by the JPMorgan
EMBI plus) to record levels indicates concerns over the GoA's
willingness to pay, not concerns over its capacity to pay.
Data Manipulation: FIEL strongly believes the GoA is

BUENOS AIR 00000753 005 OF 005


manipulating the EMAE (monthly economic activity index) and
GDP, in addition to the CPI (which was severely manipulated
in March, particularly for food items).

-- Devaluation expectations: with true inflation somewhere
between 20-30% and nominal peso devaluation of 1.5-2% per
year, the GoA model of maintaining industrial competitiveness
through an undervalued currency does not seem to be
sustainable. This is what is driving market expectations
that the GoA will eventually devalue the peso.

WAYNE

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