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Cablegate: Argentina: Economic Challenges Facing the Incoming

VZCZCXYZ0000
RR RUEHWEB

DE RUEHBU #2110/01 2981936
ZNR UUUUU ZZH
R 251936Z OCT 07
FM AMEMBASSY BUENOS AIRES
TO RUEHC/SECSTATE WASHDC 9561
INFO RUEATRS/DEPT OF TREASURY WASHINGTON DC
RUCPDOC/USDOC WASHINGTON DC
RUEHRC/DEPT OF AGRICULTURE USD FAS WASHINGTON DC
RUEHC/DEPT OF LABOR WASHINGTON DC
RHMFIUU/HQ USSOUTHCOM MIAMI FL
RUEHAC/AMEMBASSY ASUNCION 6647
RUEHMN/AMEMBASSY MONTEVIDEO 6857
RUEHSG/AMEMBASSY SANTIAGO 0865
RUEHBR/AMEMBASSY BRASILIA 6525
RUEHLP/AMEMBASSY LA PAZ OCT CARACAS 1557

UNCLAS BUENOS AIRES 002110

SIPDIS

SENSITIVE
SIPDIS

NSC FOR MICHAEL SMART
FED BOARD OF GOVERNORS FOR PATRICE ROBITAILLE
USTR FOR KATHERINE DUCKWORTH AND MARY SULLIVAN
TREASURY FOR MATTHEW MALLOY
USDOC FOR 4322/ITA/MAC/OLAC/PEACHER
US SOUTHCOM FOR POLAD

E.O. 12958: N/A
TAGS: AR ECON EINV ETRD EFIN ENRG PGOV
SUBJECT: Argentina: Economic Challenges Facing the Incoming
Government

Refs:
(A) Buenos Aires 2021
(B) Buenos Aires 1995 and prior

------------------------
Summary and Introduction
------------------------

1. (SBU) The inauguration of a new Argentine president in December
2007 will coincide with the conclusion of the Argentine economy's
fifth (2003-2007) consecutive year of 8-9% real growth, and record
levels of exports, foreign reserves, and formal employment.
Argentina also enjoys solid, if declining, budget and current
account surpluses. However, the new administration will face many
economic challenges: Argentina's good times have been accompanied by
a mounting pressure cooker of distortions and government
interventions, including inflation, price controls, alleged economic
data manipulation, growing subsidies, low investment levels, energy
shortages, stubbornly-high poverty levels and corruption. All of
these require near term attention if Argentina is to continue its
remarkable recovery from the 2001 crisis and achieve sustainable
growth levels. Delaying reforms will make their resolution more
politically and economically painful. Taking prompt corrective
measures and beginning a process of change offers an incoming
administration an opportunity to demonstrate to its citizens and to
the international community that it will take responsible action,
and that Argentina does not have to be condemned to boom-and-bust
economic cycles. End Summary and Introduction.

---------------------------------
Inflation: Old Ghost Stalks Again
---------------------------------

2. (SBU) According to domestic polls, inflation is the number one
economic problem facing Argentina, one that undermines public trust
in government and disproportionately affects the poor. Inflation
spooks the Argentine public and potential investors, given the
country's painful history of hyperinflation. As reported Ref A,
true inflation is currently running at about 15%-20% -- roughly
double the official rate -- and accelerating.

3. (SBU) Inflation is the most visible symptom of a broader problem,
an overheating economy, the consequence of the GoA's expansionary
fiscal, monetary, incomes and exchange rate policies to push
domestic demand-driven growth. Since 2005, the GoA has used
microeconomic methods -- price controls, export restraints, and
public service subsidies -- in a failed attempt to control inflation
without slowing economic output. The big test for the next
administration will be whether it has both the political will to use
more orthodox policies and/or tools to slow growth to sustainable
levels, reduce inflationary pressures, and unravel the web of
distortionary microeconomic policies. These policies are now linked
to the point where an attempt to change one inevitably requires
changes to others.

--------------
Price Controls
--------------

4. (SBU) Beginning in late 2005, in response to signs of increasing
inflation, the GOA ratcheted up pressure on businesses and
instituted "voluntary" price accords for primary consumption items
with retailers and supermarkets. Two years later these efforts have
largely failed to reduce inflation, and have further undermined
public and investor confidence. As widely predicted, the results
have been shortages, black markets, distortions and limited new
investment in affected sectors. Even the few private sector
economists who expressed qualified support for price controls always
underlined their strictly short-term nature. The longer price
controls persist, the more difficult and costly it will be for the
economy to extricate itself later. The GOA needs to find a graceful
exit or process soon.

----------------------------------------
INDEC: Alleged Statistical Manipulation
----------------------------------------

5. (SBU) Facing the failure of its dirigiste efforts to control
inflation, the GoA took a bolder step: direct manipulation of
official statistics. Beginning in January 2007, the highly regarded
GOA statistics agency, INDEC, began reporting monthly inflation
numbers significantly below market estimates. GoA officials
allegedly intimidated INDEC employees and forced those that refused
to alter the numbers to resign, replacing them with Kirchner
government stalwarts. The manipulation has apparently worsened as
the October 28 elections have approached, and the official estimate
of 8-9% inflation for 2007 is roughly half of private estimates of
15-20% (Ref A and Buenos Aires 1545).

6. (SBU) Questions are now being raised about the veracity of other
INDEC-provided data, such as GDP growth, poverty, indigence levels,
incomes, and unemployment. The GOA's actions have not only degraded
INDEC's prestige and credibility, but also further eroded
Argentina's institutional and investment climate. Some foreign
creditors even consider the GoA intervention as a "credit event," or
equivalent of a default, spurring them to sell GoA bonds. Several
parallel inflation indices have emerged, by economists, think tanks
and politicians, all adding to worsening public trust of the GOA.
One consequence has been reduced GoA influence over union wage
pressures and inflationary expectations: unions no longer believe or
accept official inflation figures, and many have laid down markers
that they will demand 2008 wage increases greater (up to 30%) than
even private inflation estimates.

--------------------------------------------- -
Public Utilities: Frozen Tariffs and Subsidies
--------------------------------------------- -

7. (SBU) Since 2002, transport fares and energy tariffs,
particularly for the residential sector, have remained largely
frozen, while international prices for gas and oil - and salaries
for these sectors' workers - have soared. A ride on the Buenos
Aires subway, for example, is just 22 cents, the same as in 2002.
To maintain these low prices, the GOA has accelerated subsidy
payments to energy, bus, rail, and air transport service providers,
often utilizing non-transparent transfer mechanisms (Ref B) that
have led to many allegations of corruption. As a consequence,
energy-related 2007 public transfers will increase to an estimated
1.5% of GDP (vs. 0.7% in 2006), a more than 100% increase over 2006
levels which, in turn, were more than 80% higher than 2005 levels.

8. (SBU) For the GOA, the calculus is simple: either continue
subsidies to maintain these everyday prices for large and important
urban voting constituencies, or ease subsidies, bringing increased
transport and energy fares - and voter wrath. The GoA will
eventually have to cut subsidies and increase these tariffs, which
could tamp soaring demand, ameliorate shortages, and create
incentives for needed investments.

-----------------------------------------
Distortionary Export Tariffs, Export Bans
-----------------------------------------

9. (SBU) Since 2002, the GOA has imposed high and distortionary
export tariffs on almost all tradable (largely agricultural)
products, allowing the GOA to insulate domestic prices from
international prices of Argentine exportable goods, partly
alleviating inflation and poverty. Export taxes have also allowed
the GOA to capture increased economic rents resulting from the
devaluation of the peso and high international commodity prices. In
2006, the GOA also resorted to a six-month beef export ban in an
attempt to moderate surging domestic prices for this product, and
still maintains beef export volume limits.

10. (SBU) Export tariffs, particularly those on primary commodity
exports, have contributed a growing share of tax collections, and is
E

now the GoA's third most important source of revenues (after VAT and
income taxes) and a key contributor to the primary fiscal surplus
(the surplus excluding debt interest payments) in recent years.
Export tariffs totaled 9.3% of total tax revenues in the first half
of 2007, and represented 64% of the GOA's primary fiscal surplus in
2006. The GoA has also made clear that export tariffs are its
mechanism of choice (under its comprehensive industrial
promotion/protection policy) to transfer wealth from the nation's
relatively well off agricultural sector to the less competitive
industrial sector (Ref E). These distortionary taxes discourage
investment and weaken competitiveness in a sector in which Argentina
enjoys comparative advantage.

------------------------------------------
Public Spending Binge, Fiscal Implications
------------------------------------------

11. (SBU) As reported Ref B, GOA spending through July 2007 has
increased almost 50% from 2006, mainly due to increased pension,
subsidy, wage and public infrastructure capital expenditures, all
with the apparent goal of buying votes for the October elections.
One of the most important accomplishments of the Kirchner
administration, a healthy primary fiscal surplus, is diminishing,
and the national consolidated balance (including provincial finances
and interest payments on debt) is now nearing zero.

----------------
Energy Shortages
----------------

12. (SBU) As a result of low tariffs, resulting high demand, and
insufficient investments, energy shortages have emerged,
particularly for natural gas and diesel (Buenos Aires 1496).
Further, private electricity sector players here (including U.S.
companies) say that the GoA's freezing of energy prices and
manipulation of the methodology used to set market prices have
unilaterally abrogated contracts, effectively confiscating funds
owed to them. The consequence has been a raft of international
ICSID arbitration claims filed against the GoA that total in the
billions of dollars.

13. (SBU) Public anger at energy disruptions during the recent
(austral) winter have certainly exacted a political cost, but the
GoA's stop-gap measures to import more electricity from Brazil and
to subsidize diesel fuel for Argentine thermal plants will likely
see the GoA through to the next (austral) summer peak demand season.
The Kirchner administration clearly believes that cheap energy that
helps expand consumer purchasing power is its best pre-election
strategy, and it has been willing to pay dearly to import peak
demand electricity from Brazil and to subsidize diesel supplies for
domestic generators. Argentina is in dire need of a wholesale
energy policy overhaul that includes not only a liberalization of
energy prices but the design and application of a clear
pro-investment energy regulatory framework. Otherwise, its strong
recovery could be in jeopardy.

--------------------------------
Undervalued Peso Fuels Inflation
--------------------------------

14. (SBU) Although nominally independent, in practice the Central
Bank has followed the direction of the executive. The apparent
policy goals behind the GOA's artificially low, "competitive" peso
are import substitution, industrialization, full employment, and
boosting exports and tourism. Also crucial for the GOA, an
undervalued peso sustains the GOA's export tariff revenues (see para
10). However, the downsides are higher inflation and the Central
Bank's loss of ability to maintain price stability. The GOA cannot
defy the principles of economics to have it both ways - maintain a
"competitive" exchange rate and use monetary policy to moderate
inflation.

---------------------------

Paris Club, Holdouts, ICSID
---------------------------

15. (SBU) The GOA faces significant debt arrears and contingent
liabilities that could add substantially to government debt in the
coming years (Ref B). These cases require resolution. The GOA owes
about $6.5 billion in Paris Club debt, including about $400 million
to the U.S. Government. It owes about $25 billion to "holdouts,"
bondholders that did not participate in the 2005 debt exchange.
Foreign multinationals, including many U.S. energy players, have
roughly $13 billion in outstanding claims against Argentina before
the World Bank's International Center for the Settlement of
Investment Disputes (ICSID), the bulk of which date from the
2001-2002 economic crisis. Roughly 19% of total ICSID claims are
held by U.S.-based firms. A number of cases have been decided by
ICSID tribunals against Argentina. Should the GoA refuse to pay out
ISCID rewards, the risk premium foreign investors demand to commit
new capital to Argentine ventures would increase, worsening
Argentina's already difficult investment climate.

----------------------------------
Poverty, Indigence and Income Gaps
----------------------------------

16. (SBU) Although Argentina has made remarkable progress in
alleviating poverty and improving income distribution since the
2001/2002 economic crisis, it still faces sobering challenges.
Overall poverty stands at about 30 percent. Almost 49% of all
citizens under 14 fall under Argentina's poverty line; 20% of this
same group are considered indigent. 41% of the labor force remains
informal. Income inequality is beginning to grow again as the
(effectively) regressive tax of inflation disproportionately impacts
the poor. Embassy contacts and private economists note that these
challenges could be socio-economic time bombs and require urgent GOA
attention.

---------------------------------------
Under-Investment and Investment Climate
---------------------------------------

17. (SBU) For Argentina to continue its recovery, even at more
sustainable growth rates of 5-6%, investment must increase above the
current levels of 22%-23% of GDP. Argentina also needs higher
quality investment; currently a substantial share of investment is
concentrated in areas such as construction that do not add
significantly to the nation's productive capacity. A recent UNCTAD
report on global foreign direct investment highlighted Argentina's
low and declining share of global FDI.

18. (SBU) Quality investment begins with a good investment climate.
According to most private sector analysts, to attract higher levels
and quality of investment, Argentina needs to address institutional
weakness, corruption, the over-concentration of power in, and the
tendency to impose abrupt regulatory changes by, the executive
branch, and perceptions of weak contractual sanctity. (Buenos Aires
1947 elaborated upon recent poor GOA marks in the areas of
corruption and ease of doing business.) The challenge is for the
GOA to address the more intractable problems of legal uncertainty,
institutional weakness, and inconsistent application of the rule of
law.

--------------------------------------------- --
Comment: A Reform Agenda for the New Government
--------------------------------------------- --

19. (SBU) Although analysts differ in their perceptions of how and
in what sequence the new government should address these often
linked and overlapping challenges, there is broad agreement on the
basics:
-- First and foremost, sustaining a strong primary fiscal surplus
is fundamental, as it has a moderating effect on inflation and
country risk premiums and allows the GoA flexibility in managing its
still substantial debt overhang. This will in all likelihood

require an incoming administration to sharpen its budget pencil and
cut billions in recently announced public infrastructure investment
spending.
-- Second, easing distortionary price controls and linked subsidies
could encourage new investment in affected sectors, though most
agree that any abrupt removal of existing controls would result in
an inflationary spike that would color Argentine consumers'
expectations.
-- Third, INDEC's institutional independence needs to be restored.
(As per ref A, the GoA is already taking steps to introduce a "new"
USG-based inflation calculation methodology that could allow the GoA
to step back gracefully from alleged manipulation.)
-- Fourth, public utility energy and transport tariffs should be
allowed to transition upwards to regional market levels, a step that
would provide incentives for badly needed infrastructure investment.

-- And fifth, the GOA must begin to address its unresolved Paris
Club, holdout, and ICSID-related obligations, which in turn could
improve Argentina's access to global capital markets and improve the
nation's investment climate.

20. (SBU) Given Argentina's volatile economic history, citizens and
markets will be especially sensitive to the actions the GOA takes --
or fails to take. There is a general consensus that the longer the
incoming GoA administration waits to take these corrective actions,
the more painful -- both economically and politically -- these
corrections will be. The Argentine economy is still enjoying a tail
wind of buoyant domestic and regional growth, continued high global
commodity prices for key Argentine exports, positive (albeit
declining) fiscal and current account balances, and manageable
financing costs. By initiating policy changes in the initial period
of the new Presidency, the incoming administration can reassure its
citizens, the markets and the international community that repeated
booms and busts do not have to be Argentina's eternal fate, and
moderate growth and stability is achievable.

WAYNE

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