The business and political moods have been going up and down much faster than the change of seasons. During our summer the country was in confrontational mode and the theme was the conflict with the Central Bank about the use of international reserves to pay the debt and the removal of Martin Redrado from the Central Bank. During the fall we enjoyed a peaceful period as we celebrated our bi-centennial with rock concerts and parades in the streets. The Kirchners’ were starting to try to woo the middle class and were struggling to improve in the opinion polls.
This calm was short-lived, however, as Argentina is now again in political turmoil mode. This time their prey were media, and other large industrial and business groups. Why did they do it at a time when things were going well? As in the story of the scorpion who asked the frog to carry him across the lake but ended up biting the frog in the middle of the crossing, meaning that they both drowned, the problem is the instincts. The Kirchner´s is to build political power through confrontation, and a peaceful period does not suit them.
The confrontation between the government and a large sector of the business community has been escalating rapidly, and all of the sudden there is a perception of a sharp deterioration in the business climate. The government, as usual, is doubling its bet, especially in the confrontation with Clarín, though for the first time it is finding that the business community is holding together and is “fighting back”. The main reason is that they are concerned about the abuse of property rights that is now affecting Clarín can eventually extend to other groups that oppose government policies.
The government’s strategy is already backfiring, as the new events raised again fears among middle class voters about the authoritarian nature of the government and its lack of tolerance. According to some pollsters, the government’s positive image is already falling, but we do not anticipate that it will lead to a change of strategy.
It is difficult to predict the economic effects of these recent events. Most likely the tension will continue as it is difficult to find a compromise solution that would satisfy both sides and that would be sustainable and enforceable. One direct effect is that investment is likely to suffer and that Argentine spreads are likely to remain on the high side.
While growth might not suffer much in the short run, as the economy is still recovering from last year’s recession, we expect that if the economy continues to move at the current pace the limits to growth will be reached very quickly, as bottlenecks will become widespread and there will be labor shortages. In this environment inflation could become a larger problem.
The second impact of the conflict was a moderate increase in Argentina’s CDS of 175 bps, though it was followed by a reduction of around 100 bps when S&P increased the rating by one notch.
In spite of the completion of the second tranche of the debt restructuring and the large amount of international reserves, investors continue to be wary about Argentina. The main reasons for the concerns are well known (INDEC, lack of agreement with the Paris Club, the relationship with the IMF), though it is also important that the government has not been willing to access the market once it could issue at a one digit interest rate. We believe that this was a mistake, and if the government had in fact accessed the market it could have generated a virtuous cycle that would have led to a reduction in credit spreads. Unfortunately, the government appears to be greedy and the interest rate at which it is willing to issue has become a moving target. Unless this attitude changes it is difficult to expect a significant reduction in credit spreads.
The recent appointment of Alfredo Mac Laughlin as executive director to the IMF, a former Secretary of Finance and previously an international banker, is good news for the market, though it is too early to know whether he will have the leeway to make progress with the Paris Club and the IMF. In the end we know who calls the shots.
The conflict did not have a noticeable effect on domestic financial conditions, as there were no signs of a rise in the demand for dollars while the spot and forward exchange rates have remained stable and the peso interest rates have not moved.
The stability of the exchange rate in the current inflationary environment is generating questions about the sustainability of this policy. It seems clear that Argentina is maintaining the adjustable peg that Redrado was advertising right and left, though Marcó del Pont has revealed a preference to depreciate the currency less, perhaps as a way to maintain interest rates low and limit the demand for dollars. This is somewhat surprising because before taking this job she was a vocal advocate of a competitive real exchange rate, while in fact she is allowing the currency to appreciate (and quite sharply) in real terms.
Our view is that the Central Bank will maintain this policy, unless there is a drastic change in the international environment such as a sharp depreciation of the Brazilian Real (which appears to be unlikely) or a significant fall in soybean prices (which does not appear to be in the cards).
The stability of the exchange rate helps to maintain interest rates at current levels, as it provides the opportunity of a Peso carry trade, which has been a good bet for the last twelve months.
There is a domestic threat to this policy, which is called inflation. The country can withstand a further real appreciation of the currency because it starts from a large current account surplus, and agricultural exports are likely to remain at strong levels while international prices remain high and the weather continues to play in our favor. However, as inflation and wage increases continue to erode competitiveness the situation is bound to become tighter. This is not likely to be a rapid process, as changes in the current account of the balance of payments do not happen overnight. Besides, the country has a large amount of international reserves which provides an additional cushion.
Nevertheless, as inflation erodes slowly but continuously, external competitiveness and at some point the current exchange rate policy will become unsustainable. It can definitely last till the end of this year, and very likely could be maintained in the first half of 2011. But this outcome to a large extent depends on whether inflation remains bounded (in the upper twenties).
In this respect, the recent central bank decision to change the monetary program in order to accommodate the large expansion of the money supply is worrisome. On the one hand it suggests that interest rates are likely to remain at current level and that the exchange rate will depreciate very slowly. More importantly, it shows that the Central Bank is not ready to take any actions to combat inflation and that in fact it is ready to accommodate a possible increase in inflation if it were to take place. In this environment there is no strong anchor to inflation, and there is likely to be a temptation to rely on a stable exchange rate as the only monetary instrument to deal with price increases.
The risks of a step increase in inflation to the 30% range have increased, and we will need to monitor closely wage increases to assess the situation. It seems that given that 2011 is an election year and that the government is not concerned about price stability, an increase in the inflation rates is all but unavoidable.