Argentina
What Lies Beneath (the Central Bank Turmoil)?
January 13, 2010

By Daniel Volberg | New York

The dramatic conflict between Argentina's president and the head of the central bank is likely to continue to make headlines in the coming weeks, but the situation may simply be a symptom of the underlying threat: continued deterioration on the macro front, particularly in fiscal management that, when combined with the administration's track record, significantly raises the risk of policy mistakes. At first glance, our assessment of Argentina's fiscal situation may seem misplaced. After all, governments around the globe have boosted fiscal spending to deal with the downturn in activity in 2008 and 2009. But our concern is that the fiscal deterioration in Argentina, along with a weakened growth dynamic, is creating a much more fragile backdrop in Argentina. And that fragile backdrop should ultimately be of even greater concern to Argentina watchers. Indeed, the current conflict between the executive branch and the central bank may be an example of the kind of shocks that Argentina may face in this more fragile environment.

Details of the Conflict

Last week, Argentina's president first publicly asked for the central bank governor to resign and, after his refusal, the president issued an executive decree relieving him of his post. At issue appears to be a delay in transferring US$6.6 billion in international reserves to a fund meant to guarantee Argentine debt. The central bank governor argued that the transfer of funds could only be made if the Executive decree establishing the US$6.6 billion dollar fund was approved by Congress. His concern appears to be that he could open himself to potential legal action if he authorized the transfer which Article 19 of the central bank charter, as currently written, forbids.

The conflict accelerated when the president issued another executive decree, this time firing the central bank governor, despite the fact that Article 9 of the central bank's charter requires the president to turn to a congressional panel to do so.

The next twist in the conflict was the intervention by the judiciary when a federal judge invalidated the Executive decree firing the central bank governor. That ruling seems based on the fact that according to the central bank charter the central bank governor can only be forcibly removed by a congressional panel made up of the president of the Senate and the heads of the Budget and Economy committees from the Senate and the Budget and Finance committees from the Chamber of Deputies. Currently in the Chamber of Deputies the committee heads are split, with one from the opposition and the other from the ruling party. In the Senate the committee heads have not been designated, but we suspect that given the balance of power in the aftermath of the mid-term elections last year, the head of the Economy Committee is likely to be an opposition politician. If that turns out to be the case then, in our view, it is unlikely that the central bank governor could be removed against his will. Thus, short of a resignation by the central bank governor or a backtracking by the authorities, Argentina may be set for a new confrontation - this time between the executive and the central bank - that is unlikely to be resolved quickly.

The confrontation between the Executive and the central bank may mean higher risks of instability in Argentina in the months ahead, but we suspect that one key reason for the turmoil is the deterioration in macro fundamentals, especially on the fiscal front. After all, it is largely because of the concerns about Argentina's fiscal deterioration last year and the associated fear by market participants that it would be unable to continue servicing its debt obligations that the authorities decided to create the US$6.6 billion dollar fund that is at the root of the current turmoil. Thus, we suspect that it is important to take stock of where the fundamentals are today and what's the likely trajectory in the months ahead. Our view is that we may see further fiscal deterioration in the months ahead as the growth recovery proves insufficiently strong in the near term. And, in turn, the combination of fiscal deterioration that drains resources away from the authorities and their low approval rankings may raise the risk of policy mistakes or coordination failures - such as the current conflict with the central bank - that should keep Argentina watchers cautious.

Poor Growth Drives Fiscal Deterioration

After six consecutive years of surpluses Argentina's fiscal accounts have dipped into the red. The big change in the first 11 months of 2009 was that tax revenue growth had fallen sharply below the pace of expenditures. The four-quarter rolling overall fiscal balance deteriorated to a deficit of Ar$3 billion or roughly 1% of GDP in 3Q09 from a surplus of 1.9% of GDP in the same period of 2008. Much of the deterioration has come on the back of sharp declines in revenue growth, while the pace of expenditures proved inelastic. Total revenues grew, on average, 11.4%Y in the first 11 months of the year - a sharp decline from the near 33% annual growth last year. By contrast, the pace of expenditures in the first 11 months of 2009 was more than twice as high as the pace of revenues, averaging 24.4%Y - a light decline from the near 31% average annual expenditure growth in 2008.

While the drop in revenue relative to expenditure has been seen across the region, we are concerned that in Argentina the issue may be more structural in nature. The underlying driver for this fiscal deterioration is poor growth performance that is driving down revenue growth and policy distortions that prevent an expenditure adjustment. Much of the decline in revenue growth comes from just three categories: income taxes, VAT taxes and export taxes. Income taxes and VAT taxes are driven by the pace of economic activity and, in the case of VAT taxes, the pace of inflation. Meanwhile, on the expenditure side much of the elevated pace of spending is driven by public sector wage growth, pensions and subsidies. With growth prospects constrained by policy heterodoxy, the fiscal slippage in Argentina may not be cyclical in nature.

We are concerned that further fiscal deterioration may still be ahead. Given the seasonal nature of fiscal expenditures - the bulk of which comes in December of every year - we expect to see a fiscal deficit of 1.6% of GDP for 2009 once the December figures come out later this month. But could it be that the worst is over and that we are about to see significant improvement in the fiscal accounts? After all, our estimates of economic activity show that Argentina's economy has bottomed out in April-May and the turnaround in activity has already translated into some sequential pick-up on the revenue front. We would like to be optimistic - and it is true that the next few months will show an easy comparison base that may exaggerate annual rates of revenue growth. Still, our modeling work suggests that given the limited economic recovery in recent months and given our forecast of 3.3% growth in 2010, the overall balance could slip further to a deficit of roughly -2.9% of GDP in 2010. However, it is clear that our call for further fiscal deterioration depends on the pace of the growth recovery.

Modest Pace of Recovery

At the heart of our call for further fiscal deterioration is our expectation of a modest pace of economic recovery. Indeed, our estimates of economic growth in Argentina differ significantly from the official data and show only a modest recovery in recent months after a severe recession. Official growth data suggest that in January-October of last year Argentina's GDP rose 0.3%Y. We estimate that in that same period activity fell 5.3%Y. However, annual comparisons are more sensitive to the downturn at the turn of 2008 - we estimate that sequential, seasonally adjusted growth has been running at an annualized pace of 4.3% in the June-November period. That is a respectable growth rebound, but we expect the pace of recovery to moderate after the initial burst - we forecast 3.3% GDP growth in 2010.

We expect the economic recovery to lose steam in the months ahead because we are concerned that policy heterodoxy will constrain a rebound in Argentina's investment. A key turning point occurred roughly a year ago when, in the aftermath of the nationalization of the private pension fund system, in October 2008 the authorities inherited large equity stakes in virtually every large Argentine corporation. Since then, the authorities have named board members to the boards of directors of some of the largest companies in Argentina, including in the energy, banking and manufacturing sectors. As a result of these measures, we believe that companies' willingness to invest in the quarters ahead may be limited. That may prove to be a significant headwind to a sustained growth recovery. Indeed, even according to the more optimistic official growth statistics, investment took a plunge in 2009, falling by 12.5%Y on average in the first three quarters. And, in our view, the current confrontation between the authorities and the central bank does little to reassure the business community that the worst of the crisis is over so that it may be safe to invest again.

An additional headwind for growth is the deterioration in the business climate for Argentina's farmers. The authorities have severely limited the farmers' ability to export beef, corn and wheat - items that account for roughly 13% of Argentina's exports - by replacing automatic export permits with discretionary ones. It is thus hardly surprising that the production of these key products is expected to see only limited recovery despite a sharp rebound in international prices. Indeed, we are concerned that this deterioration in the business environment implies that Argentina's economy can muster only a modest recovery despite a sharp recovery in external conditions, principally the rise in soft commodity prices and a turnaround in the Brazilian economy (Argentina's top trading partner).

With only modest growth recovery driving fiscal deterioration, we fear that the risk of policy mistakes and coordination failure may be on the rise. Our call is that we may see further fiscal deterioration in the months ahead as the growth recovery proves insufficiently strong in the near term. The consequence of this fiscal deterioration that drains resources away from the authorities, when combined with the authorities' low approval rankings, may be increasing risk of policy mistakes or coordination failure. Indeed, the current conflict with the central bank appears to be a good example of just this type of risk materializing. This assessment means that Argentina watchers may benefit by being more cautious.  Indeed, Argentina's financing needs and ability to service its debt have been a critical focus of market participants.

Financing Needs

Despite a deteriorating fiscal position, we estimate that Argentina will be able to continue to service its debt in 2010. While the markets were pricing a high probability of default through the first half of last year, in recent months they have been buoyed by the global recovery in risk appetite. We welcome this development since we have consistently argued that the authorities can count on significant savings and pockets of liquidity that should allow them to honor Argentina's debt obligations even without market access this year and next. But we suspect that the authorities are so keen to tap capital markets precisely because the fiscal deterioration means that they may be unsure how accessible these sources of funding may be. Indeed, the pace of fiscal slippage may be the biggest source of uncertainty about next year's financing needs.

We expect Argentina's financing gap to reach US$14.9 billion in 2010 on the back of a 1% of GDP primary deficit. But the authorities are working with the assumption of a 1% of GDP primary surplus and thus expect financing needs to be a much more comfortable near US$7 billion. We suspect that much of the difference in the projections stems from different sensitivity of revenues to growth.

But while Argentina may have the funds to cover debt servicing in the quarters ahead, we are concerned that there is a growing risk of a coordination failure whereby the authorities could lose access to these pockets of liquidity. To cover our estimate of US$14.9 billion in financing needs this year, the authorities could, in theory, rely on part of the near US$20 billion in public sector deposits, on the expansion of the monetary base, part of the US$45 billion in international reserves and other pockets of liquidity. But note that most of these pockets of liquidity are not funds directly controlled by the Treasury and require coordination with other public institutions for their disbursement. In recent years this has not been an issue, but given the administration's low approval rankings and diminishing resources, we are concerned that coordination failure may lead to unintended complications. Indeed, the current conflict with the central bank shows that the authorities may be unable to access international reserves in order to continue servicing Argentina's debt.

Bottom Line

While credit markets may be focusing on the prospect of Argentina regaining market access and wondering whether the current conflict between the executive branch and the central bank is anything more than just headline risk, we suspect that the underlying issue that may drive the outlook for Argentine asset markets in the quarters ahead may be the deterioration in Argentina's macro fundamentals, especially on the fiscal front. With economic growth likely to remain subdued on the back of intensified policy heterodoxy over the past year, we expect tax revenue growth to continue to run at an inferior pace to the growth in spending. Indeed, after six years of consecutive fiscal surpluses until last year, Argentina may be faced with further fiscal slippage and a federal deficit of 2.9% of GDP and a consolidated deficit of 4.7% of GDP in 2010. While this is hardly unmanageable, we suspect that if the markets continue to rally in the months to come they may be ignoring the rising risks of coordination failure and policy mistakes associated with the rapid deterioration in Argentina's fundamentals.

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Brazil
No Rush to Hike
January 13, 2010

By Marcelo Carvalho | Sao Paolo

While Brazil's central bank is likely to have to hike interest rates this year as slack in the economy shrinks, recent softer-than-expected data have prompted the local yield curve to rethink the interest rate outlook. Our view remains unchanged: the central bank will hike rates, but is not in a rush to do so. We reaffirm our call for policy interest rates to start climbing in April, to finish 2010 at 11.0%, or 225bp higher from current levels. While the authorities have already started to pave the way for future monetary tightening, they are not in a hurry to hike at the moment, in our view.

The Copom Will Hike ...

The central bank is likely to need to hike rates this year, in our view. With nominal policy interest rates currently at 8.75% against an inflation target of 4.5%, there is little doubt that real interest rates in Brazil remain high by international standards. However, current rates are abnormally low by Brazil's own historical standards. If sustained, secular fundamental improvement would argue in favor of further rate declines over the next several years. However, cyclical considerations argue in favor of rate hikes this year, before a long-term declining trend can be resumed later on.

Indeed, the Copom has already started to pave the way for future hikes. When the central bank remained on hold at its December 9 meeting, the accompanying short policy statement already tweaked the language to prepare markets for eventual rate hikes.

The subsequent Copom minutes, a week later, proved consistent with that message. First, the minutes recognize the slack in the economy is shrinking - they no longer describe slack as "significant" but instead talk about "remaining" slack, as measured by capacity utilization in industry and labor markets. Throughout the note, subtle changes in wording recognize a stronger economy and a less dovish tone for the inflation outlook. Second, the minutes underscore that rates are on hold "at the moment" - a reminder to markets that policy decisions are data-dependent. Third, instead of focusing just on the 500bp of cuts that took place between January and July 2009, the minutes now talk about broader policy "stimulus" - in other words, fiscal and quasi-fiscal easing, too. In fact, besides monetary and fiscal policy, the minutes now explicitly mention "credit" stimulus - remember that public sector banks have been lending aggressively.

...but Not Yet

However, the last few data points seem to temper any sense of urgency. Real GDP growth in 3Q turned out not as strong as expected, November's industrial production surprisingly declined in sequential terms, and automobile production data suggested that December's industrial production could have been soft again. While recent growth accommodation may well prove temporary, it supports the case for the central bank to wait-and-see for now.

Indeed, real GDP growth in 3Q was not as strong as expected, when it came out on December 10. The economy accelerated to a 1.3%Q pace (not annualized) in 3Q, but frustrated the market consensus expectation for a 2.0% gain. Meanwhile, the annual comparison improved to -1.2% from -1.6% in the previous quarter, but was also much weaker than consensus of a modest -0.2% decline. The entire historical series was revised. Details show that domestic demand growth remained robust, with a sequential pick-up in investment after a plunge early in the year. In 3Q, private consumption was up 2.0%Q (or 3.9%Y), investment jumped 6.5%Q (or -12.5%Y), while government consumption growth was 0.5%Q (1.6%Y).

For its part, November's industrial output disappointed, when it came out last week. IP surprisingly declined 0.2%M in November, against the market consensus for a strong 1.0%M gain. The decline interrupted a path of steady sequential improvement during ten consecutive months, although changes in the seasonal adjustment pattern may have clouded the latest readings. In all, IP plunged 20.9% from September 2008 to December 2008, but it rebounded 19.4% by November 2009 from the low point of December 2008. Base effects now help the year-on-year comparisons, which had already improved to -3.2%Y in October from -7.8%Y before. Indeed, November posted the first year-on-year increase (+5.1%), after 12 months of negative readings in this type of comparison. Details show that output of capital goods continuing to recover sequentially (+6.1%M in November). On the other hand, durable and non-durable consumer goods declined in November (-4.8%M and -0.6%M, respectively), after strong increases (+6.3% and +1.3%) a month before.

And December's IP might prove soft again in sequential terms, judging by partial preliminary data, such as auto output, electricity consumption and heavy traffic in main roads. Note that year-on-year comparisons will show a dramatic jump in December, given very favorable base effects, as a plunge a year earlier meant that December 2008 was the lowest point for many industrial indicators.

In light of recent data, the local yield curve has adjusted, reducing the implied probability of a rate hike at the January 27 Copom meeting, as well as the total hiking cycle for the year. Still, the local yield curve continues to price in monetary tightening way above 300bp by the end of 2010. By contrast, our forecast continues to see 225bp of rate hikes this year, taking the policy rate to 11.0% by end-2010.

As for timing, our forecast continues to assume the first hike in April. January simply seems too soon for any move, and there is no policy meeting in February. While a hike on March 17 remains a possibility, April 26 sounds a stronger candidate as a likely date for the first policy rate hike, in our view. After all, the detailed quarterly inflation report, to come out at the end of March, provides a convenient and timely opportunity for the central bank to lay out its case for a subsequent monetary policy ‘exit strategy' towards some rate normalization. One potential complication in the Copom's calendar is the possibility that the central bank governor himself might run for elections. If so, the law requires him to leave his post by early April, six months ahead of the general elections on October 3.

Monetary Policy Outlook

The central bank is likely to wait and see where economic growth settles after the initial rebound from recession. Is the economy growing above potential already? The answer to this question, in turn, depends on two other questions. First, what is potential growth? Second, what is the actual sustained growth at the margin, over the coming months, after an initial rebound from recession? While average trend growth seemed close to 5% in the last few years through 2008, estimates of potential growth vary and are now even harder to know with confidence, given the recession in early 2009. When does the output gap close during 2010? Most recent market estimates vary from as soon as 2Q to as late as 4Q. In all, we believe that the central bank is likely to wait for more data before it decides to move.

How preemptively should the central bank act? While opinions vary among market analysts, perceptions appear more homogeneous within the central bank. In all, in our view, the authorities are inclined to watch data carefully over the next few months in order to better assess the situation, and thus identify what is the likely underlying growth trend now and through 2010. One thing is clear - the central bank will increasingly need to focus on the inflation outlook for 2011, not just 2010. One complication for the current central bank is that market expectations about 2011 inflation in part will reflect perceptions about monetary policy under the next administration, to take power next year.

Capacity utilization is one key variable to monitor. Industrial capacity utilization plunged from a peak of 86.7% in June 2008 to a low of 77.9% in February 2009, and then rebounded to 83.8% as of December 2009, according to FGV data. That compares with a longer-term average of 80.0%, since the start of the series back in January 1980.

Can previous investment save the day in expanding industrial capacity? Looking ahead, industrial capacity utilization will depend on industrial production and capacity expansion. Recent IP disappointment throws some cold water on more exuberant growth projections, and the gradual removal of the IPI tax break on automobiles might remove some steam from upcoming readings. For its part, can capacity itself expand, in lagged response to strong previous investments that took place before the crisis hit in late 2008 and early 2009? One complication for the central bank is that investment time lags are unknown - how long does it take before investments mature and translate into actual increased capacity?  

Inflation expectations can also provide an important clue for policy rate moves. Judging by previous recent monetary tightening cycles, it is usually only after market inflation expectations have been moving higher for a while that the central bank finally embarks on a tightening cycle, although monetary authorities have recently insisted that the Copom will not stay behind the curve. 

Of course, one risk is that later on the Copom finds itself forced to hike more than it would initially envisage, if - for instance - growth roars back after recent data disappointment, and inflation concerns resurface. After all, headline inflation could move higher now in 1Q10, if heavy rains push up fresh food costs, administered prices increase on transportation costs, besides seasonal factors like school fees. In addition, ongoing fiscal expansion means that monetary policy tightening will have to do most of the heavy lifting to cool down domestic demand.

Bottom Line

While growth remains strong, the most recent data points reduce the sense of urgency for rate hikes. The central bank is likely to hike rates this year, but is not in a rush. To be sure, shrinking slack in the economy and rising inflation expectations can eventually force the hand of the monetary authorities, but the Copom is likely to wait for a few more months to assess where growth settles after the initial rebound from recession.

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