Paul Diggle
Hello and welcome to Macro Bytes the economics and politics podcast from Aberdeen. My name is Paul Diggle
Luke Bartholomew
And I'm Luke Bartholomew.
Paul Diggle
The Argentinian economy has a history going back decades of chronically low growth, high inflation, periods of crisis. But under President Javier Milei, a flamboyant libertarian economist who brandished a chainsaw on the campaign trail to symbolise the public sector cuts he would make, Argentina's actually been returning to a degree of economic orthodoxy. The country is in an IMF programme of structural reforms and is gradually being let back into international capital markets. So how has Milei started to turn the economy around? What more is there to do? And what happened to that firebrand rhetoric from the campaign trail? Well, Luke and I are joined by Tettey Addy, emerging market economist here at Aberdeen, to answer these questions. Welcome Tettey.
Tettey Addy
Hi. Happy to be here.
Paul Diggle
So let's start Tettey by describing how bad Argentina's macro situation was before the Milei took office at the end of 2023.
Tettey Addy
Sure. So to understand the context behind where Argentina is currently at, it's worth looking at the actions in particular of the two governments that led to Milei’s presidency. So back in 2015, Argentina saw a major transition with the election of Mauricio Macri as president and his market friendly government coming to power. Now, this saw the economy returning to international financial markets after a long period of being closed off and protectionist. The governments did inherit a fragile economy with an underdeveloped financial sector but there was plenty of optimism at this time around Argentina's potential, as policy makers aimed to carry out various reforms and re-engage with investors, which led to renewed inflows of capital at that time. Now, by 2018, though, things were beginning to look a bit worse for Argentina to say the least. Now the economy was hit by a combination of external shocks that had weighed on various emerging market currencies. The impact on the Argentinian peso and domestic prices being exacerbated by a drought affecting the crucial agricultural sector. So, this worsening backdrop led the government to seek a new IMF deal later that year. But the policy aims of this deal but ultimately derailed by 2019. Now this is due to various factors, including worsening market confidence regarding the minority government's capacity for reform, alongside signs of a likely change to a new, less market friendly government in upcoming elections. So, from this, we saw capital flight, peso depreciation, which altogether underscored inflation rising to more than 50% just ahead of those elections later that year. So ultimately in the elections, we did see a new administration led by President Alberto Fernandez, which then chose to broaden a range of preexisting capital controls while also moving the pesos exchange rate to a ‘crawling peg’. So, with these policy changes, but continued structural issues with the economy, a worsening of foreign currency liquidity, and the series of global shocks in the following years you get a long list of factors that affected Argentina. Altogether, this led to the government having to get another IMF deal in 2022. Now, despite that deal, market concerns over fiscal policy saw interest rates remain very restrictive for the government, and a ramp up in pre-election spending in 2023 further exacerbated price pressures. Now, ahead of this vote, Argentina then had inflation at around 140%, while the poverty rate was around 40%. So all these crises and worsening living standards laid the ground for Javier Milei to capitalize on the electorate's discontent - with him being elected on a pledge, as you said Paul, to take a chainsaw, in his words, to the economy.
Paul Diggle
Great. So you've got this combination of chronically low growth, high inflation, unsustainable fiscal policy, a very overvalued exchange rate in the peso, and then this emergence of a sort of shadow or parallel exchange rate called the ‘blue dollar’ rate in Argentina, negative FX reserves, multiple defaults on sovereign debt, a huge spread to other emerging market bonds, effectively locking Argentina at points, out of capital markets. So, a pretty, difficult macro combination. What Tettey though is the root cause behind all of that?
Tettey Addy
Sure. So I would say root cause, you know, a lack of political capital for various governments to carry out necessary reform. Milei has so far been able to carry out more change than had been expected, but the structural fragilities are still there. Vulnerability to external shocks has meant that policy changes have generally been, you know, either implemented if they have been - and then quickly derailed or just struggled to get off the ground in the first place.
Luke Bartholomew
So, as you say there, Tettey, this long history of economic mismanagement, low institutional credibility, that ultimately ended up in something like outright fiscal dominance, where monetary printing was used to finance the budget deficit. And that's obviously what caused this big pickup in inflation towards the end of the previous government. So why don't we talk a little bit then, about what Milei's policies have been to tackle some of this? What policies has he pursued so far?
Tettey Addy
Sure. So since coming into office, the Milei administration has adopted shock therapy tactics in its handling of the economy. Among a range of measures the two pillars of this have been regarding fiscal policy and the exchange rate. Now of the previous government's use of money creation to finance pre-election spending Milei has overseen the end of that previous approach, and major cuts to primary expenditure in real terms across the board. Meanwhile, on the FX side, Milei devalued the peso by 55% against the dollar in December 2023, after he came to power in order to relieve pressure on reserves, given that they were propping up the over-valued official exchange rate, then moving it to a weaker crawling peg thereafter. Now that initial devaluation did lead to inflation spiking to a peak above 280% last year, which also increased poverty. But the disinflationary impact of this fiscal shift and the tight management of the peso since then, have actually seen price growth slow more sharply than many had expected when Milei first came in. In fact, reduced pressure on purchasing power allowed Argentina to come out of its previous recession from Q3 of last year. But as of April, inflation is down to 47% year over year and around 3% percent month on month, which still sounds very high but shows a marked turnaround for the country. So this disinflation and a return to a fiscal surplus for the first time in well over a decade have seen Argentina’s sovereign yield relative to other EMs, narrow considerably from previous levels, even if they are still fairly high. And the progress towards economic stabilisation also paved the way for the latest IMF deal in April, which provides a much-needed boost to liquidity and aims to help further reform progress.
Paul Diggle
Great. So two pillars, as you say, the cut to spending and then the peso devaluation and the new FX regime, and then this latest development - the IMF deal. So let's go through each of those then. First, the fiscal measures. Tell us Tettey or give us a sense of how much he's cut on the fiscal front, and the change in the fiscal deficit over that period.
Tettey Addy
So at the end of 2023, the previous Fernandez-led government had left the budget deficit at 4.4% of GDP, up from 3.8% just a year earlier. Since then, Milei’s policies led to the fiscal balance shifting to a 0.3% surplus at the end of last year, with a primary surplus at 1.8%. Now, this was largely led by cutting expenditure by around six percentage points versus the trend of previous years to show how sharp the cuts have been. Now, the biggest reductions, in real terms, were in the areas of social spending, though that is still the largest component, alongside subsidies and capital expenditure. At the same time, revenue as a share of GDP has held quite steady. Now, the spending cuts did exacerbate the pain that the population felt in the months after Milei came to power with cuts to pensions having been especially contentious. But despite that, support for the president and the government has held very strong. Now, again, the market reaction to this fiscal turnaround has been very positive. We've seen the spread for Argentina's yields compared to the US, narrow by around 1200 basis points since the end of 2023, towards the 700-basis point range. Now, that is still a fair bit above the Latin America average of around 440 bps compared to the US, but that compression has still been ultimately very impressive. Now that being said, though, it is worth, still being cautious about how sustainable this improved fiscal backdrop is. Real GDP growth is expected to rebound by around 5 to 5.5% this year, depending on the IMF or market expectations. But that comes off two years of recession. So that facilitates quite a rebound this year. But beyond that, the government's constraining of public investment, in particular risks seeing growth in the medium-term fall short of currently bullish market expectations. At the same time, limits on social spending could risk weighing on public support over the coming years as well.
Luke Bartholomew
And then so talking about the currency politics that is the other big pillar that you sketched out there. Clearly there was this one-off big devaluation and then the crawling peg that was put in place. Why was that devaluation necessary, and then why the crawling peg after that? And then can you just talk again about some of the consequences of that big exchange rate adjustment?
Tettey Addy
Sure. So, in the wake of, you know, the tight management of the currency before the previous elections, it did leave the real effective exchange rate overvalued and was also being a major drag on the strained currency reserves. So, after that sharp devaluation for the peso, when Milei came into office, it had a crawling peg where the authorities would weaken it by just 2% per month. And that was later cut to just 1% at the start of this year. Now, the crawling peg aims to help anchor inflation expectations, but it did still see the persistence of this longstanding gap between the official and parallel exchange rates for the peso. With already low reserves being used by policymakers to support the overvalued official peso rate, a lot of the private sector had to go via the black market to access foreign currency at much weaker exchange rates. Now for years, that had had very distortive impacts on the economy, which alongside critically low liquidity for FX had markets pricing in a large devaluation again for this year up until April.
Luke Bartholomew
And you talked a little bit there, or you mentioned, the distinction between real exchange rate and the the nominal exchange rate. I think it is worth dwelling on that for a moment. So the real exchange rate, of course, takes into account inflation movements as well, not just the nominal movements in FX markets. And so really does capture the price the importers and exporters have to pay, or at least the adjustments in those. And whilst there has been this big nominal depreciation in the currency, the real exchange rate is now actually appreciating. And the reason for that being that inflation is running higher than the crawling peg so far to allow the depreciation. So, what problems has that caused. And is that storing up issues for the future or what does that mean for different parts of the Argentine economy?
Tettey Addy
So, the limited depreciation of the nominal exchange rates while inflation remained high, has led to Argentina's real effective exchange rate rising by around 28% over the past year. And that's a well above any other rise among the major emerging markets over the same period. Now, while individuals in Argentina may have been able to enjoy the benefits of a strong real exchange rate, the drawbacks for the wider economy, as you pointed out, are quite notable. Now the pesos real strength and cooling inflation have led to increased import demand, while the overvalued currency also weighs on the competitiveness of Argentina's exports. Now, this poses problems for a country that has long struggled to broaden its export base beyond the currently limited scope of agriculture. And although Argentina's current account did return to a surplus last year, the overvalued peso is still a drag on potential net trade growth and foreign reserves over the period where it still remains overvalued in this state.
Paul Diggle
Okay, so lots of challenges from the overvalued exchange rate and that large depreciation and then managed depreciation lower haven't necessarily solved the problem just yet given the rise in inflation that they caused. The real effective appreciation. And that I think gets us on to the IMF deal, because one key feature of that is that the peso moved to a managed float, which was likely see it continuing to depreciate over time, causing this external rebalance, which is necessary. Amazingly, this is Argentina's 23rd IMF deal. Why did they need it? What does it require of Argentina?
Tettey Addy
So yes, the deal announced in April will see the IMF provide Argentina with $20 billion over the next four years, with an immediate provision of 12 billion, giving a much needed boost to FX liquidity. Now, again, even after Milei devalued the peso when he first came in, it still
remains overvalued at this time. And, you know, before the deal, net reserves remained in negative territory. Just showing how much of a need there was for this, boost to come in. And again, as you said, this is Argentina's 23rd deal. But that being said, the current deal is at least different from those of the past few governments in that it does follow a major progress by Milei towards a semblance of stabilisation for the economy.
Now, in exchange for these funds, Argentina has moved the peso to a managed float. This initially began with the peso allowed to fluctuate freely in a band of 1000 to 1400 per dollar, with those bands widening by 1% per month. Now that will most likely see the peso remain overvalued for at least the rest of this year.
But it is a positive step for the FX regime. Additionally, the deal has seen Argentina loosen some, though not all, of its capital controls. The notable ones that have been removed include a previous monthly limit of $200 per person for purchasing FX, while firms will also now be able to repatriate profits to outside Argentina in the current fiscal year. Now, when the deal was first announced, there were widespread expectations that the peso would immediately sell off towards its new lower band. However, it's actually held largely steady since the transition, with Milei having mocked those that bet against the peso in the first place. This looks to have been supported by the marked improvement in sentiment regarding Milei’s policies, alongside current expectations for a return to positive real interest rates, late next year and the fairly bullish growth outlook depending on the forecast in question. Sentiment could definitely deteriorate again, under new pressure on the peso, given the fragile state of Argentina and its history, but for now, markets at least appear optimistic regarding its prospects, which should relieve pressure on the currency and allow for a gradual rebuilding of reserves.
Luke Bartholomew
So, yeah, I guess all pretty standard IMF stuff there in terms of the structural reform they're looking for - relaxing capital control rules, fiscal discipline, insisting on primary surpluses, broader deregulation, which makes me wonder, you know, at some level, what we've been talking about does seem like relatively standard, for better or for worse orthodox ‘Washington consensus’ as it was once called style reforms. And maybe that is starting to bear fruit in the way that orthodox economics would expect. But, you know, when we were observing Milei back on the campaign trail and, you know, his sort of valence, I guess, in popular political debate even now is that he's meant to be a much more radical figure than that. You know, he talked about shock therapy, famously wielded his chainsaw, said he'd abolish the central bank, would fully dollarize the economy, you know, he’s campaigned as a libertarian ideologue rather than a reforming pragmatist. So, I guess my question is, you know, what's next? Are the coming years all about continuing with this again, quote unquote ‘Washington consensus’, gradually rebuilding the supply side of the economy in line with orthodox policy? Or are those more radical things that he previously talked about - are they still to come? And if so, what are the constraints on implementing them?
Tettey Addy
Sure. So markets have definitely been positively surprised by the extent of reform seen by Milei so far. But they're definitely political realities that do hinder some of the more radical aspects, and with some upcoming electoral challenges, potentially being hurdles. But time will tell. In that respect. So, the next big test for the government will be the midterm elections in October, which will see large shares of the seats in the upper and lower houses is being contested. Now, it's worth noting that the major policy shifts overseen by Milei so far have been managed, despite his LLA party holding very small numbers of seats in both houses. That's been done through a mix of executive orders and dealmaking to get support from like-minded parties. But in terms of how sustainable that is, markets at least seem to be hoping for increased seat share after these upcoming votes. Now, the fragmented political backdrop in Argentina does make it very difficult for any single party to win a majority. But fortunately for the president, it does look like there will be an increased seat share coming up later this year, given current polling and a very strong performance by the LLA in the recent Buenos Aires city elections. Now beyond October, making enough progress for Argentina to regain attractiveness as a destination for capital will remain a challenge over the medium and long term. The administration currently plans to further loosen peso and capital controls next year, assuming inflation does moderate sufficiently further. But Argentina's history means we can't rule out these plans being delayed, or for progress on the FX front to actually reverse course should the peso see too much volatility. There have also been announcements of plans for a major tax amnesty regarding individuals use of previously undeclared foreign currency. Now, this aims to bring FX reserves that the public have stashed away back into circulation in the economy to boost activity and liquidity. But whether that will prove successful will take time to tell. Now, in terms of fiscal policy, again, the cuts to public investment do risk weighing on production capacity over coming years without a rebound in private investment. However, the business environment still remains very challenging for firms with a very outsized influence from the state, and privatization progress are likely to remain sluggish for some time to come. Reforms to the highly generous pension system, also alongside other social spending, do risk being delayed and derailed if Milei’s popularity deteriorates after these upcoming elections. So overall, the economy is definitely on better footing than it was before Milei came to power. But whether the government can continue making enough further gains for Argentina to sustain a meaningful return to international markets remains uncertain.
Luke Bartholomew
Yeah, I mean, I guess the fact that what are we on the 23rd bailout now, as we talked about earlier, one could suggest that that isn't the most encouraging of track records. And then just looking at the broader track record of Latin America, South America, it tends to be that these stabilization policies do end up running out of steam eventually. But we will see. I think that is all that we have time for this week on Macro Bytes. So as ever, please do indulge me if I remind you all, if you have not already, to like and subscribe wherever it is that you get your podcasts. And then all that remains is for me to thank you, Tettey for joining us. And thank you for listening. So thanks very much and speak again soon.
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