Argentina: Javier Milea’s “Shock Therapy” is necessary but difficult to implement

Argentina’s GDP represents only 0.6% of world GDP. The country’s main trading partners, such as China, the United States and the eurozone countries, are able to absorb the shock. Due to close trade ties with Argentina, only Latin American countries may be at risk.

Candidate Javier Milei will be officially enthroned by the president in Argentina on December 10, 2023. He will have to implement “shock therapy” to get the country out of a long period of economic and social crisis. Her plan, called the “Chain Plane”, is primarily economic. It aims to transform the growth model through ultra-liberal inspired proposals that reject the omnipresence of the state in favor of individual freedoms and the privatization of the economy.

The reconstruction of Argentina will have to take place over a period of 35 years and in three stages:

  • During the first phase, Mr. Milei advocates a drastic reduction in public spending (by 15% of GDP) and the implementation of reforms to reduce taxes. At the same time, it proposes measures to support the flexibility of employment, foreign trade and capital flows.
  • The second stage will focus on reducing pension and pension funds, as well as reducing the number of employees in ministries and social plans.
  • Finally, the last phase will involve the abolition of the central bank and the dollarization of the economy. Several non-sovereign ministries will also be eliminated, notably health, education, environment, science and technology, transport, social affairs, public works and women’s rights.

“Shock therapy” necessary to limit chronic imbalances

On paper, the new president’s stabilization program appears coherent and necessary given the difficulties the economy is currently facing.

The first concerns chronic inflation. In October it was 143% (cf. graph 1). The introduction of dollarization and aggressive cuts in public spending should, in theory, allow the authorities to control two main sources of inflation:

  • Excessive weakness of the peso: the exchange rate against the dollar has weakened significantly this year. The official exchange rate devalued in August by 20% rose to 356 per dollar today (compared to 167 in November 2022). There are many downward pressures. On the one hand, real interest rates remain negative despite monetary policy tightening on several occasions, leading to massive capital flight. On the other hand, the current account returned to deficit. The severe drought experienced since the beginning of the year has worsened the harvest of staple crops (maize, soybeans, etc.) and reduced export earnings. The interventions of the central bank were not enough and even caused a drop in foreign exchange reserves(1) (cf. graph 2). They fell to $18.6 billion in October (3 months of imports), compared to a peak of $65 billion in 2019 (16 months of imports);
  • Chronic budget imbalances financed money creation: the positive impact of the public finance recovery strategy implemented in cooperation with the IMF in 2018 was short-lived. The movement reversed in 2019 with the economic slowdown and the Covid-19 pandemic. Today, the public finance deficit is around 6% of GDP (cf. graph 3). It is financed mainly by the creation of money supply in circulation. This increased by 112% year-on-year in September (cf. graph 4).

The new administration’s stabilization plan is also welcomed for maintaining IMF assistance programs important to the country’s macroeconomic stability. In a situation where external financing needs are high, foreign exchange reserves are collapsing, and prospects for a return to international bond markets are limited, the question of sources of borrowing must be asked. Unorthodox support, such as a line swap with China, certainly offers short-term solutions. However, relations with the IMF remain a key element in the long term. Indeed, Argentina is its largest debtor, with credit agreements concluded as of 2018 (57 billion in October 2018 and 44 billion in March 2022). While the outgoing government has since failed to respect budget targets in return, Mr Milei’s promises of significant cuts in public spending should ease negotiations with the institution, especially during the next planned payout by the end of the year. .

Proposals difficult to implement

Despite the ambitious program being widely welcomed by financial markets, there are questions about its feasibility finally regarding the rapid overcoming of the crisis in Argentina. The proposals will indeed be difficult to implement.

  • Dollarization and central bank abolition: although it allows avoiding the risk of exchange rate devaluation, dollarization seems to us to be unusable at this stage. The country does not have enough liquid dollars to replace its monetary base. This is currently estimated at around USD 25 billion, while foreign exchange reserves continue to decline. A new large dollar loan will be required to complete this project.

At the same time, the role of the central bank will change completely. On the one hand, it would no longer be a lender of last resort and would have to provide the financial system with a credible system of banking supervision to prevent a large-scale banking panic. On the other hand, dollarization will deprive the state of monetary policy because it will depend on the decisions of the Fed.

Ultimately, dollarization and abolition of the central bank is not sensible, while the desired positive results are not guaranteed. In the 1990s, Carlos Menem introduced a “currency board” system relatively similar to dollarization to curb hyperinflation.(2) 2000-3000% per year. The episode ended in 2001 with a banking crash, a massive social crisis and an explosion of poverty. The experiment was not successful elsewhere in Latin America either (Panama in 1904, Ecuador in 1999, El Salvador in 2000 and Venezuela in 2018).

  • Drastic reduction in public spending: if we do not question the necessity of this goal, its success is conditioned by the speed of the reform train. However, the new president’s room for maneuver is narrow. His coalition, Libertad Avanza, won only 10% of the seats in the Senate and 15% in Congress. He also lacks support among governors, whose influence in the national legislature is crucial because no party candidate was elected in the provincial election. His alliance with former president Mauricio Macri is not enough to reach half of the 257 MPs and 72 senators. Passage of reforms, especially in areas such as public finance, will therefore have to come either through an alliance with defeated candidate Sergio Massa’s centre-left Peronist opposition or through an authoritarian tour de force. In any case, political uncertainty will be high and will weigh on the country’s fiscal consolidation process.

Limited impact on the global economy

In this context, we believe that the peso will remain under pressure. The economic outlook will worsen and imbalances will not be resolved quickly. In addition, the need to stabilize the high interest rate financial system will further fuel concerns about Argentina’s debt solvency. On the other hand, we rule out a default crisis. The country has significant support from the IMF to cope with the shock.

Ultimately, it remains to be seen what consequences the uncertainties will have for the rest of the world. We believe that exchange rate impacts should be limited to fragile developing countries. The impact on growth and global markets will be small. Argentina’s GDP represents only 0.6% of world GDP. The country’s main trading partners, such as China, the United States and the eurozone countries, are able to absorb the shock. Due to close trade ties with Argentina, only Latin American countries may be at risk.

Argentina: Inflation (%)
Argentina: foreign exchange reserves (in billions of dollars)
Argentina: budget deficit (% of GDP)
Argentina: money supply (M3, one-year change, %)

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