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Argentina Faces Challenges And Opportunities After Its Restructuring

Now that Argentina has successfully concluded its complex US$100 billion commercial debt restructuring with bondholders, the Alberto Fernandez Administration is poised to focus its efforts on turning around the Argentine economy. Important macroeconomic distortions and inconsistencies have characterized the Argentine economy over the last several decades, leading to volatility in and a secular decline in living standards, as well as contributing to a sequence of sovereign defaults. Higher growth and low inflation are key to raise living standards and reduce poverty and inequality, which are set to deteriorate markedly amid the COVID-19-induced double-digit contraction in real GDP this year. Notwithstanding policy efforts to mitigate the deterioration, the pandemic is compounding the recession and complicating the policy response needed to subdue the spike in inflation of the prior two years.

Following conclusion of the debt restructuring, we raised our long-term sovereign issuer credit ratings on Argentina to 'CCC+' (from selective default [SD]) with a stable outlook on Sept. 7. The rating balances the risks associated with near-term challenges of high inflation, low growth, large fiscal imbalances, high financing needs, and ongoing pressure in the foreign exchange markets against the important relief gained from restructuring with a favorable near-term interest and amortization profile.

The significant near-term challenges facing the economy besides growth and inflation include communicating a path toward fiscal consolidation consistent with the availability of financing in the local market and from multilateral creditors, managing dynamics in the foreign exchange market, and negotiations with the IMF.

Given various policy uncertainties, and mixed signals from members of the economic team and Peronist government coalition, pressure continued to mount, even after the restructuring concluded, on the parallel peso exchange rates and on the level of international reserves. This prompted the announcement in mid-September of another series of even tighter restrictions to access foreign exchange at the official rate for households, corporates, and nonresidents. In addition, negotiations with the IMF just began in August to reconfigure the parameters of the Standby Arrangement and smooth out a heavy repayment schedule that kicks in end of 2021 on its US$44 billion in outstanding debt with the fund. This dialogue provides the opportunity to devise an overall economic strategy and move closer to clearing arrears with the Paris Club of bilateral creditors as well. The tone of discussions with the IMF and the government's outlining further detail on policy initiatives and direction as part of that conversation could strengthen investor confidence.

We consider tackling the dual challenge of lackluster growth and persistently high inflation that has eluded policymakers in recent decades to be of most importance because it has underpinned a trend decline in social conditions in Argentina--a key metric for policymakers, politicians, and the Argentine electorate. Similarly, it has also undermined Argentina's sovereign creditworthiness. Weaknesses in political institutions and ideological divide have contributed to a track record of sharp changes in government policies following changes in political leadership, which in turn has persistently weighed on growth, consistent fiscal performance, and an ability to meet debt service.

Success in addressing some of the key policy longer-term structural challenges facing the Fernandez Administration to jumpstart growth and lower inflation could lead to better creditworthiness over time, with Argentina breaking out of the lower end of the speculative-grade category, including a series of defaults, over the past three decades.

Growth, Investment, And Exports Have Been Declining

For the past decades Argentina has battled a prolonged period of stagflation. More recently, the economy has failed to grow in a sustained manner since 2010 with alternating years of mild GDP expansions and contractions. Some economic volatility is correlated with the political cycle, as public-sector spending ahead of presidential or midterm legislative elections has tended to support higher economic growth, but structural challenges transcend this dynamic.

Chart 1

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Real GDP growth averaged 1.9% from 2000-2019, with real GDP per capita growth averaging 0.9%. Growth over the last decade was somewhat lower, at 1.4% from 2010-2019, and per capita GDP growth averaging 0.35%. We project GDP per capita will be around US$8,500 in 2020, down from a recent peak of US$14,600 in 2017, and to remain below that peak at US$10,900 in 2023. Ongoing macroeconomic imbalances, external vulnerability, low investment, inflation, and microeconomic challenges weigh on our expectations for a robust recovery after the pandemic.

A key constraint to growth has been very low and volatile public- and private-sector investment. With heightened macroeconomic uncertainty, high inflation, and low domestic savings, investment has hovered around 15% of GDP over the past 20 years. Public investment in particular has remained subdued considering the increase of general government expenditure over GDP within the same period, to 41% in 2016 from 28% in 2000, and down to about 36% for 2019. Total investment averaged 16% during 2000-2019--rising to 20% by 2007 from 11% in 2000 amid the peak of the commodity boom but declining to an average of 17% through 2016 and 14% in 2019 amid a recession.

Chart 2

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Chart 3

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Furthermore, the country has remained generally closed in terms of international trade (in contrast with reliance on foreign financing). Similar to volatility in growth and investment, exports to GDP has trended up and down over the last 20 years. While it rose to 23% on average from 2002-2008 from 11% in 2000, the gains from real peso depreciation and the commodity boom seemingly dissipated and exports to GDP showed a persistent decline to 11% on average over 2015-2017 before some recovery in 2018-2019, though it remains below the 2011-2012 peak.

The sum of exports and imports to GDP has remained below 25% of GDP, highlighting the closed nature of the Argentine economy--similar to Brazil but lacking its massive domestic consumption market. A more open economy could support better growth and investment in Argentina. But as it stands, the closed economy, combined with a longstanding reliance on external or foreign currency borrowing, poses an important vulnerability for the economy.

The Importance Of Policy Consistency And Predictability

Successfully tackling structural weaknesses in investment, exports, and growth would entail establishing a predictable, consistent, and solid policy record on both macroeconomic and microeconomic rules of the game. In our view, private investment is a key factor for growth because, notwithstanding the recent commercial debt restructuring, government debt to GDP remains high and the authorities appear likely to use cash flow relief and limited fiscal space to bolster social policies--that are often subject to market failures. With limited funds for public investment, despite the large public-sector participation in the economy, sounder macro and micro policies that complement each other could strengthen the foundation for private investment in Argentina. But both have a variable track record in recent decades.

Consider the volatile exchange-rate policy in the last two decades, which went from a 1-to-1 convertibility regime during the 1990s to a float in 2001. That policy evolved to multiple exchange rates under foreign exchange controls until 2015, a rapid swing to a managed free-float with no foreign exchange restrictions, to a crawling peg with preset pace of depreciation within bands and rules on foreign exchange intervention under the auspices of an IMF program in 2018. In September 2019, foreign exchange controls were re-imposed, leading to today's multiple exchange rates with progressively tighter controls on foreign-exchange transactions. The absence of a stable exchange-rate regime, let alone rapid ruptures and persistently high inflation, undermines visibility for foreign direct and portfolio equity inflows, domestic private investment, and development of a local currency capital market.

There have been swings in regulation and business framework predictability for the private sector over the last three decades. Economic crises in any emerging or advanced economies often lead to governments stepping in to mitigate broader economic risks from distressed companies. During the 1990s, numerous companies were privatized or government presence was reduced. This swing on approach and policy was followed by a series of reversals and expropriations over the past two decades, including some of the same companies sold off in the 1990s. Among the most famous is the 51% share in state-backed energy company YPF in 2012, but the list includes Correo Official in 2003, Agua y Saneamientos Argentinos in 2006, Aerolineas Argentinas/Austral in 2008, and Fábrica Argentina de Aviones (Fadea) in 2010. As a result, there are numerous cases of litigation pending at international settlement agencies. The recent debate about potential government intervention in Vicentin, an agricultural company that had entered bankruptcy proceedings in 2019, raised concerns once again about the potential for microeconomic instability and unpredictable rules of the game.

These are just some examples of recurrent policy swings that have undermined local and foreign investment appetite in Argentina, limited local capital market development, and reinforced private-sector savings accumulation outside the country. Furthermore, these have contributed to the Argentine peso being only a transactional currency, rather than a trusted store of value. In our view, building the foundation for a consistent, less volatile policy track record is important to support investment, exports, growth, and lower inflation, and with them social well-being. Realizing such a track record likely means building political consensus around and progressing on some key structural reforms.

Growing Exports Would Likely Require A Shift In Trade Policy

The Fernandez government has highlighted the importance of growing Argentina's export base. In general, high tariff and nontariff barriers weigh on the Argentine economy's openness. Apart from Brazil, in Latin America, Argentina stands out with a weighted average applied tariff on manufactured goods of 9%, compared with less than 2% for Chile, Mexico, and other advanced economies. These trade barriers hit capital and intermediate goods, keep imported inputs low in locally produced goods, and contribute to higher prices for consumer goods, weighing on the lower-income population disproportionately.

Argentina has maintained bilateral or regional agreements with Mercosur but has been unable to successfully negotiate other trade agreements. The future of the recently negotiated EU-Mercosur deal remains pending, and how the agreement might boost Argentine exports, investment, and growth remains unclear. To take advantage of the trade deal opportunity, additional policy steps and reforms are likely needed.

Argentina's composition of exports does not immediately lend itself to incorporation in global value-added production chains and is not labor intensive. Goods comprise over 80% of Argentina's exports of goods and services, and about 60% of goods exports are dominated by agricultural-related complexes (soy, cereals, beef, fish foodstuffs, etc.). Mining accounts for another 8% of exports. Meanwhile, manufactured goods are only 10% and are essentially car exports to Brazil.

Oil and gas exports have doubled as a share of exports in the last four years--but to just 7% of goods exports. After a decline in production because of the hit to global energy prices this year, hopes remain for increased rigs in the Vaca Muerta region to invigorate oil and gas output. But the hope for Vaca Muerta to turn around balance of payments and growth dynamics in a meaningful way needs to be considered in the context of a low starting point, notwithstanding its vast geological potential--as the world's second-largest shale gas deposits. Furthermore, successful development faces local infrastructure, tax, and labor and regulatory bottlenecks. Coupled with uncertainties about extensive foreign exchange restrictions and global oil and gas prices, this may render other global jurisdictions more profitable.

Given Argentina's well-educated labor force compared with regional peers, there are prospects to further expand incipient IT service exports. Like Vaca Muerta, however, while they have grown, they comprise a small share of the current export mix. IT/telecommunication exports averaged 14% of total service exports, or under 3% of exports of goods and services over the last four years. Successful development of this export potential will also rely not just on ongoing gains in education, but also other supportive investment policies.

Tackling A High And Complex Tax Burden

Argentina's tax burden has risen over the past two decades to finance a larger public sector, but it has also become more complex. General government revenue to GDP rose from an average 24% at the beginning of the 2000s to an average 35% of GDP during 2014-2017 on higher taxes and social security contributions; it then declined amid recession to 31% in 2019. To finance social safety nets, pensions, and subsides, Argentina has raised many different kinds of taxation, including income and wealth taxes, value-added taxes (VAT) and inflation taxes, export duty taxes (created in 2002), and gross receipt taxes. Newly created taxes, which sometimes overlap with subnational government taxes, have weighed on private investment and added pressure for tax evasion in general, and for business to remain informal, avoiding taxes and labor restrictions.

Chart 4

image

As of 2020, there were 165 taxes to pay across all three levels of government in Argentina: 41 at the national level, 39 at provincial, and 85 at the municipal. However, 90% of revenue collection comes from only 11 taxes, with 154 taxes accounting for just 10% of total collection. This underscores inefficiencies and complexities in the tax structure and the importance of reforming the overall composition of taxation across Argentina's three levels of government. Besides the magnitude of the tax burden, simplicity could improve the environment for doing business.

In general, the tax regime is not progressive and has various overlapping and cascading distortionary taxes. Provincial turnover taxes impede flows across provincial borders. Financial transaction taxes promote use of cash and weigh on formalization and deepening of credit markets.

Personal income taxes are paid by only 15% of the population given a high base income threshold. The Monotributo system, aimed at formalizing lower-income workers, is also used by higher-income independent professionals. Argentina's VAT base has various exemptions and preferential rates that imply less than 50% of potential VAT revenue (were rates applied to all consumption).

Pensions Are A Key Component Of High Inflexible Spending

Given the importance of reducing fiscal imbalances but also supporting growth, raising taxes off an already high and complex base would not likely foster increased private investment. While a simplification of the tax regime appears important, so may be cuts in some less essential spending and greater public-sector spending efficiency.

The increase in the tax burden followed the need to finance a larger size of government. General government expenditure rose to 40% of GDP over 2014-2017 from 25% in the early 2000s. The rise in spending tended to be concentrated on higher current spending, which is politically more difficult to cut. In particular, spending increases were concentrated in transfers to the private sector, social security, and personnel expenditures. The transfers to private sector include social programs and subsidies to keep energy price increases below inflation.

The size of the state is a public policy choice, but there appears to be space for efficiency gains, and rationalization and reprioritization of spending programs. The recent commercial debt restructuring provides important relief on a key inflexible portion of the budget, namely interest payments, which rose to 13% of general government revenue in 2019 or over 4% of GDP. But beyond interest, other inflexibilities and inefficiencies in noninterest or primary spending budget could be tackled.

Chart 5

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Argentina's social security regime is a potential candidate for reform--particularly in the context of an aging population and comparatively generous benefits internationally. Following a shift to individual defined contribution capitalization funds in the 1990s, the system reverted to a pay-as-you-go regime in the 2000s. Under the pay-as-you-go system, pension expenditure has consistently increased, putting more pressure on fiscal accounts, including increased nondiscretionary spending. As of 2019, pensions were the single largest component of spending. Pensions are periodically updated to follow inflation and salary increases. But the system is not in balance, with a deficit that is covered by nonpension revenue. The politics around indexation formulas are complex. While some progress was made in previous years, allowing for some fiscal space on the margin, the political difficulties in passing broader reform has kept risks from pension spending ever present on the budget.

Federal Versus Provincial Fiscal Challenges

As a federal republic, roles and responsibilities for provision of public services span three government levels, with provinces responsible on delivering key services such as education, health, and security. However, spending responsibilities at the local level exceed their own revenue generation capacity, and coparticipation transfers from the national government have not always been sufficient to close this imbalance. Moreover, similar to the sovereign dynamics, provincial spending has also expanded over the last two decades, representing 12% of GDP in 2005 to 16% in 2014-2017. In many regions the increase has been explained by a constant raise in payroll, aimed to compensate the lack of private employment. However, this has led to little room to execute infrastructure spending, and in some cases it has increased the dependence on nonautomatic cyclical transfers and short-term costly debt.

With the completion of the sovereign debt restructuring, many Argentine provinces will move ahead with their own pending restructuring deals--jointly restructuring about US$13 billion in international debt, about half of which corresponds to the Province of Buenos Aires.

The overall provincial debt burden is not as high and the average fiscal situation not as severe as at the national level. But local governments are restructuring and liquidity pressures across the system will inform the magnitude of restructuring of local debt. So will the national macroeconomic and political scenarios in which local governments operate, including market access.

Over the past five years there were fiscal consolidation efforts at the local level, with the overall local government deficit improving to 0.3%-0.4% of GDP in 2018-2019 from 1% in 2015. However, sensitivity of local finances to macroeconomic challenges in Argentina were particularly visible in the second half of 2019 and exacerbated by the COVID-19 pandemic. Following the debt restructurings, the commitment from local administrations to fiscal sustainability will be key to avoid future defaults and eventually increase capacity to execute infrastructure that contributes to the provincial economic development.

Persistently High And Volatile Inflation

Argentina's long history of inflation (with episodes of hyperinflation) is deeply rooted in economic expectations. The general population is used to a relatively high inflation level, and workers demand salary adjustments to compensate for the real wage losses through union-led politically complex negotiations. Inflation averaged over 20% the past two decades, and it averaged 30% from 2009-2019, rising above 50% in 2019. Given the peso isn't seen as a store of value, the focus on the U.S. dollar as a savings vehicle, the swings in exchange rate policies, and the consequent pass-through effect, inflation is not only high, but also volatile. The indexation of key utility prices to U.S. dollars and repressed inflation from delayed removal of subsidies and increasing obligations from monetary policy instruments (such as central bank notes [LELIQs]) have not allowed for disinflationary plans to build enough credibility to impact and guide expectations.

Chart 6

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While formally independent, the Central Bank of Argentina (BCRA) has long lacked de facto independence. Board members are often replaced before their mandate expires, and new members are appointed with each new presidency. There is no established track record on a consistent monetary policy framework to lower inflation, and at times there weren't reliable measures of inflation.

The Macri Administration failed in its attempts to tame inflation and inflation expectations by establishing first an inflation targeting regime, and then a monetary aggregate targeting regime under the auspices of the IMF Standby Agreement. Under the Fernandez Administration, central bank management has yet to outline a formal policy regime but aims to lower inflation via a more ad hoc approach relying on monetary policy tools (interest rates), exchange restrictions, and price controls. Under sequential governments, not just the current administration, BCRA's policy execution has been compromised by its recurrent financing of the Argentine Treasury. This has reflected a long-standing track record of small local capital markets. In light of the current government's limited market access, it relies on BCRA to provide key financing via a transfer of profits and advances, as prior governments have as well.

Labor Regulations Weigh On Formal Employment

Aside from a less complex and burdensome tax structure, lowering some of the barriers to formal labor could also likely be an important step toward increasing private-sector investment. According to the OECD 2019 Economic Survey on Argentina, about one-third of labor is informal. A significant portion of Argentine workers do not have access to contributory pensions, sectoral health insurance schemes, and protection against the income loss associated with unemployment. Rigid labor laws protect formal workers. In general, high severance payments compared with sovereign peers upon dismissal of a formal worker limit incentives to hire formal workers. Potentially the construction sector's unemployment insurance scheme is one that could be extended more broadly in the economy: monthly employer contributions accumulate on individual worker accounts. Such individual accounts can then be used to finance unemployment. Lowering informality, like elsewhere in the region, is challenging and likely needs a comprehensive strategy, including both stronger incentives for formal employment and stronger enforcement of existing requirements to become formal by workers and firms.

Updated Local Competition Policy Is Key To Boosting The Economy

Argentina has the highest barriers to entry in the domestic market compared with regional peers according to data from OECD. The OECD Product Market Regulation Indicator (PMR) and its subindicators measure the competition-restrictiveness of product market regulations across a wide range of countries. Argentina has the highest restrictiveness of product market regulations compared with all OECD peers, according to the latest data, and this includes restrictions at the provincial levels of government.

In particular, the OECD highlights significant barriers to entry in Argentina's network and services sectors. This appears to affect the competitiveness of other sectors' as well if they use inputs from these regulated sectors of the economy. Meanwhile the manufacturing sector is characterized by having only a small number of young firms, and OECD analysis indicates that young firms create more jobs. The average Argentine firm is 27 years old, compared with 21 years in Latin America and 17 years in all OECD economies. Over the last decade and across all countries the OECD analyzed, 42% of all jobs were created by enterprises less than five years old. In Argentina, 6% of firms are younger than five years.

Argentina's starting point underscores potential for more buoyant employment growth with vibrant small business creation. The 2017 entrepreneurship law has been an important step to reduce administrative burdens for small startup companies in particular because it allows incorporation one line in one day. However, barriers for creating most companies are still very high.

In addition, OECD recommends strengthening the operation and financial autonomy of the country's anticorruption office and guaranteeing adequate resources to fulfil its mandate to improve the business environment.

The Importance Of Consolidating Key Macro And Micro Policies

To tackle various post-pandemic macroeconomic challenges and strengthen its creditworthiness in the near and medium term, Argentina will need to establish policy consistency and reduce fiscal and monetary imbalances, including lower inflation and a more stable exchange-rate regime. Progress in tackling a complex and high tax burden, rationalizing some public-sector spending, and creating more flexible labor and product markets could support higher private-sector investment. So would deeper local peso-denominated capital markets that facilitate financing for firms. All of this in turn would likely contribute to more robust trend growth--and prove supportive for sovereign creditworthiness.

Regarding near-term creditworthiness, in particular, over the next 12 months, we could raise our ratings on Argentina following successful negotiation of a new IMF program that smooths a heavy repayment schedule and amid signs that fiscal and monetary policy articulation is stabilizing inflation and exchange-rate dynamics. We could also raise the rating if there is a more pronounced economic recovery that supports stronger fiscal outcomes and lower financing needs. Implementation of structural fiscal measures to reverse the deterioration in Argentina's fiscal profile could also support a higher rating. This could also open access to broader market-based funding by local and external private creditors.

Related Research

This report does not constitute a rating action.

Primary Credit Analysts:Lisa M Schineller, PhD, New York (1) 212-438-7352;
lisa.schineller@spglobal.com
Sebastian Briozzo, Buenos Aires (54) 114-891-2185;
sebastian.briozzo@spglobal.com
Secondary Contacts:Patricio E Vimberg, Buenos Aires (54) 114-891-2132;
patricio.vimberg@spglobal.com
Constanza M Perez Aquino, Buenos Aires (54) 114-891-2167;
constanza.perez.aquino@spglobal.com
Carolina Caballero, Buenos Aires (54) 114-891-2118;
carolina.caballero@spglobal.com
Tomas Marinozzi, Buenos Aires + 54-11-4891-2153;
tomas.marinozzi@spglobal.com

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