Without meaningful reforms, we do not expect the 2018 target to be met
• Argentina’s ruling coalition (Cambiemos) obtained an important victory in the primary elections for congress. The popular support for the administration (if confirmed in October elections) gives it political capital to continue with the necessary fiscal adjustments and to pass reforms.
• The fiscal deficit is wide and the government targets a gradual fiscal consolidation. While the government is on track to meet the deficit target for this year, we do not expect the 2018 target to be met without meaningful fiscal reform. Sticky payroll and pension expenditures work against a fiscal deficit reduction.
• A gradual fiscal consolidation means a growing debt/GDP ratio in the next few years, although to still- moderate levels. However, given the high proportion of foreign currency debt, exchange-rate mismatch is a risk.
In August, Argentina’s ruling coalition (Cambiemos) obtained an important victory in the primary elections for congress. The results indicate that President Macri’s party’s presence in the lower house will likely rise to 105 seats (or 40.9% of the total), from 87, while in the Senate, seats held by Cambiemos would reach 25 (or 34.7% of the total). If these results are confirmed in the upcoming mid-term election (October 22), Cambiemos will continue to be the largest party in the lower house, while in the Senate, it will be close to the Peronist block (with 26 seats).
Although the government will not be able to secure a majority in either of the two houses of congress, the popular support for the administration gives it political capital to continue with the necessary fiscal adjustments and to pass reforms.
But the fiscal challenge is significant. In 2016, the federal government’s primary deficit stood at 4.3% of GDP, while the nominal deficit was 5.9%. If it wasn’t for the 1.7%-of-GDP one-off revenue related to the amnesty for undeclared assets (of which 1.3% was recorded last year and 0.4% this year), the deficit would have been even larger. Furthermore, we note that the provinces recorded a nominal deficit of 0.9% of GDP last year.
The government targets a gradual fiscal consolidation. Early this year, the Treasury announced a primary deficit goal of 4.2% of GDP for 2017, falling to 3.2% in 2018 and 2.2% in 2019. In our view, three factors should make gradualism sustainable: the still low level of public debt with markets (23.7% of GDP in 2016) and multilateral agencies (5.5% of GDP), benign external financial conditions for emerging markets, and the perception (reinforced by the results of the primary elections) that policy changes in Argentina are unlikely to be reversed in the near term.
The government is on track to meet the deficit target for this year, but, without meaningful reforms, we do not expect the 2018 target to be met. A primary deficit of 4.2% of GDP this year seems achievable. In fact, the 12-month rolling primary deficit is not far from that level. If we exclude the revenues related to the tax-amnesty program recorded last year and also some one-off expenditures in the end of 2016, the 12-month rolling primary deficit was 4.4% of GDP in June. But given that the government will have no resources linked to the tax amnesty in 2018, 3.2% of GDP looks too ambitious, as it means a fiscal consolidation of 1.4% of GDP.
An important piece of the deficit-reduction strategy lies in continuing to slash utility subsidies. Last year, the government reduced the subsidy bill to 3.6% of GDP (from 4.5% in 2015), mostly by increasing electricity tariffs. This year, expenditures for subsidies will likely fall to 2.7% of GDP and the government aims to reduce them to less than 1% of GDP in 2019. There is no need for congressional approval to reduce subsidies, but that doesn’t mean that it doesn’t have a cost in terms of political capital (given that a popular backlash would be likely, particularly in the case of transportation tariffs). Moreover, trimming subsidies exerts pressure on consumer prices, further complicating the central bank’s disinflation challenge.
But other components of expenditures have a strong inertial behavior and are unlikely to fall as a proportion of GDP, especially if disinflation materializes. Pensions (and other social benefits) currently represent around 48% of primary spending, while wages account for 14% of the total. There is no formula to determine the increase in public-sector wages, but workers (through unions) and the government negotiate pay increases once a year, and past inflation historically plays an important role in the negotiation outcomes (although this year was an exception). The adjustment of pensions comes twice a year, following a formula that uses the nominal growth in wages (estimated by INDEC for formal and informal workers) and the revenues collected by the social security system in the previous six months. As a result, pensions are also heavily influenced by past inflation. We note that in order to achieve disinflation and fiscal sustainability at the same time, it is crucial to adopt more forward-looking inflation measures when adjusting pensions and wages: delinking payments from past inflation allows reducing inflation and also prevents fiscal expenditures from rising (as a proportion of GDP) when nominal GDP growth is slowing. A reform would be necessary to change the formula dictating pension adjustments (established in an ordinary law). On the other hand, increasing public-sector wages in line with expected inflation does not need a change in legislation, although it also costs political capital.
In all, we expect the fiscal deficit for next year to reach 3.8% of GDP (above the 3.2% official target). While tax revenues usually increase at the same pace as the nominal GDP, in 2018 they will likely fall as a proportion of GDP (from 18.3% in 2017 to 17.9% in 2018) as there will be no revenues related to the tax amnesty. So fiscal consolidation would come from the expenditure side. We forecast primary expenditures to fall by 0.9% of GDP, to 22.8% due to lower subsidies (2.4% of GDP, down for 2.7% in 2017), a reduction in capital expenditures (to 2.2% from 2.4% this year) and a contraction of other discretionary expenditures (by 0.5%, to 4.5% of GDP in 2018). On the other hand, payroll expenditures would fall only slightly (by 0.1% of GDP), while social security spending will likely rise by 0.3% (to 10.6% of GDP), although the increase is due to extra adjustments owed to some pensioners. A key assumption behind our forecast is that the government will manage to give wage increases next year that are in line with expected inflation (we used our current forecast for inflation in 2018, 16%), with readjustment triggers if inflation rises above the expected level.
For 2019, we estimate a reduction of the primary deficit to 3.0% of GDP, but again above the 2.2% official target, based on a new reduction in subsidies and capital expenditures. However, the risk is for a higher deficit, given that 2019 is an electoral year.
To reduce uncertainty over the fiscal consolidation path, the government indicated that it will send a fiscal responsibility law to congress. The bill would freeze (in real terms) current expenditures of the federal government and provinces. In a province running a nominal deficit, the cap would apply to total expenditures. Also, the bill would put a ceiling on public sector employment growth.
A gradual fiscal consolidation means a growing debt/GDP ratio in the next few years, although to still-moderate levels. Given our primary-deficit and growth forecasts, an assumption of a 4% real interest rate (roughly the nominal yield of a 10-year dollar Argentine bond discounted by U.S. inflation) and a stable real exchange rate, net debt (that is, debt with the private sector and multilateral institutions) would climb to 38% of GDP by the end of next year (from 33.8% by the end of 2017) and to 41.4% by the end of 2019. We note that 87% of Argentine net debt is in foreign currency; while this reduces the interest burden on government debt, it leaves the public debt/GDP ratio very sensitive to exchange-rate fluctuations. If the real exchange rate reverts to its 20-year average (which is not our base case, as we expect Argentina’s government to continue to have more access to external financing than in the past), the net debt/GDP would jump to 49.4% by the end of 2019.
Retaining confidence of foreign investors and rating agencies is, thus, key to the government’s gradualist strategy. But for that the administration needs to forge ahead with fiscal reforms, unpopular though they may be in the near term. Markets should, as a result, carefully monitor the government’s legislative priorities on the reform front, as well as their reception by Congress.
João Pedro Resende
Juan Carlos Barboza