Defenders of the legacy.

Photographer: EITAN ABRAMOVICH/AFP/Getty Images

In Argentina's Economy, It Takes Three to Tango

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With inflation ticking up and strikes on the horizon, critics of Argentina's President Mauricio Macri are sharpening their attacks on his economic policies. The truth is, however, that the new president came into office with few good -- much less easy -- choices, and is so far making the best of them.

When Macri delivers his much-anticipated speech to launch the 2016 session of Congress on March 1, you can expect to hear a lot about "legacy" -- a buzzword that, in the Argentinean context, refers to the economic mess bequeathed to him by his predecessor, Cristina Fernandez de Kirchner. The Kirchner legacy is indeed complex, encompassing important long-term factors such as a run-down infrastructure, a fat and ineffective public sector and lagging public education. But its short-term policy implications could be reduced to a simple trilemma: Correct the exchange rate, reduce inflation, and grow.

Choose any pair of objectives and you will see how they conspire against the third one. Take the first two, for example. The exchange-rate depreciation needed to lift controls and revive foreign investment inevitably translates into higher inflation (in double digits since 2007, and artificially contained at 26 percent in 2015 thanks to frozen tariffs and an exchange rate anchor that appreciated the peso to pre-2001 crisis levels); in turn, to contain inflation the central bank should tighten monetary policy (raise interest rates) to cool demand, deliberately inducing a recession. The government could instead choose to prioritize growth -- a smart choice given the strategic importance of mid-term elections in October 2017 and the stagnation of Argentina´s economy for the past four years. Yet then its options would be a reversion to the damaging policies put in place by the Kirchners, or an inflation rate higher than during their tenure (which is, in fact, the most likely scenario).

Faced with this conundrum, the government appears to have chosen an interior solution: Do a bit of each, gradually. (Full disclosure: I was recently appointed a director at the state-owned Bank of Investment and International Trade.) The elimination of the “cepo” (the local slang for foreign exchange restrictions) was immediate as promised, but selective: Only demand from individual investors and new trade and dividend flows were allowed free access to foreign exchange, pushing forward most of the pent-up institutional demand. Predictably, this led to a sudden but rather smooth correction of the dollar from 9.7 to 15 pesos over two months. Also predictably, this correction pushed up monthly inflation, from about 2 percent in November to close to 4 percent in December and January. And inflation will probably be as high in February, when the full impact of a recent elimination of electricity subsidies comes through. Simultaneously, the new Central Bank governor raised the interest rate from 29 percent to 37.5 percent, a timely but far from dramatic hike given the inflation peak shortly thereafter.

Focusing on the individual goals, critics usually claim that the government has fallen short on all fronts -- although, at 15 pesos per dollar, the exchange rate adjustment is near target. Moreover, for the general public, Macri´s first two months may appear to have brought back stagflation, this time seasoned with a weaker labor market and rising inflation that could presage real wage cuts, strikes, and a premature end to his political honeymoon.

The truth, however, is that the Kirchner legacy did not leave much of a choice. Inflation has always been inertial and high (and, had tariffs and the exchange rate moved with inflation, it would have been higher than the 2 percent that people saw). And the pass-through from the devaluation, while higher than in neighboring countries, still amounted to only 20 percent (the inflation rate rose by 10 percent even as the currency devalued by about 50 percent). That's about half the pass-through associated with a 20 percent devaluation that took place in January 2014.

Macri faces the same kind of constraints in dealing with interest rates: The recent decline could be interpreted as inflation neglect, but any move higher could hurt an already contracting domestic demand. And while a more depreciated exchange rate could spur FDI, its effect on the trade balance would not be as virtuous: It is more likely to compress imports than to foster exports, which are largely inelastic (commodities) or regional (mostly directed to a collapsing Brazilian market). Not to mention the cost of a more depreciated peso in terms of inflation and the never-ending speculation of further devaluations.

Unexpectedly, this government is exhibiting a welcome gradualist sensitivity on the fiscal front, the apparent residual variable of the trilemma. By leaving the large fiscal deficit untouched, in the hope that a rapid settlement with Argentina's holdout creditors will re-open its access to international finance, the government seems to recognize that its political fate depends on rekindling growth and creating jobs.

What next? On the positive side, the government will likely reach an agreement with holdouts, which should dampen exchange rate pressure and help pay the fiscal bill. On the less positive side, March opens a complex wage negotiation in a context of inflation that is both volatile and uncertain (a new credible consumer price index will have to wait another two months), with unions making demands that would be partially met with fiscal resources, in the form of income tax breaks and higher family allowances.

March will also bring, with the resumption of parliamentary sessions, a political litmus test: the government´s ability to gather, through moral and fiscal suasion, the opposition votes needed to pass key measures, including the proposed holdout payment. Last but not least, with Brazil's never-ending contractionary adjustment as a sobering reminder, there is the looming threat of recession that makes fiscal austerity even less likely.

So far the government has confronted the legacy of Argentina's last decade by striking a fine balance between economic and political constraints and mostly resisting the technocratic allure of shock therapies that can be politically costly. But the next two months will be critical to assess whether it has retained enough political capital to meet Argentina's continuing challenge: the quest for a sustainable road to development.

(Notes author's appointment as a director at a state-owned bank in fourth paragraph in article published Feb. 26.)

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Eduardo Levy-Yeyati at e.yeyati@gmail.com

To contact the editor responsible for this story:
James Gibney at jgibney5@bloomberg.net