Argentina: The Unfinished Revolution

President Menem will soon step down, leaving key reforms undone and the economy in a slump

Leaning against a box of spark plugs in the auto-repair shop he owns in the Palermo neighborhood of Buenos Aires, Osvaldo Giro recites some depressing numbers. Even though the garage is in one of the city's most affluent areas, business has slumped, forcing Giro to cut his prices nearly 40% in the past four years. As a result, he and his seven mechanics are earning a third less than they were two years ago. "I'm working hard and my employees are working hard, but instead of getting ahead, we're slipping further behind," he complains.

Like Giro's business, Argentina's economy is floundering. From the growing ranks of the unemployed to Giro's $800-a-month mechanics to the owners of the $35,000 cars they repair, Argentines are deeply frustrated by the country's second recession since 1995. The economy will shrink by around 3% this year, keeping wages stagnant while the 14.5% jobless rate climbs higher. Brazil's devaluation in January and low prices for Argentine exports helped push the country into its latest downturn. Meanwhile, Argentina's currency board, which pegs the peso to the U.S. dollar, limits the government's ability to use monetary policy to revive the economy.

But there's a deeper cause of Argentina's woes--its stalled reform program. As President Carlos Menem prepares to step down after 10 years in office, it is clear that the economic revolution he started by stamping out hyperinflation, selling off state-owned companies, and opening Argentina's markets is being left unfinished (table, page 31).

Worse, it's likely to stay that way. The two leading candidates in the Oct. 24 election, front-runner Fernando de la Rua of the opposition group Alliance and Eduardo Duhalde of Menem's Peronist party, don't appear interested in pushing for labor, tax, and fiscal reforms that would improve Argentina's competitiveness but require further belt-tightening. "Neither of the two candidates is making a serious proposal to the country about what they'll do or how they'll do it," says Felipe Noguera, a Buenos Aires-based political analyst.

Leaving so much work incomplete increases the risk of doing business in one of the world's most attractive emerging markets. By far the richest nation in Latin America, Argentina's $8,250 gross domestic product per capita in 1998 was 19% higher than South Korea's, 72% higher than Brazil's, and nearly double Mexico's. Multinationals from Whirlpool Corp. to Renault have invested more than $25 billion since 1994. Argentina also grabs attention on Wall Street as the region's most active foreign debt issuer, with $7 billion worth of paper sold abroad this year.

For now, Argentina seems fit enough to avert a market meltdown. The country's $26.6 billion in reserves appear sufficient to fight off any speculative attack on the peso. Argentina's eight-year-old currency board requires that each peso in circulation be backed by reserves. The fact that the banking system is dominated by large foreign institutions such as Spanish banks Santander and Bilbao Vizcaya has discouraged Argentines from capital flight. Furthermore, the International Monetary Fund has suggested that it would help Argentina if necessary.

But as Brazil learned last year, reserves can drop precipitously if investor confidence wanes. Missteps by Argentina's leading candidates, renewed uncertainty in Brazil, or even a devaluation in China could prompt investors to pull money out of Argentina. On top of that, the currency board could come under increasing pressure if the government fails to control its growing budget deficit and mounting national debt. The debt, expected to reach $145 billion this year--46% of GDP--has worried investors since Duhalde remarked in July that he might seek a moratorium on interest payments. He retracted the comment after the Buenos Aires stock market plummeted 9% in one day.

FARMERS' FURY. The dismal economic situation is making Argentina an increasingly unruly place. On July 28, police in the northern province of Corrientes fired rubber bullets and tear gas into a crowd of at least 5,000 public employees demanding their past-due salaries. Menem's government backed down and said it would give the province $55 million to pay its workers. The same day, riot police blocked 300 schoolteachers from setting up a protest camp outside the presidential offices in Buenos Aires. In May, the government had agreed to give teachers a $100 per month raise and introduced a vehicle tax to pay for it. But when 270,000 truckers went on strike in July to protest the tax, Menem postponed the tax.

Nearly every group imaginable is unhappy. On July 21, 10,000 farmers marched to the presidential offices to demand tax cuts, cheaper fuel, and easier access to credit to soften the blow of low commodity prices. Six days later, perhaps bearing in mind that the agriculture sector produces almost 60% of Argentina's $25 billion in annual exports, Menem agreed to give the farmers an $800 million credit line and help with debt restructuring. "These are the hardest times I can remember," says Arsenio Pagnuco, a 62-year-old farmer from Santa Fe province who took part in the protest. Pagnuco, whose net income is as little as $200 a month, owes the Banco de la Nacion $80,000 in loans.

With industrial activity down 14% from last year, business leaders are also becoming impatient. Auto makers, whose output is down 48% from last year, are asking for lower taxes to make their products more competitive. Horacio Losoviz, president of the national auto makers' association and the local subsidiary of truckmaker Iveco, estimates that taxes account for 40% of the average car's sticker price.

The growing restlessness--underscored by a rising wave of violent crime in Buenos Aires--raises the question of whether Argentines will stick with the currency board. The system is credited with slashing inflation to zero, but it becomes the scapegoat in times of recession. The rigid monetary policy has come under increasing scrutiny since Brazil's devaluation, which made Argentine products less competitive at home and abroad. "Main Street has not prepared itself for this," says Pedro Lacoste, who runs a Buenos Aires economics think tank bearing his name. "People don't understand why there is no money and no jobs."

Neither Menem's government nor the next one will be in a position to appease Argentines. Some analysts believe the budget deficit could reach $7 billion this year, about 2.3% of gross domestic product. While that's not alarming by international standards, it is deeply troubling for Argentina since the country's credibility in the markets hinges on fiscal discipline. Foreign crises such as Mexico's 1994 financial crash and Brazil's devaluation hit Argentina harder than any other economy in Latin America.

In Menem's first term, it seemed Argentina could do no wrong. After taking office in 1989, he boldly privatized nearly every money-losing state-run company, bringing $14 billion into the government's coffers in four years. In 1991, he imposed the currency board, which slashed annual inflation from 20,000% to 4% in four years. He opened up the country by cutting average trade tariffs from 35% to less than 20% and eliminating restrictions on foreign investment. He did all this by 1994.

When Menem easily won reelection in 1995, economists were hoping for an ambitious "second wave" of structural changes. Their goal would be to make Argentina a more competitive economy and put it on a course for sustained high growth. Investors hoped that the new wave of reforms would include loosening Argentina's inflexible labor laws, simplifying the tax system, overhauling the health-care system, and restructuring finances in the provinces.

PERON HANGOVER. But Menem, who until earlier this year considered asking courts to change Argentina's election rules to allow him to run for a third term, backed off when faced with the prospect of confronting labor leaders and the provinces' woes. "The reforms Menem directed before 1993 were among the deepest in the world, and were done in record time," says Jorge Avila, an economist with the University of the Center of Macroeconomic Studies in Buenos Aires. "But almost nothing has been accomplished in his second term."

In some areas, such as telecommunications, Argentina has leaped into the modern world under Menem. But in many ways, the country still remains plagued by the structural weaknesses of a developing nation. For example, the health-care system for workers, badly managed by labor unions, is a hangover from the era of dictator Juan Domingo Peron a half-century ago. The union-run clinics, funded by payroll contributions, offer such low-quality care that many private-sector employers must also pay for alternative health care for their employees--a big drain on companies.

Chronic problems that run deeper than the economy have also gone uncorrected. Judges, police officers, and government officials are so widely perceived as corrupt that few Argentines trust public institutions. Because of wasteful spending and poor tax collection, "public hospitals are run down, schools are underfunded, and police are poorly paid," says Gustavo Pittaluga, a director with steelmaker Acindar.

The unfinished agenda clearly takes a toll on millions of Argentines. The rigid labor laws burden businesses with hefty severance and tax payments and make it burdensome for employers to hire part-time workers. Greater labor flexibility could help reduce Argentina's unemployment rate, which has hovered in the mid-to-high teens for five years.

A freer labor market could benefit 21-year-old Ariel Martinez, who was laid off five months ago from his $900-a-month job as a freight handler for U.S. health-products giant Johnson & Johnson. One morning in late July, Martinez was first in a line of hundreds of people waiting to drop off their resumes for job openings with a Buenos Aires supermarket. Martinez, who is married and has a six-month-old son, is so desperate that he left his home in Villa Lugano, an hour outside Buenos Aires, at 4:30 a.m. to arrive downtown by 5:30--five hours before the company opened its doors. Martinez is getting some help from his mother and mother-in-law but adds: "If I don't get a job soon, I don't know what will happen. I'm scared for my family."

For businesses, the lack of progress on tax reform has been a big setback. The government hits Argentine companies with an array of levies from a tax on corporate debt to a 21% value-added tax, on top of hefty highway tolls and phone rates. The VAT is killing consumption of big-ticket items. General Motors Corp., which returned to Argentina five years ago after leaving the country in 1978, is operating its newest plant, in the central city of Rosario, at a paltry 30% of capacity. GM has had to trim its workforce from 2,100 in September, 1998, to 1,400 today. The decline in domestic demand plus the devaluation in Brazil has been "a double whammy" for the auto industry, says Basil Drossos, president of GM in Argentina. Drossos praises Menem's efforts to maintain economic stability but complains that "the overall tax structure is becoming onerous."

Business leaders believe that more efficient income-tax collection would allow the government to reduce other taxes. Overall evasion is estimated at 40% of all taxes due. "Legitimate companies are carrying the weight of the population that doesn't pay its taxes," says Acindar's Pittaluga.

Industry's woes are provoking friction with Brazil. Since Brazil's devaluation, Argentine exports to its northern neighbor are down 30%. At the same time, the slump has pushed Brazil's exports to Argentina down by more than 20%. It's the first time since the two nations opened the Mercosur trade bloc in 1991 that total trade has declined.

Menem's government, feeling pressure from manufacturers, said in mid-July that it would limit the entry of Brazilian cotton textiles and steel. In retaliation, Brazil broke off talks with Argentina on trade in auto, sugar, and shoes. On July 30, Menem repealed the restrictions after meeting with Brazilian President Fernando Henrique Cardoso in Brasilia. But the dispute underscores the frailty of Mercosur in times of economic turmoil.

To reduce the trade volatility caused by devaluations, Menem supports a common Mercosur currency or adoption of the U.S. dollar by Argentina. The goal of dollarization would be to reduce the perception of risk associated with doing business in the country. But a Mercosur currency or dollarization appears to be years away. Neither Duhalde nor de la Rua has voiced enthusiasm for dollarization, and both insist they will stick with the currency board.

The political transition is still making both Argentines and foreigners nervous. Duhalde, 57, who is trailing de la Rua by 13 points in opinion polls, has unsettled investors by blaming many of Argentina's woes on the global economy. De la Rua has raised eyebrows by vaguely criticizing the "absence of state" during Menem's two terms. "I'm concerned with how the candidates are communicating," says Guillermo Jofre, chief financial officer of Impsat, a telecom service provider. "It's a reflection of how they will run the country."

De la Rua, 61, is a somber, austere man who appeals to the many voters who see Menem's government as frivolous and corrupt. Despite his ambiguous remarks, de la Rua has surrounded himself with economic advisers who believe in orthodox policies and strict budget controls. Jose Luis Machinea, a possible Economy Minister if de la Rua is elected, favors allowing more competition in privatized sectors such as telecommunications to reduce the costs.

Investors are bracing for more surprises from Duhalde, who bills himself as a traditional populist Peronist. In a recent news conference with foreign media in Buenos Aires, Duhalde gave rambling, sometimes confusing answers on topics from corruption to unemployment. Although he now says he would not declare a debt moratorium, he suggests that the subject should be open for discussion. "Our economic situation is due to a foreign crisis"--the devaluation of the Brazilian real--he says. "Why should countries that make the necessary adjustments have to suffer?"

Duhalde and Menem, the symbolic leader of the Peronist party, had been on unfriendly terms since Duhalde mobilized sufficient support to squash Menem's hopes of running for a third term. But after avoiding the issue for weeks, on Aug. 2, Menem announced that he would back Duhalde. Nevertheless, Duhalde's best hope for the presidency could be an alliance with former Economy Minister Domingo Cavallo, who installed the currency board and is widely regarded as the father of economic stability in Argentina.

TAX CUTS. Cavallo is now campaigning for President under his fledgling Action for the Republic party but is trailing with about 10% in opinion polls. Cavallo's support would become crucial if the two leaders are forced into a runoff. To win in the first round, a candidate must receive at least 45%, or 40% with a margin of 10 percentage points over the second-place finisher.

For now, Cavallo seems happy playing the foil to de la Rua and Duhalde. He calls for eliminating the employer's contribution to payroll taxes and slashing the VAT. And he says he would introduce labor reform that would cut business costs by 20%. Argentina won't fall apart if de la Rua or Duhalde is elected, Cavallo says. "But with them the economy grows maybe 2% a year. With me it would grow 8%," he boasts.

Few analysts expect the next government to do anything bold. Economist Avila believes that de la Rua will win, in part because voters are fed up with the Peronists. But don't expect any daring measures, he adds. That doesn't bode well for Argentina's long-term prospects. Even if the country averts a meltdown, it has wasted an opportunity to move forward.