Cavallo Hits the Ground Galloping

But Congress wants to rein in some of his proposed reforms

Action: That's what Domingo Cavallo promised when he accepted the challenge of reviving Argentina's economy. So far, he has not disappointed. Barely a week after being named Economy Minister, Cavallo had already persuaded a fractious legislature to grant him emergency powers, secured support from Brazil to rejigger import tariffs, flown to Spain to reassure jittery foreign investors, and forced politicians to work over the weekend. "Cavallo deserves some kind of medal," says Hector Marsili, president of the Argentine subsidiary of U.S. commodity trader Cargill. "It's pretty much the first time in 70 years that Congress has worked on a Sunday."

Cavallo's energetic response to Argentina's 33-month recession has cheered investors. The benchmark FRB bond recorded its largest gain in two years on Mar. 26, the day the lower house of Congress voted to grant Cavallo wide-ranging powers to curb a yawning fiscal deficit and bolster the government's ability to meet payments on its $124 billion public debt.

So Argentina is in the clear, right? Well, not exactly. Cavallo may be a wizard, but even his powers may not be enough to bring a moribund economy back to life. New data show that gross domestic product contracted by 2% in the fourth quarter of 2000 compared with the same period last year--a bigger-than-expected slide.

And while legislators are prepared to allow Cavallo wide leeway on changes in taxes and tariffs, they have stopped short of issuing him the blank check he wanted. For instance, Congress has explicitly barred him from sacking public-sector workers and privatizing remaining state-owned companies, including the national tax agency. Congress has also blocked Cavallo's plan to revamp the country's labor laws, which he claims "inhibit job creation" and contribute to unemployment, now running near 15%. Indeed, Standard & Poor's cited political risk as a major factor in its decision to downgrade Argentina's debt rating to B+ on Mar. 26. "Support for Cavallo came about only because of a crisis, not through conviction," says Diana Mondino, managing director at Standard & Poor's in Argentina. "We are worried that political support will wane."

Thus the Big Bang of reform that Cavallo wants may well elude him. That means the supply-side measures he's proposing will have to do the trick. The 54-year-old Harvard University-trained economist has vowed to restore the competitiveness of Argentine business by slashing production costs by 20%. Tax relief for the country's cash-strapped companies is high on his agenda. Cavallo wants to do away with a 1.5% annual tax on assets and another levied on interest paid on corporate loans, which he claims are disincentives to investment.

CURRY FAVOR. To the chagrin of Argentina's partners in Mercosur--the South American common market that also includes Brazil, Uruguay, and Paraguay--Cavallo is also tinkering with tariffs. Duties on imports of capital goods from outside Mercosur will fall to zero from 14%, a boon to local companies that rely on purchases of foreign-made machinery and equipment. Meanwhile, tariffs on consumer-goods imports from outside the trade bloc will rise to as high as 35%, which will benefit local producers of footwear, toys, and packaged food, among others. It's hard to see how Argentine industry can become more efficient if it is shielded from competition. Then again, Cavallo must curry favor with key sectors to build support for his policies. "He has chosen to reduce the costs of those sectors that speak loudest," says Juan Luis Bour, director of the Foundation for Economic Research on Latin America (FIEL), a Buenos Aires think tank.

Indeed, not everybody is pleased by Cavallo's methods. For smaller businesses, higher tariffs on consumer-goods imports could be damaging. "If I try to pass these increases on to my customers, I'll be in deep trouble," says Andy Strauss, owner of Gelfix, a company that supplies the local food industry. And businesspeople and consumers alike are appalled by Cavallo's plan to introduce a 0.6% tax on all financial transactions above $1,000. The levy, effective on Apr. 1, is expected to draw as much as $3 billion a year into the public coffers.

STRAITJACKET. Ironically, Argentina's lagging competitiveness has its roots in another of Cavallo's policies: the currency board. Introduced in 1991, when Cavallo was Economy Minister under former President Carlos Menem, the system pegs the peso to the U.S. dollar at a fixed rate of 1 to 1. Although it is credited with ridding Argentina of hyperinflation, many now view the currency board as a straitjacket. The strong dollar has Argentine exporters struggling to compete in world markets. It has also pushed up local operating costs, dimming the country's attractiveness in the eyes of foreign investors.

Cavallo says he remains committed to the currency board. More than 60% of all bank loans made in Argentina are in dollars, so a devaluation would almost certainly spark a massive wave of consumer and corporate debt defaults. Yet at a Mar. 26 meeting with business leaders in Madrid, Cavallo floated the idea of one day pegging the peso to a basket of currencies, including those of other major trading partners, such as Brazil and the European Union. "It's Cavallo's style to throw out these proposals," says Liliana Funes, financial analyst at Raymond James Argentina. "The market knows that the political framework is too weak at this time to implement such a huge change."

For now, investors both at home and abroad are focused only on the present. If Argentina's economy does not begin to show signs of improvement by midyear, analysts will dust off their doomsday scenarios of default and devaluation. "Cavallo has the government out of its short-term fix," says Joyce Chang, head of emerging-market research at J.P. Morgan in New York. "But I haven't adjusted my growth forecasts yet, and I won't until I see some change in the figures." Cavallo's got more than his reputation riding on a recovery. If he manages to yank Argentina back from the financial precipice, the two-time Economy Minister could have a clear shot at the presidency come 2003. But first, there's that cliff ahead.

By Colin Barraclough in Buenos Aires

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