Latin America: Argentina's Prat-Gay faces his biggest hurdle
After Mauricio Macri took power in Argentina at the end of last year, finance minister Alfonso Prat-Gay scored a number of quick and important wins. He settled with the holdout bond investors, removed FX restrictions and started to tackle inflation. But now he faces his toughest challenge – tackling the fiscal deficit.
Illustration: David Manion
After a breathless start to his economic stewardship of the Argentine economy, finance minister Alfonso Prat-Gay is, for the moment, grounded. The first stage in the proposed cut of large energy subsidies – core to the Macri administration’s economic plan – has been postponed by a ruling from the country’s supreme court.
The judicial reversal led to Prat-Gay’s first retreat. In September he brought a budget to parliament that cut next year’s fiscal deficit target. Whereas he had previously forecast a deficit of 3.3% in 2017 (from 4.8% this year and on to 1.8% in 2018), he acknowledged the time needed to achieve fiscal solvency will be longer than that (the earlier version already stressed the importance of gradualism).
Responding to the budget, a Goldman Sachs report qualified Prat-Gay’s mantra of gradualism: “The budget proposal recognizes that, in a best case scenario, the fiscal consolidation would be exceedingly gradual, and will ultimately depend on economic growth.”
The budget pares 2017’s primary fiscal target back to 4.24%, largely as the result of an increase in pension payments that will add 0.6% of GDP a year to public expenditure. This new target is consistent with a 21% year-on-year increase in expenditures (excluding debt interest) and a 22.4% year-on-year increase in revenues. The budget also projects debt interest payments equivalent to 2.53% of GDP, leading to an overall fiscal deficit (without including central bank transfers) of 6.8% of GDP in 2017, close to the 7.1% of 2015.
If this 2017 primary target is met, it would mean that the fiscal consolidation of Macri’s administration would amount to just 0.3% of GDP in its first two years. Throw in optimistic assumptions on wage negotiations and energy tariffs, reasonable-but-still-uncertain assumptions about the recently launched tax amnesty and the size of the economic recovery in 2017, and there is a chance that there will be zero fiscal consolidation before 2018.
It’s not like you can step in and, in seven months, erase the mistakes of the past 12 years - Alfonso Prat-Gay
This halt in progress could make it appear that Prat-Gay’s rapid-fire successes of the first seven months have worn off. But that would be unfair. He is tackling serious and deeply entrenched issues from the previous government’s economic legacy.
“It’s not like you can step in and, in seven months, erase the mistakes of the past 12 years,” says Prat-Gay. Talking specifically about the energy subsidies – and by extension the challenge of fiscal consolidation: “This is another of the ticking bombs we inherited, like el Cepo [the cap on foreign exchange transactions] and the holdouts. In terms of size, it’s probably the biggest. Bear in mind that last year the last government spent four points of GDP subsidizing energy and transport to every single Argentinian.”
Prat-Gay says “there is no plan B” on the reduction in tariffs. He points to the fact that 80% of consumers had paid their higher gas bills before the supreme court ruled against the increases as proof that, high as the percentage increases were (capped at 400%), the nominal levels of the new rates were bearable for the public. The government also put in place schemes to avoid the increases for the poorest 30%.
'Reconnecting with world'
Though Prat-Gay seems up for the challenge, there was a time when he hoped president Mauricio Macri would not call on him to be Argentina’s new finance minister. As last November’s presidential election campaign neared its conclusion, Macri’s team was confident of victory; Prat-Gay harboured hopes of becoming the foreign minister.
“My view was – and still is – that there are two areas where the soothing work had to be done,” says Prat-Gay, now ensconced in his spacious office in the Hacienda building, which is overlooked by the Casa Rosada, the presidential residence. “One was obviously the economy, but the other one – just as important as the economy – was reconnecting with the world. And so that was originally where I thought I could add value. And then of course the president got someone much better.”
Prat-Gay’s warm endorsement of Susana Malcorra, recruited by Macri to lead Argentina’s international relations from her post as chief of staff to UN secretary general Ban Ki-moon, hints at the close working relationship the two have struck up in the first year of the administration.
Prat-Gay was given the administration’s toughest challenge: to normalize a highly dysfunctional economy, gradually enough to prevent an economic crisis, but fast enough to maintain the confidence of the markets and convince the population that there is progress. This balancing act is all the more important because the ruling coalition has a minority in both congress and the senate.
Ultimately, Macri’s decision was an easy one. Prat-Gay’s experience – he became Argentina’s central bank governor at the age of 37 and oversaw the reduction of inflation from 40% in 2002 to 3.7% in 2003, as well as having been a senior capital markets banker at JPMorgan – gave Macri’s economic team instant credibility and the confidence of the markets.
Macri has also been able to rely on Prat-Gay in the international area. “Our work is closely coordinated with the foreign minister, and we get along very well,” he says. “There is much to be done, and I’ve spent more time than one would have expected catering to the foreign audience.”
That international exposure included the opportunity to make a short presentation to the heads of the G20 in Shanghai as well as an invitation to attend the G7. Prat-Gay says his message was simple: “To let the world know that we were back in business.”
Argentina’s re-engagement with the world was always going to be a popular event, but its resonance has been heightened by the rising global tide of populism and protectionism. The UK’s Brexit vote, the growth in radical political parties in Europe and Donald Trump’s presidential candidacy in the US place Argentina’s story in stark relief.
“It’s interesting, we are leaving behind those demons – and we have more than our fair share of experience with both,” says Prat-Gay. “In particular the last administration was very good at fostering both populism and protectionism. My take is that what is going on in Argentina runs a lot deeper than what we are doing as the current administration. It’s beyond setting up an impressive cabinet. We have had sea-changing elections last year and, essentially, the Argentine people are asking for change. And that’s what we are delivering.”
Prat-Gay’s point is that the mandate given to Macri has been heeded by Argentina’s entire political class and that is helping the finance minister.
“I know the world was very excited about the way we dealt with the holdout issue for example,” he says, “but we wouldn’t have been able to do that without the approval from congress – and particularly the opposition.”
The government secured the backing of more than 75% of the senate when passing the law to pay the bondholder hold-outs. Prat-Gay points out that nominally more senators from parties of the previous administration voted in favour of the deal due to the relatively small number of seats held by parties in the current administration.
“Up until about six months ago, these [senators] would never have even come close to considering [a deal] with the holdouts,” he says. “I think this is important for the world to understand. It’s the entire Argentine people who showed populism fatigue. This is also what we sense in the opinion polls – we have had to take a few tough measures and yet the approval rating for the president is still extremely high – around the 60s [in August]. You don’t see that in too many places around the world these days.”
Yet Prat-Gay is also keenly aware that support for the president and his administration’s new path is fragile. The life cycle of populist regimes usually ends with a spectacular bust, but in Argentina Cristina Kirchner’s administration did just enough to keep the economy from blowing-up until she left office. The absence of a full-blown crisis arguably makes the transition to an orthodox macroeconomic model easier, but it also makes the politics more difficult.
“The constraints we were facing were everywhere to be seen,” says Prat-Gay. “On the social front, 30% of the population lives under the poverty line. People were asking how we were going to be able to run the economy in the face of trade unions when we don’t have a majority in either chamber.
“Gradualism on the fiscal and on the monetary side,” is the answer, he says. “Frankly there is no other way. If we had pushed for a swifter approach we would have hit the social and political constraints.”
But to buy the time for that gradualism some things needed to be done quickly. The first was lifting el Cepo, which the administration did within four days. This bought domestic credibility, international plaudits and helped ease the solvency challenge at the central bank.
The other pressing issue related to the desire to narrow the fiscal deficit over time. To do so, the government needed to finance itself abroad. That required access to the international markets, which in turn, required a deal with the holdouts.
Alfonso Prat-Gay is both confident in the progress being made in the
“The holdouts issue was the missing link for the gradual approach to be credible,” says Prat-Gay. “I remember one of my first press conferences when I explained our inflation and fiscal targets. The obvious question was: if we didn’t have access to the [international] market how on earth are they going to finance the fiscal gradualism?
"We were not very explicit about the financing because we didn’t want the holdouts to realize how important it was that we got a deal. Only when you look at it from that point of view do you realize that it was very important for us to make that deal with the holdouts as quickly as possible – any other timing would have been extremely costly for the government and the country.”
With the holdout issue behind it, the government raised $16.5 billion in debt – closely followed by a further $2.75 billion. States and corporates followed. The running total of international debt issuance from Argentina now stands at $29.4 billion.
The focus is now on lowering inflation (back over 40%), igniting growth, cutting the fiscal deficit and trying to prevent the over-valuation of the peso. Prat-Gay stresses the challenge is one for the life of the administration. He says that by 2019 inflation will be around 5% and the fiscal deficit will be down to 1% of GDP.
“We would like people to keep an eye on whether we are meeting the medium-run targets,” he says. “If we miss one quarter, so be it. But let’s make sure that the trend is in the right direction – and there is no question that the trend is in the right direction.”
Critics suggest this desire to be judged on the trend is because the government is struggling with its short-term targets. Martin Redrado, who served as head of Argentina’s central bank between September 2004 and January 2010, is the chairman of Fundacion Capital, an institution focused on economic research and public policy. He says there has been a lack of progress on cutting the fiscal deficit (he calls the government’s approach to the adjustment of the energy tariffs “naive”), which complicates tackling inflation.
Redrado argues that too much is being asked of monetary policy (despite praise for the newly found independence and performance of the central bank) and without “a clear path” on the fiscal approach.
“Unfortunately, in Argentina, credit is only 12% of GDP so monetary policy is not a very strong lever,” he says.
However, Prat-Gay is both confident in the progress being made in the economic transition and phlegmatic about the criticism: “To me, being criticized on both sides is a sign we are doing things right,” he shrugs.
The debt dynamics are sound too. Capital Economics predicts that if this year’s fiscal deficit is repeated for the next three years, the gross debt of the public sector would still only hit 75% of GDP in 2019, which is high but manageable. Probably more likely is a middle way with some slippage and debt nearing 70% by 2019.
Prat-Gay also says the government will be increasingly able to finance the fiscal transition domestically. While this year’s deficit was financed by the international market, next year’s should be largely financed by a tax amnesty. The government has not assigned a baseline figure for the total amount of undisclosed offshore funds held by Argentine nationals that will be declared. The highest estimates are around $100 billion, based on estimates of total hidden assets of $400 billion.
The domestic capital markets are a huge issue – that was part of the legacy as well. This is essentially an underleveraged and underinvested economy - Alfonso Prat-Gay
The amnesty has been carefully structured to avoid a large-scale repatriation that would further increase the value of the peso – Argentines can declare funds and leave the capital offshore. Payment can be a direct fine, 10% for the early-bird offer until the end of this year and then 15% until the end of March 2017. Real estate assets are levied 5%. Declarations can avoid a fine by subscribing to government bonds (a three-year zero coupon or a seven-year zero coupon that is non-tradable for four years), with the nominal investment one-third of the declared funds.
Bank of America Merrill Lynch has assumed a figure of $35 billion for its model of how the amnesty will play out. It says that would lead to direct revenues of $3 billion and indirect financing of $4 billion. At $60 billion, the bank predicts $5 billion of revenues and almost $7 billion in financing.
“The tax amnesty means a lot going forward – giving us tax returns this year and financing for the next couple of years,” says Prat-Gay. “We are confident that it is going to be a good number but the main uncertainty is the mix, whether people bite the bullet and pay the tax – which is a juicy rate compared with other tax amnesties in the region. On the other hand, whatever we get in terms of the bonds will be very helpful for financing next year. 2017 has the ‘hump’ of maturities and once that is clear the maturity profile is good.”
After that, the domestic capital markets should be ready to take up the strain. “The domestic capital markets are a huge issue – that was part of the legacy as well,” says Prat-Gay. “This is essentially an underleveraged and underinvested economy.
“We are recovering access to financing in two stages: the first was the low-hanging fruit – the international market. But the tougher one – and that is an absolute must – is part of the second generation of structural reforms. There is no way of planning a development programme without deep local capital markets that can intermediate savings with investment. This year we have relied almost entirely on foreign savings, but this is just the transition, it’s not going to be like that in the future.”
Ultimately, if Prat-Gay is to be successful, the key economic ingredient will be growth. Growth will increase government revenues and make today’s sticky nominal expenditures a smaller proportion of GDP. Growth will lower unemployment, boost consumption and reinforce the government’s popularity ahead of key mid-term elections next October.
That is why, despite the desire to cut the fiscal deficit, the government is spending more as 2016 winds down, boosting public-sector spending, especially on infrastructure. Announcing the budget for 2017, Prat-Gay said any big reduction of the large fiscal deficit “could threaten the incipient economic recovery”.
Monetary policy will be isolated in the near future in its fight with inflation and, therefore, the peso might not depreciate in line with domestic inflation. And that is why economists expect inflation to fall to 21% by May, but then “the moderation in the annual rate will likely be much more modest,” he says.
Prat-Gay’s budget forecasts GDP growth of 3.5% for next year against a consensus view of 3%.
“The relative price adjustment in the first half of this year came as a burden on the consumer – that took purchasing power away and created the drop in retail sales,” he says. “Everything is pointing to lower, not higher, inflation. We are now getting the mirror image in the second half of the year in terms of purchasing power. Add to that public spending and public works and the apparent turnaround in Brazil, as well as what we are seeing in the agricultural sector, and we will get to 2017 with the best possible scenario.”
So, while there has been slippage and revision to key economic milestones, Prat-Gay insists the overall vision remains and is confident that this administration will succeed in transforming the country’s economic model by the next presidential election in 2019.
“In our original forecasting, we took the first year to clean up the rubbish from an economic point of view,” says Prat-Gay. “And now we are setting the stage for a competitive economy and sustainable growth and the fruit of that is just around the corner. There is nothing in the environment that we can see that makes us think that isn’t going to happen.”