What's next for Argentina and the IMF?

What's next for Argentina and the IMF?

The Economist Intelligence Unit has, for some time now, been highlighting the growing risk that the Argentinian authorities could fail to secure a new IMF lending arrangement this year. A number of factors are impeding a relatively rapid deal, including the government's mixed messaging, its policy inconsistencies and its susceptibility to political pressure. On this basis, there is substantial risk attached to our expectation that an IMF deal will be signed in the first quarter of 2022. In this article, we draw out the implications for our baseline forecast, along with alternative scenarios that could play out should negotiations with the Fund drag on or break down altogether.

Scenario 1: Pragmatism reasserts itself (55% probability, baseline forecast)

Although it is clear that the government, led by Alberto Fernández of the Frente de Todos (FdT) Peronist coalition, is currently putting political considerations ahead of the need for policy consolidation, we continue to believe that a (slightly) delayed IMF deal will materialise. Despite a lull in negotiations, we expect the Argentinian government to continue to make good on its obligations falling due to the Fund. We consider it likely that talks between the two sides regarding the terms of an extended fund facility (EFF) will gather pace once the November 14th mid-term legislative elections have taken place. Broadly speaking, we expect both sides to agree on the need for fiscal and monetary tightening. However, haggling over other programme conditionalities—including changes to the exchange-rate regime, the labour market and the regulatory regime overning external trade—will prevent a deal from being reached by year-end. Nonetheless, we believe that the Argentinian authorities will be motivated to reach a compromise in the first quarter of 2022, given that principal and interest payments to the Fund are set to grow substantially over the course of that year.

Under this baseline scenario, we expect fiscal consolidation to take place relatively gradually but steadily, allowing the primary fiscal account to return to balance by 2024. There is a possibility, however, that the Fund insists on tighter policy than we have forecast, given the need to quickly eliminate deficit monetisation.
Measures aimed at reining in public expenditure are likely to include subsidy reductions, cutbacks to provincial funding and reforms to the public procurement process (to improve efficiency and reduce costs). On the revenue side, reforms will probably focus on eliminating tax loopholes and curbing tax evasion. We do not rule out the possibility that a recently instituted one-off wealth tax will be made permanent. Monetary policy is also likely to be tightened, with real interest rates brought back to positive territory to incentivise localcurrency savings and promote financial sector development.

Although we assume progress on fiscal and monetary tightening, inflation will fall only gradually. In part, this reflects the fact that prices of regulated goods and services, which have been artificially subdued, will eventually have to be increased. However, it also reflects our assumption of a more hands-off approach to currency management under the EFF (and some currency pass-through to inflation). We also envisage a partial easing of currency controls over time, particularly on current-account transactions. However, restrictions on flows of portfolio capital (which are much more volatile) are likely to remain in place.

Argentina has a fair amount of bargaining power, given the commitments that it has already secured from the Fund, and because the IMF is likely to be more lenient in the context of the pandemic. For these reasons, we do not expect the government to have to commit to all of the structural reforms that an EFF would normally entail. We therefore assume that a number of structural limitations (including inflexible labour market rules, huge barriers to international trade and limited access to credit) will continue to constrain Argentina's potential growth. That said, assuming progress in correcting major macroeconomic distortions, the EFF could lay the groundwork for more sustainable long-term growth on the back of a stabilisation dividend. Although the sovereign itself will not be in a position to access international markets anytime soon, state-owned enterprises and Argentinian corporates could possibly begin to re-issue international bonds towards the end of the 2021- 25 forecast period.

Scenario 2: Argentina plays hardball (30% probability)

In a second scenario, talks between the Argentinian authorities and the Fund drag on for much longer as Argentina holds out for a deal with minimal conditionality. This scenario could play out in one of two ways.

One possibility is that Argentina enters into arrears on its IMF debt; the alternative is that the two sides agree to some form of standstill arrangement or payment deferral. In a context where Argentina alone accounts for about 30% of the total outstanding credit due to the Fund, the government's bargaining power should not be underestimated. Moreover, leniency on the part of the Fund towards Argentina would not be without precedent. In January 2002 the Fund agreed to defer repayments due under a supplemental reserve facility (SRF) by a year, when Argentina claimed that it was no longer capable of servicing its debts in the aftermath
of a deep financial crisis. In January 2003 the IMF granted Argentina another one-year extension on its SRF obligations and provided it with some modest new financing under a transitional, eight-month stand-by arrangement (SBA). The current situation is admittedly quite different from the one that Argentina faced in the early 2000s, but it would not be beyond the realms of possibility for the Fund to use the context of the pandemic to agree to provide temporary debt-service relief.

Whether or not a standstill is reached would have significant implications for the extent of the damage to Argentina's reputation and the domestic investment climate. However, in either eventuality, an important outcome would be that Argentina would (at least temporarily) not service its debt to the Fund by drawing down on its foreign reserves.

If Argentina did defer its payments to the Fund—either with the IMF's consent or without it—external liabilities would be significantly lower in the short term. Once obligations to the IMF are excluded, the government's debt-service burden falls to an average of US$4.9bn in 2022-23, which would be more manageable.

However, that outcome would be far from benign. Cut off from access to international capital markets, even ervicing a modest amount of debt would be difficult for Argentina, making fiscal consolidation all but essential. However, without the constraints of an IMF agreement, the government would be likely to pursue a less effective home-grown plan. In this scenario, we would expect the government to resort to more distortionary methods of consolidation, such as additional tax hikes on the agro-industrial sector and higher capital gains taxes. Spending cuts would be much slower to materialise, keeping the fiscal deficit wider than under our baseline forecast. Although the government would probably seek new financing from China, it is far from guaranteed that this would be forthcoming, at least in the amounts that Argentina would require. We would therefore expect deficit monetisation to continue apace. As a result, monetary policy would remain subservient to fiscal policy for much longer, leading to a prolonged period of negative real interest rates, easy money and high inflation.

More broadly, we would expect legal and regulatory risks to remain high. Investment policy would remain incoherent, with the state playing a pivotal role in picking winners and losers in the economy, which would in turn weaken business confidence and increase capital flight pressures. The current regime of draconian capital controls would therefore have to be maintained for longer, and probably even tightened.

Even assuming that this is the case, however, the Banco Central de la República Argentina (BCRA, the central bank) will be constrained in its ability to influence the longer-term trajectory of the exchange rate. For context, the BCRA has made net foreign-currency purchases of US$6.2bn in the year to date, but it has been forced to use about half of this sum for currency-management operations and transfers to the Treasury. As commodity prices soften—and without other sources of US dollar inflows—the BCRA's firepower will only weaken.

In this scenario, we would expect growth to be weaker than under our baseline forecast, reflecting a longer period of economic instability and a poorer investment climate. Even if the current or next government were to return to the Fund to seek a new deal in 2023 or 2024, Argentina would have incurred significant reputational damage in the interim. In addition, the slow pace of policy consolidation in the early part of the forecast period will mean that fiscal and monetary policy will have to be much tighter in 2024-25 to unwind macroeconomic distortions. In this scenario, Argentina's access to capital markets would be delayed for at least a few more years relative to our baseline scenario.

Scenario 3: Argentina goes rogue (15% probability)

In a third scenario, the Argentinian government abandons any pretence of negotiating in good faith with the Fund and opts instead to go it completely alone. If the Fernández administration were to take such a drastic step, it would effectively imply an abandonment of what little commitment it had to economic orthodoxy.

Consequently, in this scenario, we would expect the government to double down on its worst policy impulses: fiscal policy would remain highly expansionary and large deficits would be financed entirely by the BCRA.

With sustained money printing raising the risk of a hyperinflationary spiral, the government would be forced to generate new revenue streams, making expropriations of dynamic businesses or industries more likely.

These moves, however, would be extremely damaging for confidence in the peso, prompting the government to tighten capital controls further in a bid to mitigate currency volatility. Nonetheless, the combination of portfolio dollarisation and capital flight would cause a rapid drain of foreign reserves. The BCRA might seek to bolster available liquid reserves by activating an existing swap line with the Bank of China, but this would provide only a brief reprieve. Sooner rather than later, we would expect Argentina to enter a cycle of devaluation, inflation and recession.

The growth outlook would be bleakest under this scenario. Any impetus to growth provided by fiscal expansion would be short-lived and largely offset by the crowding-out of private capital. Moreover, assuming that a balance-of-payments crisis materialises, it would imply a significant setback to the post-pandemic recovery. If this scenario were to play out, there would be important implications for longer-term growth.

Even if a more market-friendly administration were to come to power at the next general election (in 2023), it would face an uphill battle in bringing public debt under control and regaining investor confidence. As a debt pariah, Argentina would remain shut out of international capital markets, even in the long run.

We believe that this scenario is the least likely to materialise. Such a dramatic shift in policy would require substantial political buy-in, not only from the FdT coalition (which is split almost evenly between moderates and hardliners), but also from the general public (which has frequently voiced strong opposition to the government's more controversial policy manoeuvres). However, inking a deal with the Fund will not be easy either, especially bearing in mind that a substantial chunk of the unwieldy ruling coalition is very clearly antiIMF, and we will be on the lookout for signs that the government is abandoning good-faith negotiations with the Fund.

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