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R 251936Z OCT 07
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TO RUEHC/SECSTATE WASHDC 9561
INFO RUEATRS/DEPT OF TREASURY WASHINGTON DC
RUCPDOC/USDOC WASHINGTON DC
RUEHRC/DEPT OF AGRICULTURE USD FAS WASHINGTON DC
RUEHC/DEPT OF LABOR WASHINGTON DC
RHMFIUU/HQ USSOUTHCOM MIAMI FL
RUEHAC/AMEMBASSY ASUNCION 6647
RUEHMN/AMEMBASSY MONTEVIDEO 6857
RUEHSG/AMEMBASSY SANTIAGO 0865
RUEHBR/AMEMBASSY BRASILIA 6525
RUEHLP/AMEMBASSY LA PAZ OCT CARACAS 1557

UNCLAS BUENOS AIRES 002110 
 
SIPDIS 
 
SENSITIVE 
SIPDIS 
 
NSC FOR MICHAEL SMART 
FED BOARD OF GOVERNORS FOR PATRICE ROBITAILLE 
USTR FOR KATHERINE DUCKWORTH AND MARY SULLIVAN 
TREASURY FOR MATTHEW MALLOY 
USDOC FOR 4322/ITA/MAC/OLAC/PEACHER 
US SOUTHCOM FOR POLAD 
 
E.O. 12958: N/A 
TAGS: AR ECON EINV ETRD EFIN ENRG PGOV
SUBJECT: Argentina: Economic Challenges Facing the Incoming 
Government 
 
Refs: 
(A) Buenos Aires 2021 
(B) Buenos Aires 1995 and prior 
 
------------------------ 
Summary and Introduction 
------------------------ 
 
¶1. (SBU) The inauguration of a new Argentine president in December 
2007 will coincide with the conclusion of the Argentine economy's 
fifth (2003-2007) consecutive year of 8-9% real growth, and record 
levels of exports, foreign reserves, and formal employment. 
Argentina also enjoys solid, if declining, budget and current 
account surpluses.  However, the new administration will face many 
economic challenges: Argentina's good times have been accompanied by 
a mounting pressure cooker of distortions and government 
interventions, including inflation, price controls, alleged economic 
data manipulation, growing subsidies, low investment levels, energy 
shortages, stubbornly-high poverty levels and corruption.  All of 
these require near term attention if Argentina is to continue its 
remarkable recovery from the 2001 crisis and achieve sustainable 
growth levels.  Delaying reforms will make their resolution more 
politically and economically painful.  Taking prompt corrective 
measures and beginning a process of change offers an incoming 
administration an opportunity to demonstrate to its citizens and to 
the international community that it will take responsible action, 
and that Argentina does not have to be condemned to boom-and-bust 
economic cycles.  End Summary and Introduction. 
 
--------------------------------- 
Inflation: Old Ghost Stalks Again 
--------------------------------- 
 
¶2. (SBU) According to domestic polls, inflation is the number one 
economic problem facing Argentina, one that undermines public trust 
in government and disproportionately affects the poor.  Inflation 
spooks the Argentine public and potential investors, given the 
country's painful history of hyperinflation.  As reported Ref A, 
true inflation is currently running at about 15%-20% -- roughly 
double the official rate -- and accelerating. 
 
¶3. (SBU) Inflation is the most visible symptom of a broader problem, 
an overheating economy, the consequence of the GoA's expansionary 
fiscal, monetary, incomes and exchange rate policies to push 
domestic demand-driven growth.  Since 2005, the GoA has used 
microeconomic methods -- price controls, export restraints, and 
public service subsidies -- in a failed attempt to control inflation 
without slowing economic output.  The big test for the next 
administration will be whether it has both the political will to use 
more orthodox policies and/or tools to slow growth to sustainable 
levels, reduce inflationary pressures, and unravel the web of 
distortionary microeconomic policies.  These policies are now linked 
to the point where an attempt to change one inevitably requires 
changes to others. 
 
-------------- 
Price Controls 
-------------- 
 
¶4. (SBU) Beginning in late 2005, in response to signs of increasing 
inflation, the GOA ratcheted up pressure on businesses and 
instituted "voluntary" price accords for primary consumption items 
with retailers and supermarkets.  Two years later these efforts have 
largely failed to reduce inflation, and have further undermined 
public and investor confidence.  As widely predicted, the results 
have been shortages, black markets, distortions and limited new 
investment in affected sectors.  Even the few private sector 
economists who expressed qualified support for price controls always 
underlined their strictly short-term nature.  The longer price 
controls persist, the more difficult and costly it will be for the 
economy to extricate itself later.  The GOA needs to find a graceful 
exit or process soon. 
 
---------------------------------------- 
INDEC:  Alleged Statistical Manipulation 
---------------------------------------- 
 
¶5. (SBU) Facing the failure of its dirigiste efforts to control 
inflation, the GoA took a bolder step: direct manipulation of 
official statistics.  Beginning in January 2007, the highly regarded 
GOA statistics agency, INDEC, began reporting monthly inflation 
numbers significantly below market estimates.  GoA officials 
allegedly intimidated INDEC employees and forced those that refused 
to alter the numbers to resign, replacing them with Kirchner 
government stalwarts.  The manipulation has apparently worsened as 
the October 28 elections have approached, and the official estimate 
of 8-9% inflation for 2007 is roughly half of private estimates of 
15-20% (Ref A and Buenos Aires 1545). 
 
¶6. (SBU) Questions are now being raised about the veracity of other 
INDEC-provided data, such as GDP growth, poverty, indigence levels, 
incomes, and unemployment.  The GOA's actions have not only degraded 
INDEC's prestige and credibility, but also further eroded 
Argentina's institutional and investment climate.  Some foreign 
creditors even consider the GoA intervention as a "credit event," or 
equivalent of a default, spurring them to sell GoA bonds.  Several 
parallel inflation indices have emerged, by economists, think tanks 
and politicians, all adding to worsening public trust of the GOA. 
One consequence has been reduced GoA influence over union wage 
pressures and inflationary expectations: unions no longer believe or 
accept official inflation figures, and many have laid down markers 
that they will demand 2008 wage increases greater (up to 30%) than 
even private inflation estimates. 
 
--------------------------------------------- - 
Public Utilities: Frozen Tariffs and Subsidies 
--------------------------------------------- - 
 
¶7. (SBU) Since 2002, transport fares and energy tariffs, 
particularly for the residential sector, have remained largely 
frozen, while international prices for gas and oil - and salaries 
for these sectors' workers - have soared.  A ride on the Buenos 
Aires subway, for example, is just 22 cents, the same as in 2002. 
To maintain these low prices, the GOA has accelerated subsidy 
payments to energy, bus, rail, and air transport service providers, 
often utilizing non-transparent transfer mechanisms (Ref B) that 
have led to many allegations of corruption.  As a consequence, 
energy-related 2007 public transfers will increase to an estimated 
1.5% of GDP (vs. 0.7% in 2006), a more than 100% increase over 2006 
levels which, in turn, were more than 80% higher than 2005 levels. 
 
¶8. (SBU) For the GOA, the calculus is simple: either continue 
subsidies to maintain these everyday prices for large and important 
urban voting constituencies, or ease subsidies, bringing increased 
transport and energy fares - and voter wrath.  The GoA will 
eventually have to cut subsidies and increase these tariffs, which 
could tamp soaring demand, ameliorate shortages, and create 
incentives for needed investments. 
 
----------------------------------------- 
Distortionary Export Tariffs, Export Bans 
----------------------------------------- 
 
¶9. (SBU) Since 2002, the GOA has imposed high and distortionary 
export tariffs on almost all tradable (largely agricultural) 
products, allowing the GOA to insulate domestic prices from 
international prices of Argentine exportable goods, partly 
alleviating inflation and poverty.  Export taxes have also allowed 
the GOA to capture increased economic rents resulting from the 
devaluation of the peso and high international commodity prices.  In 
2006, the GOA also resorted to a six-month beef export ban in an 
attempt to moderate surging domestic prices for this product, and 
still maintains beef export volume limits. 
 
¶10. (SBU) Export tariffs, particularly those on primary commodity 
exports, have contributed a growing share of tax collections, and is 
E 
 
now the GoA's third most important source of revenues (after VAT and 
income taxes) and a key contributor to the primary fiscal surplus 
(the surplus excluding debt interest payments) in recent years. 
Export tariffs totaled 9.3% of total tax revenues in the first half 
of 2007, and represented 64% of the GOA's primary fiscal surplus in 
¶2006.  The GoA has also made clear that export tariffs are its 
mechanism of choice (under its comprehensive industrial 
promotion/protection policy) to transfer wealth from the nation's 
relatively well off agricultural sector to the less competitive 
industrial sector (Ref E).  These distortionary taxes discourage 
investment and weaken competitiveness in a sector in which Argentina 
enjoys comparative advantage. 
 
------------------------------------------ 
Public Spending Binge, Fiscal Implications 
------------------------------------------ 
 
¶11. (SBU)  As reported Ref B, GOA spending through July 2007 has 
increased almost 50% from 2006, mainly due to increased pension, 
subsidy, wage and public infrastructure capital expenditures, all 
with the apparent goal of buying votes for the October elections. 
One of the most important accomplishments of the Kirchner 
administration, a healthy primary fiscal surplus, is diminishing, 
and the national consolidated balance (including provincial finances 
and interest payments on debt) is now nearing zero. 
 
---------------- 
Energy Shortages 
---------------- 
 
¶12. (SBU) As a result of low tariffs, resulting  high demand, and 
insufficient investments, energy shortages have emerged, 
particularly for natural gas and diesel (Buenos Aires 1496). 
Further, private electricity sector players here (including U.S. 
companies) say that the GoA's freezing of energy prices and 
manipulation of the methodology used to set market prices have 
unilaterally abrogated contracts, effectively confiscating funds 
owed to them.  The consequence has been a raft of international 
ICSID arbitration claims filed against the GoA that total in the 
billions of dollars. 
 
¶13. (SBU) Public anger at energy disruptions during the recent 
(austral) winter have certainly exacted a political cost, but the 
GoA's stop-gap measures to import more electricity from Brazil and 
to subsidize diesel fuel for Argentine thermal plants will likely 
see the GoA through to the next (austral) summer peak demand season. 
 The Kirchner administration clearly believes that cheap energy that 
helps expand consumer purchasing power is its best pre-election 
strategy, and it has been willing to pay dearly to import peak 
demand electricity from Brazil and to subsidize diesel supplies for 
domestic generators.  Argentina is in dire need of a wholesale 
energy policy overhaul that includes not only a liberalization of 
energy prices but the design and application of a clear 
pro-investment energy regulatory framework.  Otherwise, its strong 
recovery could be in jeopardy. 
 
-------------------------------- 
Undervalued Peso Fuels Inflation 
-------------------------------- 
 
¶14. (SBU) Although nominally independent, in practice the Central 
Bank has followed the direction of the executive.  The apparent 
policy goals behind the GOA's artificially low, "competitive" peso 
are import substitution, industrialization, full employment, and 
boosting exports and tourism.  Also crucial for the GOA, an 
undervalued peso sustains the GOA's export tariff revenues (see para 
10).  However, the downsides are higher inflation and the Central 
Bank's loss of ability to maintain price stability.  The GOA cannot 
defy the principles of economics to have it both ways - maintain a 
"competitive" exchange rate and use monetary policy to moderate 
inflation. 
 
--------------------------- 
 
Paris Club, Holdouts, ICSID 
--------------------------- 
 
¶15. (SBU) The GOA faces significant debt arrears and contingent 
liabilities that could add substantially to government debt in the 
coming years (Ref B).  These cases require resolution.  The GOA owes 
about $6.5 billion in Paris Club debt, including about $400 million 
to the U.S. Government.  It owes about $25 billion to "holdouts," 
bondholders that did not participate in the 2005 debt exchange. 
Foreign multinationals, including many U.S. energy players, have 
roughly $13 billion in outstanding claims against Argentina before 
the World Bank's International Center for the Settlement of 
Investment Disputes (ICSID), the bulk of which date from the 
2001-2002 economic crisis.  Roughly 19% of total ICSID claims are 
held by U.S.-based firms.  A number of cases have been decided by 
ICSID tribunals against Argentina.  Should the GoA refuse to pay out 
ISCID rewards, the risk premium foreign investors demand to commit 
new capital to Argentine ventures would increase, worsening 
Argentina's already difficult investment climate. 
 
---------------------------------- 
Poverty, Indigence and Income Gaps 
---------------------------------- 
 
¶16. (SBU) Although Argentina has made remarkable progress in 
alleviating poverty and improving income distribution since the 
2001/2002 economic crisis, it still faces sobering challenges. 
Overall poverty stands at about 30 percent.  Almost 49% of all 
citizens under 14 fall under Argentina's poverty line; 20% of this 
same group are considered indigent.  41% of the labor force remains 
informal.  Income inequality is beginning to grow again as the 
(effectively) regressive tax of inflation disproportionately impacts 
the poor.  Embassy contacts and private economists note that these 
challenges could be socio-economic time bombs and require urgent GOA 
attention. 
 
--------------------------------------- 
Under-Investment and Investment Climate 
--------------------------------------- 
 
¶17. (SBU) For Argentina to continue its recovery, even at more 
sustainable growth rates of 5-6%, investment must increase above the 
current levels of 22%-23% of GDP.  Argentina also needs higher 
quality investment; currently a substantial share of investment is 
concentrated in areas such as construction that do not add 
significantly to the nation's productive capacity.  A recent UNCTAD 
report on global foreign direct investment highlighted Argentina's 
low and declining share of global FDI. 
 
¶18. (SBU) Quality investment begins with a good investment climate. 
According to most private sector analysts, to attract higher levels 
and quality of investment, Argentina needs to address institutional 
weakness, corruption, the over-concentration of power in, and the 
tendency to impose abrupt regulatory changes by, the executive 
branch, and perceptions of weak contractual sanctity.  (Buenos Aires 
1947 elaborated upon recent poor GOA marks in the areas of 
corruption and ease of doing business.)  The challenge is for the 
GOA to address the more intractable problems of legal uncertainty, 
institutional weakness, and inconsistent application of the rule of 
law. 
 
--------------------------------------------- -- 
Comment: A Reform Agenda for the New Government 
--------------------------------------------- -- 
 
¶19. (SBU) Although analysts differ in their perceptions of how and 
in what sequence the new government should address these often 
linked and overlapping challenges, there is broad agreement on the 
basics: 
--  First and foremost, sustaining a strong primary fiscal surplus 
is fundamental, as it has a moderating effect on inflation and 
country risk premiums and allows the GoA flexibility in managing its 
still substantial debt overhang.  This will in all likelihood 
 
require an incoming administration to sharpen its budget pencil and 
cut billions in recently announced public infrastructure investment 
spending. 
--  Second, easing distortionary price controls and linked subsidies 
could encourage new investment in affected sectors, though most 
agree that any abrupt removal of existing controls would result in 
an inflationary spike that would color Argentine consumers' 
expectations. 
--  Third, INDEC's institutional independence needs to be restored. 
(As per ref A, the GoA is already taking steps to introduce a "new" 
USG-based inflation calculation methodology that could allow the GoA 
to step back gracefully from alleged manipulation.) 
--  Fourth, public utility energy and transport tariffs should be 
allowed to transition upwards to regional market levels, a step that 
would provide incentives for badly needed infrastructure investment. 
 
--  And fifth, the GOA must begin to address its unresolved Paris 
Club, holdout, and ICSID-related obligations, which in turn could 
improve Argentina's access to global capital markets and improve the 
nation's investment climate. 
 
¶20. (SBU) Given Argentina's volatile economic history, citizens and 
markets will be especially sensitive to the actions the GOA takes -- 
or fails to take.  There is a general consensus that the longer the 
incoming GoA administration waits to take these corrective actions, 
the more painful -- both economically and politically -- these 
corrections will be.  The Argentine economy is still enjoying a tail 
wind of buoyant domestic and regional growth, continued high global 
commodity prices for key Argentine exports, positive (albeit 
declining) fiscal and current account balances, and manageable 
financing costs.  By initiating policy changes in the initial period 
of the new Presidency, the incoming administration can reassure its 
citizens, the markets and the international community that repeated 
booms and busts do not have to be Argentina's eternal fate, and 
moderate growth and stability is achievable. 
 
WAYNE