Public Information Notice No. 05/83

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Argentina

June 30, 2005

On June 20, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Argentina.¹

Background

Argentina's economy has rebounded strongly from the financial crisis in late 2001. Reflecting buoyant domestic demand, real GDP grew close to 9 percent in both 2003 and 2004 bringing real output level back to the peak level achieved prior to the crisis. From early 2003, confidence rose steadily, and both private consumption and investment rebounded. Export receipts have increased—initially reflecting higher commodity prices—and imports remain below pre-crisis levels. International reserves have recovered, and bank deposit and external payments restrictions have been progressively dismantled.

The robust resurgence in money demand was a key aspect of the recovery. Inflation—after spiking in 2002—remained moderate (reaching only 3¾ percent in 2003 and 6 percent in 2004) despite the almost 300 percent depreciation of the currency. Given the softness of labor markets and a freeze on public service prices, real wages recovered only slowly and the real exchange rate remains somewhat depreciated.

Fiscal performance was strong in 2003 and 2004, mainly as a result of improvements in tax administration and robust economic activity. The consolidated primary surplus reached 3.0 percent and 5.1 percent of GDP in 2003 and 2004, respectively, as total revenues rose from 23 percent of GDP in 2002 to 29 percent of GDP in 2004. The strengthening of tax administration and strong VAT and income tax collection were important factors behind the fiscal performance, but distortive taxes (export and financial transactions taxes) also account for close to 20 percent of total revenues. Social and capital spending accelerated towards the end of 2004, resulting in end-year expenditures exceeding original budget targets by considerable margins.

Social indicators began to improve from end-2002 at a steady, but gradual pace. The headline unemployment rate fell to about 13 percent in March 2005 from 17.8 percent in December 2002, although an additional 4.1 percent of the labor force is employed under emergency social assistance programs. The share of the population living in extreme poverty fell to 17 percent in June 2004 (from 24.8 percent two years earlier) and the share of the population below the poverty line declined from a peak of 58 percent to 44 percent in June 2004.

During the first part of 2005, economic conditions have remained generally favorable. Growth has continued in the first quarter (at 8 percent year-on-year) and consumer and business confidence indicators remain at high levels. Inflation, however, has accelerated amid rising demand, increased capacity constraints, growing wage pressures and monetary accommodation; consumer prices rose by 5.2 percent during the first five months of 2005, bringing the 12-month inflation rate to 8.6 percent. A strong trade balance and a significant reduction in private capital outflows have facilitated a sharp rise in international reserves to over US$22 billion.

The approved budget for 2005 aims for a consolidated primary surplus of 3.8 percent of GDP on a cash basis. During the first five months of 2005, the federal government achieved a primary surplus of 1.9 percent of annual GDP.

Monetary policy has moved toward a tightening phase. Since January 2005, the central bank increased its policy interest rates on three occasions by a total of 125 basis points, bringing the repo rate to 3.75 percent, and has increased steadily the interest rates it pays on short-term Lebacs. However, renewed foreign exchange interventions since April have contributed to an acceleration in base money.

Argentina's global debt exchange offer was launched in January 2005 and closed on February 25 with a 76 percent participation level. As a result of the debt restructuring, Argentina's debt burden has declined to 72 percent of GDP (from 147 percent of GDP in 2002) and the debt service profile has improved considerably. Nonetheless, approximately US$20 billion in principal in default remains outstanding. The settlement of the debt exchange was completed on June 2 due to a delay resulting from legal action by some nonparticipating creditors to attach the tendered bonds.

Executive Board Assessment

Executive Directors noted that Argentina is emerging from a difficult period in its history, and has made a strong recovery from the 2001 financial crisis. Directors recognized, however, that, while much has been accomplished, many challenges lie ahead. They noted that the current growth momentum and accompanying political stability provide a critical window of opportunity for the government to leave the crisis behind and undertake the policies—committed to in 2003 under the current stand-by arrangement—that would ensure long-lasting and equitable growth.

Directors emphasized that, for the recovery to be sustained, the authorities need to take action on a number of fronts: to continue with responsible macroeconomic policies, guarding particularly against inflation; to undertake structural reforms that will boost factor productivity and raise potential growth above its historic rate; to strengthen the financial system and revive intermediation; to normalize relations with creditors; and to ensure that the fruits of growth are equitably shared and that the still vulnerable sections of the community are adequately protected.

Directors noted that prudent macroeconomic policies in 2003-04 have provided an anchor for the recovery of confidence. They commended the authorities for their steadfast implementation of fiscal policy, which produced record levels of primary surplus and demonstrated the potential for Argentina to move away from its high level of national indebtedness. Directors congratulated the authorities on achieving two years of low inflation, which was key to the recovery process. Monetary policy has taken advantage of resurging demand for pesos to rebuild international reserves while keeping both interest rates and inflation low.

Directors noted, however, that the macroeconomic policy stance could weaken in 2005 relative to 2004, at a time when the output gap is closing and inflationary pressures are mounting. They urged the authorities to tighten both fiscal and monetary policies to contain inflation. They also cautioned that the authorities' efforts to apply moral suasion and administrative measures to stabilize prices are unlikely to be effective and could have adverse consequences on the investment climate.

Directors noted that the primary surplus target of 3.8 percent of GDP in the 2005 budget represents a sizeable injection of fiscal stimulus, but welcomed indications that the target might be exceeded again this year. They urged the authorities to put in place measures to ensure the achievement of a higher primary surplus, preferably closer to the level achieved in 2004, particularly in the event that revenues are higher than expected. While recognizing that the government has over-performed its primary fiscal surplus target during the first five months of 2005, Directors noted that further fiscal consolidation is needed to avoid a budgetary financing gap from arising in the second half of 2005, and emphasized the need to maintain tight expenditure for the rest of the year.

Directors welcomed the authorities' recent efforts to raise interest rates, but believed that additional tightening would be desirable. They recommended that base money be brought to the lower end of the authorities' target range, which could require reduced foreign exchange intervention and a further rise in interest rates. A number of Directors also cautioned against the inflationary risks of using monetary policy to pursue exchange rate stability, and recommended that the authorities clarify their commitment to price stability as the prime objective of monetary policy, while a few Directors stressed that the central bank needs to have the necessary operational autonomy to effectively combat inflation. In this context, most Directors called for a greater degree of nominal exchange rate flexibility, while noting that the government's foreign exchange market intervention policy should be transparent, and stressing that competitiveness is best achieved through structural reforms and prudent macroeconomic policies. A few Directors also cautioned against the use of capital controls as a means to resist upward pressures on the exchange rate.

Directors called for the steadfast implementation of key structural reforms committed to by the government under the Fund-supported program. They urged the authorities to take advantage of the current favorable situation to implement structural measures that had been committed to under the current stand-by arrangement. A few Directors also noted the importance of strong ownership and careful sequencing of such reforms.

Directors noted, in particular, that structural fiscal reforms are crucial to sustain strong budgetary performance and enhance growth prospects over the medium term. They commended the authorities for the progress in restoring fiscal prudence and restraining overspending by the provinces. Nevertheless, most Directors underscored the importance of strengthening the institutional fiscal framework, including the Fiscal Responsibility Law, while acknowledging the political constraints facing the authorities. A few Directors also called for the establishment of clear rules to reinforce the role of the Federal Council for Fiscal Responsibility. They called for more binding constraints on provincial spending and borrowing, less discretion of federal financing to provinces, better coordination of fiscal policies across levels of government, increased budgetary transparency and consistent accounting standards at the provincial level, and more equitable and stable intra-governmental revenue sharing. In that context, a few Directors highlighted the constitutional difficulties faced by the authorities in advancing the recommended structural and fiscal reforms. Directors called for a phasing-out of distortionary taxes on exports and financial transactions, and a few emphasized that this measure should be revenue neutral and that it should not increase the share of revenues to the provinces at the expense of those of the central government.

Directors welcomed the progress in implementing the banking sector recovery strategy developed in 2003. They commended the authorities for maintaining the supervisory and regulatory framework under very difficult circumstances, while noting that considerable temporary regulatory forbearance has been extended. Directors emphasized, however, that the banking system remains vulnerable and undercapitalized relative to international standards, and that several issues remain pending, in particular with regard to the compensation for policy-induced losses and the judicial clarification of losses from amparos. Directors stressed the need to ensure that prudential standards are applied strictly, including the announced regulatory phase-in of market valuation of government bonds and limits to bank exposure to the public sector. At the same time, Directors recommended that incentives for early recapitalization of banks be strengthened. They also noted the expanding role of public banks and urged the authorities to articulate a strategy which would clarify the role of the public sector in the banking system going forward.

Directors observed that the situation in the regulated utilities sector is not sustainable, and that failure to resolve outstanding issues would have damaging consequences for macroeconomic stability, the investment climate, and future growth. Directors urged the authorities to quickly reach collaborative long-term agreements with the utility concessionaires that would ensure an appropriate economic return and adequate future investment in the sectors, as committed to in the current Fund-supported program. Directors also stressed the importance of putting in place, at an early date, an updated regulatory framework that would provide regulatory certainty and find an appropriate balance between protection of consumers and provision of necessary investment incentives.

Directors viewed the recently completed debt exchange as an important step toward normalization of relations with creditors. They stressed that for Argentina to emerge fully from the financial crisis and regain access to capital markets, the authorities need to develop a forward-looking strategy to resolve remaining arrears outstanding to private creditors consistent with the Fund's Lending into Arrears policy. Directors also noted the need to normalize relations with bilateral official creditors through a Paris Club agreement, and to maintain regularized relations with the European Investment Bank.

Directors emphasized that debt sustainability for Argentina will require a steadfast implementation of fiscal and structural policies. They noted that only under a proactive reform scenario, including a high and sustained fiscal effort, would the debt-to-GDP ratio return to more comfortable levels over the medium term and allow an early exit from the use of Fund resources.

Most Directors considered appropriate that the authorities should have the flexibility to draw on their international reserves to finance the significant levels of debt service, including repurchases to the Fund, that fall due in the near term, while some Directors raised questions regarding the use of international reserves for this purpose. They noted that it would be important for the use of reserves to be made in a manner that does not impair the financial soundness or autonomy of the central bank.

The Executive Board also discussed the issue of arrears to the European Investment Bank (EIB) which arose in 2003 and caused nonobservance of continuous performance criteria under the standby arrangements of January 2003 and September 2003. The misreporting of these arrears gave rise to five noncomplying purchases, and breaches of obligation under Article VIII, Section 5 of the Fund's Articles of Agreement. On December 10, 2004 Argentina cleared these arrears to the EIB. On the basis of this corrective measure, the Executive Board granted waivers of the nonobservances of the performance criteria underlying the misreporting and agreed that no further remedial action was warranted with respect to the breaches of Article VIII, Section 5.