Last week, Argentine President Cristina Fernadez moved to take over the Argentine subsidiary of Spanish oil company Repsol, YPF. The rationale behind the move has been an energy crisis affecting the country, which Fernandez has put down to underinvestment of oil and gas fields by YPF, as well as mismanagement. The real issue is one of price controls, subsidies and restrictions, all done in the name of maintaining short term consumption growth. The subsequent decimation of investment potential via inflation and restrictions to capital formation have led Argentina on the brink of a vicious cycle of inflation, money printing and more inflation, that in many ways has already begun.
This particular story really begins with the presidency of Carlos Menem in the early 1990s. After suffering from hyperinflation in the late 80s, the Menem administration instituted a Convertibility Plan, aimed at bringing about stability and economic growth. The foundation of this plan was the pegging of the peso to the US dollar at 1:1. This, combined with IMF backing, attracted foreign capital to Argentina and the country embarked on a period of economic growth.
This was short-lived however, as the increased legitimacy in the eyes of foreign creditors became a mechanism by which Argentina could increase its debt loads. As Pierpaolo Barbieri wrote in the WSJ a few days ago:
Hard-won low interest rates, however, led to a domestic borrowing and spending binge, not unlike Greece’s after it joined the euro zone. Price stability, growth and renewed faith in the country’s economic fortunes eventually gave way to sky-high unemployment, widespread poverty and credit lines from the International Monetary Fund.
The figures come from the Argentine Central Bank. The increased debt and credit flowing into the country did create a bit of a boom at first, but the boom waned towards the latter half of the 90s as foreign investment tapered. This led to a spiral beginning with Argentina trying to prevent the inevitable recession brought about by the disappearance of foreign investment credit. Needing more debt to accomplish this in the midst of that supply drying up led to an increase in their interest payments. In turn, this meant that even more debt would be required to both service existing debts and take on new stabilizing debts. The currency peg didn’t help either. As a result of the increased deficits, debts and money supply, the fundamental value of the peso weakened. Yet it remained artificially overvalued thanks to the peg. The peg itself was not the problem, but rather the increased debts and expansions of the supply of credit that it enabled. Ultimately the inability to keep the game going is what culminated in the crisis and default in the early 2000s.
I mention this to point out that the collapse in the early part of the 2000s, and the issues Argentina face today have little to do with the privatization of many utility companies (including YPF) that were part of Menems reforms. Those reforms have been criticized recently in a few Guardian articles, which praise Fernandez’ actions for ‘reversing past mistakes,’ and being a ‘timely retort to rampaging capitalism.’
These assessments are misguided to say the least. The implication is that once again free markets and capitalism have failed us and it’s about time that we reverse the trend and have the state play a larger role in the marketplace. As I alluded to before, the free market reforms Menem installed were only a piece of his overall policy, and were not responsible for the meltdown that occurred. Furthermore, the Argentine government has embarked on several initiatives since the default which can hardly be described as capitalist. It is these measures, taken with the short term interest in mind, that have set the stage for the troubles Argentina face today.
Failure of Interventionism or Capitalism?
The default and subsequent devaluation of the peso became problematic for natural gas companies after the government imposed a price freeze on natural gas tariffs in January 2002. These tariffs were previously quoted in dollars, so the policy, which required prices to be quoted in now devalued pesos, amounted to a price cut. This happened at a time when the international price of natural gas was rising. The effects of this were predictable – the dramatic cost reduction led to a spike in demand and shortages. From this article in The Economist in 2004 (emphasis mine):
Most Argentines now pay only a third as much as their neighbours for gas and electricity. So demand has soared. Each month, some 30,000 of them have been converting their cars to run on compressed natural gas, which costs 40 centavos ($0.14) a litre, compared with 2 pesos ($0.71) for petrol. Meanwhile, since prices are at around one-third of the level required for a reasonable return on investment—and many of the electricity companies are in default on their dollar debts—supply has stagnated.
The bold is key, with respect to the charges President Fernandez has leveled on YPF of failing to adequately invest in oil and production. Mark Weisbrot in a Guardian article linked above further fleshes out that argument, writing that:
Repsol, the Spanish oil company that currently owns 57% of Argentina’s YPF, hasn’t produced enough to keep up with Argentina’s rapidly growing economy. From 2004 to 2011, Argentina’s oil production has actually declined by almost 20% and gas by 13%, with YPF accounting for much of this. And the company’s proven reserves of oil and gas have also fallen substantially over the past few years.
The lagging production is not only a problem for meeting the needs of consumers and businesses; it is also a serious macroeconomic problem. The shortfall in oil and gas production has led to a rapid rise in imports. In 2011 these doubled from the previous year to $9.4bn, thus cancelling out a large part of Argentina’s trade surplus. A favourable balance of trade has been very important to Argentina since its default in 2001. Because the government is mostly shut out of borrowing from international financial markets, it needs to be careful about having enough foreign exchange to avoid a balance of payments crisis. This is another reason that it can no longer afford to leave energy production and management to the private sector.
There is no mention here of the price controls imposed in 2002, or the further actions taken by the government in later years:
The government of President Nestor Kirchner raised export taxes to a minimal rate of 45%, up from 5%-45%, in an effort to hold down prices on domestic supplies and bring in an additional $1 billion/year in revenue for the state. The new plan caps the maximum market price of Argentine crude oil at $42/barrel for domestic sales, subsequently limiting the prices of products in relation.
From Bloomberg (emphasis mine):
Export sales from oil, gas, petrochemicals, gold and copper in Argentina totaled $10.7 billion in 2010, or 16 percent of total exports, according to the national statistics agency. Argentina places a 100 percent tax on oil exports above about $45 per barrel, compared with a global price that has ranged from $75 to $114 per barrel this year.
The move ensures “equal treatment to all production activities,” according to a statement in today’s official gazette.
Underscoring the protectionist nature of the Fernandez administration, economist Claudio Loser points out that:
(Argentina)has introduced about 110 restrictive measures since 2009 affecting 174 countries, more than any other individual country.
The most absurd of these has been the recent restriction on imported books, which apparently presents a health problem because:
…you handle the book and possibly wet your finger with your tongue to turn a page: that can be very serious for human health
This refers to the lead content in the ink used in foreign books. The measures are designed to promote domestic printing of books, and should one want to purchase a book from overseas, one would have to travel to the customs office at the airport to pick it up once it has passed inspection.
It doesn’t take intimate knowledge of rocket science to understand the potential issues that sort of policy could create, and specifically for the oil companies, the incentives to reduce production. The results that Weisbrot describes above are more or less accurate. The charts below display the oil and gas production of the time in question, along with energy reserves.
The source is the BP Statistical Review of World Energy, 2011. As one can see, oil and gas production has indeed dropped over the last decade, which has led to shortfalls, but the catalyst for this has been government policy. The price controls enacted by the government in the face of rising energy prices internationally has led to companies becoming more unwilling to use their resources producing oil in Argentina, when they could do so elsewhere and earn higher revenues thanks to the increased prices prevailing there. In response to the lower supply from the oil companies, the government has increased energy imports, becoming a net importer of energy when it was once a net exporter.
The populist narrative put forth by the government (note the stated goal of equal treatment in the Bloomberg quote), endorsed by Weisbrot, is economically deficient and shows a lack of understanding of simple pricing mechanisms. This is particularly true of Weisbrot, who points to the saga as some sort of indictment of the ability of the private sector to handle the production of energy. The truth is that the concept of profit and loss is instrumental in determining what goods and services should be produced and how much of them should be produced. Distortions of the price level do nothing but change incentives, usually leading to shortages as we have seen here. The same phenomenon has been noted over the years in the markets for basic goods and services such as beef, bananas, prescription drugs and electronics.
That hasn’t stopped people like Weisbrot from claiming that the policies employed by the Argentine government in the wake of the default have been a massive success. Once again from the Guardian article above he writes:
between 2002 and 2011, Argentina’s real GDP grew by about 90%, the fastest in the hemisphere. Employment is now at record levels, and both poverty and extreme poverty have been reduced by two-thirds. Social spending, adjusted for inflation, has nearly tripled. All this is probably why Cristina Kirchner was re-elected last October in a landslide victory…
….It is interesting that Argentina has had such remarkable economic success over the past nine years while receiving very little foreign direct investment, and being mostly shunned by international financial markets. According to most of the business press, these are the two most important constituencies that any government should make sure to please. But the Argentinian government has had other priorities. Maybe that’s another reason why Argentina gets so much flak.
The model behind this growth has been one of government support for increased consumption. This has in large part been fuelled by the global commodity boom, which has enabled the government to increase its spending. From this Bloomberg piece dated March 2011:
Outlays on everything from highway construction to pensions climbed 37 percent last year from 2009 — and increased 39 percent in January of this year alone. Fernandez’s largesse is made possible in large part by the global commodities boom.
Foodstuffs such as soybeans, wheat and flour accounted for about 70 percent of the country’s export revenue in 2010, according to Agritrend SA, a Buenos Aires-based research company.
Export tax revenue, led by a 35 percent levy on soybeans, rose 11.2 percent in February from a year earlier to 3 billion pesos ($740 million).
Argentina’s 40 million people are spending, too — as a way to protect themselves from rising prices. They’re buying everything from flat-screen televisions to cars and even property. Sales of such goods as home appliances, toys and clothing soared 39.5 percent in December from a year earlier, the biggest increase for that month since at least 1998. Auto sales gained 43.3 percent in unit terms, the most since 2004.
Demand for construction supplies such as cement, steel and paint was up 20 percent in December. Consumption helped push economic growth to 9.2 percent last year from 0.9 percent in 2009. Fueling that growth — and inflation — is government support for annual wage increases of 30 percent or more.
Prices — and wages — have been rising so fast that in November and December, the Central Bank of Argentina was unable to print enough money to meet the demand for cash from consumers and companies trying to cover year-end salaries and bonuses. As Argentines lined up at empty ATMs in the middle of a heat wave, the central bank took the unprecedented step of hiring Brazil‘s mint to crank out 160 million 100-Argentine-peso notes, so that there would be enough cash for individuals eager to buy holiday gifts and start their summer vacations.
Mentioned in that quote is the high rate of inflation that currently plagues the Argentine economy and renders the excitement over its growth rates in many quarters to be suspect. The government officially states the inflation rate at 9%, while many private economists place the rate at above 20%. Splitting the difference leaves us with a rate of roughly 15% inflation, which surely depresses the real rate of growth. It is true that the employment figures have improved as per Weisbrot’s quote, but it is hardly sustainable.
The economic theory is straight from the Keynesian playbook. Government spending has been ramped up to maintain subsidies keeping utility and energy prices artificially lower, boosting demand. This has been the impetus for the rising prices and increased consumption, falsely characterized by mainstream commentators as economic growth. Further subsidies to support wage growth have been needed in response to the increase in prices. The increase in employment noted by Weisbrot is also to be expected given the government support. These short term boosts to the economy have won Fernandez many plaudits and made her campaign for reelection in 2011 a successful one.
But as usual, short term measures compromise long term sustainability. The costs of this policy have come via the very boost to consumption that alleviated much of the short term pains following the default fallout. The increased price level has led to increased costs of doing businesses. Continuing from Bloomberg:
Inflation in Argentina is putting a lot of pressure on costs for importers, says Hector Trevino, chief financial officer of Coca-Cola Femsa SAB, Latin America’s largest soft- drink bottler. The Mexico City-based company saw its Argentine freight costs jump almost 70 percent and salaries climb 35 percent during the fourth quarter of 2010, he said in a conference call with analysts in February.
“The impact that we have had in freight cost in Argentina and salaries is tremendous,” he said.
Companies with employees in Argentina, which raise wages to keep pace with inflation, feel a similar pressure.
“In 2010, payroll costs in Argentina were up about 20 percent in dollar terms,” Antonio Brufau, chief executive officer of Repsol YPF SA (REP), Spain‘s biggest oil company, said in a Feb. 24 news conference in Madrid. In 2011, those costs will rise as much as 25 percent in pesos, he added.
These increased costs leave firms in the position of having to raise prices, or cut costs by firing workers. Through price controls, the government has removed the former option, lowering prospects for decent returns. In terms of the energy space, Metrogas, Argentina’s largest natural gas provider filed for bankruptcy, citing the damaging effects of the price freezes, while UK firm BG Group and French firm GDZ Suez both left the country. More generally, the Argentine economy has faced increased capital flight at a time when it needs capital investment the most.
The capital flight, exacerbated by the inability of Argentina to borrow thanks to the early 2000s default, has put Argentina in a precarious situation. The government’s response has been to double down on the interventionism. Enacting capital controls, demanding that exporters repatriate export revenue, and calling on its central bank to play a larger role in the economy have all been key features of their response.
From an economic standpoint, these measures will only stoke inflation further. To reiterate, the increased subsidies administered to boost short term consumption and employment have also boosted the cost of living, which in turn, requires further outlays from the government to subsidize further rounds of consumption at these higher prices. This sort of spiral is reminiscent of the foreign investment driven debt spiral that took place in the 1990s. This time around the increased production of high priced commodities provided the government with the impetus to embark on various projects. The high domestic costs imposed on these firms in the form of taxes, price controls and restrictions led to a predictable drop in that production and capital flows. The government has turned to the central bank to help make up the difference (read: print more money). Like Fed chairman Ben Bernanke, the head of the Argentine Central Bank has no qualms about printing more money, and in fact declares that it has no effect on the rising prices. Her views are as follows:
Inflation is a result of companies being unable to meet consumer demand and should be resolved by boosting loans for production, Mercedes Marco del Pont, the current central bank president, says. She plans to increase the money supply by 28 percent this year to accommodate economic growth, a move she says won’t affect inflation.
“The price problem doesn’t have monetary roots,” the Yale University-educated central banker, 51, says. “The conditions that could cause inflation to accelerate don’t exist in Argentina.”
As stated before, the fact that companies can’t meet demand stems from the fact that demand has been artificially boosted by price controls and subsidies, policies which were made in response to high inflation in the first place. The simultaneous shackling of supply in various manners already discussed above completes the picture. Her suggestion that the price issues are not monetary in nature is completely laughable and can only come from your typical mainstream hubs of economics.
The money aggregates have turned upwards post default, and have resulted in regular inflation levels of upwards of 20%. This will only continue if the Central Bank continues to pledge support for the policies of the Argentine government.
Returning to the YPF issue, the underlying issues that prompted its decline in production are still in place. This means that in order to ramp up production of energy to levels the government finds acceptable would be to do so at a loss. The discovery of new shale is a source of such energy, but the proper investment outlay will still need to take place in order to realize that production. The government covering these losses and plugging the gaps created by its own doing would likely necessitate both higher taxes and increased regulation of the economy, or even more money printing by the central banks, exacerbating capital flight and inflation pressures respectively. Even more expansionary policy would then be needed to keep the inflation from hitting the people too hard by subsidizing consumption at this new, higher price level. Unfortunately, the ultimate price Argentina will have to pay for the continued short term propping of its economic model is yet another bout of hyperinflation. The seizure of YPF is merely a symptom of the folly of Argentine state intervention, representing the latest attempt to perpetuate failed economic theories.