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The Crisis of Argentina and How to Reduce Country Risk – Daniel Lacalle (01/18/2019)

Argentina maintains a high country risk. In fact,  it is currently the second highest in Latin America and the third of the emerging countries if we include Turkey.

What is the country risk? It is the spread between the yield of the sovereign bond of a nation compared with the United States Treasury bonds, the lowest risk asset. Investors demand higher-yielding bonds due to the risk of the issuer’s economy, to compensate for the currency and solvency risk.

Argentina’s country risk increased by 130% in 2018 due to delayed reforms, constant devaluation and loss of foreign exchange reserves. The country risk has fallen significantly from its high of 817 basis points to the current 706. However, it remains the second highest in the region after Venezuela.

The reasons why a rich and high-potential country like Argentina has a higher country risk than allegedly weaker developing countries are easy to explain:

  • The countries with the highest country risk are also those that have abused most of the financing of public spending by the central bank through the printing of currency.
  • Argentina has a higher country risk than apparently more fragile economies due to the constant refusal on the part of the successive governments to adopt a prudent monetary policy and to defend the purchasing power of the currency. When inflation rises and the currency is devalued due to this misguided monetary policy, the purchasing power of that currency is destroyed, and the country’s investor security erodes.

Risk increases because investors perceive that no relevant structural reforms are being carried out, and this limits potential growth and increases the risk of inflation and default. The default probability increases with the downward spiral of printing money to finance increasing public and extractive spending, triggering inflation and raising taxes, which leads to lower growth, less investment and more displacement of the private sector.

That is the reason why countries with a relatively low debt to GDP ratio but huge monetary imbalances fail before countries with high debt to GDP but a prudent monetary policy that does not directly finance public spending. It is not the same to create a transmission mechanism of monetary policy such as quantitative easing — with all its flaws — which curbs inflationary risk by generating firewalls in the transmission process because it is done through credit, unlike directly prints money to finance current spending. The second destroys the economy, it is a direct transfer of wealth from the savers and salaries to the government and makes confidence in the currency disappear. Argentine citizens know this well.

Country risk must be contained not only because it leads the state to finance itself at a higher cost and with less demand, but because it drags the financing capacity of the real economy, companies, and families.

It is not just bad for public finances. If yield soars in the asset that supposedly has less risk of the nation, the sovereign bond, it leads to a whole chain of negative impacts on the financing of the real economy, the cost of financing of companies and families rises much more and credit dries up.

The only way that Argentina will erase its unnecessarily high country risk is by cutting bloated public spending, lowering taxes, attracting investment and improving ease of doing business. But more importantly, it needs to stop financing public spending by printing pesos once and for all.

In 2018 Argentina was among the four countries in the world with the highest inflation, below Venezuela, South Sudan, and Iran, according to the International Monetary Fund.

Argentina is also among the countries with the highest tax wedge, in fact, the highest total tax burden in the world, according to the World Economic Forum. The total tax rate absorbs all corporate profits.

In the index of economic freedom published by the Heritage Foundation, Argentina has improved; but it continues to appear in one of the worst positions, number 144 of a total of 180 countries. We must emphasize that the Nordic countries, which are used constantly in television debates in Argentina as an example, are among the countries with the greatest economic freedom, ranking between 12 (Denmark) and 26 (Finland). It is worth remembering this factor when talking about prosperity and redistribution. There is no social policy if economic liberty and prosperity are not the primary objectives.

Similarly, in the Doing Business index — which measures the ease of creating jobs and companies — Argentina appears in a slightly improved position with respect to 2017, but far below where it should be. Argentina occupies a very poor position, 117 of 190 countries. Again, the Nordic countries rank between number 3 and 13, at the head of the table.

High inflation, high taxes, low economic freedom and very high burdens on investment. Four factors that worsened significantly in the Cristina Fernández de Kirchner tenure and that the Macri administration has not done enough to improve.

Only eliminating the unbridled printing of pesos from the Central Bank and the useless political spending financed with the rising money supply, Argentina would climb at least twenty positions in these indexes. If the tax and bureaucratic burden were reduced to levels similar to those of the surrounding countries and the OECD average, Argentina would be — as it deserves — an international center of capital attraction and global investment and one of the countries with more solid growth. Only by cutting the impoverishing inflation, the crazy printing of pesos and reducing taxation and bureaucracy, Argentina would climb to the Top 50 in the aforementioned rankings, quickly approaching Chile and Costa Rica, and shortening the enormous distance with France, the United Kingdom or the Netherlands. This would reduce the country risk to at least region average levels.

A public expenditure that already reaches more than 45% of GDP; and denying the devastating effect of the predatory monetary policy lead Argentina to constant and uninterrupted currency crises, unbridled inflation and to discourage long-term investment and prudent saving. The imprudent use of the national currency as a subterfuge to cover enormous internal imbalances has only led to the fact that, again, it has lost 51% of its value in 2018 and that inflation continues to undermine the country’s potential.

Argentina has all the ingredients to be a global leading economy. But the erroneous monetary policy, the unbridled political spending and the extractive bureaucracy and taxation make the country a promise that always seems to be a disappointment because of internal factors.

Originally published at Dlacalle.com

Daniel Lacalle has a PhD in Economics and is author of Escape from the Central Bank Trap, Life In The Financial Markets and The Energy World Is Flat.Twitter