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Friday, November 25, 2011

In Argentina Subsidy Cuts To Redress Government Spending


In Argentina, Subsidy Cuts To Redress Government Spending

In Argentina, Subsidy Cuts To Redress Government Spending
Workers on an energy tower in Mendoza, Argentina
Summary
Argentine officials have announced that the government will enact a series of subsidy cuts, slated to begin Dec. 1. The move, made in part to curtail the effects of heavy subsidization and government control of financial systems, is made possible by the political capital Argentine President Cristina Fernandez de Kirchner gained in her electoral victory in October. The cuts are necessary if Argentina wants to redress its financial issues and trim spending in the future, but it may cost Fernandez her political capital.
Analysis
Starting Dec. 1, the Argentine government will begin to cut subsidies to natural gas, electricity, water, mining, bank insurances, gambling institutions, airports and telecommunication services by anywhere from 24 to 37 percent. The Argentine government spent around $17 billion in 2010 — roughly 19 percent of the government’s total budget, or about 4 percent of gross domestic product — on subsidies for various sectors. The announced cuts are expected to save the government between $4.2 billion and $6.3 billion in 2012, according to high-level government sources quoted by newspaper La Nacion.
Prior to the Oct. 25 elections, the administration of President Cristina Fernandez de Kirchner increased spending in several areas to help secure popular support for her re-election bid. But the high levels of government spending that have typified the last decade of Argentina’s populist politics have proved unsustainable, and, now that the elections are over, Fernandez has the political capital to redress these policies. Ultimately, the subsidy cuts were based on economic realities, but they will have political consequences — which Fernandez hopes will not come at the expense of the political support she currently enjoys — and will determine whether further fiscal cutbacks will be possible, or desirable, in the future.

Phased Cuts

Originally announced Nov. 2 by Argentine Minister of Economy and Vice President-elect Amado Boudou and Minister of Planning Julio de Vido, the subsidy cuts will occur in multiple phases.
The first cut will apply to natural gas, water and electricity and will begin Dec. 1. Subsidies that cover about 40 percent of the price for these services for businesses will be removed. On Jan. 1, the same subsidy cuts will take effect for households in the wealthier neighborhoods of Buenos Aires, including Barrio Parque and Puerto Madero. The government will then increase prices to the entire city and, eventually, to the rest of the country. While the wealthy neighborhoods will have no choice but to pay higher prices for these utilities, the government will continue subsidizing the bills for poor households that apply for an exception. This phase of subsidy cuts will save the government roughly $832 million.
Transportation subsidies in Buenos Aires are scheduled for removal in March 2012. Prices currently are fixed at 1.10 pesos ($0.26) for subway fare and range from 1.20-1.75 pesos for bus fare; these fares are expected to increase by anywhere from 100 to 300 percent. Buenos Aires’ poor may apply for an exception, which will grant prepaid Universal Electronic Ticket System cards. The details of this phase of subsidies have not been finalized, however, particularly with regard to the subway system, which the central government wants to turn over to city management.
Notably, the decision to enact substantial cuts on consumers is a significant shift in Argentine policy. The decision to remove subsidies is a result of longstanding policies that entailed spending increases based on internal borrowing and high tax rates on industrial and agricultural exports, policies that are proving unsustainable.

A Matter of Politics

In the lead up to the Oct. 25 general elections, Fernandez’s government ramped up its spending in several areas, including pension fund payouts and child welfare payouts. It also allowed greater access to subsidized food supplies. This, as well as an estimated growth rate of 8 percent for 2011, instilled in voters a sense of prosperity that generated enough support for Fernandez to win the first round of elections with ease.
Now that elections are over, the reality in Argentina is that market distortions caused by heavy subsidization and government control of financial systems are beginning to take a serious toll. While Argentina has seen an average growth of 8 percent over the past decade, government spending has grown to five times its 2004 amount. The government has expanded the money in circulation by 30 to 40 percent, and inflation is somewhere between 25 and 30 percent. Both the exchange rate of the peso in relation to the dollar and prices on key consumer goods, including water, natural gas and electricity, have stayed largely stable (though the peso has been gradually devaluing over the past year from 3.97 to 4.26 pesos to the dollar). Strict price controls have harmed productive capacity in these goods, most notably in energy, by limiting profits and discouraging investment. This resulted in Argentina’s becoming a net importer of energy across the board in 2011 after ceasing to be a net natural gas exporter in 2007.
Uncertainty about these policies within the Argentine public, coupled with growing concerns from Argentine economists of a serious slowdown in 2012, has led many Argentines to abandon the peso and invest in the dollar. Reaching an estimated rate of $3 billion per month, the flight to the dollar, as well as fears of a currency crisis, pushed the Fernandez administration to enact numerous exchange controls and to regulate more strictly the repatriation of earnings back to Argentina by mineral extraction companies. In response to the capital flight, the Argentine central bank spent an estimated $2.7 billion in reserves in August and September to control the value of the peso. The fear of political backlash forced the government to wait until after the elections to enact capital controls to help stem the outflow of central bank funds.
Indeed, these decisions ultimately come down to politics. After her decisive electoral win in October, Fernandez has enough political capital to make what would otherwise be risky moves. With the phased elimination of subsidies, the government hopes to limit the impact of higher prices on the lower and middle classes. Notably, she has managed to secure the support of Argentina’s most powerful union, the General Confederation of Labor (CTG). The CTG will support the Fernandez administration as long as the subsidy cuts do not affect its members’ income stability. The Fernandez government will take this into account as it tries to mitigate the impact of these subsidy rollbacks on laborers. Ultimately, there is no real guarantee that Fernandez can keep this level of political support, particularly as the policies begin to take effect.
Inflation in Argentina is already very high, and removing subsidies will lead to an immediate increase in prices. But it is unclear whether the government will allow prices to become more flexible across the board to encourage investment. Without a liberalization of prices, Argentina’s strict price policies will continue to undermine Argentina’s productive capacity. Paradoxically, liberalizing prices will compromise the support of labor organizations like the CTG. In any case, the success or failure of these subsidy cuts will play a key role in determining whether further liberalization will be possible in the future.