Subsidy Reform: A Symbolic Move To Address Economic Imbalances
BMI View: Argentina's decision to cut subsidies for domestic gas and water by an average of 20% aligns with our view that the country is gradually undertaking steps to rein in its fiscal deficit and strengthen its precarious balance of payments (BoP) position. While these latest measures will only save a relatively small US$1.6bn, we emphasise that the move has considerable symbolic importance. It aligns with a number of positive economic developments that indicate the government is growing more serious about tackling Argentina's deficits. It also generates momentum behind longer-term plans to halve electricity and natural gas subsidies that account for as much as 5% of GDP.
Although we believe the risks to our broader macroeconomic outlook for Argentina are weighted to the downside, BMI's Country Risk team has been encouraged by President Cristina Fernandez de Kirchner's much-needed attempts to address mounting economic imbalances ( see 'Rally Sustainable On Improving Policy Trajectory', March 20 2014). While Kirchner's hand has been forced by the devaluation of the Argentine peso in January 2014 and the subsequent collapse in consumer and investor sentiment, reform has long been needed - with cuts to energy subsidies now in the spotlight.
|Financial Account: A Key Swing Factor For Reserves Position|
|Argentina - Current & Financial Accounts, US$bn & Foreign Currency Reserves, % chg y-o-y|
In this context, the government has announced that it will cut subsidies for gas and water by around 20%, and ultimately halve spending on subsidies such as electricity and natural gas that account for around 5% of GDP. If such reform can be delivered without further stoking high inflation, we note that cutting subsidies for consumers could make investment in domestic gas production more attractive and help curb fuel imports - narrowing the current account deficit. Equally, longer-term reform of electricity subsidies might have a similar impact, drawing much-needed investment into Argentina's power sector.
To start by looking at the country's broader economic position, there have been a series of positive economic developments in Argentina over the first few months of 2014, which create upside to Argentine equities and fixed income. The adoption of more moderate economic policies and efforts to improve relations with the international financial community - part of an effort to gain proper access to global financial markets - have been bolstered by the introduction of a more credible consumer price index after the old one was sullied by allegations of government manipulation ( see 'New Inflation Index A Crucial First Step To Improving Confidence', February 14). There have also been positive revisions to 2013 GDP estimates, as well as a resolution to the dispute with Spanish oil major Repsol following the Argentine government's 2012 expropriation of YPF.
Furthermore, the improved outlook is reflected at an industry level. To this end, we view the government's recent move to reform subsidies as an attempt to improve the country's fiscal position. Argentina posted its largest primary budget deficit for more than 20 years in 2013 and its widest current account deficit since 2000 - with energy imports and debt repayments draining reserves.
Although there is likely to be some public resistance to price rises, we have long believed such reform would be necessary to encourage investment into Argentina's potentially lucrative oil and gas sector - with low rates all the way along the domestic gas production and delivery chain stymieing production potential. To put the issue in context, despite the Energy Information Administration (EIA) indicating Argentina may hold the world's second largest shale gas reserves, there has been a steady decline in gas production in recent years. This has underscored the need for such reform and the introduction of more attractive financial incentives, and has also widened Argentina's current account deficit on account of reliance on greater volumes of imported gas in the face of growing demand.
|Huge Resource Potential|
|Top 10 Countries With the Highest Technically Recoverable Shale Gas, tcm|
As such, if the country is to realise its below-ground potential the government was ultimately going to have to cut subsidies and allow the cost of production to be passed along the gas production and supply chain and ultimately onto consumers - something it is now attempting. To this end, the move to cut gas subsidies for bill payers aligns with the government's revision of wellhead natural gas prices, which were increased from USD5 per mn British Thermal Units (mnBTU) to USD7.50/mnBTU in a bid to further incentivise production. This move, along a deal between Chevron and YPF that will allow the US super-major to begin exploration in the highly-promising Vaca Muerta shale formation, all supports our view that the outlook in the oil and gas sector is improving gradually ( see 'Reforms Bolster Long-Term Growth Prospects', March 27 2014).
Similarly, although no details have been released concerning potential revisions to electricity subsidies, a reduction in such subsidies would allow companies to pass on greater costs to consumers and invest in much-needed new capacity and grid infrastructure. With Argentina's population currently paying some of South America's lowest rates for household gas, electricity and water, utilities' margins are under pressure and this has curtailed investment; highlighted by the blackouts in Buenos Aires at the beginning of 2014 ( see 'Blackout Sparking Power Grid Investment', January 22 2014).
Symbolic But Politically Sensitive
That said, at this stage, while our analysis of this development is broadly positive from an economic perspective, we reiterate that the reforms are limited in scope and will likely prove unpopular in an election year.
We highlight that, over the longer-term, any significant enhancement of the gas or power sector will depend on the delivery of substantial reform - something that may provoke a public outcry. In this regard, the country started subsidising electricity and natural gas in 2002 to help bolster the economy following the collapse of the economy in 2001; however, as the economy recovered, it has proved very difficult to rein in because of fears over the political backlash.
In terms of actual delivery on the ground, the government has sold the move to cut gas and water subsidies to the Argentine people on the basis that any government savings will be channelled into greater social spending. Furthermore, economically important industries, but also the disabled and those who are welfare dependent will be exempt, while middle class and wealthy families will shoulder the biggest burden. According to a government presentation distributed by the planning ministry (cited by Reuters), gas bills may rise as much as 161% for the biggest consumers and water bills may rise 306%.
|Expenditure To Rise Faster Than Revenue, Widening Shortfall|
|Argentina - Primary Budget Balance, ARSmn (12-Month Rolling, LHS) & Revenue and Expenditure, % chg y-o-y (3-Month MA, RHS)|
As a consequence, many consumers will be paying higher utility bills, and we highlight that Argentina must balance subsidy reform with the impact of inflation, which has already been boosted by the devaluation in January and increased by around 30% year-on-year (y-o-y) in 2013. This will be a difficult balance to strike and may make it more difficult as the government negotiates with Argentina's dominant unions during annual wage negotiations. At the time of writing, school teachers in Buenos Aires are on strike, having demanded a 35% increase in salaries.