Milei’s "shock therapy" faces an uphill battle in Argentina

The economic “shock therapy” prescribed by Javier Milei, the new libertarian president of Argentina, reflects the free market and fiscal discipline convictions of the president and his clear understanding of the small window of opportunity he has to implement the policies needed to stabilize and transform the country. His strategy is full of economic and political risks, but it seems to offer the maximum chances of success given the constraints he faces.

Milei took office on December 10 in the wake of an economic crisis and economic mismanagement by his predecessor, Alberto Fernández. Annual inflation in 2023 was higher than 200 percent, the second highest inflation in the world, and will likely continue moving upward for several months. GDP per capita is below the 2008 level, and Argentina’s poverty rate is the highest since 2002. Its economy has been shut out of international capital markets for more than for four years amid extreme controls on the balance of payments, a multiplicity of exchange rates, and a very high primary fiscal deficit financed by central bank credit. As Milei said in his inaugural speech, things will get worse before they get better (see my PIIE colleague Monica de Bolle’s blog posts for additional analysis on Argentina).

Initial steps to stabilize the economy: Achieving a balance budget, normalizing key relative prices, and ending central bank financing to the government

After Milei took office, the finance minister announced a fiscal adjustment of 5 percent of GDP to reach a balanced budget by the end of 2024 and a 100 percent devaluation of the official currency, after which it will be depreciated monthly by 2 percent. He also adjusted several public sector and regulated prices after long delays dictated by electoral politics and ended central bank financing to the federal government.[1]

These steps reflect the view shared by most economic analysts that fiscal dominance is at the core of the inflation problem in Argentina. Inflation is also influenced by backward-looking dynamics in wage adjustments and inflation expectations. The initial phase of the adjustment program is generating a burst of higher prices as the adjustments in regulated prices and currency devaluation feed into the consumer price index (CPI). A deep recession will also take place as the fiscal consolidation kicks in and as the decline in household income depresses consumption and uncertainty weighs on investment.

There are only a few international precedents of fiscal adjustments of this size, which highlights the high-risk nature of the plan and its substantial costs burdening different segments of society. The composition of the fiscal adjustment balances the medium-term need to reduce government expenditure with the urgent need to complement this effort with an important revenue component to increase the probability of achieving a balanced budget. In the design of the fiscal program it was important to minimize the fraction of the adjustment that needs congressional approval.[2] But the proposed adjustment still relies too heavily on inflation to reduce the real value of entitlements. The impending recession, the exchange rate correction, the fiscal contraction, and a good harvest should help to produce an important current account surplus, which together with official financing from multilateral institutions should help address Argentina’s foreign currency obligations and accumulate international reserves.

These macroeconomic measures were followed by aggressive proposals to deregulate and open the economy

These initial measures were followed by an emergency presidential decree to deregulate the economy, including important changes to the country’s labor laws, privatization of the remaining state-owned enterprises (SOEs), and weakening the political power of unions. This decree was followed by a legislative proposal sent to Congress to reform pensions and taxes, along with a battery of structural reforms.

The presidential decree is already in effect, although it can be blocked by Congress or challenged in the courts. The legislation will be discussed and eventually approved or rejected by Congress. These measures, if enacted, should guarantee that important components of the fiscal adjustment will become permanent and that productivity will increase. This ambitious stabilization and reform package had a positive market response as sovereign risk dropped, the exchange rate gap sharply narrowed, and asset prices increased more than they have in years. However, the still quasi-distressed level for asset prices indicates that, although Argentina is off to a better start than many expected, the government still faces a low probability of success.

A second phase of the stabilization strategy will need to be unveiled soon

Following this period of upfront adjustment in fiscal policy, the exchange rate, and prices, inflation should begin to fall by the end of the first quarter of 2024, when the authorities would be well advised to announce the second stage of the stabilization effort. In this stage, the government must propose a new set of rules for the exchange rate (given that the 2 percent rate of crawl will not be credible), official prices movements, and some income policies to coordinate wage adjustments. The objective of this second stage would be to help the inflation stabilization process, anchored by the fiscal effort and a preannounced rate of crawl for the exchange rate, achieving a faster disinflation with a lower sacrifice ratio.

An important question is whether a new jump in the exchange rate and in regulated prices will be needed before moving both to what should be a more sustainable and realistic rate of crawl. Another relevant question relates to when the central bank should unify the exchange rate and completely free up the balance of payments. In my opinion, unifying the exchange rate and liberalizing the balance of payments should wait until inflation is in the low teens and Argentina has a substantially larger level of international reserves. With a liberalized capital account, high inflation, and a low level of international reserves, the demand for domestic assets will be highly volatile, leading to very high exchange rate volatility, which Argentina has not tolerated in the past. In addition, it seems that the best monetary policy instrument that Argentina can use, once this second stage of the stabilization program is in place, will be the rate of crawl of the official exchange rate, which—together with announced movements of public sector price adjustments—will be the anchor to build its incomes policies to coordinate private sector price and wage adjustments.

In the next few months, and especially after a second stage of the stabilization plan is announced, the following results should start to materialize.

1. The delivery of the strong fiscal adjustment, including a guarantee that the permanent and non-inflation dependent components of the adjustment are approved by Congress as quickly as possible.
2. An important reduction in monthly rates of inflation by the second and third quarters of the year, which opens the door to expect annualized inflation for the last quarter of 2024 of around 50 percent.
3. A recovery of economic activity in the second half of the year.

Fast delivery on these dimensions will be key to sustaining political support for this program. Although Milei’s second round vote of 55 percent of the electorate was impressive, and there is strong popular support for his approach to stabilization and reform, it is logical to think that his approval rating will drop. Political support in Latin American countries where an election was decided in a second round typically shifts back to first round vote percentages relatively soon after the election. Milei’s party’s representation in Congress is small (37 out of 257 representatives in the lower house and 7 out of 72 in the Senate), and he has no representation at the provincial level. If his approval rating drops, different groups suffering under the adjustment and reforms, such as pensioners, workers, and recipients of social programs, will mobilize and press for compensation. The political parties will then distance themselves from Milei’s program, undermining the program’s credibility, increasing financial instability and potentially leading to a collapse of the demand for local assets.

Possible scenarios for second half of 2024 and 2025

What are the possible scenarios for the second half of 2024 and 2025? Milei’s campaign pledge to “dollarize” Argentina’s currency has been put on hold. But is dollarization still possible?

1. Goldilocks scenario: Inflation drops sharply in the second quarter of 2024 and returns to moderate levels (a range between 15 and 30 percent as defined by Dornbusch and Fischer[3]) by the end of 2024 or the first half of 2025. In this case, the stabilization strategy continues with the objective of achieving single-digit levels in 2026 supported by an appreciation of the currency and a relatively strong re-monetization process.
2. Middle of the road scenario: The full scale program discussed above succeeds in correcting relative prices, generating positive economic growth territory but with inflation still finishing the year at very high levels. This scenario points to a long stabilization process that can take more than four years, as has been documented by the IMF for Chile, Colombia, and Mexico.[4]
3. Collapse and hyperinflation: If the fiscal adjustment gives way to social unrest, or inflation does not drop (and the adjustment in relative prices is not accomplished), successive rounds of exchange rate and price adjustments will take place leading to even higher levels of inflation, a collapse of the demand for money, and lower fiscal revenues. In this scenario inflation will drift towards hyperinflation levels.

If the first scenario materializes, a low probability event, it will make total sense for Milei to follow the path travelled by the large Latin American economies that have achieved low inflation and managed a flexible exchange rate regime by converging to an inflation targeting regime. More likely, Argentina will end up in either scenario 2 or 3. In the second scenario, dollarization will be a very tempting proposition (versus a protracted disinflation under a soft inflation targeting framework), especially if a good harvest gives the central bank the ability to rebuild its international reserves and high inflation liquifies the government and central bank liabilities. The goal would be for Milei’s government to dollarize and leapfrog to single-digit inflation very quickly. It would also make strong political sense for Milei, since the country will have mid-term elections in October 2025. If the economy goes into hyperinflation, the third scenario, the most likely outcome would be dollarization.

The reformist zeal of the Milei administration, including its intention to front load the adjustment and reforms and its geopolitical alignment to the G7, makes it highly likely that the IMF program signed in 2022 with the previous government that is now off track will be quickly brought back to life. The financial support provided in the earlier program might also be increased to avoid the net positive payments[5] that Argentina must make to the IMF. This adjustment might even provide for some positive net disbursements of resources to the country in 2024. Small upward adjustments to the lending programs by the Inter-American Development Bank (IADB) and World Bank might also occur.

Argentina now has a president with a very strong commitment to deliver the kind of economic reforms and stabilization policies that the country needs. However, because Milei is a total outsider to Argentinean politics and his political capital is under construction, the old political class will be waiting in the wings to deal a deadly blow to this bold attempt at stabilization, reform, and modernization.

Notes

1. This program is very similar to the International Monetary Fund (IMF) 2018 program that had as its main targets a balance primary budget and a zero-base money growth target. The key differences are that at that time the capital account was fully open, and therefore the zero-base money growth target was complemented with an intervention rule in the foreign exchange market, whereas the current program has very tight capital controls.

2. Only one third of the total fiscal adjustment requires congressional approval, and the revenue component is 2.2 percent of GDP.

3. Moderate Inflation. Rudiger Dornbusch and Stanley Fischer. The World Bank Economic Review, Vol. 7, No. 1 (Jan. 1993), pp. 1-44.

4. IMF Country Report No 16/346. Argentina Staff Report. November 2016.

5. The net positive payment is the difference between payments by Argentina to the IMF and new disbursements by the IMF to Argentina.