Argentina Economic and Financial Weekly for

UNCLAS BUENOS AIRES 000459

SIPDIS

SIPDIS

PASS FED BOARD OF GOVERNORS FOR PATRICE ROBITAILLE
TREASURY FOR DAS LEE, RAMIN TOLOUI AND CHRIS KUSHLIS
NSC FOR SUE CRONIN
AND OCC FOR CARLOS HERNANDEZ
USDOC FOR ALEXANDER PEACHER
USDOL FOR ILAB PAULA CHURCH AND ROBERT WHOLEY
USSOUTHCOM FOR POLAD
OPIC FOR GEORGE SCHULTZ AND RUTH ANN NICASTRI

E.O. 12958: N/A
TAGS: EFIN ECON ELAB ALOW AR
SUBJECT: Argentina Economic and Financial Weekly for
the week ending February 24, 2006


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Weekly Highlights
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- The peso was unchanged against the USD, closing
again at 3.08 ARP/USD.
- IADB postpones a USD 500 million loan approval for
Argentina.
- U.S. Judge rules in favor of two holdout hedge
funds.
- Congress approves a bill reforming the Magistrate's
Council.
- GOA runs an ARP 1.6 billion primary fiscal surplus
in January - lower than expected.
- Private investment increased 30 percent in 2005.
- Commentary of the Week: "The New Inflation
Scenario"

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MARKETS
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The peso was unchanged against the USD this week,
closing again at 3.08 ARP/USD.
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1. The peso remained flat versus the USD this week,
closing at 3.08 ARP/USD. Earlier in the week, the
peso depreciated one cent to 3.09 ARP/USD after the
Central Bank (BCRA) purchased USD 92 million in the FX
market on February 21. The BCRA then kept up its
active intervention by purchasing a total of USD 175
million and EUR 21 million which were neutralized by
increased exporters' sales as well as inflows to
purchase domestic bonds. That allowed the peso to
recover its lost cent and close the week at 3.08
ARP/USD -- unchanged from last Friday's close. BCRA
daily purchases of FX averaged USD 44 million in
February, bringing the accumulated purchases to USD
1.5 billion since the beginning of the year. BCRA
reserves stand at USD 21.3 billion, as of February 21.
The peso exchange rate has depreciated 1 percent since
the beginning of the calendar year.

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ECONOMY / FINANCE
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IADB postpones a USD 500 million loan approval for
Argentina.
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2. On February 22, the Inter-American Development
Bank (IADB) board decided to postpone until March 1
discussions on a USD 500 million loan approval for
Argentina. Many IADB representatives asked for more
time and details about the specific purpose of the
adjustment loan. The GOA expects the IADB will
eventually approve the loan. If approved, this loan
would be the first adjustment loan received by the GOA
without the umbrella of an IMF program. Meanwhile,
the World Bank (WB) maintains on hold loans to the GOA
for USD 875 million.

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U.S. Judge rules in favor of two holdout hedge funds.
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3. Judge Thomas Griesa of the Federal Court for the
Southern District of New York ruled in favor of two
hedge funds controlled by Greylock Capital. The hedge
funds sued the GOA to recover USD 227 million of
principal and past-due-interest. In spite of the
ruling for the holdouts, it will be difficult to
enforce as the GOA has no sovereign assets to be
seized.


4. Separately, a German Court rejected the GOA
argument of financial instability and allowed two
holdout investors to continue with their claims. This
decision could pave the way for further claims for EUR
1.5 billion, according to press reports.

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GOA considering issuing USD 500 million in
international markets.
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5. On February 23, business newspaper El Cronista
Comercial reported that the GOA is considering tapping
international markets as early as mid-March for USD
500 million. The GOA will seek an additional USD 500
million at a later date, depending on market
conditions. The new instrument would reportedly be a
USD denominated bond issued under U.S. or U.K.
legislation, becoming the first issuance under non-
domestic law after the debt restructuring. However,
this transaction could run the risk of attachment due
to the suits pursued by holdout investors. GOA
financial needs for 2006 are limited - as low as US
1.5 billion according to some financial analysts.

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Congress approves a bill reforming the Magistrate's
Council.
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6. On February 22, the Chamber of Deputies approved -
- after a nine-hour debate -- a bill to reform the
Magistrate's Council. The bill was approved by a vote
of 148 to 89. The controversial reform reduced from
20 to 13 the members of members of the Council that is
responsible for appointing and removing judges.
Before the reform, the Council consisted of eight
legislators (four senators and four deputies),11
legal experts, and one representative of the executive
branch. With the reform, the Council will now consist
of six congressmen, six legal experts and one
representative of the executive. The Senate had
already approved the bill at the end of 2005. Critics
of the bill argue that the reform shifts the balance
of power in the judicial system in favor of the
government, casting doubts on the independence of the
judicial system. The approval of this bill --
introduced by Senator Cristina Fernandez de Kirchner,
the President's wife -- is viewed as a political
victory for President Kirchner and shows that the
President is gaining support in the lower Chamber
where the administration does not enjoy a majority of
seats.

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BCRA accepts bids for a record high of ARP 2.2
billion.
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7. The BCRA received bids of ARP 2.4 billion in its
February 21 Lebac auction, well above the ARP 1.3
billion in Lebacs that came due during the week. As
in the last three auctions, the BCRA was more than
able to roll over its maturities by accepting bids for
ARP 2.2 billion. The yield on the 42-day Lebac
decreased from 6.80% to 6.79%. The yield on the 77-
day Lebac dropped 10 basis points to 7.0%. Lebacs for
other maturities were withdrawn due to lack of
interest. Investors concentrated more than 55% of
their bids in Nobacs of more than 9 months and the
BCRA accepted bids for ARP 1.2 billion of Nobacs (54%
of the accepted amount in the auction). The yield on
the nine month Nobac and the two year Nobac remained
unchanged at 3.13% and 5.57%, respectively. As in the
previous auction, investors are showing interest in
Nobacs, since these instruments have a variable rate
and provide a higher yield and protection than Lebacs,
which have a fixed rate and are no longer issued with

CER (CPI-linked index) adjustment. This shift from
Lebacs to Nobacs allows the BCRA to extend the
maturity of its liabilities as Nobacs are longer term
instruments compared to Lebacs, which were recently
issued at very short-terms due to the BCRA's rejection
of higher interest rates.

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Bank profits totaled ARP 1.9 billion in 2005.
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8. According to a BCRA report, the financial system
posted profits of ARP 232 million in December,
bringing its accumulated profits to ARP 1.9 billion
for 2005. Public bank profits totaled ARP 129 million
while private bank profits reached ARP 93 million in
December, bringing accumulated profits to ARP 1
billion and ARP 810 million during 2005, respectively.
The profits came mainly from interest income due to
credit expansion, which demonstrates that the
financial system is returning to it core activity.
Loans to the private sector increased 37 percent to
ARP 46.3 billion in 2005 (compared to a 26 percent
increase in 2004).

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GOA runs an ARP 1.6 billion primary fiscal surplus in
January - lower than expected.
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9. The GOA announced a primary fiscal surplus of ARP
1.6 billion in January, below market expectations of
ARP 1.9 billion. In January, fiscal resources
increased 30.7 percent y-o-y, at a lower rate than
expenditures, which rose 37.1 percent y-o-y. A GOA
official argued that the higher growth rate of
expenditures is due to stronger investment
expenditure. The primary fiscal surplus decreased 2
percent y-o-y. The BCRA consensus forecasts an ARP
22.6 billion primary fiscal surplus for 2006.


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GOA studying increasing the minimum threshold for the
income tax.
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10. The GOA is studying increasing the minimum
threshold for the income tax from ARP 1,835 to ARP
2,400 per month for single employees, and from ARP
2,235 to ARP 3,000 per month for married employees,
beginning in April. Taxes are paid on income earned
that is above this minimum threshold. According to
official estimates, this measure will have an annual
fiscal cost of ARP 530 million. Additionally, the GOA
stated that will introduce changes to the deductions
allowed to compute the income tax, so as to extend the
benefits to a larger number of tax payers. However,
this move requires Congressional approval since the
GOA is not allowed to change the income tax law by an
ordinary decree. The GOA is also considering
increasing the maximum amount exempt from the assets
tax, which has not been revised since the 2001
devaluation in spite of CPI and nominal wage increases
since December 2001.

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Private investment increased 30 percent in 2005.
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11. According to an INDEC report, total private
investments -- Capital Formation and Mergers and
Acquisitions - increased 30% y-o-y to USD 14.1 billion
in 2005, showing a 368% increase from the 2002 level.
Mergers and Acquisitions totaled USD 4.7 billion,
while Capital Formation investments reached USD 9.4
billion (67% of the total). The highest investment
level was reached in the infrastructure sector,
followed by the manufacturing industry and the mining

sector. Foreign investments were mainly concentrated
in the manufacturing industry and mining sectors.

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January industrial production index up 4.7 percent y-o-
y.
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12. The industrial production index increased 4.7
percent y-o-y in January, below the BCRA consensus of
7.8 percent. During January, the fastest-growing
sectors were tobacco production (up 13 percent),
minerals (up 11.7 percent),and plastic and rubber (up
10.9 percent),which were partially offset by a sharp
decrease in car-production (down 42.9 percent). The
index decreased 6.4 percent m-o-m non-seasonally
adjusted. The disappointing result is mainly
explained by the low performance in the automobile
industry affected by plant retooling. The BCRA
consensus survey forecasts 6.4 percent industrial
production growth for 2006.


13. The industry-wide capacity utilization index
reached 64.9 percent in January, compared to 66.1
percent in January 2005. The sectors showing the
highest capacity utilization were oil refining (92.7
percent),metal based industries (84 percent),and
paper and cardboard (76.9 percent). The sectors with
the lowest capacity utilization were auto production
(18 percent),metal-mechanical excluding cars (52.8
percent),and non-metallic minerals (55.7 percent).

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Commentary of the Week: "The New Inflation Scenario"
By Manuel Mora y Araujo. [Note: Translated and used
with permission of the author, from an article
published February 7 in La Cronista Comercial. End
Note.]
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14. Current inflation is higher than had been
expected one or two years ago. The society's
inflation tolerance, however, has been better than
expected. The correlation between monthly variation
in prices and the variation in government approval
ratings has practically disappeared. This correlation
had been nearly perfect for the last 15 years.


15. The reason for the higher inflation is clear: a
combination of high growth in the economy, strong
internal and external demand, post-crisis realignment
of prices, a less tight monetary policy than orthodox
policy might suggest and, last but not least, possible
collusion or price fixing by companies. Insofar as
the majority of analysts stress the first factors
mentioned, the government stresses the last one. The
government justifies its policy of price agreements in
response to private sector collusion, plus the need to
manage inflation expectations.


16. The reason for society's inflation tolerance,
however, is less clear. There are two hypotheses.
First, Argentines' memory of inflation is always the
1970's, which ended with the hyperinflation of the end
of the 1980's. The end result of that period was
stagflation which later affected most of the world.
In Argentina, stagflation hit with uncommon force and
was probably less tolerable as a result of the stalled-
economy component than because of the inflationary
component (which is why countries experiencing
economic growth where able to tolerate inflation much
better). In contrast, the current inflation is
accompanied by high rates of growth and a previously
unheard-of fiscal surplus and has yet to reach
dangerous levels. A majority of the population,
moreover, believes the inflation will not reach these
levels.


17. Second, the current inflation has had a distinct
impact on different sectors of society. The majority
of formal workers in the private sector during the
past three years have had income increases that have
exceeded the rise of prices. Although there has not
been an increase of subsidies for those in the lowest
income brackets, many have found employment that, on
average, substantially improves their incomes. In
contrast, the middle class, employed in the public or
informal sector, is the most affected by rising
inflation. The central government's efforts, and
practically all of its public communications, are
directed to these two sectors to reinforce their trust
among the poor and the middle class that the
government is working daily to protect them. As long
as the economy keeps growing, private incomes keep
rising, and trust in the government does not waver,
there is no reason to expect that the situation will
change or that the government will change its message.


18. For the government it is clear that the objective
is not to have the lowest possible inflation but
rather inflation compatible with high rates of growth.


19. Abroad, particularly in the business community,
attention is focused primarily on the government's
approach to managing a problem before it becomes a
problem itself, because that shows how the government
will approach future problems. This approach is
perceived to be unorthodox and causes concerns; the
government's communication effort to generate
favorable expectations is insufficient on the
inflation front. All indications are, however, that
the Government of Argentina is little affected by the
business community's concern. The GOA trusts that
investment rates will continue to be relatively high
and has confidence in the robustness of its fiscal
surplus policy.


20. It may be taken for granted that high-risk
investors who are prepared to operate in competitive
unregulated markets will think little of Argentina, no
matter what the current government does (without a
doubt, that is one reason for the chronically low
competitiveness of our economy). Meanwhile, investors
that are looking for opportunities in secure niches or
in areas with regulated businesses, with high profit
and low risk, are driven more by their capacity to
lobby (both the Argentine government and their own
government, whose support they expect in order to be
able to operate in Argentina) than by the
uncertainties of the country. For the most part, the
Argentine government is not worried about investment
flows.


21. If the government does not have a low inflation
goal, where does it put a limit on what is acceptable?
Presumably, it will happen when inflation is on the
verge of being uncontrollable or when it becomes
intolerable for society and, thus, turns into a
political problem.


22. In conclusion, Argentina will probably spend the
year in the present situation of high growth
accompanied by high inflation. This scenario ensures
political stability as long as the scenario
experiences no significant changes in either of its
two elements: high growth must continue, the rate of
inflation should not rise. If this scenario were to
change for the worse, the consequences would be
significant: government policy would have to change or
the political climate would have to change. It is
unlikely, however, that this latter variant will
occur. [Note: We reproduce selected articles by local
experts for the benefit of our readers. The opinions
expressed are those of the authors, not of the
Embassy. End Note.]


GUTIERREZ