Fernandez Faces Tough Choices
As pre-election polls indicated would be the case, President Cristina Fernandez easily secured a second term at elections held on October 23, winning slightly less than 54% of the vote. With the support of lawmakers from the FPV faction of the PJ and officially allied parties, she will begin her new term with majority backing in both legislative chambers. The main question going forward is whether Fernandez intends to use her impressive mandate to finally make the difficult policy choices that will be necessary to ensure macroeconomic stability over the medium term.
Capital flight increased sharply in the period leading up to the elections, contributing to a weakening of the peso. In a bid to stem the outflow of capital and ease pressure on reserves, the government ordered energy and mining companies to repatriate export revenues and tightened restrictions on purchases of US dollars in late October.
The volatility occurred against the backdrop of a significant increase in the budget deficit, which nearly doubled in September, reflecting heavy pre-election spending on wages and public works projects. In early November, the government quite unexpectedly announced the elimination of energy subsidies from profitable businesses.
The move has been interpreted as a signal that Fernandez is prepared to make a course correction in the direction of economic orthodoxy. However, at this point, the government appears to be improvising, and it is too early to tell whether that is indeed the case. In that regard, the lifting (or not) of the cap on electricity tariffs that has been in place for a decade would be a more reliable gauge of Fernandez’s intentions.
No Time for Complacency
Political stability is unlikely to be threatened to any significant degree in the near term, as Prime Minister Hasina Wazed’s Awami League controls a majority of seats on its own, all but ruling out the possibility that divisions within the governing coalition might endanger the survival of the regime before the completion of its term in early 2014. That said, the main opposition BNP is doing what it can to make life difficult for Hasina. In October, opposition leader Begum Khaleda Zia initiated a long-march campaign designed to galvanize support for an anti-government protest movement.
The BNP suffered crushing losses at the 2008 elections, but it cannot be counted out as a contender in 2013 unless the government honors its pledge to reduce poverty. Recent progress toward improved ties with India offers some hope for increased investment from that source, particularly in the area of power production, which is essential to addressing the electricity shortages that are both an obstacle to achieving full economic potential and a source of public discontent that might be exploited by the BNP. However, the Indian government’s deliberate approach to finalizing an agreement for the sharing of water and transportation facilities on the Teesta River and a political controversy over two dams currently being constructed by India on the Barak River point to a risk of a diplomatic setback.
Biya Once More
Despite evidence of spreading popular discontent and signs of tension within the governing RDPC, President Paul Biya easily won a seven-year extension of his mandate at an election held on October 9, taking nearly 78% of the vote. In general, the only real threat to the RDPC’s dominance stems from the possibility that Biya’s term might be cut short by death or incapacitation. The president has made no effort to groom a successor, and his unexpected departure would likely produce a power vacuum, triggering a struggle for control that could splinter the RDPC.
Biya has promised massive investment in roads, electricity supply, and rail, and has proposed an equally ambitious plan to boost direct employment in the agricultural sector from 45,000 to 165,000 by 2014. If the government follows through with these plans, there could be opportunities for foreign companies, although there will also be a risk that the government might fail to secure the funds required to keep its side of the bargain.
A Test of Leadership
Over the last decade, three different presidents have attempted to implement tax reforms, only to see their efforts stymied by the lack of a reliable legislative majority and the ease with which even a tiny bloc of lawmakers can stall bills using procedural maneuvers. However, the elusive objective appears to be with President Laura Chinchilla’s reach.
Under an agreement struck with PAC leader Otton Solis, the government won fast-track authority for a package of tax reforms, which could come to a vote in the Congress in time to implement the changes in January 2012. In return, the PLN has promised to add provisions that would impose new taxes on companies operating in the country’s free trade zones beginning in 2015.
The PAC’s tax proposals have run into heavy opposition from the local business community and pro-business lawmakers in the Congress, including members of the PLN. It is unlikely that the PAC will be persuaded to drop its demand for the controversial taxes, but their inclusion in the final bill could doom the entire package.
Chinchilla’s handling of the tax reform will have significant implications for other key items on her administration’s agenda. Approval of the PAC’s tax proposals over the objections of the ML and the PUSC would undermine the government’s chances of enlisting the support of those parties for reforms of the labor code and the electricity sector, both of which are likely to face strong opposition from the PAC.
Policy Battles Pose Risk of Instability
The September 2011 general election took place amid heightened anxiety over the implications of a spreading debt crisis within the euro zone for European economies in general, and expectations of the need for fiscal tightening in 2012. The left-leaning electoral coalition formed by the SD and the further-left SF focused its campaign on the theme that the incumbent center-right coalition would trim the deficit by weakening the social safety net, a message that resonated with an increasingly insecure electorate.
Although the SD, the SF, and the liberal RV failed to secure a majority of parliamentary seats, SD leader Helle Thorning-Schmidt managed to win confirmation of her government with the backing of the far-left Red-Green Alliance. The divergent views of the coalition partners and their informal allies on key issues, including the best means of reducing the fiscal deficit, will give rise to serious political challenges.
Despite a significant stimulus component in the 2012 budget, the Finance Ministry is forecasting a deficit of slightly more than 5% of GDP. However, with the economy likely to have contracted in the third quarter, the risk of a recession that results in a significantly larger deficit is growing. In that event, pressure for stronger austerity in 2013 would throw the survival of the government into serious doubt.
Fiscal Constraints May Benefit PRD
The 2012 presidential election will pit Danilo Medina Sanchez, the nominee of the incumbent PLD, against Hipolito Mejia, a former president who defeated Medina in 2000. Recent polls show the two men running neck and neck, while President Leonel Fernandez’s approval rating has fallen to a dismal 30%. Medina has sought to distance himself from Fernandez, but is no doubt expecting to benefit from the president’s ability to engage in heavy public spending in advance of the election.
Unfortunately, recent fiscal developments suggest that Fernandez might face some constraints on that front. Failure to hit the deficit target under the country’s standby agreement with the IMF led to a four-month delay in the completion of the most recent review of the government’s performance. The opposition has pointed to the government’s fiscal failures as evidence of the Fernandez administration’s wasteful spending.
Given the limited scope for stimulus spending and a worsening external outlook, annual real GDP growth is forecast to slow to about 4% in 2011, after expanding by 7.8% in 2010. The slowdown will help to ease demand pressures, but high commodity prices will prevent a significant near-term fall in the inflation rate, which is forecast to average 8.3% in 2011.
Risks Will Persist
Political tension is rising amid preparations for legislative elections set for December 29, but given the uncertain prospects for President Alpha Conde’s RPG, the opposition is likely to participate in the elections, even under rules deemed to be unfairly skewed to the advantage of Conde’s allies, rather than opting for a boycott. Consequently, the outlook for political stability remains as uncertain as before Conde’s election.
The recent adoption of a new mining code was definitely a well-timed policy success for Conde. Key provisions raise the ceiling on the state’s stake in future joint ventures from 15% to 35%, establishment a minimum investment of $1 billion, and increase customs duties from 5.6% to 8% for all companies operating in the sector. Existing operations will also be subject to revised tax rules, as well as requirements related to transparency and social responsibility.
Although politically popular, the changes to the mining rules come at an inauspicious stage of the commodity cycle, as global prices of aluminum have been in steady decline since April. A lack of clarity in some areas — particularly with regard to the state’s right to increase the public stake in mining operations — creates the potential for a certain degree of flexibility in negotiating the terms of new contracts, but given the very uncertain political outlook, the risk of discriminatory application of the rules is likely to figure more prominently in the decisions of investors.
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