Consulado y Centro de Promocion Argentino en Shanghai

ARGENTINA ECONOMIC OVERVIEW N?27
(June 2004)

FIRST QUARTER BALANCE AND ENERGY CRISIS

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* The economy again showed strong dynamism during the first quarter of the current year (+10% y-o-y).

* However, economic activity showed some signs of slowing down in April.

* The slower pace of growth may be partly due to the fact that the high rates of the first quarter are difficult to sustain over time and also to the energy crisis.

* The main causes of this crisis are the distortion of relative prices of fuel, the strong drop in hydroelectric energy generation and restrictions on transport capacity in some gas pipelines.

* In this context, energy problems threaten to take away at least one point from the 7.5% y-o-y growth rate originally expected for this year.

* The government has therefore taken a number of measures aimed at restricting gas demand, increasing fuel offer in the short term, and expanding production and transport capacity in the medium term.

* Nevertheless, the good performance of Argentina's economy in 2003 and in the first quarter of 2004 points to high growth for this year, at least 6 %.
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STRONG ECONOMIC GROWTH IN FIRST QUARTER... SLOWDOWN IN SECOND?

During the first quarter of this year, the economy continued showing strong growth with low inflation rates, good fiscal performance and employment recovery. The economy grew by approximately 10% y-o-y during the first three months of this year, so it is already 7.6% below the peak reached during the second quarter of 1998 (after falling 21% below that percentage at the height of the crisis). In general, all activities, contributed to the good performance of the economy on a y-o-y basis: construction grew 34%, utilities 19%, supermarket sales 9.5% and industry 14% (particularly, the automobile industry, publishing and printing products, and agrochemicals). In this expansionary context, private employment in large cities grew 7% y-o-y during the first three months of this year.

Inflation increased 2% during the first four months of this year. Nevertheless, it is expected that the inflation rate of this year will be higher than last year's rate (8% vs. 4% y-o-y), owing to a certain increase in public and private sector wages, to the increase in some utility rates (particularly gas and electricity) and the significant increase in commodity prices during the last period of 2003 and the beginning of 2004.

On the fiscal front, economic growth and improved tax administration continued to translate into higher revenues (+29% in real terms during the first four months of this year). Therefore, primary results of the National public sector reached ARS 5.6 billion during the period January-April, more than doubling the result of the same period of 2003 and meeting the first semester fiscal target.

Since April, however, the impressive growth rate shown by the economy during the first months of this year seems to have slowed down. Specifically, during April, industrial activity fell 3.9% in deseasonalized terms compared to March (+9.4% y-o-y), whereas construction dropped 4.9% in deseasonalized terms compared to the previous month (+16.2% y-o-y). This slowdown may partly be explained by the high growth rates of the last quarter of 2003 and the first quarter of the current year, which could hardly be sustainable in the long term, and suggests a slowdown of activity for the rest of the year, but also due to the energy crisis.

The energy sector problems may potentially cool down economic performance, through natural gas service interruptions, or through the replacement with more expensive fuels or the impact of gas shortage in electricity supply. This problem particularly seems to threaten the industrial sector: iron and steel plants, the food industry (mostly the oil industry), petrochemicals, construction materials (concrete, ceramics and glass), chemistry and cellulose and paper production are the largest consumers of natural gas.

HOW DID THE ENERGY CRISIS ARISE?

A combination of factors explains the difficulties which the energy sector is undergoing, mainly focused on the natural gas sector, and strongly related to the electricity sector.

On the demand side, household consumption of natural gas began to accelerate in August 2003, increasing 29% y-o-y during the last five months of 2003 and 24% during the first quarter of 2004. This dynamism has not been the case in any other period since Gas del Estado was privatized in 1993. The highest expansion rates during the first months of 2004 were among the largest gas consumers, such as the industrial sector (+19% y-o-y), CNG (+24% y-o-y) and thermoelectric plants (+40% y-o-y), whereas household consumption of natural gas has practically stagnated (+1% y-o-y). Furthermore, in March of this year, the domestic gas consumption level was similar to that of the coldest months of previous years, such as May 2002 and August 2001, which heralds more problems in the winter months when the seasonal demand of the residential segment increases due to the low temperatures.

Not only did domestic demand increase, so did natural gas exports, 90% of which go to Chile, and which showed significant dynamism, with a 16% increase in 2003 and a 27% y-o-y increment during first quarter of 2004 (before exports restrictions were introduced).

The reason for the high growth rate of natural gas demand is not only the result of improved economic activity. The decrease in the price of natural gas compared to substitute fuels and the remarkable reduction in electricity generation by hydroelectric plants also accounted for higher gas consumption levels.

In this regard, there was a significant distortion in relative prices of fuel after the collapse of the Convertibility system. As natural gas prices were pesoized at a one-to-one Argentine peso/US dollar rate and remained virtually frozen, other fuel prices were influenced by local currency depreciation and also by international oil price fluctuations. Consequently, there were increases in excess of 100% in prices of natural gas substitute fuels between 2001 and 2004 (gas oil: +150%, fuel oil: +300%, kerosene and bottled gas: +140%). Accordingly, new relative prices meant that alternative fuel expenditure in the industrial sector was between 2 and 4 times higher (according to whether gas oil or fuel oil) than natural gas; in the residential sector, the ratio was between 4 and 6 (depending on whether kerosene or bottled gas) and for automobiles substitute fuel expenditure was between 3 and 4 times higher (according to whether gas oil or gasoline) compared to CNG (compressed natural gas).

To the changes in relative prices was added the situation of the electricity generation sector since almost half of domestic gas consumption growth during the first quarter of this year is due to the higher gas demand of power plants. Low rainfall levels led to a sharp drop in the energy offer made by hydroelectric plants (which account for 50% of electricity generation), -39% y-o-y during the last four months of 2003 and -29% during the first quarter of 2004, which was offset by higher production at power stations and, to a lesser extent, at nuclear plants.

As regards the supply side, aside from the debate as to whether companies made investments or not to improve gas production and transport capacity in the late 90s, natural gas production increased 11% in 2003 and 18% in the first two months of 2004. Although this was not enough to cover the significantly higher demand, as evidenced by gas cuts to companies with interruptible supply (by paying a lower rate than that of a firm supply contract, but also subject to energy cuts if there is a gas shortage), and also by difficulties in the renewal of firm contracts whose terms have expired within recent weeks.

Notwithstanding the response capacity of natural gas producer companies to supply the demand, there are also restrictions in the transport sector due to the intensive use of some gas pipelines, which may be overloaded during the winter season. In the first two months of 2004, gas pipeline utilization capacity increased 25% y-o-y, reaching 85% in February, a level similar to that of the coldest months of other years, such as May 2003 and August 2001 and 2002.

GOVERNMENT MEASURES TO REDUCE THE IMPACT OF THE CRISIS ON THE ECONOMY

In this context, the government reacted with a number of measures in the short and medium term in order to avoid gas cuts in the residential sector and in industrial and thermal plants:

- RESTRICTION ON NATURAL GAS EXPORTS: Law 24,076, which defines the regulatory framework for the sector, establishes that the authorization to export is subject to the priority of ensuring the domestic market supply. In this regard, the natural gas exports rationalization program created by the Energy Secretariat at the end of March established a temporary restriction schedule in respect of external sales, which will be applied if natural gas injection is lower than the domestic demand of certain users (residential, industrial users with firm contracts and factories).

- INCREASE OF THE ENERGY OFFER: through natural gas imports from Bolivia, fuel-oil imports from Venezuela and electric power imports from Brazil.

- INCREASE OF WELL-HOLE GAS PRICE FOR LARGE USERS AND CNG: well-hole gas price increased for industrial users (between 15% and 30% according to the province), thermal plants (between 20% and 35%) and CNG stations (between 20% and 30%). This is the first adjustment of rates, which will end in July 2005, when the average price of the fluid will be 1 dollar per million BTU compared to the current average of 50 cents per dollar. The newly ordered adjustment will not affect residential and commercial users of natural gas.

- INCENTIVES PROGRAM FOR SMALL AND MEDIUM GAS AND ELECTRICITY USERS: the Rational Energy Utilization Program (REUP), based on the program used in Brazil to mitigate the energy crisis in 2001, basically provides that users who cannot spend 5% less than last year, and those who use more than 600 kilowatts/hour of electric power per 2-month period and 1,000 square meters of gas yearly (for the Federal Capital and the Greater Buenos Aires area), will have increases in energy prices over the additional amounts consumed. Users whose consumption is below the specified levels will not have an increase in their invoices even if they consume more than the previous year. If the consumption levels are reduced by more than 5% compared to the previous year, in the first case, or below the consumption of last year in the second case, users will have a discount for the energy not used.

- DOMESTIC ENERGY PROGRAM: a program for the next five years of ARS 11.14 billion has been announced for the energy sector. Of the total, ARS 425 million relates to current measures and ARS 10.72 billion to works to be completed in the following four years. In order to finance part of these expenses, duties on petroleum and oil exports were increased by 5%, 15% for liquefied petroleum gas and 20% for natural gas. The measures include the creation of a state-owned energy company, ENARSA. The partners of the company will be the Argentine State (53%), the provinces (12%) and the private sector, with the remaining 35% of stocks being offered on the Stock Exchange. The company will explore and exploit sea oilfields, together with private, provincial and foreign companies. The program includes works to increase electricity generation and transportation capacity, and also the development of natural gas transportation capacity.

In this context, solving the energy crisis has become a new challenge in order to consolidate the recovery of economic activity and attain sustainable growth, in addition to other challenges already existing, such as the renegotiation of the debt, the consolidation of public sector primary surplus, the return of long-term bank loans, a monetary policy based on inflation targeting, the definition of a regulatory framework for public utility companies and the progress of international trade negotiations.

Although it is difficult to quantity their potential impact, it is clear that the energy difficulties threaten to take away some point from the 7.5% annual growth initially expected for this year. To this could be added the effect of the latest changes in the international scenario (see International Economic Overview N?21). If the fall in the price of agricultural commodities continues and fears of lower world growth materialize, the external context could also start to have an impact on expansion pace of the local economy. For the time being, however, the great dynamism shown by the Argentine economy in 2003 and in the first quarter of 2004 points to a high growth rate for this year, of at least 6%.