By Phil Torres, Global Co-head of Emerging Markets & Alan Buss, Senior Sovereign Research Analyst
The Argentine peso hit another record low, in nominal terms, to close out the month of April. In order to counteract the decline and stabilize the currency, Argentina pushed short-term rates above 70%—again. With the further decline of its currency and economy, the odds of Argentina defaulting rose. Although the country has suffered recurring economic crises most of the last century, there are some encouraging positive developments that may, if given time, right the course.
In 2018, Argentina's credit had a foreign exchange (FX) liquidity crisis related to fiscal deficits that could no longer be funded. As a result, Argentina entered an International Monetary Fund (IMF) 36-month Stand-By Arrangement (SBA) aimed to solve both the short- and medium-term liquidity needs so the country could pursue very difficult fiscal adjustments through 2020. Thus far, it has received more than $38 billion in support to date, out of its $57 billion program.
The country's leadership, particularly President Mauricio Macri, who is highly market friendly and a known IMF ally, was instrumental in securing the IMF's rapid and easy involvement. The upcoming presidential election in October may change the course Macri has set out for the country. Macri has poor polling results largely related to the country's economic distress. His opponent for the election is expected to be former President Cristina Fernández de Kirchner (CFK), the anti-market, anti-IMF social democrat.
Further complicating matters politically and economically for Macri is the accelerating inflation rate— rising from 25.6% this time last year to currently 54%. Argentines are accustomed to high inflation and rapidly transition from the domestic peso to the US dollar (dollarization) to protect wealth from inflation and political fears. However, this dollarization wave risks a vicious cycle unless it is offset by central bank intervention or real-sector inflows.
Near term pivot points
Negative. Inflation persistence is historically extreme in Argentina due to indexation and historical experience. To date, the Central Bank's efforts have failed to counter the inflation trend and the inflation rate continues to rise in spite of the Central Bank's new and highly conservative approach it adopted late last year—targeting a zero nominal base money growth and sticking to strict FX intervention bands. It may need to constrict monetary policy even further to gain control of the value of its currency. This extremely constrictive monetary policy would likely further restrict economic growth and strain Macri's re-election chances further.
Positive. The current account deficit has closed sharply and may be in surplus, the result of a large soybean harvest and collapsing consumer imports. Earlier this year, central bank foreign exchange reserves increased from Central Bank dollar buying (part of the official IMF agreed intervention policy) when the FX was at the stronger side of the official intervention band. These factors suggest the currency may be undervalued and available to a real rally if locals' dollarization can be reversed. A sustained currency rally could be a source of a virtuous cycle for the country and its asset values. Additionally, net FX reserves, including an untapped currency swap with China, are roughly $40 billion USD in the context of an economy that has already dollarized by close to 90%.
Negative. The fiscal deficit is programmed, per the IMF agreement, to be funded primarily by the IMF and the remainder (roughly 30% of total needs) with short-term T-bills (Letes). The IMF agreement assumed a roughly 60% private sector average annual roll-over rate through 2019. If the roll-over rate comes in much lower than the 60% average for the year, the government may print pesos, take from FX reserves, or default without further IMF support. In April, the total rollover rate (public and private sector) fell from near 100% in early 2019 to 67%, suggesting the private sector roll-over rate was meaningfully below 60%.
Positive. To date, budgetary adjustments have succeeded. Year on year change in fiscal spending for 2018 was -9% and 2019 is expected to be -11%—difficult belt tightening during an election year. Consequently, the government met their 2018 primary deficit target and are on track to achieve a balanced primary budget balance by the end of 2019. These notable achievements put them modestly ahead of the IMF's goal of a primary fiscal surplus in 2020. As mentioned, the IMF prescribed roll-over rate for the Letes is 60%; however, the local authorities recently (April 2019) announced Treasury balances are at historically high levels and suggest average roll-over rates can comfortably be as low as 40%.
The elimination of the twin current account and budget deficits goes a long way in reducing the country's vulnerabilities. If fiscal targets are met and the currency is stable or stronger in real terms, the country's debt/GDP ratio should be on a clear downward trajectory.
Exhibit 1: Argentina 5-year credit default swap (CDS) implied probability of default
Exhibit 2: Argentina CDS implied probability of default
Source Exhibits 1 & 2: Bloomberg. As of April 19, 2019.
Where we stand on Argentina
We think the probability of default is far lower than currently implied by market pricing. However, the country is a high-risk case (Exhibits 1 & 2). We are concerned about the market either anticipating or reacting to a CFK win, and closing financing options in spite of improving fiscal balances. Both CFK-related and other opposition leadership all speak positively of the IMF deal. However, we worry the market or the IMF won't fund CFK in a manner consistent with the current IMF SBA.
We infer, extracted from 5-year credit default swap (CDS) prices, that the market roughly projects CFK to have a 40% chance of election versus 30% each for Macri or a moderate Peronist coalition. Our estimates of where credit spreads trade under the various scenarios should be taken with a large "grain of salt"—especially a CFK victory. However, these estimates offer us an opportunity to compare what we think the market has priced-in compared to what we think as the more likely scenario. We think the implied 40% odds of a CFK victory are too high; however, those odds are in line with two recent polls by consulting firms Insomnia and Elypsis (Exhibit 3).
Exhibit 3: Market implied pricing of election odds vs. AAM estimates of election odds
|Market Implied Pricing of Election Odds|
|Odds of winning election||Default Risk||Risk Premia||Final Spread||Implied Return|
|AAM Estimates of Election Odds|
|Odds of winning election||Default Risk||Risk Premia||Final Spread||Implied Return|
*Returns are estimates without coupon and an instantaneous credit spread change to a 5yr CDS. Depending on the timing of the spread change returns would be very different than estimates above.
Argentina has a high portion of its debt denominated in foreign currency and—given the extreme sensitivity and interaction between politics, inflation, nominal currency value, and debt sustainability—the country exists in a series of unstable equilibriums that change rapidly under virtuous or vicious cycles. Argentina is presently experiencing a vicious cycle change. We expect any new equilibrium point to be led by currency stability further stabilized with related slow successes in inflation and politics. The latter two will likely require many months before any stability can truly be expected.
As a consequence of the wide range of election outcomes and our view that any stabilization will be led by central bank success with the currency, we think that very short duration peso denominated bonds should outperform USD bonds in the near term. Further, given that Argentina is no stranger to rapid inflation and sovereign default, many companies have designed their balance sheets and operations to be as immune as possible to sovereign difficulties. Consequently, we think high quality Argentine USD denominated corporate credits have a higher probability of surviving a sovereign default and have become cheaper along with the sovereign. We think our outlook represents a somewhat more sanguine view of the Argentine complex than is currently priced-in which, if implemented with the instruments described above, has the potential to offer modestly improved asymmetry to the wide range of possible outcomes.
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