In this note we seek to explain how we understand and approach a likely restructuring of Argentina's external private sector bonds. Our analysis is divided into two parts: the historical background of Argentina's debt problems to understand why Argentina is, again, expected to restructure its external bonds; and our structural approach to estimating a long-run fair value for Argentine debt, under a variety of restructuring scenarios.
When Argentina's previous president, Mauricio Macri, began his four-year term in December of 2015, he inherited a country with low FX reserves, current account and primary fiscal deficits, long-lasting high inflation and an overvalued currency. The country traditionally printed money to balance its fiscal deficits (which contributed to persistently high inflation and low desire amongst locals to hold wealth in pesos). The country did, however, have low debt/GDP as a consequence of having been legally isolated from USD capital markets.
Typically, a macro policy adjustment in this situation would include reducing government spending and devaluing the currency substantially. The former would help balance fiscal accounts through reduced outflows, while the latter would generate export-led growth and tax revenues. This policy is politically difficult as it often results in a severe recession, but ideally generates long lasting economic growth.
Argentina is somewhat unique to many emerging market credits in that exports are a particularly small part of the economy (roughly 10%). Further, a small portion of this already small figure are FX sensitive sectors, manufactured goods. The economy does not generate much foreign exchange and it does not benefit from currency weakness to the degree other economies might—there is no natural rebalancing effect for the economy.
The government instead chose a middle ground path of avoiding a severe recession by maintaining government spending. To accomplish this, the government both printed money and borrowed from the capital markets to balance fiscal accounts. Debt/GDP at the time was moderate and credit markets were amenable to risky credits, like Argentina. This macro policy path had the benefit of being politically palatable in a historically populist society that would likely reject both austere policy and then-President Macri.
Macri had hoped his plan could stimulate domestically led growth, improve government revenues and slowly reduce the deficit. He promised methods to reduce inflation that, combined with the GDP growth, would affect a real appreciation of the peso. The policy gambled that higher GDP growth and a stronger peso would, in the future, offset the short-term increase in external debt/GDP. The core idea to the plan was continued access to capital markets, allowing Argentina to borrow money to be used to stimulate domestic GDP. Consequently, the money borrowed from the capital markets, both in Argentinian Nuevo peso (ARS) and US dollar (USD)-denominated terms, was necessary to bridge the time this transition would take.
However, if and until exports grew sufficiently, any improvements in GDP growth or reduced inflation would be coincident with consumption-led import growth and a widening of the current account. This current account widening would place weakening pressure on the peso that could only be offset by continued foreign in-flows or central bank FX intervention.
There were portions of the plan that were mutually exclusive under most scenarios, and the lynch-pin to success was a sustained real appreciation of the peso. In the International Monetary Fund's 2017 Article IV review, it stress tested the debt sustainability analysis with a one-time 30% depreciation of the peso and found that external debt/GDP rose to a challenging (by global standards) 74%.
Exhibit 1: Real depreciation shock
Source: International Monetary Fund. "Argentina: 2017 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Argentina." Washington, D.C., December 29, 2017.
Four years later, and with the benefit of retrospect, we can easily see Macri's debt-funded growth plan was rather tenuous. Disinflation, before the multiple waves of currency depreciation, never occurred. Domestic growth did rebound, however, the current account widened as expected. Together, they proved to be a major cause of currency weakness that was exposed when, globally, foreigner's appetite for non-USD collapsed in 2018.
Compounding the structural problems with then-President Macri's macro policy plans, as detailed above, is local saver's dollarization aka capital flight, which is historically a significant potential flow. As the currency weakened, money printing replaced borrowing, inflation soared, and large scale capital flight ensued. In fact, the IMF's historic $60 billion+ bailout has proven too small to offset capital flight, stabilize reserves, and catalyze new external financing relative to this capital flight. The failure of Macri's policy and massive capital flight is the primary reason why, in spite of the IMF bailout, the country's economy has collapsed and requires capital controls. Debt/GDP estimates now appear deeply unsustainable.
Accordingly, it is our expectation that Argentina will require a large haircut for true long-term sustainability. Assuming Argentina's deep-seated underlying political economic issues persist as they have for generations, failure to substantially lower the debt burden will likely result in high 'exit' yields in the short run, continued bouts of extreme volatility in its currency, higher required rates of return for future investment, and a circularity that will eventually lead to a long-run low PV for foreign currency-denominated market debt. That is, should a haircut be small and favor current bondholders, we would likely view the restructured bonds as a negative NPV investment over the long term.
A technical analysis of the long-term fair value of Argentina's international bonds
It is important to caveat that the NPV estimates included in this analysis are not necessarily how we think bonds will actually restructure; however, we think this approach serves as a valuable reference point to compare against any restructuring terms. Further, in the event that restructuring terms are more favorable than current market prices and higher than our estimates of NPV, we may be inclined to overweight Argentine bonds tactically while expecting bonds to, over the long term, have a negative expected value.
In order to determine our estimated range for the long-run fair value of Argentina's USD-denominated bonds, we make required assumptions for the following: 1) primary deficit/GDP, 2) GDP growth in USD terms, 3) debt service prioritization of certain intra-governmental entities, 4) seniority and debt service prioritization of IMF (and successor) loans, and 5) timing of market access.
Primary deficit/GDP: Argentina has historically run a substantial primary budget deficit. The only sustained exception in the past century was during the period post-2001 default, where the economy grew at an average 7% from 2002 to 2011 driven by global growth momentum and rising prices for certain commodity exports such as oil and soybeans. During this period, the Kirchner administration took advantage of its fiscal surplus position and significantly expanded its social programs. But as global growth began to slow in 2008, instead of cutting government spending, Kirchner maintained the social program status quo by printing money. Despite early efforts by Macri, when he came into the Presidential office to implement a degree of austerity, he, too, ran budget deficits.
Argentina has a new presidential administration as of December 2019, with Cristina Kirchner as vice president and Alberto Fernandez as President. We expect this administration to err down the path of least resistance with respect to government spending; that is, no further austerity.
Exhibit 2: Primary balance: Argentina vs. average emerging market country
Sources: AAM calculations with EIU data and forecasts. As of October 2019.
Although the IMF-agreed plan for a primary budget is a surplus of 1% for 2020, we are skeptical of its near-term sustainability given Argentina's history and the implied consequences of such an abrupt change. Additionally, a budget consolidation to 1% surplus would be considered unusual compared to other IMF-engaged sovereigns. That said, we do see a long-term trend toward improvement. Accordingly, given our conservatism in other aspects of this analysis, trending improvement, as well as the potential future benefit from Vaca Muerta, our base case for a medium-term primary surplus of 1%, while optimistic, appears reasonable.
GDP growth in USD terms: Argentina's historical GDP growth is roughly 2.5% with considerably volatility. If, and until, the natural gas field of Vaca Muerta produces in earnest and/or the manufacturing base is rebuilt, we expect Argentina to achieve similar rates of GDP growth. Our expectation is that Vaca Muerta does not start producing and/or exporting materially for another five years. Therefore, we do not credit the country in the near term with this source of potential growth as a core scenario, though we recognize this as a potential source of future upside.
Inherent debt prioritization with intra-governmental entities: 35% of Argentina's estimated $310 billion of government debt is held by intra-governmental organizations such as public pensions. Additionally, of the estimated $121 billion of hard currency market debt, an estimated 21% is held by intra-governmental organizations. We expect the administration to follow global convention and default on foreigners before its local population. Though payment may change in form or mechanism, we believe payments to these entities are effectively senior.
IMF and successor seniority: When the fund engages with a sovereign as a creditor, its policy is to effectively be the senior stack of the capital structure. We understand this policy to be flexible with payment date re-profiling, but not a haircut or other restructuring. Accordingly, given limited market access, we assume the $60 billion+ loan is rolled by the IMF itself and debt service continues to be paid in a priority position, as an unimpaired creditor, at a low IMF rate. In the event the IMF loan amortization continues on schedule (US$1.8 billion in 2021, US$20.3 billion in 2022, US$22.3 billion in 2023 and US$7.9 billion in 2024) and the loan is refinanced at higher rates, it's possible that the increased interest alone would exhaust all remaining available sources of cash under our assumptions. In that event, there would be nothing left for other foreign currency-denominated market debt service without borrowing (or effectively borrowing by mechanisms like printing cash) and subsequently increasing the total debt amount (Exhibit 3).
Exhibit 3: Sovereign sources and uses
|Base year USD (billion)
||Proforma USD (Billion)|
|Primary Surplus (Deficit)||4.47||4.47|
|BCRA Transfers [Seniorage, reserves, Leliq debt service]||2.68||2.68|
|Rolled Shortfall @ IMF rate of 3.4%||2.18||5.49|
|Intra-Arg Public Debt Service||2.50||2.50|
|IFIs + Loans||0.67||0.67|
|Excess Cash (Shortfall) in USDbn||1.63||(1.69)|
|Hard-Currency Portion of Market Debt||0.77||0.77|
|Cash Available for Foreign Debt Service||1.25||(1.30)|
|Proforma: Assumes IMF Loan Refinanced into Market Debt at Current Average Coupon 8.85%|
Sources: AAM calculations and assumptions with JPM, BAML, and MS data.
Timing of market access: IMF debt sustainability analysis and lending is based on good prospects for the sovereign to regain market access in a timely manner. According to the IMF, "In the event that the financing gap cannot be filled with fresh resources (from the official and/or private sector), the Fund's policy on financing assurances explicitly encourages 'the restructuring of creditors' claims on the country on terms compatible with balance of payments viability."1 Considering the large policy uncertainty with the incoming administration, extreme debt burden, low growth and limited prospects for improvement, persistent and high inflation, we believe that market access is closed until most of these issues are resolved.
True debt sustainability is dependent on a meaningful restructuring of Argentina's external debt and we estimate that modest haircuts will not be sufficient. We have considered scenarios such as coupon reductions, maturity extensions, and programs similar to Uruguay and Ukraine. However, given the IMF's near-term amortization burden, our base case is a restructuring that looks similar to the 2005/2010 pars/discount exchange with low near-term cash coupons made up for by near-term PIK payments, growing future amortizations and growing future cash coupons. Regardless of the form, we assume that the market price of new debt, driven by the exit yield, will trend towards a long-run value governed by true affordability and underpinned by the present value of future cash flows available for debt service. To derive this, we first estimate a medium-term cash flow available for debt service assuming:
A medium-term run-rate GDP of US$450 billion - US$500 billion; 1% of GDP primary surplus and 0.6% of GDP BCRA Transfers (net of seigniorage, reserve accumulation, and Leliq debt—seven-day liquidity notes—service)2; IMF debt is rolled and continued to be paid at current rates; All intra-governmental debt is effectively rolled and paid at slightly lower rates; All IFIs, Paris Club and bi-lateral loans are rolled and continued to be paid at current rates; The same proportion of debt-service in hard currency market debt persists leaving 77% of remaining cash available for foreign debt service.
We then calculate the present value of the remaining cash flow using a perpetuity growth model with an 8% discount rate (important to note: this is not the exit yield) and 2.5% perpetuity growth rate. To estimate how this value compares to existing bonds prices, we divide our resulting present value of cash flows by the total par value of existing hard currency market debt that is not owned by intra-governmental agencies. Ultimately, with some sensitivities around GDP and our fiscal surplus assumptions, we arrive at an estimated range of recovery rates for a generic Argentine bond of 25% - 56%. Comparing these estimated recovery rates to current market prices, we see bonds as either roughly fair value or meaningfully over-valued, implying a negative asymmetry to an expected return over the full IRR horizon.
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