No quick fix for Argentina

Argentina’s fall from grace has trampled all over what had been one of the most compelling recovery stories of recent vintage, where reform efforts from its new, market-friendly government had started to reverse years of economic mismanagement.

International investors were eager to play along; since Mauricio Macri took office in late 2015, Argentina has issued almost US$50bn of sovereign hard currency bonds. At the turn of the year, it remained a top pick among many emerging market fund managers. But the upbeat mood quickly unravelled.

A strengthening US dollar in the spring rattled emerging market sentiment, and Argentina – without a deep enough domestic investor base to count on – suddenly found itself struggling to roll over short-term debt.

Panic rapidly spread. The Argentine peso tumbled by around 25%. Its bonds sold off; by the end of May, the 100-year issue was being bid at around 83 cents on the dollar (having traded above par just a few months earlier), Thomson Reuters data show. Efforts by the central bank to stem capital flight by cranking interest rates up to 40% from 27.25% in the space of a week did little to turn the tide. In early June, weary from the battle, the Macri administration agreed a US$50bn rescue package with the IMF.

Yet while that deal – a three-year standby arrangement – was supposed to ease the immediate pressure (US$15bn of that cash was front-loaded), investors had other ideas. An emerging market rout in August sparked by a currency crisis in Turkey quickly turned on the peso, forcing the central bank to raise interest rates to 45%. Later that month, with markets still unsettled, Macri triggered a further sell-off by asking the IMF to accelerate its rescue payments to reassure investors the country could meet its funding needs next year. As the peso slumped to fresh record lows, the central bank was yet again compelled to jack up rates, this time to a staggering 60%.

“Argentina was always going to be vulnerable to short-term capital flows, and they don’t have a lot of options – they can either sell dollars or they can hike rates,” said Siobhan Morden, head of Latin America fixed income strategy at Nomura. “This [rate hike] should provide some short-term breathing room, but the problem with Argentina is there is no quick fix.”

The situation, therefore, remains on a knife edge. The IMF has said it will re-examine the phasing of the programme given the adverse market conditions, and Argentina has vowed to impose greater austerity in return. It will now seek to eliminate the primary fiscal deficit by the end of 2019, having previously agreed to a target of 1.3% of GDP. But with an election due next year, the political cost of cutting at a much faster clip could put Macri’s re-election hopes at risk – a potentially far gloomier outcome for anybody holding Argentine debt.

“If you ask investors, many will tell you they don’t want this administration to sacrifice 100% of their political capital if we may see populism back in office, so there is a fine line here,” said Diego Pereira, chief Argentina economist at JP Morgan. “Politically speaking, this is walking on eggshells.”

While Macri recognises that investors have lost confidence with his gradualist approach, the government had started to repair much of the mess it inherited from the previous administration. The IMF’s original requirement to cut the fiscal deficit to 2.7% of GDP by the end of this year should be well within reach; the deficit had already fallen to 1.7% of GDP in the first six months of the year from 2.9% in the same period of 2017.

Wiggle room

Encouragingly, the government does have some wiggle room to further trim its outgoings, according to Fernando Jorge Diaz, Argentina economist at Citigroup. For instance, it could reduce energy and transport subsidies, which remain quite high, he said. It could also pare infrastructure spending, particularly if its recently introduced public-private partnership programme proves a success. And while next year’s target is now even more ambitious, the government has said it will impose taxes on exports to help meet it. That would mean leaving pensions and other politically sensitive social transfers untouched, said Diaz.

The IMF may also be more sympathetic to Argentina’s political backdrop. Given the deal will span this government and the winner of next autumn’s election, if the targets the fund imposes are too stringent then it could foment further domestic unrest, potentially ushering in a new administration that is unwilling to commit to the programme. That means the IMF is likely to be more lenient with softer targets such as inflation, according to Gustavo Rangel, chief economist for Latin America at ING.

“It is one of those situations where if the medicine is too strong you can kill the patient, so the IMF doesn’t want to push Macri so much that he becomes unelectable,” Rangel said.

But Macri’s chances of securing a second term are already far from assured, particularly as the country grapples with a weak economy and stubbornly high inflation, which continues to squeeze consumer spending. Oxford Economics already forecast that Argentina will head into recession in the middle of this year, but it now thinks the downturn will be deeper and longer, with GDP expected to contract in 2018 by 1.4% and inflation likely to hit at least 37% by the first quarter of next year.

“There’s no conviction yet for a two-term presidency because you need to enter into an economic cycle of recovery first, which wouldn’t occur until earliest next year, so that’s what we’ll have to monitor and there’s no quick fix for that either,” said Morden.

Fragmented opposition

One bright spot for Macri: the opposition is fragmented. On one side are the Peronists and on the other is former president Cristina Fernandez de Kirchner, who remains a potential candidate despite the weight of corruption scandals mounted against her. The former currently lacks any clear leadership and the latter would be unlikely to muster enough votes to win if she did decide to run, analysts say. But the latest bout of turmoil risks not only galvanising support for Macri’s opponents, it could destabilise the ruling coalition party, Cambiemos.

That means there is no room for further blunders from Macri’s administration, a combination of which contributed to the sell-off that wrong-footed many debt holders earlier in the year.

“[There were] some domestic policy errors, which started with the way inflation targets were revised at the end of 2017, and then in January you had the central bank easing monetary conditions and the country issuing US$9bn from external markets while inflation was accelerating – that cocktail proved to be explosive,” said Pereira.

Market-watchers say technical factors also compounded the sell-off, given the extent to which investors had built up hefty positions in Argentine debt.

“Argentina was a little bit of a victim of its own success,” said Alberto Boquin, a research analyst at Brandywine Global. “For two years, they managed to seduce Wall Street; there were a couple of surveys that showed Argentina was the biggest overweight position of many emerging market managers. So, obviously, when things got bad broadly across EM, that was the biggest position that had to be solved.”

While holdings have been trimmed, many investors remain long. Morden says the fall in bond prices earlier in the summer was so sudden that by the time yields had shot up to 9%, Argentina’s valuations looked cheap again, reducing the incentive to heavily unwind those positions. And while Argentina’s bonds had deteriorated since then – the yield on the Century bond jumped above 10% at the end of August, albeit partly because of skimpy late summer liquidity – rumours in early September of a credit line with the US pushed prices higher again, suggesting the roller coaster in bond yields is unlikely to end soon.

Many specialist investors are taking a measured view, attributing much of the volatility to the wider stress dragging on emerging market assets.

“We’re in a risk-off environment, so people are more cautious on Argentina,” said Paul McNamara, an investment director at GAM Investments. “In a more positive environment for EM, then suddenly Argentina would tend to look very attractive. That’s the way EM works: it’s a risk asset class, so when it goes well it goes very well and when it goes bad, it goes badly – and Argentina was the high-risk end of a high-risk asset class.”

How soon Argentina is able to regain access to international capital markets therefore hinges as much on broader risk appetite as it does on Argentina’s economic health. But given the further downturn in August, the country’s stark vulnerability to contagion from elsewhere – even with the backstop of the IMF – means there can be no slip-ups on the fiscal front.

“Argentina had one spare life and they’ve kind of blown it now,” said McNamara. “They really need to get things right from here.”