While bond investors have put more capital into serial defaulter Argentina than any other emerging market in 2016, a shock election result or disappointing inflation numbers next year could cause a reversal, writes Aaron Grehan.

 

In a year of political surprises, especially this month’s US election of Donald Trump, capital has flooded back to Argentina in 2016 after an era of being shunned; not least due to fears over the veracity of government data under the Kirchner era.

However, sentiment towards and flows into emerging markets have sharply reversed since Trump’s victory on the prospect of tighter US monetary policy, higher bond yields and a stronger dollar. Despite the more challenging outlook and recent sell off in emerging-market assets, Latin America’s third largest economy looks capable of riding out the reverberations of a Trump presidency better than many on the continent.

That said, despite the progress in opening domestic markets to overseas investors and a commitment to addressing its data problems since the election of Mauricio Macri as president in November 2015, Argentina still faces fundamental challenges in its economy.  

The country’s economy shrank by 3.4 per cent on an annualised basis in the three months to June[1]. Similarly, while the rate of inflation seems to be slowing – with the consumer prices index increasing up by 2.4 per cent month-on-month in October from 4.2 per cent in May – an annualised inflation rate of 40.5 per cent in April shows that Argentina remains vulnerable to price shocks.

This is not reflected in the clamour for local-currency Argentinian sovereign debt, however, which suggests growing confidence among bond investors that inflation is under control. Investor demand for local currency assets has helped boost foreign-exchange reserves from a nine-year low of $20.6 billion last December  to $24.6 billion by September[1].

Return from exile

The election of a business-friendly administration and their orchestration of a 30 per cent devaluation in the peso and removal of capital controls have been key pillars to Argentina’s resurrection plan. But, the $4.6 billion settlement with four ‘holdouts’ – led by US hedge fund Elliott Management – in February after Argentina’s bond default in 2001 was arguably the biggest feather in Macri’s cap. During a 15-year legal battle, creditors had attempted to embargo numerous assets, including an Argentine navy training ship and satellite launches, to claw back the $1.7 billion that a New York court ordered they were owed from defaulted bonds[2]. Settling with the holdouts paved the way for the country’s return to the international capital markets after over a decade in exile.

Perhaps reflecting the lengths investors will go in the chase for yield and improving domestic outlook, a country that had not issued a bond to overseas investors for over ten years has been able to sell around $24 billion in sovereign debt in 2016, more than any other developing market. Argentina’s €2.5 billion ($2.8 billion) euro-denominated issue in October followed a $16.5 billion issue in April and $2.75 billion deal in June. Despite a bulging fiscal deficit of 63.0 billion pesos ($4.1 billion) in October, widening from 38.9 billion pesos in September, and inflation running close to 40 per cent, the nation had no difficulty in placing its 3.875 per cent five-year and 5.0 per cent 10-year euro–denominated bonds in October.

Creditability restored

When Argentina’s cabinet chief, Anibal Fernandez, stated in June 2015 that the country had a lower poverty rate than Germany or Denmark, it highlighted the lack of credibility of data during the last administration. One of Macri’s first actions was to reform the state-run Indec statistics institute in an effort to rebuild credibility at home and overseas.

For the record, Indec revealed in September that 32.2 per cent of the nation’s 43 million inhabitants[1] lived in poverty; in stark contrast to the previous administration’s claims that the figure was around five per cent. Nevertheless, the poverty rate is up by around three percentage points since December 2015, according to the Catholic University of Argentina as the impact of Macri’s austerity drive is felt.

The authorities allowed the International Monetary Fund (IMF) to examine Argentina’s finances for the first time in ten years in September. The IMF looks set to lift the censure slapped on the previous Cristina Fernández de Kirchner regime in February 2013 for failing to provide accurate inflation data by the end of 2016. Such a rubber stamp would be another sign, along with the demand for Argentinian debt and credit ratings upgrades from Moody’s and Fitch in 2016 to B3 and B respectively, of how the government has regained some of the credibility that had been lost.

Recovery position

Macri’s plans to create an investment-led recovery are fraught with implementation risks, however. While he has enjoyed much support so far, his Cambiemos coalition’s rescue plan and fiscal targets have slipped.

Argentinian output is forecast to expand by 2.7 per cent in 2017 after contracting by 1.8 per cent this year, according to the IMF’s latest World Economic Outlook, published in October[3]. Meanwhile, inflation is expected to drop from around 40 per cent at the end of this year to close to 20 per cent by the end of 2017. Even the halving of inflation in a year would miss the domestic central bank’s inflation target for 2017, set in September, of between 12 per cent and 17 per cent for 2017, with price rises then targeted in the 3.5-6.5 per cent range in 2019.

Achieving the central bank’s ambitious inflation target, or at least getting close to it, will be key to retaining the support of international investors. Similarly, the result of forthcoming wage negotiations with trade unions, gas price increases and tax amnesty inflows will be key indicators of just how much goodwill the administration retains.

It isn’t only the support of foreign investors that the government needs to hold on to, however. Providing a ‘feel good’ factor to the electorate in the shape of substantially lower inflation and improving growth expectations would help vindicate the recent austerity measures in the run up to the biggest short-term political risk – mid-term elections due next autumn.

Despite missing some economic targets, Macri’s administration has generally exceeded expectations so far. Furthermore, the Peronist opposition parties are fragmented and likely to remain so, aiding the coalition’s prospects at the mid-terms. The risk of an upset at the polls, and jolt to the reform drive, looks relatively low. That said, such a risk cannot be discounted and disappointing economic data next year may erode support for Macri, increasing the possibility of a shock result.

Kindness of strangers

Argentina will rely on foreign investors to finance its recovery for some time. Many other structural changes are required to turn the economy round and better management of government expenditure would help.

Additionally, having been being battered by Brazil’s deepest recession on record in the last two years[4], a pick-up in its neighbour’s prospects would help Argentina. Indeed, the IMF expects that after slumping by another 3.3 per cent this year, the country’s largest trading partner – 21 per cent of the country’s exports cross the border to Brazil[1] – will grow by 0.5 per cent in 2017.

The success of an Argentine tax amnesty launched in May on an estimated $500 billion of unregistered funds held offshore will also influence the speed with which public finances are repaired. So far, the government has already raised $21.9 billion, above the $20 billion it had hoped to generate from the amnesty to pay pensions and fund infrastructure projects[5]. Argentina joins Brazil, Chile and Indonesia among jurisdictions that have launched tax amnesties in recent years. For instance, Chile raised $1.5 billion in 2015 from its amnesty, more than ten times the amount forecast. Meanwhile, Indonesia launched one in July that attracted 3,516 trillion rupiah (US$268 billion) of its 4,000 trillion rupiah target in the first three months alone[6].

Expanding bond universe

While growth and inflation are areas where there is significant room for improvement, the pace of reform this year has been encouraging and investors continue to give Macri the benefit of the doubt. This, however, should be put in the context of the broad-based positive shift in sentiment towards emerging markets in the first ten months of 2016, which has been fortuitous for an administration desperate to attract foreign capital.

Given the sudden shift in mood towards emerging markets as investors contemplate the potential effect of a Trump presidency on the global economy, it will be increasingly important to differentiate between emerging markets. While outflows from developing nations this month have triggered a broad-based sell off in the region, Argentina’s largest risks – like those in Brazil – appear mainly idiosyncratic and domestic. Latin American economies such as Mexico, Columbia and others in central America seem far more exposed to the potential effects of the new presidency, not least from a more protectionist US trade policy.   

With Argentinian ten-year US dollar bonds issued in April yielding around seven per cent, they still offer potential rewards for yield-hungry investors in a low-yield world. Furthermore, while the spread between the Argentinian ten-year debt and US Treasury equivalent has widened to 470 basis points from around 415bp since the US presidential elections, this is below the 571bp spread when the deal launched.

Short-term risks aside, the prospects for the country’s debt market look more encouraging over a five to ten year period. Policymakers have recognised the country has been over-reliant on external debt, and are looking to deepen local markets as corporate and provincial issuance emerges to support sovereigns. Provincial governments, for example, are expected to issue $7.9 billion in new bonds this year[7]. And in the run up to the mid-term elections, total Argentine debt issuance in 2017 may top this year’s $24 billion. That said, getting inflation under control is a key requirement to keeping international investors on side.

Macri’s reforms have come at little, if any, political cost as the opposition party struggles to address the corruption legacy of the Kirchner regime. The administration has curtailed the influence of the unions, traditionally among the most powerful political forces in the country, with repeated strike calls from the country’s second biggest union, the Argentine Workers’ Central Union, having little success.

Investors should not take this period of relative political calm for granted, however. Aside from the need to meet domestic growth and inflation targets, investors will be keeping a keen eye on how Argentina – like the rest of the emerging market universe – is impacted by a Donald Trump US presidency. 

 

 

[1] Source: Trading Economics, 22 November 2016

[2] Source: “Argentina creditor takes debt battle to space”, Wall Street Journal, 25 March 2014

[3] Source: World Economic Outlook October 2016, IMF

[4] Source: “Brazil heads for worst recession since 1901, economists forecast”, Bloomberg, 4 January 2016

[5] Source: “Argentines have declared $21.9 bln so far in tax amnesty program – gov’t”, Reuters, 22 November 2016

[6] Source: “Indonesia’s tax amnesty ‘exceeds expectations’”, The Straits Times, 1 October 2016

[7] Source: “Argentina’s provinces take advantage of low interest rates to issue debt”, Reuters, 7 November 2016

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