No pain, no gain: Argentina gears up for necessary adjustment
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Emerging Markets

No pain, no gain: Argentina gears up for necessary adjustment

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Argentine president Cristina Kirchner appears determined to leave the hard work to her successor, with economic activity grinding to a halt until elections in October. But there is optimism that the medium term future can be bright

Calling an Argentine mobile phone can be a vexing experience. One Buenos Aires-based interviewee insists by email that his phone is showing full signal, but the screeching coming down the line would suggest otherwise.

“Cell phones here are a joke,” he says loud and clear, thanks to Skype. “We can only hope that the flow of investment we should see with the next government can bring Argentine networks up to international standards.”

Muddling through

But he will have to wait. The latest central bank data — for 2013 — shows that foreign direct investment was just 2% of GDP for the year. And despite signs of a softening in policy in the first half of 2014 as the government came to agreements with Paris Club creditors and expropriated oil company Repsol, Argentine president Cristina Fernández is no longer in the mood to woo foreign investors.

This means all but no hope of a solution to the long-running holdout saga under her government. Shorn of access to dollars, the current exchange rate is artificially strong as the central bank finances pre-election spending.

“The government is running a populist policy until October elections,” says Sebastián Vargas, Argentina economist at Barclays. “It is not depreciating the currency in order to maintain real wages and dollar wages high, but at the same time it is increasing public spending, which will be financed by money printing if it does not find financing abroad.”

With yields suggesting market access, by early 2015 Argentina was hoping to seek greater flexibility by raising dollars via local law bonds. But in February, Deutsche Bank and JP Morgan suspended plans to run the bond sale amid the threat of legal action from holdout creditors.

And in March, US judge Thomas Griesa ruled that custodian bank Citi could not continue to process interest payments even on Argentine law bonds until holdout creditors were paid.

However, on March 22 Griesa appeared to reverse his decision and allow Citi to make two interest payments, one at the end of this month, and the other on June 30, to hedge funds.

Hopes were briefly lifted that this could presage an end to the debt stand-off. However, it soon became clear that this was a one-off, and designed to help Citi exit the custody business in Argentina.

Perversely, Argentina’s July 2014 default was followed by a substantial rally in its debt — not because of anything Fernández has done, but because the closer October 2015 becomes, the more likely Argentina will get through to elections. (Fernández, despite her efforts to change the constitution earlier in her term, cannot stand for a third term.) The yield on the government’s 2024 Bonar bond fell from over 12% in mid-2014 to below 8% by February.

“It might be hard to understand that a country in default can have these yields, but in effect the market is financing the next government,” says Martin Ivancich, partner and head of sales at Latin America specialist house Copernico Capital Partners. “We have a good view on flows into the country and, at least in terms of equity markets, they are high for such a small market.”

There is unanimity among the finance community that a new government will be able to resolve the holdout situation in a matter of months after taking office.

For the interim, the government has been able to raise just enough dollars via a currency swap agreement with China and offshore bond sales from quasi-sovereigns that the expected decline in international reserves of up to $5bn between now and the elections should not be critical.

“As we are so close to elections, the reserves situation is not too serious,” says Pedro Rabasa, director at Empiria Consultores in Buenos Aires. “But the government has to be able to manage the situation: by not letting reserves fall too far in its support of the currency; and at the same time not letting the currency depreciate too rapidly.

“The important thing is that the government does not put its foot in it and do too much damage.”

Andrés Borenstein, economist at BTG Pactual in Argentina says the government has shown it “is not prepared to commit absolute suicide”.

The country has “a reputation problem but we’ve never predicted a doomsday situation”, he says. “We think Argentina can muddle through until the elections.”

Holdout optimism

All major presidential candidates from market favourite Mauricio Macri to peronista Daniel Scioli are expected to move swiftly to negotiate with holdout creditors and enable the government to return to international markets.

“Any holdout solution will not be quick and there is a lot of fine print to discuss,” says Borenstein. “But a president looking at an eight year horizon will know he cannot be out of the market for that long.

“A new president cannot start cutting spending brutally as it will cause a recession and so most of the money to finance the deficit will have to come from markets.”

As Vargas points out, there is no sustainable option for the next government but to regain market access. Indeed, the generous external conditions and high commodity prices that allowed the country to remain out of the market for more than a decade are over.

“It does not mean a holdout solution will be a walk in the park, but it’s not that expensive,” he says. “Solving the situation will probably cost around 3% of GDP, which is a small price to pay for being able to grow again.”

There are no magic solutions. Argentina is unlikely to be able to pay in full in cash straightaway and the holdouts are unlikely to negotiate too much, so an agreement may take time and be paid in bonds.

But investors are excited as the country looks set to return to the financial fold within a year after more than a decade in the wilderness.

“Argentina has been off the radar for foreign investors for a long time, so now it is offering multiple very attractive investment opportunities in a world of low rates,” says Ivancich. “It is the third largest economy in Latin America but is still considered a frontier market in equity markets. With a change in management, the country might be able to change its course dramatically.”

Apart from the favourable interest rates that a low-levered economy like Argentina is likely to be able to benefit from in bond markets, capital could return to the country quickly. Ivancich says that the first movers could be Argentines themselves bringing money back on-shore, before foreign investors enter.

“With a better business environment, the flow of capital towards Argentina could be so strong that in one year’s time the government could have the opposite problem it has today: a currency that is strengthening too fast,” says Ivancich.

Urgent issues

Beyond the holdout situation, the country’s other major economic problems — including high inflation and the fiscal deficit — are likely to be tackled soon.

But these problems are serious enough that it would be naïve to believe that Argentina is just a few bond contracts away from becoming the economic powerhouse that many believe it can be. Inflation has fallen from the 35%-40% range of last year but remains above 25%, while Credit Suisse estimates that, excluding profit transfers and temporary advances from the central bank, last year’s overall deficit reached 5.3% of GDP. This is only likely to grow in the run-up to elections.

“I remain very cautious on 2016 because all the issues in the Argentine economy are growing by the day as the government leaves the problems for the next regime,” says Rabasa. “The adjustment will not be easy.”

This normalisation of the economy will “necessarily” involve some pain, says Vargas of Barclays.

“We are looking at very high real wages and very protected sectors of the economy,” he says. “Openness hurts.”

FX adjustment could delay FDI

Perhaps the trickiest of these adjustments, however, will be correcting the artificially overvalued exchange rate. Again, all presidential candidates have pledged to remove the cepo cambiario measures that limit access to dollars in the country. But suddenly freely floating the peso would be dangerous.

“One major challenge will be the exchange rate,” says Borenstein. “A government will have to first adjust the exchange rate and only then will it be able to liberalise the FX mechanism.”

Indeed, without a supply of dollars to back up the exchange rate, a painful devaluation could occur. A gradual process is needed.

“No doubt there will be some kind of pass-through to inflation. But if there is confidence in the market and demand for money, that can be reduced,” says the BTG economist.

Yet such a gradual process means that the return of swathes of capital to the country could also be gradual until investors are satisfied that the exchange rate has reached a stable and sustainable level.

“Initially investment will increase only in the form of debt that stays in dollars,” says Rabasa. “I do not see FDI increasing at the currently overvalued exchange rate.

“There is a lot of interest and opportunity in Argentina, but foreign investors will want to see an adjustment and stabilisation in the exchange rate and normalisation of the economy before committing.”

But if Rabasa is right that there is strong appetite in debt markets for Argentine risk, it will at least enable the government to shift its source of financing from the central bank to the markets.

And Vargas is hopeful that the next president will have the political capacity to make important changes, even if they are painful.

“The good thing is that the next government will have the validation of the ballot to pursue change,” he says. “I imagine it will enjoy an extended honeymoon period with Congress and the press, which should help it in any period of pain.”

Vast natural resources, high quality companies and one of the best-educated populations in the region mean that Argentina in an improved business climate should bare fruit in the medium term.

“Improving the business climate probably won’t mean going back to a small state, but I think the country needs to make regulatory bodies more independent,” says BTG’s Borenstein. “Foreign companies have invested well below what they should have invested in Argentina, so if the environment is appropriate there is a lot of potential.”

If he is right, we may even be able to carry out interviews by phone in a couple of years.

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