Argentine central bank meets today and is expected to keep rates steady at 60%. The peso has come under pressure again after a brief period of calm. We continue to warn that regardless of the measures taken already, Argentina is likely to remain under pressure within the context of a broad-based EM sell-off.
The IMF granted a 3-year $50 bln Stand-By Arrangement for Argentina back in June. $15 bln was made available immediately, with the remaining $35 bln to be disbursed quarterly over the life of the program (assuming program targets are met).
Macri’s recent request last month to speed up disbursements was not taken well by the markets. In response, the IMF said that it would work with Argentina to “strengthen the program, including consideration of reexamining the phasing.” However, we do not think speeding up disbursements will materially change Argentina’s situation. Increasing the amount might boost sentiment, but the program is already one of the largest on record.
Argentina announced a new export tax to help narrow the budget deficit. All shipments of primary exports will be taxed at a rate of 12%. However, the tax will be capped at 3-4 pesos per USD value exported, depending on the product. The measure is a reversal for Macri, who has been eliminating distortionary taxes enacted during the Kirchner and Fernandez years.
The widening graft probe so far has spared Macri whilst ensnaring former President Fernandez. She has denied any wrongdoing. Many have already been arrested and include business leaders from the construction industry as well as senior officials from the Fernandez administration. As a senator, Fernandez enjoys immunity from imprisonment but she can still be charged and face trial.
Midterm elections last year were a positive development for Macri. His Cambiemos coalition picked up seats in both houses of congress. More importantly, Macri ally Esteban Bullrich defeated former President Cristina Fernandez in Buenos Aires province. Since then, however, Macri’s popularity has suffered and is likely to fall even more after seeking IMF aid.
The next election will be held in October 2019. Due to the IMF’s perceived role in Argentina’s last major financial crisis, going to the IMF is likely to hurt Macri’s popularity. So too will the likely recession, the second in three years under Macri. The current crisis in Argentina warns of a potential Peronist comeback in 2019, which would not be taken well by markets.
A BRIEF HISTORY LESSON
Juan Peron first emerged on the political scene in 1943. After the military coup that year, Peron became Vice President as well as the Minister of War and Labor Secretary. During his tenure, Peron united the workers’ movement and enacted several measures designed to help the working class. He believed that the state should take a leading role to ensure cooperation between industry and labor. This became the crux of Peronism.
Peron introduced measures to address severance pay and retirement benefits. While this made him popular with the workers, Peron faced strong opposition from the existing political parties and the business elite. Peron eventually lost the support of President Edelmiro Farrell and was forced to step down and was jailed in 1945. Strikes and protests in support of Peron led to his immediate release.
Peron was elected President in 1946. Not surprisingly, he won 56% of the vote due to strong support from workers and labor unions. The period 1946-1955 was a turning point in Argentina’s economic development. A reliance on agricultural exports was replaced by an emphasis on developing light industry as part of an import-substitution strategy. Many foreign-owned industries were nationalized, including railways, phone, and power.
The new, expanded role of the state was embodied in a new constitution that was promulgated in 1949. It sought to put social justice and the general welfare of society as the goal of all political and economic activity. In other words, Peronism was enshrined in the Constitution.
Peron was reelected in 1951 with 62% of the vote. Women were allowed to vote for the first time, due largely to First Lady Eva Peron (Evita) and her focus on women’s rights. Tragically, Evita died of cancer in mid-1952, just a month after her husband took office again. Evita was highly popular, acting as the glue that helped hold Peronism together. Her death signaled the beginning of the end for that first era of Peronism.
The economic situation had also worsened. A drop in agricultural prices as well as drought conditions from 1949-1952 weighed on the economy. Industry began to desert Peron, and opposition within the military grew. After a failed coup attempt in June 1955, Peron was overthrown that September by the military and was exiled to Paraguay and later Spain.
During Peron’s absence, Peronism continued but it became increasingly fractious. Indeed, one could argue that Peronism had always been made up of many different factions that needed a strong unifying figure at the head. Peronism was outlawed and the 1949 constitution was annulled. The party was banned from running a candidate in the 1958, when limited democracy was restored.
Peronism returned in 1973 under the new name of the Justicialist Nationalist Movement (later the Justicialist Party or PJ), as the military allowed the first elections in ten years. Returning from exile, Peron won the presidency again with 62% of the vote. His second term was cut short by his untimely death in 1974. His widow and third wife Isabel took over as President but she was then overthrown in 1976 following a chaotic period of intra-Peronist struggles.
Within the Peronist movement, these fissures grew and deepened after the death of Juan Peron. Those fissures can be traced to the current split within the modern Peronist movement. During President Menem’s tenure, several Peronists left the party to form breakaway movements, with each claiming to be the true heir of Juan Peron.
The 2003 election saw Peronist Carlos Menem running against Peronist Nestor Kirchner. Kirchner and his wife and successor President Cristina Fernandez both came from the leftist wing of Peronism, which went on to form the Front for Victory. Fernandez’ handpicked successor Daniel Scioli lost to Mauricio Macri in 2015, ending nearly 15 years of Peronist rule.
The economy is facing strong downside risks. The Treasury Ministry recently cut its growth forecast for this year to zero from 0.5% previously. After granting Argentina a standby program, GDP growth was forecast by the IMF at 0.4% in 2018 and 1.5% in 2019 vs. 2.9% in 2017. GDP rose 3.6% y/y in Q1. However, monthly data in Q2 suggest a -4.2% y/y contraction. Due to even tighter fiscal and monetary policies, we see downside risks to the growth forecasts and potentially an outright recession this year.
Price pressures remain high and likely to rise further due to the weak peso. CPI rose 31.2% y/y in July, the high for this cycle and well above the 12-17% target range. WPI rose 47.1% y/y in July, also a cycle high and portending further acceleration in CPI inflation. August CPI data will be reported Thursday and is expected to accelerate to 33.9% y/y.
For a short period, the initial rate hike to 40% in May was successful in calming markets. However, spillover from Turkey and nervousness about the graft scandal ended that calm, necessitating further tightening in August to 45% and then to 60%. The bank pledged not to cut rates until December.
While we think 60% should be high enough to stabilize the peso, that is clearly not the case. The inflation-peso feedback loop remains in play and so we do not know when inflation will peak. The situation remains very fluid, but we note that the higher rates go and the longer rates stay high, the greater the economic costs.
The fiscal outlook bears watching. With the IMF program in place, fiscal tightening will be extended several years out. Program targets for the primary balance (ex-interest payments) are -2.8% of GDP for this year, -1.3% in 2019 and +0.2% in 2020. The nominal deficit was equal to -6.5% of GDP in 2017, and the IMF expects it to narrow to -5.1% in 2018 and -3.8% in 2019. Argentina just announced further budget cuts, shaving off ARS12.5 bln in 2018 and ARS53 bln in 2019. Recently announced export taxes should add to revenues, but the likely recession may prove to be too much.
The external accounts should improve. Export growth has slowed, but import demand is slowing even faster due to the recession. The current account deficit was -4.8% of GDP in 2017, and the IMF expects the deficit to narrow to -3.6% of GDP in 2018 and -3.2% in 2019.
Foreign reserves dropped significantly this year despite the injection of IMF money, due largely to ongoing FX intervention. From the peak of $62 bln in January, reserves fell to $48.5 bln in mid-June before being boosted by IMF funds to $63.3 bln. Reserves resumed their downward trajectory and as of yesterday, reserves fell to $51.1 bln. They cover more than 6 months of imports (good) but are equivalent to a little over two thirds of the stock of short-term external debt (not good). Overall, we view the nation’s external vulnerabilities as remaining high.
The peso continues to underperform. In 2017, ARS fell -14.5% vs. USD and was the worst EM performer. The next worst were TRY (-7%), BRL (-2%), and IDR (-1%). So far in 2018, ARS is -51% and is the worst performer. Next worst are TRY (-41%) and BRL (-21%). Our EM FX model shows the peso to have VERY WEAK fundamentals, and so we expect underperformance to continue.
USD/ARS made a new all-time high near 41.36 August 30, which prompted the last 15 percentage point hike to 60%. The central bank has been holding dollar auctions from time to time and has also intervened directly at times. While the IMF typically doesn’t like to see its program money wasted on FX intervention, an exception was clearly made for taking limited action to help support the peso in dysfunctional markets. We expect further peso weakness ahead, with a likely test of that 41.36 high.
Argentine equities are underperforming after a stellar 2017. In 2017, MSCI Argentina was up 78% vs. 34% for MSCI EM. So far this year, MSCI Argentina is -56% YTD and compares to -13% YTD for MSCI EM and -16% YTD for MSCI Frontier. Our EM Equity Allocation Model has Argentina at UNDERWEIGHT. With tight monetary and fiscal policies posing downside risks to growth, we expect Argentine equities to continue underperforming.
Argentine bonds have underperformed. The yield on 10-year local currency government bonds is +746 bp YTD and is the second worst EM performer, behind only Turkey at +811 bp. Shorter-dated paper has fared even worse as a result of the 60% policy rate. With inflation likely to move higher and the central bank likely to keep policy tight or possibly even tighter, we think Argentine bonds will continue to underperform.
Our own sovereign ratings model shows Argentina’s implied rating steady at B+/B1/B+. This suggests some modest upgrade potential for actual ratings of B+/B2/B, as Macri’s reform program bears fruit. However, downgrade risks are now brewing. Much will depend on how long the current market turmoil drags on, as a deep recession will hurt many of the nation’s credit metrics.