Argentine central bank surprised markets with a 500 bp hike in the policy rate yesterday. It is clear that an aggressive orthodox policy response is a necessary but not sufficient condition for stabilizing a nation’s financial markets. We warned back in May that regardless of the measures taken, Argentina is likely to remain under pressure within the context of a broad-based EM sell-off.POLITICAL OUTLOOK
President Mauricio Macri was elected in October 2015 on a platform of economic reform. Tired of the failed populist policies of the Kirchner/Fernandez wing of the Peronist party, Macri was elected in the second round over Peronist candidate Daniel Scioli.
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 section will explain why. The next elections will be held in October 2019.
The widening graft probe so far has spared Macri whilst ensnaring former President Fernandez. She has denied any wrongdoing. So far, 15 have been arrested and include business leaders from the construction industry as well as senior officials from the Fernandez administration.
The IMF granted a 3-year $50 bln Stand-By Arrangement for Argentina 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 decision to request IMF aid is fraught with potential pitfalls, however. Due to the IMF’s perceived role in Argentina’s last major financial crisis, going to the IMF could hurt Macri’s popularity. Furthermore, adherence to IMF-mandated austerity will be difficult as the 2019 elections approach.
A BRIEF HISTORY LESSON
For much of the 1990s, Argentina was the poster child for IMF programs. After a protracted period of hyperinflation, President Raul Alfonsin resigned in 1989, five months before his term was to end, and President Carlos Menem took over. After another bout of hyperinflation, the government administered shock therapy in the form of a currency board that was installed in early 1991 by Economy Minister Domingo Cavallo. Supported by a traditional IMF program of austerity (which after all was sorely needed), Argentina enjoyed strong growth and relative stability through much of the 1990s.
The seeds for the next crisis were planted by continued fiscal slippage, however. Financed by heavy debt issuance, wider budget deficits were posted as Argentina strayed from a strict currency board. Despite the relative success of the so-called Convertibility Law, several IMF programs were needed due to stresses stemming from the Tequila Crisis of 1993-1994 and the Asian crisis of 1997-1998. Through it all, Argentina stuck to the IMF-sponsored austerity programs and still enjoyed average growth of 6% from 1991-1998.
President Fernando de la Rua was elected in 1999 to replace the outgoing Menem. He inherited a deteriorating situation. The economy contracted four straight years from 1999-2002, weighed down in large part by austerity programs administered by the IMF. Given the peso’s peg to the USD dollar, the broad-based greenback rally from 1995- 2002 hurt Argentina’s export competitiveness and added to the economic stresses.
Relations between Argentina and the IMF soured at the end. An IMF program of $7.2 bln for Argentina was approved in March 2000 and augmented in September 2001 to $21. 6 bln. It all ended in tears late that year as austerity measures failed to prevent a default in December. The IMF halted disbursement of funds that month over disagreements with Argentine policies, and perhaps hastened the endgame. Indeed, capital flight accelerated and the government enacted the so-called “corralito” that basically froze all bank accounts.
President de la Rua resigned in December 2001 amidst rioting and protests against austerity. He was replaced by interim President Adolfo Rodriguez Saa, who was forced to step down after a week in office and was replaced by Eduardo Duhalde. Duhalde quickly recognized the inevitable and devalued the peso in his first month in office.
The last IMF program was a transitional stand-by program for $3 bln, approved in January 2003 and meant to serve as a bridge loan. As the IMF wrote, the loan was made “with the expectation that the transitional stand-by credit will be succeeded by a multi-year IMF arrangement after the election in late April 2003 of a new government.” Interestingly, Duhalde supported little known Nestor Kirchner over former President Menem in the 2003 election.
The economic chaos of 2001-2002 paved the way for the election of populist President Kirchner in 2003. Kirchner quickly ended the IMF program, paid off Argentina’s entire obligations to the IMF in December 2005, and vowed to go it alone. This approach carried over to his successor and wife Christina Fernandez. The two were able to follow their populist approach to governing in large part due to booming commodity prices, which helped boost the economy despite poor economic policies. Under these two, the IMF became the scapegoat for all of Argentina’s problems.
The economy is facing strong downside risks. The Treasury Ministry just 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 so far in Q2 shows a -3.2% y/y contraction. Due to even tighter fiscal and monetary policies, we see downside risks to the growth forecasts and outright recession this year.
Price pressures remain high and likely to rise further due to the weak peso. CPI rose 29.5% y/y in June, the high for this cycle and well above the 12-17% target range. WPI rose 44.1% y/y in June, also a cycle high and portending further acceleration in CPI inflation. July CPI data will be reported tomorrow and is expected to accelerate to 31.2% y/y.
For a short period, the aggressive rate hike to 40% was successful in calming markets. However, spillover from Turkey and nervousness about the graft scandal ended that calm, necessitating further tightening to 45% yesterday. 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.
The external accounts should improve. Export growth has slowed, but import demand is slowing even faster. 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 ended July at $58 bln. As of yesterday, reserves fell further to $56.6 bln. They cover about 6 months of imports (good) but are equivalent to only three quarters 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 -37% and behind only the worst performer TRY (-41%). After ARS, the next worst are BRL (-15%), RUB (-13%), and ZAR (-13%). 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 30.50 yesterday before the surprise rate hike. Press reports suggest Argentina obtained permission from the IMF to use some of its reserves to help support the peso. While the IMF typically doesn’t like to see its program money wasted on FX intervention, but Argentine policies could make a case for limited action to help support the peso. We expect further peso weakness ahead.
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 -49% YTD and compares to -10% YTD for MSCI EM and -13% 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 +349 bp YTD and is the second worst EM performer, behind only Turkey at +899 bp. Shorter-dated paper has fared even worse as a result of the 45% 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, 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.