Summary
Seeking Alpha – Argentina went through a confidence crisis over the last month, as external and internal factors coupled and pressured the currency.
Macri’s gradualist reform program became under pressure and, as the dust settles, some changes are in order.
Asset prices have suffered a severe correction and are worth a look.
Argentina has been making headlines pretty regularly recently and not for the best reasons. Argentina-related assets have been under immense pressure over the last month as the economy faced a confidence crisis based on multiple internal and external factors. The peso weakened over 20% since April 26th, when the currency started suffering market pressures. The 2.5-year old market-friendly Macri administration suffered its first major economic test in the middle of its gradualist reform program and had to resort to the IMF for stabilization assistance. Although volatility has settled, investors are still nervous.
We analyze the internal and external factors that caused the currency crisis, policy responses, and the new road ahead for the economy. Argentina equities such as Banco Macro (BMA), Grupo Financiero Galicia (GGAL), Pampa Energía (PAM), and YPF (YPF) are down up to 30% since late April. If the stabilization efforts by the government prove successful and the economic turnaround gets back on track, this may be an attractive entry point for the Argentina story.
What Caused The Crisis?
Internal Factors
Argentina is in the middle of an “economic normalization” process started in December 2015 by the newly appointed coalition government led by former business tycoon Mauricio Macri. Macri inherited a completely distorted economy where among others:
- Annual inflation was above 30%, although official inflation statistics were not trustworthy as the previous administration had tampered with them.
- Inflation, although extremely high, was not a reflection of the true economic imbalances, as the former administration artificially appreciated the peso to avoid further inflation and to transfer the political costs of devaluation to its successor.
- Government deficit was above 6% of GDP, although precise figures are not available as the previous administration also refused to provide accurate information.
- Tax pressure, measured as a percentage of GDP was 32.1% (2015), the second highest in Latin America after Cuba.
- Regulated energy prices had been frozen below production costs for many years, which resulted in zero investment from the producing companies, and the need to import energy and subsidize end consumers.
- Public transportation prices were below service cost, with the government subsidizing end consumers.
- The Central Bank was completely subordinated to the government and its balance sheet was under extreme pressure, with foreign reserves below USD 25.000 million and mounting obligations in the futures market from selling cheap dollars to appreciate the peso.
- Poverty levels, although not entirely trustworthy due to price statistics, were above 30%.
Faced with this complex starting point, the Macri administration decided to pursue a “gradualist reform program”, aiming to correct most of these imbalances over a 4/8 year period, while growing GDP and reducing unemployment and poverty. Ambitious?
The pillars of this gradualistic approach were:
- An independent Central Bank with the responsibility of taming inflation with monetary policy tightening and an inflation targeting system. Aggressive inflation targets were set for the 4-year term.
- Very gradual fiscal consolidation with reductions in government spending while lowering tax pressure for businesses and individuals and maintaining social coverage plans for the most vulnerable sectors of the population. Annual fiscal deficit targets were set, with the fiscal balance being achieved in a potential second term.
- Normalization of the energy markets and other markets with the elimination of subsidies and fostering investment in new production.
- Encouraging foreign direct investment and local investment in multiple sectors including energy, mining, agriculture, and manufacturing.
- Fostering exports through a competitive exchange rate and the elimination of red tape.
Needless to say, the plan rested on fiscal deficit financing for several years before the balance was achieved. Given high levels of domestic inflation and relatively undeveloped domestic capital markets, most of this financing would have to be secured externally and in foreign currencies.
Markets appeared to buy into Macri’s plan, as the government was able to navigate the first two years of its term with relative tranquility. Times were good, and investors were confident, even betting on a 100-year bond last June.
Domestically, the government received a vote of confidence in October last year, defeating former president Cristina Kirchner and winning a significant, though not majoritarian, portion of Congress. The defeat of Mrs. Kirchner was very encouraging for markets, with debt yields plummeting to multi-year lows and local equities surging.
Unsurprisingly, the first two years of the administration were characterized by over-execution on the fiscal front, as conservative targets were beaten and under-execution on the monetary front, as results came in short of aggressive inflation targets.
Complications appeared late December last year, as two events seemed to distort the relative smoothness with which the gradualist agenda was being executed. First, the government had some unanticipated trouble pushing a pension reform, with questionings from both coalition partners and opposition. Second, the government decided to soften its inflation targets for the following years and the Central Bank consequently decided to relax its monetary policy, lowering interest rates by 150 basis points (from 28.75%) during January. Markets hated the move, as it was interpreted as government meddling with CB independence. In this context, the peso fell 14% between December and January, and yields rose.
A tense calm dominated the first quarter of 2018, as the market expected further results on the fiscal and inflation agendas before making a move. In April, however, the combination of several events triggered the escalation of the currency crisis:
- Inflation for March came in at 2.3% according to the National Statistics Institute, far above the pace needed to hit the annual target. This, coupled with the scheduled jump in regulated energy prices for April, uneased the political opposition, which proposed a change in the energy market normalization scheme. The market believed that, if it went through, such a change would seriously impair the fiscal consolidation path.
- The soybean complex, Argentina’s largest exporter, suffered its worst drought in 40 years, with soybean production plunging over 30% according to USDA May estimates. This affected the availability of dollars in the FX market, as exporters did not provide the usual supply of foreign currency.
- A change in the tax law enacted in December, under which investments in securities issued by the Central Bank (Lebac) became subject to income tax both for foreign and domestic investors, resulted in investor selling the peso-denominated Lebacs and buying dollars in April and May.
- As the peso started to depreciate in late April, the Central Bank attempted to intervene by offering dollars from its foreign reserves. This proved to be counterproductive as internal pressures coupled with external factors as most EM currencies slid. After a couple of days, the Central Bank decided to stop fighting the global trend and refrained from selling further. The markets read this as a sign of weakness from the CB and the rout deepened.
External Factors
To varying degrees, most emerging economies have suffered the rise in the US dollar and the US Treasury yields in 2018. Unsurprisingly, the most vulnerable economies have suffered the most, with Turkey and Argentina taking the lead.
Being in the middle of an economic reform project that is still largely based on US dollar denominated external financing, the rise of the greenback and Treasury yields that “spiraled” in May precipitated a “rush for the doors” in Argentina assets, especially its currency but also debt and equities.
The combined pressure of the internal and external factors resulted in a three-week-long currency crisis that made international headlines in which the peso fell over 20% against the dollar. On May 8th, with pressures mounting against the peso, President Macri announced that Argentina would reach out to the IMF to negotiate a “standby arrangement” in order to stabilize the situation and “secure financing through 2019”.
May 15th marked the zenith of the crisis, as USD 30,000 million in peso-denominated Lebacs were due for rollover. Markets feared that, if a significant proportion of investors decided not to roll over, there would be a definite run against the CB’s reserves.
Fears subsided as the CB was able to roll over 95% of the Lebac stock and, remarkably, the Treasury was able to place over USD 2,000 million in peso-denominated 5- and 8-year fixed rate bonds, most of it to foreign institutional investors. This was a confidence boost for the peso and the government sighed. Markets relaxed, and the currency appreciated over 3% over the last week.
The Aftermath
It seems as though the government was able to navigate the crisis, although it came out of it with several bruises. The initial consequences of the crisis are both political and economic:
- International reserves reported by the Central Bank are down USD 6,000 million since the crisis started in late April, almost 11%.
- The CB was forced to hike short-term interest rates to 40% (over 1,200 basis points above January lows) in order to generate an appetite for the peso. These rates are unsustainable and, if they were to be sustained, would have a negative and significant impact on the real economy.
- Yields on federal, provincial, and corporate debt rose to levels not seen since prior to the October 2017 election, when markets feared that a win by Cristina Kirchner could result in a populist comeback.
- US-traded Argentina equities suffered, with the Global X MSCI Argentina ETF (ARGT) down more than 10% and Banco Macro down more than 30% at one point.
- The government was forced to announce changes in its fiscal consolidation path, with more aggressive targets announced. For 2018, primary fiscal deficit target was reduced from 3.2% to 2.7%. This was announced by Treasury minister Dujovne in a press conference on May 4th.
- Macri was forced to announce the initiation of negotiations with IMF on May 8th. This may have potentially significant political consequences in a country that does not have happy memories of past IMF interventions.
- In a press conference on May 16th, Macri recognized coordination mistakes in the handling of the crisis and made changes in the economic policy-making team, with Treasury Minister Nicolás Dujovne assuming oversight responsibilities over other economic ministers.
- Treasury minister Dujovne, speaking to international media on May 14th, acknowledged that the currency shock will probably have a negative effect on inflation (revised upwards) and growth (revised downwards). Time will tell of the significance of the impact but, with presidential elections next year, this is definitely not good news.
Investors will have to wait a couple of months to fully understand the consequences of the crisis. Among other things, they will look out for:
- The ongoing negotiations and final agreement with the IMF. Expectations range from a USD 20,000 million to a 40,000 million credit facility. The final number and conditions/covenants agreed upon will be closely watched. A satisfactory amount will probably be very positively received.
- The inflationary effect of the currency devaluation over the next couple of months. Controlling the “pass-through” is vital for the government. The 15% inflation target for 2018 will undoubtedly be surpassed, but the question is by how much.
- The negative effect on growth. The Treasury and the IMF were expecting real GDP growth of 2.5% for 2018. It remains to be seen if it will have to be moved down.
- The effect on government approval ratings. With presidential elections coming up next year, President Macri needs to maintain approval ratings if he wants a shot at reelection.
- The voting of the opposition-proposed tariff bill. Although Macri has already announced, it will veto the tariff reduction law if it is passed by Congress, investors will want to see if the government can beat it in Congress.
- The effect of the turmoil on the cohesion in the governing political coalition and on the political opposition.
Equities Aftermath: Initial Thoughts
Banks
Argentina banking stocks have done extremely well over the last two years, as investors priced in the expected growth in lending, as Argentina’s private lending/GDP ratios converge to regional averages. Lending to the private sector grew 22% in real terms in 2017 according to the Central Bank and was expected to grow at similar rates in 2018 and 2019. This currency crisis found the banking system in good shape (unlike 2001, when the system failed), with adequate regulatory capital levels and no currency mismatches, and the banks went through the crisis suffering very little stress.
The hike in short-term interest rates by the CB will probably have some effect on private borrowing. The longer these rates remain in place, the more significant the effect on lending volume will be. Net interest margins will probably tick upwards if rates remain high, but not immediately, as most of the outstanding credit is short term but at fixed rates.
Banco Macro is down more than 30% since late April; Grupo Financiero Galicia is down 30% since April, Banco Frances (NYSE:BFR) is down 28% and Grupo Supervielle (SUPV) is down 28% in a month.
Utilities
Utilities were under intense pressure as the gradual tariff normalization scheme being executed by the government came under political threat. Investors had already priced in the scheduled price increases and feared not only that future increases might be at risk but also that recent increases may have to be undone. It is unlikely that the tariff normalization scheme will be altered, given that if the opposition bill goes through Congress, the President has already announced it will veto it. Importantly, as part of the new tariff scheme in place, the government pays electricity generators USD denominated rates.
Central Puerto (CEPU), the largest electricity generator in Argentina, is down almost 25% in May. Edenor (EDN), the largest electrical distributor in the country, is also down 25%. Transportadora de Gas del Sur (TGS), the largest mainstream gas pipeline operator, was down 15% at one point.
Oil & Gas
Oil & Gas producers went through the crisis with a relative hedge, as oil prices surged over the last month. The government had already normalized the domestic oil market in 2017, with local prices fluctuating with international prices. However, as a way to mitigate the short-term potential surge in inflation due to the devaluation, the government and O&G companies have agreed not to raise prices for two months.
YPF, the main oil & gas producer and retailer in the country, is down 9% in May. Pampa Energía with both oil & gas and utility exposure was down 13% at one point but rose sharply last week.
Industrials
Export-driven industrials such as Tenaris (TS) (with high exposure to oil & gas) and Ternium (NYSE:TX) should be winners from the exchange rate adjustment, as they have significant operations abroad and most of their revenues are dollar denominated. Both are up more than 8% in May.
Domestic market-oriented industrials such as cement producer Loma Negra (LOMA) should be under significant pressure going forward. Investors had already priced in robust growth in cement sales as the government pushed an infrastructure agenda. Now, however, infrastructure spending is being revised as more aggressive fiscal targets are sought. Loma Negra is down almost 30% in May.
Other
Cresud (CRESY), a real estate holding with operations in Argentina and Israel, is down more than 17% in May. Cresud’s results will benefit from the exchange rate adjustment on its Israel operations. Moreover, being the largest agricultural landowner in the country, the Company will probably benefit from better peso priced exports.
Telecom Argentina (NYSE:TEO), the largest telecom operator in the country, is in the middle of a merger process with Cablevision, the largest cable operator, with the definite antitrust approval pending. Telecom is down 22% since late April.
MercadoLibre (MELI), Latin America’s leading e-commerce platform, is down 15% since late April. MercadoLibre’s operating results from Argentina in USD terms will take a hit from the FX adjustment, though it is unlikely that volume growth will suffer. Argentina, Brazil, and Mexico are MercadoLibre’s main markets.
Despegar (DESP), Latin America’s leading online travel retailer, also has regional exposure and its performance should be relatively hedged from Argentina’s volatility. Still, DESP is down 18% since late April.
Takeaways
After years of neglect, Argentina became a darling of international markets in 2015 as investors bought into the turnaround story based on Macri’s gradualist normalization plans. The currency crisis was certainly unexpected, and its full impact is still to be determined, but I believe the story is still there, albeit with some implementation changes and valuations are much more compelling than in early April. For investors with emerging market experience and stomach, Argentina is definitely worth a look.
By Jaime Campo
Value, long-term horizon, investment advisor, foreign companies
Published in Seeking Alpha
Disclosure: I am/we are long TEO, CRESY, CEPU, BMA, TGS.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
