Conclusion: Keep a small space on your white board(s) for the risk of another large-scale Argentine default over the long-term TAIL. At a bare minimum, another bout with domestic hyperinflation is an elevated risk over that duration, as the country seeks to deplete the very resources it needs to maintain stability in its currency.
In NOV of 2010, we wrote a note titled, “Is Argentina Signaling a Cyclical Peak in Emerging Market Asset Values?” in which we used Argentina’s country-specific fundamental outlook to highlight our generally-bearish thoughts on EMs. Using the MSCI EM Equity Index as a proxy for “EM asset values” we were roughly +4% too early in making that call (though the index did experience a -31% peak-to-trough decline in the months following our publication). Looking to Argentine equities specifically, the country’s benchmark Merval Index is down roughly -29% since NOV 4, 2010. In addition to the equity market crash, the nation’s 5yr CDS jumped +378bps (roughly +62%) since then and its currency, the Argentine peso, is down -10% as well.
As with all of our research, the point is never to take victory laps, but rather to inform our clients on pending material risks (+/-) that we view as increasingly probable. With Argentina, another round of domestic hyperinflation (per IASB standards) is not at all out of the realm of possibility over the long-term TAIL. Ironically, this is likely to come alongside a continued popping of Bernanke’s Bubbles across the commodity market(s). As we walk through in the analysis below, structurally lower commodity prices = a structurally higher probability that Argentina is forced to default on its external sovereign debt over the long term.
Per the oft-maligned Institute of Statistics and Census of Argentina (INDEC), agricultural and petroleum products account for 66.2% of Argentina’s export revenue. Soybeans alone make up 24.1% of the total, followed by fuel and energy products at 12.2%, and then cereals (mostly wheat and corn) at 8.3%. The reason we focus on Argentina’s export revenue is because FX reserves have become the primary source for Argentina’s servicing of its existing stock of external debt – especially given that Argentina remains locked out of international credit markets largely as a result of private creditor holdouts from its $95B default in 2001 and subsequent ’05 and ’10 restructurings (eventually totaling 92.6% of the original defaulted amount).
Recent legislation has dramatically increased Argentina’s reliance on its stock of FX reserves to service international debt. In MAR, the Argentine Senate approved President Fernandez’s proposal to eliminate the “free-and available” clause from the 1991 Dollar Convertibility law that was largely responsible for helping Argentina overcome hyperinflation by pegging the peso at a 1x1 rate vs. the USD. This allows the Argentine Treasury to use all of the central bank’s FX reserves to fund whatever purchases policymakers desire, including servicing international debt. Previously, the law had stipulated that the country was only able to tap FX reserves in excess of the domestic monetary base.
The Treasury, which now has unmitigated access to the central bank’s $47.5B in FX reserves, has already used $16.2B of FX reserves since 2010 to service the country’s external debt; another $5.7B of those reserves are budgeted for debt service in 2012, leaving the country with $41.8B at year-end (assuming no little-to-no growth in the existing stock). At that pace – which could easily accelerate given the socialist agenda of President Fernandez – Argentina will run out of reserves by 2020 (again, assuming no growth). Per Bloomberg, Argentina has $82.3B, $31.5B, and $2.2B in USD, EUR, and JPY denominated debt outstanding, respectively.
In addition to tapping FX reserves for debt service, the rule change now gives the president access to increased “loans” from the central bank (now 20% of LTM total vs. 10% prior). We view it as highly unlikely that the central bank is paid back on time and/or at all if the sovereign is ever in a pinch – lest it continue nationalizing domestic assets, such as the recent YPF SA takeover. The ouster of Spain’s Respol from its controlling stake in its Argentine unit is but one of a long series of credibility-damaging maneuvers Fernandez has either initiated or endorsed since winning reelection last fall:
- New legal restrictions (up to criminal prosecution) on domestic purchases of foreign exchange;
- Legislation forcing importers to require approval from the federal tax agency for all overseas purchases; and
- Forcing dividend-paying banks to hold 75% more capital (designed to deter them from making dividend payments to international shareholders).
The common theme with these measures is that they have each been more-or-less designed promote financial repression in the form of quashing capital outflows, which, in essence, artificially prop up central bank reserves. Over the long term, however, there is little the country can do to salvage the near-irreparable damage Fernandez has done to the country’s already-low international credibility among investors. Capital inflows will become increasingly scarce over the long-term TAIL, limiting growth in FX reserves, which would already be under assault in a sustained Strong Dollar environment. The following commentary in the wake of the YPF SA seizure lends credence to our long-held view:
- “I am seriously disappointed by yesterday’s announcement. We expect the Argentine authorities to uphold their international commitments and obligations, in particular those resulting from a bilateral agreement on investments with Spain.” – European Commission President Jose Barroso
- “A takeover sends a very negative signal to international investors and it could seriously harm the business environment in Argentina. The measure creates legal insecurity for all European Union and foreign firms in the country.” – European Union Foreign Policy Chief Catherine Ashton
- “Argentina aimed to take over YPF cheaply and the company demands compensation… The expropriation isn’t anything more than a way to cover up the social and economic crisis Argentina is suffering at the moment.” – Repsol Chief Executive Officer Antonio Brufau
As an anecdote, I’ve exchanged correspondences with former Argentine Central Bank Chief Martin Redrado over his 2010 termination for refusing to tap FX reserves to supplement public spending and service international debt due to its inflationary consequences; needless to say, his worst fears are being realized in real-time. More importantly, perhaps the worst is yet to come for his home country.
As such, keep a small space on your white board(s) for the risk of another large-scale Argentine default over the long-term TAIL. At a bare minimum, another bout with domestic hyperinflation is an elevated risk over that duration, as the country seeks to deplete the very resources it needs to maintain stability in its currency. Per the chart below, the FX non-deliverable forwards market is pricing in a -20% decline in the Argentine peso over the NTM. At this pace of introducing new [bad] economic policy initiatives, we’d expect even more downside over the long-term TAIL.