Argentina – The return to orthodoxy and the opportunity to go long ARS

The compelling economic challenge in most major economies is for an improved coordination of policy across reflationary levers, so that policy-makers can tackle the slow burning global growth crisis. The extreme degree of policy coordination – Helicopter money – may be a desired end-state for many economies. There is of course a dark side to such a policy of “inflationary” deficit financing. Emerging markets are replete with examples of central banks under-writing fiscal spending in a manner that has spurred economic dislocation and undermined investment returns. The damage these policies have reaped on various emerging markets stems from the fact that, unlike candidates for helicopter money, many emerging market central banks have monetised fiscal debt at a time when there is no zero bound problem for monetary policy and when the key economic challenges are not insufficient demand and downside risks to inflation. Argentina provides a prime example of the problems of inappropriate inflationary deficit financing. A decade of populist rule left the new President with a legacy of unsustainable budget deficits, high inflation, weak economic growth and an unpredictable regulatory regime. In contrast to many key leading economies, Argentina’s challenge is to disentangle monetary and fiscal policy and thereby return to economic orthodoxy. Reining in the budget deficit is a critical success criterion for the government’s stabilisation plan. While the government faces a daunting economic challenge, the market has expressed confidence in President Macri by maintaining long positions in the country’s Eurobond debt. By contrast, following a maxi-devaluation, sentiment in the ARS remains weak. However, we think that the risk premia on the ARS priced into the FX forward curve is too high since a tight monetary policy and a more stable ARS could be crucial components of a stabilisation plan over the next 12-months. We see value in establishing short-USD/ARS positions, which can potentially bring to investor portfolios a high return trade that is uncorrelated to prevailing market beta.

The ARS risk premium priced into the FX forward curve seems to high: opportunity to short-USD/ARS

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Source: Bloomberg

The chequered past of the EM variant of Helicopter money

The key global challenge – an improved coordination of reflationary policies

Our core thesis is that to break the global growth crisis, policy-makers need to have a better co-ordination of policy across geographies and reflationary levers. The extreme case of co-ordination involves “Helicopter money”where monetary and fiscal policies merge, with a view to policy-makers expanding growth and inflation expectations without being concerned about higher budget deficits leading to future, offsetting, fiscal tightening measures. Although, as we have noted, Japan shows how in a world economy replete with QE, the line between fiscal reflation and helicopter money is a blurred one: with the BOJ owning 43.1% of outstanding JGBs and rising fast, the government’s fiscal liabilities are increasingly in highly supportive hands. (The Global Growth Crisis – A better coordination of reflationary levers?.) As the debate slowly turns to improved policy coordination, it might be timely to look at the dark-side of this policy approach – when policy coordination can result in unequivocally negative outcomes. The example of Argentina springs to mind, with its history of inflationary deficit financing and run-away inflation. In contrast to many developed markets, the key challenge in Argentina is to break the symbiotic link between fiscal and monetary policy and thereby normalise policy settings.

Helicopter money = inflationary deficit financing, but with some critical differences

Helicopter money is another term for inflationary deficit financing, a trend that has eroded the portfolio returns of many an EM investor. However, in practical terms, the two phrases are very different. The currently mooted helicopter money is appropriate for an economy displaying particular characteristics:

 

  • A central bank that is faced with a zero bound problem for setting interesting rates…
  • …and has already undertaken QE but is encountering diminishing money multiplier effects.
  • Where the key macro economic challenges are insufficient aggregate demand and downside risk to price stability.
  • Where fiscal multiplier effects would be larger than those associated with monetary policy and where inflationary deficit financing could increase the efficacy of fiscal stimulus even more.

 

Inflationary deficit financing: a long and troubled history in emerging markets

These conditions are invariably absent in many EM economies where central banks have been required to monetise debt. In the case of Argentina, central bank deficit financing has been an alternative to fiscal restraint and has been implemented in the context of already high levels of inflation and artificially low/ negative real yields. The decade of populist economic policies that ended with the election last December of the more technocratic President Macri, resulted in a legacy of fiscal profligacy, economic weakness and rampant inflation. In this respect, President Macri’s challenge is to restore Argentina to economic orthodoxy and policy normality.

Chart 1. Argentina’s fiscal deficit – the source of many ills

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Source: IMF

Argentina’s budget deficit – the touchstone for policy and economic normalisation

 

A wide budget deficit is a legacy of the populist era

The touchstone of any successful economic stabilisation in Argentina will be a notable reduction of the budget deficit. Unless this is dramatically reined in, financial and economic stability are likely to remain elusive. If we strip-out some unorthodox policies that the former government classified as revenue (such as central bank deficit financing and property income), the budget deficit measured 7.4% of GDP last year, up from 4.3% in 2014 and a 0.4% surplus in 2008. (Chart 1.) The ballooning deficit reflected a series of unsustainable populist policies such as utility price subsidises which measured 5% of GDP at end-2015 and a surge in public sector employment. President Macri is targeting a budget deficit of “virtually zero” in 2019.

Chart 2. Inflation has been a key consequence of the budget deficit

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Source: Bloomberg

The budget deficit has driven inflation higher

Price stability was the most obvious casualty of this expansionary fiscal policy. The government was unable to finance the deficit through traditional channels, in part because a long-running conflict with international creditors precluded external financing. As a consequence, central bank deficit financing became a persistent feature of the economy, and measured around 2% of GDP last year. While downside risks to inflation prevail in much of the world, in a country such as Argentina where a history of high inflation has embedded price rises in business and household expectations, higher money supply growth can quickly result in price gains. Chart 2 shows high levels of Argentinian inflation, with the nationwide CPI rising by 26.9% last year. Reduced inflationary deficit financing is a necessary condition for curtailing inflation and for the government reaching it’s target of lowering CPI growth to 25% this year (which appears unrealistic following the ARS devaluation as we discuss below) and 17% in 2017. To complicate matters further, there is a circularity to the problem: many government liabilities and expenditure items are indexed to inflation and hence rapid price gains weaken its fiscal position.

Chart 3. Policy unpredictability has reduced the appetite for the private sector to expand leverage

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Source: Bloomberg

High inflation and the uncertain economic and policy backdrop has lowered private sector leverage

The budget deficit also impacts economic growth. Wide budget deficits, high inflation and the increasingly unorthodox policies aimed at financing the budget deficit and maintaining financial stability (such as capital controls, export quotas and policy-directed negative real yields), have created a climate that is not conducive to the demand for and supply of credit. As a result, Argentina’s private sector has extremely low levels of leverage, which has come at the expense of economic growth. However, given the need for Argentina’s private sector to withstand an unpredictable policy climate and an uncertain economic backdrop, the reluctance to increase leverage is entirely understandable. Chart 3 shows that non-financial private sector credit measured just 15.6% of GDP at end-2015. The low level of private sector debt also reflects Argentina’s history of high inflation, which has eroded the value of outstanding debt. Meanwhile, chart 4 highlights how the unpredictable economic climate has had a deleterious effect on economic growth in recent years.

Chart 4. Stagflation has been a common occurrence in Argentina during the populist era

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Source: Bloomberg

The President Macri era policy shift

 

Reduced public spending

Since assuming office last December, President Macri has tried to break the Gordian knot of the fiscal problems that have come to define Argentina’s policy framework. In terms of public spending, a 20% reduction in utility charges comprised a 1% of GDP fiscal tightening (but of course, residual utility subsidies remain around 4% of GDP). The public sector workforce has been reduced and the government tried to impose restraint on discretionary expenditure commitments.

Revenue diversification strategy

On the revenue side, the government resolved it’s legal conflict with hold-outs from the 2005 and 2010 international debt exchange, which laid the foundation in April for a USD16.5bn bond issue, which was Argentina’s return to international capital markets after a 15 year hiatus. Access to foreign capital provides a critical diversification of revenue sources for the government that could ease the financing burden on the central bank. The government also implemented a wave of additional policies aimed at encouraging increased capital inflows. The government unified the previous system of multiple exchange rates and moved from an FX peg, that was defended by strict capital controls, to a ‘dirty floating” exchange rate regime and relatively open capital account. The result has been a 53.2% surge in USD/ARS since the FX policy shift on 16th December, which corrected much of the prior over-valuation of the exchange rate regime, but such moves were a pre-requisite for a resumption of notable capital inflows.

Creating a more predictable economic climate

The efforts at creating a more stable and predictable investment climate also saw the government implement sweeping domestic policy changes. The central bank governor was replaced and monetary policy was tightened as the government moved way from the policy of suppressing real yields. The Baibair interbank lending rate was increased from 19% in November 2015 to 40% in March. Argentina’s statistical agencies have been transformed in order to correct for the previous system of politically influenced statistical inaccuracies. The government has also pledged to reduce regulatory fluidity, whereby the prevailing business climate was often roiled by sudden changes to regulatory policy, with the most obvious disruptions being those to foreign exchange controls.

 

The scale of the challenge remains daunting: 2016 to see a recession and increased inflation

The 2016 recession will be deep

The Macri administration has transformed the policy framework of Argentina and raised hopes for a normalisation of the country’s economic, policy and financial climate. However, the scale of the challenge ahead leaves little room for complacency. The pro-cyclical tightening of fiscal policy is expected to result in a deep recession this year, with the IMF forecasting, perhaps optimistically, a 1% decline in real GDP in 2016. Recent economic data has surprised the the downside, with June industrial production faling by 6.4% Y/Y (expectatiosn were for a -3.5% decline) and June construction spending was down 19.6% Y/Y, which continues a rapid decline from the 4.0% growth rate seen at end-2015.

Inflation has surged

The immediate outlook for inflation has also deterioriated sharply. The slump in the ARS, while necessary, has ushered in a surge in inflation and given Argentina’s traditional of indexation, second round price effects can be expected. The CPI rose to 47.1% Y/Y in June, and in 3M3M terms rose 77.4% (Chart 2). The government’s 25% inflation target for 2016 appears too ambitious. (The one positive of the surge in inflation of that the uptrend in public debt will be moderated as fixed liabilities are inflated away. Indeed, inflation is the primary reason why government debt/ GDP has fallen from 137.7% of GDP in 2002 to 56.5% last year. Chart 5.)

Chart 5. Inflation has reduced the government’s debt burden

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Source; Bloomberg

 

…while pressure on the fiscal accounts remains intense

Meanwhile, progress on reining in the budget deficit will be a long and painful affair. The surge in inflation will naturally widen the budget deficit given indexed government expenditure items, while the recession will erode the revenue base. The IMF’s forecast of the budget deficit narrowing only 1pp of GDP in 2016 to 6.4% appears realistic. The target of a “virtually” balanced budget by 2019 also appears difficult to achieve given the scale of pro-cyclical and unpopular fiscal tightening measures that would be required. (Already, President Macri’s honeymoon period may be over as economic weakness and fiscal tightening has sparked anti-austerity demonstrations). The problem is compounded by weak global growth, which reduces the potential for a positive external shock of strong external demand easing the government’s fiscal problems. An indication of the economic challenge ahead was seen in the June budget deficit data which ballooned to ARS43bn, or fully 25% of the cumulative deficit over the past 12 months. While reduced, central bank deficit financing is likely to remain an important component of fiscal policy for the next 2 years, which means that even the still high 17% 2017 target for inflation is a stretch target.

 

The market has bought Argentinian assets, and disliked the Peso

Argentinian Eurobonds have rallied hard

Despite the economic challenges, investor demand for Argentinian assets has surged since Macri assumed power. The low yielding global climate has naturally helped the market accept the risk premium being offered by Argentinian assets, but there is also a belief that a new era has begun in Argentina as orthodoxy replaces populism. In terms of Argentinian external debt, the USD16.5bn bond issue in April was almost four times over-subscribed and the performance of the new securities since April has been strong. (Chart 6.) The yield on the 2026 10yr bond, for insance, has declined 59bp since issue to 6.5%, which is price terms alone has generated a 4.1% return. This has reflected a tightening of spreads during a period of rallying USTs. Long positions in Argentinian Eurobonds have been a favoured way for international investors to position for Argentina’s economic turnaround, which would be associated with a reduced risk and credit premium.

Chart 6. Argentina’s recently issued Eurobonds have performed well

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Source: Bloomberg

Equities remain a traditional safe haven nominal asset

The Argentinian equity market has also performed strongly. The benchmark MERVAL index is up 29.3% year-to-day, although this is far less of a reflection of foreign investor demand. Indeed, given their nature as nominal assets, equities have traditionally played a safe haven/ wealth preservation role for Argentinian investors unable to place their funds overseas and who are concerned about their nominal wealth being inflated away.

 

The market’s scepticism towards the value of the ARS…

The ARS, however, has attracted a far more sceptical investor base, and it is easy to understand the pervading negativity. As we have noted above, the government faces a deep challenge as it tries to rein-in it’s budget deficit, which will slow the pace at which inflation can fall. High inflation differentials to trading partners are the conditions for a steady and persistent downward pressure on the ARS, and the government is likely to be wary of returning to a prolonged period of an overvalued exchange rate at a time when it is trying to encourage export growth in order to help narrow a current account deficit that measured 2.6% of GDP in Q1 2016. (Chart 7.) This creates a steady and persistent medium-term downside risk to the ARS. Besides which, with FX reserves of just USD24.9bn and with the government committed to not returning to the path of capital controls, the central bank will be able to do little more than smooth market fluctuations rather than fight ARS weakness.

Chart 7. A lifting of export restrictions and the end of the over-valued ARS policy can help narrow Argentina’s current account deficit.

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Source: Bloomberg

…could provide an opportunity to go long the Peso

The markets expectations for continued ARS depreciation is reflected in the USD/ARS forward curve. (Chart 8.) The USD/ARS spot rate is currently 14.85, and the 3-month NDF prices this at 15.86 and the 12-month NDF prices this at 17.93. This amounts to an annualised USD/ARS premium of 27.2% and 20.7% respectively. However, we believe that this premium is excessive and that there is an opportunity short USD/ARS via the FX forwards, and collect carry as the ARS out-performs the forward curve.

Chart 8. The wide USD/ARS forward premium reflects pessimism towards the Peso

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Source: Bloomberg

 

Reasons for the USD/ARS to under-shoot the FX forward curve

There are several reasons to look for the ARS to outperform market expectations:

  • Following the maxi-FX adjustment since Macri assumed power, the ARS has addressed much of it’s prior over-valuation and is broadly fair value.
  • Of course, 47% inflation will quickly erode that regained competiveness, but there is reason to believe that the government will tolerate a stronger currency as it battles to reduce inflation. We have already noted how the indexation of public spending means that a weaker currency automatically widens the budget deficit, and hence there is an incentive for the government to try and reduce inflation while it engages on it’s long and painful path of fiscal austerity. A tight monetary policy could play a critical role in taming inflation or at least slowing the pace at which second round inflation effects build. A stronger, or least more stable ARS could play a positive role in reducing these second round price effects, and a tight monetary policy could help provide this currency stability. Tighter monetary policy and a more stable ARS could be an immediate path of less resistance for the authorities at they try and rein in the budget deficit at a time of growing political opposition to continued austerity.
  • The low leverage levels of the private sector mean that they can withstand a period of sharply higher nominal and real interest rates. This increases the potential for tight monetary policy to play a role in taming inflation and hence aiding fiscal consolidation.
  • The alternative to trying to limit second round price effects via a tight monetary policy and more stable ARS woud be an increased need for further pro-cyclical fiscal tightening measures, which carry an increasingly expensive political cost. In the early phase of it’s stabilisation plan, the govenrment cannot therefore afford to have a laissez-faire approach to the performance of the ARS, and significant fiscal problems would emerge were it to depreciate in line with the FX forward curve over the coming 12 months. This argues for an initially tight monetary stance.
  • Classic, orthodox economic stabilistaion plans – which are rooted in the IMF’s theoretical stabilisation model – involve an intial adjustment of an over-valued exchange rate and then a tight monetary policy for a period of time to help stabilise the newly floated currency and to help curb inflation while structural reforms and fiscal consolidation takes place. A depreciating currency following an intial valuation adjustment is considered problematic for a stabilisation program in its crucial early stages.

Short USD/ARS 12 month forward

For these reasons, the market’s focus on expressing a positive view on Argentina via the Eurobond market might leave open the opportunity for a short-USD/ARS position. It is likely to be a fairly wild ride, and hence despite lower implied yields, a 12-month short-USD/ARS NDF position might be preference to a 3-month position since mark-to-market risk could be easier to manage. A particularly appealing entry level could be a 12-month USD/ARS outright above 18.0 or a 12-month implied yield of above 22%, but we would recommend scaling into long positions at current levels, particularly given that bid-offer spreads can be 2% wide and so a degree of finesse may be required to build an attractive entry level. Alternatively, with 3-month USD/ARS vol at 26%, investors may favour optionalising their short-USD/ARS exposure. The additional appeal of the trade is that Argentina’s problems are so idiosyncratic that the short-USD/ARS trade will likely have a relatively low correlation to broader emerging market beta and indeed to broad-USD trends. Indeed, a long ARS trade may have a lower correlation to market beta than a long Argentinian Eurobond trade, given that many holders of this debt will be doing so as a “core-plus” component of an portfolio and hence could be forced to reduce market risk were we to see a repeat of the December-February emerging market weakness which roiled investor portfolios. Short-USD/ARS positiosn therefore offer potentially high returns and uncorrelated alpha.