Argentina – From Bad to Worse

We appear to be on the cusp of a more serious crisis in Argentina, as things are moving from bad to worse. Spot ARS has dropped as much as 20% earlier today, while the implied “blue chip” FX rate has fallen nearly 10% over the past two days. The central bank does not appear to be intervening by selling dollars, hence the outsized moves this week. The depreciation is probably a (misguided) way to try to preserve Argentina’s dwindling FX reserves. The weaker currency will only stroke inflation further which is hovering above 28% y/y. Compared this with interest rates of 21% (i.e. very loose monetary policy) then add expected devaluation and one can easily see why nobody would want to hold pesos.

Negotiations continue with the Paris Club regarding the latest debt proposal from Argentina, with the organization saying it is too early to respond. Recent press reports suggest the Paris Club wants the IMF to get involved in the talks. Relations between the IMF and Argentina are strained, to say the least. In terms of an IMF bailout, we think the agency would respond if asked but the likely conditions it would impose on Argentina will probably prevent the country from requesting a program. In the past, Venezuela and Argentina have been known to help each other out financially, but Venezuela is unraveling too and is in no shape to give Argentina any dollar funding.

The fundamentals in Argentina continue to deteriorate. Growth is slowing from the peak 8.3% y/y rate posted in Q2 2013. This was boosted by low base effects, and Q3 slowed to 5.5%. Q4 growth so far is tracking around 2.5%. Meanwhile, inflationary pressures are rising but the official measures are not reliable. Opposition lawmakers’ estimate for December inflation rose to 28.4% y/y from 26.8% in November. This is well above the official measured rate of 10.9% in December.

The external accounts are getting more worrisome. The current account has moved to a deficit, with the 4-quarter total rising to -$3.5 bln in Q3. This is the highest it’s been since Q4 2001. While it remains fairly small as a percentage of GDP (around -1%), the trend is one of widening. What’s worse, the capital account has consistently been in deficit since 2011. The trade surplus has narrowed, but remains fairly high.

Foreign reserves continue to fall, reaching $30.6??? bln in December and falling below $30 bln so far this month. These are the lowest levels since November 2006. Part of the erosion is from capital flight, but part of it is also due to the government continually raiding the central bank for hard money to repay external debt.

We believe that all of these negative external trends have pushed Argentina into trying to regain access to international capital markets. Recently, it made an offer to the Paris Club to try and clear its arrears. There is also still the issue of private sector holdouts from its last debt restructuring. Even if Argentina can address these issues, the fundamentals have deteriorated so much that we would not expect much investor demand for Argentina paper anytime soon. In an environment of negative EM sentiment, Argentina is amongst the worst of the worst.

Yet despite this backdrop, the Merval index continued to make new highs even today before dropping. MSCI Argentina was the best EM performer in 2013, up 64%. MSCI measures dollar returns and so FX adjustments are taken into account. MSCI Argentina is now down -15%. With a big devaluation in the works as well as a potential debt crisis, we do not see how Argentine equities can continue to perform well. We see a sharper and deeper correction ahead for this market. Argentina’s 5-year CDS prices spiked 280 bp to 2336 bp, according to Bloomberg pricing.

We continue to expect the currency to remain under pressure, and this is likely to feed into a deeper debt and/or currency crisis in Argentina at some point down the line, possibly this year. The potential for a crisis in Venezuela is also quite high.

While many investors have stayed clear of these two problem countries, we highlight the risk of contagion. Brazil is the most exposed to Argentina with regards to trade flows, but those risks have declined. Argentina is Brazil’s third largest trading partner behind the US and China, in both exports and imports. Through 2005, Argentina was Brazil’s number two trading partner but was then supplanted by China. As a side note, China supplanted the US as Brazil’s number one trading partner in 2009. So, any collapse in Argentine GDP and/or equities should not have a huge spillover on Brazil. However, given the overall negative bias on EM in general, there will likely be some collateral impact on EM as a whole.