An update on Argentina

Argentinian assets have been under material pressure in recent days.  I thought it would be useful to write my thoughts on the recent moves and implications for markets going forward.

Over the past two months, the Argentinian peso had become overvalued in real terms following large inflows from foreign investors in 2017. These capital flows caused the nominal exchange rate to depreciate by much less than inflation. Those investing in Argentinian assets cited the carry trade theme, relatively low volatility, and  the entering of Argentinian local currency sovereign bonds into the JP Morgan Government Bond Indices as investment rationales. However, the tide started to turn late last year when the Central Bank of Argentina (BCRA) made a policy mistake by raising the 2018 inflation target from 10 to 15%. The adjustment of the inflation target subsequently allowed the BCRA to cut interest rates in early January this year.

The cut in interest rates dented the BCRA’s credibility, and concerns grew about whether monetary policy was free of interference from the government. Another policy mistake was the announcement of a 5% tax on Argentinian peso Treasury bill investments, which impacted both locals and foreigners and led to a reduction in holdings of Argentinian peso Treasury bills by investors. Higher than expected inflation readings, and a strengthening of the US dollar finally generated large pressures on the Argentinian peso. After attempting to support the local currency by buying over USD 5 billion worth of pesos in the currency market, the BCRA finally realised that its monetary stance had to be tightened. We have now witnessed three emergency hikes (a combined 12%), bringing the policy rate to an eye-watering 40%. I believe the monetary authorities will now be successful in slowing the depreciation of the currency going forward.

The overvalued peso also contributed to Argentina’s current account deficit widening 5%. I expect the current account deficit to begin to start narrowing again as the currency moves into equilibrium (say, to 24-26 against the US dollar by year-end) and the economy slows as a result of the monetary and fiscal tightening (a 0.5% tightening of the fiscal deficit was also announced). The implications of this will be higher inflation this year and possibly next, lower growth and a further decline in Macri’s popularity.

If this a default situation? Not yet. I see this as a re-pricing of Argentinean risk which had started earlier in the year, coupled with an already ongoing emerging market sell-off in the local and hard currency space.

On the positive side, I believe that there are two silver linings for the time being.

Firstly, the next election is not until late 2019, so there is some time for the authorities to take its bitter medicine this year – including more utility tariff hikes, a depreciation of the peso, and attempt to control the next public wage negotiations in September. Accepting these tough measures will allow the economy to readjust over the course of 2018. The opposition and Peronists are still divided, so while Macri’s re-election chances and policy continuity look much more complicated now, it is still not a given that Argentineans will choose another populist government.

Secondly, the IMF may be prompted to get involved. Unlike other countries which would ideologically be opposed to an IMF program (Venezuela for sure, potentially Turkey, while Ecuador is uncertain as always), the authorities may end up under a program if they lose access to the markets and/or Argentina experiences a balance of payment crisis fuelled by capital flight. Argentina and the IMF have had a tumultuous relationship in the past, but under different administrations (Menem, Nestor and Cristina). The goal in this case, for both sides, would be to ensure stability so that Argentina does not return to its failed populist policies under a new administration. The current government is full of technocrats that understand this and, if push comes to shove, would convince Macri that this is his least worst option. Such an event would provide sufficient funding sources until at least the end of next year.