Argentina’s central bank has sought to reassure investors after the peso reached record lows on Thursday, with a massive hike in interest rates from 45% to 60% and a large auction of $500m USD. While there are no signs of significant contagion to other emerging markets, the situation in Argentina needs to be closely monitored, especially the potential impact from Brazil given the strong ties between the two countries. Based on Bank of International Settlements data, Argentina’s 60% rate represents the maximum policy rate of any central bank in the last 15 years. Croatia had the second highest rates of 39.9% in 2009 (Figure 1).
Figure 1: Historical Maximum Policy Rates of 38 Major Central Banks (Last 15 years)
Source: Bank of International Settlements as of 30th Aug 18.
The initial sell-off was triggered on Wednesday when President Mauricio Macri asked the International Monetary Fund to release $50 billion in credit earlier than had been agreed. This followed an outsized auction of $300 million in exchange for pesos in order to defend the currency (daily auctions usually fall below the $300 million limit). This large auction spooked investors and, with a lack of other natural sellers of USD (e.g., local exporters), the peso fell.
The lack of dollar sellers would normally have required further intervention (via another USD auction), but that did not happen, signaling that the central bank was not willing to defend the peso. Instead, it looked as if the central bank had stepped aside to allow the market to find its equilibrium. Currency depreciation helps to reduce Argentina’s current account deficit and improve the country’s competitiveness. Estimates suggest that a level between ARS 38 and 43 to the USD would be ideal for the economy.
Bond prices have surprisingly been more resilient than the peso. Price levels of the three Argentinian bonds in the widely followed JPM GBI EM Global Diversified index (GBIEM) are shown below (Figure 2).
Figure 2: Argentinian Bond Prices
The weight of Argentinian bonds in the GBIEM index stands at 0.7% and the market value of the bonds is USD 7.5bn, with the shortest maturity bond maturing only in November 2020. Longer-term holders of emerging market debt have long-tenured exposure, but the sudden moves in the market so far this year have caught some hedge funds and other short-term investors by surprise. They had been attracted to the high yields of short maturity debt and hoped the government would rein in inflation and deliver growth. Given the difficult fiscal challenges the government faces, these investors are now looking to get out.
While Argentina’s mounting debt is a cause for concern, it appears that the selloff has been overdone for now. Dollar-denominated debt that is maturing over the coming years is shown in the table below. Total foreign currency reserves currently stand at about USD 51bn, which, along with IMF support, should be sufficient to service external debt for a few years (Figure 3).
Figure 3: USD-denominated Debt Maturing in the Next 3 Years in Argentina
Clearly, its debt pile in USD is worrying investors. Argentina also has high level of local currency debt (Figure 4). The USD value of local currency debt maturing in the next three years totaled USD38bn as of Wednesday. With the peso sell-off, it stood at $34bn when the exchange rate reached 40 – one benefit of the falling currency.
Figure 4: ARS-denominated Debt Maturing in the Next 3 Years in Argentina
Given the cash injection from the IMF, it looks as if Latin America’s third-largest economy has its short-term funding needs covered. Investors will be closely watching President Macri. If he is forced to resign amid increasing hardship for his countrymen, there is the risk that Argentina might once again default on its debt. If this happened or the government had to enforce capital controls, Argentinian debt would likely be removed from global fixed income indices. Nigeria and Egypt have previously had to impose capital controls, as a result of which international investors had to wait a few months to fully repatriate their portfolio investments.
Fundamentals in Argentina have gradually deteriorated. Real GDP is expected to grow only at 0.5% this year vs. 2.9% in the previous year. Inflation (CPI YoY %) is expected to increase to 28.1%, up from 25.3% in 2017. The recent currency depreciation would also have a knock-on effect on inflation and it may trend even higher. Presidential elections are due in October 2019. The country appears to be going through a catharsis, but can it come out the other side in a year and re-elect Macri? The market doesn’t seem to think so at present.
As emerging markets have come under pressure this year, investors have been focused on the weakest links: countries with both high negative current accounts (as % of GDP) and high budget deficits (as % of GDP). As can be seen from Figure 5 below, Argentina, Turkey and Brazil seem particularly vulnerable. Elections are scheduled in Brazil for next month, so the currency is likely to be highly volatile in the coming months. Almost half the countries (by market value in GBIEM) had elections this year and all these countries have had a volatile few months leading into and after the elections. Brazil and Argentina have strong trade links, so a selloff in Brazil could have a contagion effect on Argentina as well. While it may be premature to assume contagion into all other emerging economies, however, caution is clearly warranted.
Figure 5: Current Account/GDP vs. Budget Balance/GDP (%)
Source: Bloomberg as of 31st August 18 (GDP and Budget Balance figures for last 12 months)
The views expressed in this material are the views of James Cavanagh and Abhishek Kumar through the period ended 08/31/2018 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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