Fixed Income Boutique
We continue our Market Update mini-series on South America by heading to the Southern Cone1, crossing the border somewhere between the magnificent Iguaçu/Iguazú Falls, where Brazil meets Argentina and Paraguay, and the mouth of the Quaraí river, where the border with Argentina ends and Uruguay begins.
There are some similarities between the two economic giants of South America, Brazil and Argentina. Given the immensity of their respective croplands and pasture areas, both are agriculture powerhouses. But Brazil has a much broader range of natural resources and a larger domestic market that consumes most of its agricultural output, while Argentina relies mostly on international markets as an outlet for its grain and oilseed production. It’s a key difference as Argentina depends on agricultural exports as a source of US dollar revenues. While relying on a single sector can be a curse (e.g., in case of drought that can ruin the harvests), the silver lining is that it can immunize the economy from external shocks, as the demand for food commodities remains fairly stable.
It would be tempting to continue drawing comparisons between the two countries at the political level, with both nations sharing a common weakness for illiberal democracy and populist authoritarianism in the 20th century. But Argentina deserves a focus of its own, because the one question any EM investor has in mind is why a once-rich country (7th largest economy in the world before the Great Depression) became a serial defaulter, repeating the same mistakes? It‘s like the time loop in Groundhog Day, the excellent 1993 fantasy film starring Bill Murray and Andie MacDowell.
The prosperity of the Argentine republic found its roots in the 19th century and the golden age ended in the 1930s with a military coup, followed by a decade of economic crisis and political instability. Then came Juan Domingo Perón, an army colonel who served as President of Argentina from 1946 to 1955 and from 1973 until his death in 1974. Founder and leader of the Justicialista movement to which more than half of today’s politicians still adhere, Perón reshaped the country into an authoritarian-populist system based on nationalist corporatism and political patronage. Economically, his policies included:
All these at the expense of the country’s net international investment position (the accumulation of past current account surpluses).
Peronism is neither right wing nor left wing. Perón himself was a fierce anticommunist and admirer of Benito Mussolini’s corporatist model. But his political descendent Cristina Fernández de Kirchner is aligned with the radical wing of the São Paulo Forum (an international conference of Latin American & Caribbean leftist parties). And Carlos Menem, who served as president from 1989 to 1999, was a free-market neoliberal enthusiast (although I confess, I struggle to understand his allegiance to Peronism).
Peronism has many similarities with modern national-populist movements by promoting sovereignism, national unity beyond the left-right divide and a worship for an historically charismatic leader. But it goes beyond by establishing a state corporatism putting all stakeholders (state-controlled unions and trade associations) on a patriotic mission aiming at a supposedly fair distribution of the national output.
The 44 years of Peronism cannot be blamed for all the problems that Argentina went through. The 21 years of military dictatorships did a lot worse. But the ideology behind Peronism is one of the seminal factors that led the country to a post-war record of seven debt defaults (not counting two defaults of the 19th century that belong to a bygone age). National-populism, à la Perón, makes defaulting an easy way out of economic downturns, because it would be socially unjust to burden public finances with high servicing costs of an all-of-sudden illegitimate and odious debt. But until then, borrowing at any cost is just fine.
The victory of Mauricio Macri in the presidential election of 2015, instilled high hopes into the antiperonista camp. The population had had enough of the Kirchnerist policies (modern far-left version of Peronism) and gave a free hand to Macri’s center-right coalition. The first half of his term was a honeymoon, gradually delivering a streak of macro- and micro-reforms that delighted the markets.
But Macri’s gradual approach did not work. Partly because it was too gradual given the legacy of the previous administration, but also because he never managed to rein in deep fiscal imbalances, thus incapacitating the disinflationary policy of the central bank. In EM, ex-food inflation is always a fiscal phenomenon. He then chose the worst possible route by yielding to the original sin of EM – borrowing massively in US dollars. Why not? After all, he had the trust of international capital markets and the foreign debt as a share of GDP was relatively low. However, Argentina is one of those countries where even moderate levels of indebteness quickly become unsustainable. According to the Debt Intolerance Hypothesis (Cf. Reinhart, Rogoff and Savastano, 2003), emerging countries that struggle to reduce debt levels in periods of economic expansion are more prone to default in economic downturns even when their debt levels are relatively moderate. Persistently high inflation, currency and maturity mismatches of the debt, weak institutions, and political instability are aggravating factors. And Argentina definitely ticks all those boxes.
Then, Argentina started to borrow even more. These massive debt portfolio inflows dwarfed the size of the local peso bond market and drove the real exchange rate (the nominal exchange rate deflated by the respective inflation rate) to absurd levels that made the balance of payments fragile. The bubble burst at the end of 2017, when the conflict between the treasury and central bank made clear inflation could not be brought under control. The sequel was a descent into the abyss with a collapse of the exchange rate, an explosion of the central bank’s liabilities and a gigantic IMF program that ended up in a fiasco and a new default in May 2020.
In the meantime, Peronists were back in business with the Fernández ticket winning easily the 2019 election. And then it was Groundhog Day again: more spending than the state can afford, kick the can down the road with the external creditors (blaming Macri and the IMF), control the capital account to conceal the balance of payments crisis, freeze prices to pretend there is no rampant inflation, and ask a bankrupt central bank to print money to fill all the shortfalls.
So, with such a dismal picture, what’s in it for EM investors? Let’s be clear, Argentine bonds are neither a carry-trade opportunity nor a spicy diversification for a passive investor. We do not see the local bonds as attractive enough given the high risk of currency debasement. However, discerning active investors will look closely at the valuations of the global bonds in US dollar. The yields are almost irrelevant given the high probability of default before maturity, but the implied recovery rates (in case of default) are low enough to make the risk/reward of the trade attractive, in our view. Especially if, like us, you believe that a new IMF program is on the cards sooner rather than later. Peronists do not like to pay down debt, but they know that doing nothing could quickly reduce their popularity – which is one of the few things they care about.
Investing in emerging and developing countries is not only about rewarding the countries that display the best metrics in terms of macroeconomic and/or debt sustainability indicators. As an active investor, it is also essential to look for those situations where a thorough bottom-up analysis can reveal an asymmetric risk/reward in security valuations. We believe that Argentina is one of those cases.
For more on investing in distressed EM sovereign debt, make sure to listen to Carlos de Sousa and Thomas Laryea’s excellent podcast on this topic by clicking here .
1.South America below Tropic of Capricorn, comprising Brazil’s southernmost four states, plus Argentina, Chile and Uruguay