http://bulltick.com/wp-content/uploads/2013/12/ArgentinaUpdateDecember172013.pdf

Argentina Economic Update--Winds of Change

Please Follow This Link For PDF Document

We recently spent a few days in Buenos Aires, meeting clients, pundits, and government officials. We come back with one recurring theme: winds of change are in fact blowing in Buenos Aires. In our view, the velocity of erosion of external reserves is affecting the stability of “the model”, and some increased pragmatism appears to have surfaced among some key government officials. As one qualified source told us, 2014 will most likely be a year in which major work is followed in trying to recuperate the stability of the capital account. In other words, 2014 will likely be a year in which the authorities abandon the idea of just trying to close the leaks of the current account and instead look for more efficient ways to reignite the irrigation flow of the capital account (in order to restore order in the balance of payments).
Clearly, if the idea is in fact to solve the problems that are currently affecting Argentina’s capital account, such a goal can only be achieved via advancing in one very simple theme: regaining credibility. Without credibility, the capital account will not move from delivering high deficits into showing positive balances. And the process of building up credibility includes difficult choices, such as allowing a faster adjustment of the official exchange rate, following relevant efforts to reduce the size of the country’s fiscal imbalances, and working towards achieving the normalization of the relationship of Argentina with the world and the international financial community in general.
In fairness, we have seen some evidence that the economic authorities are in fact moving ahead with policies geared at trying to address some of these pending issues. Among other things, the Argentine government has moved forward with (1) trying to reach an agreement with Repsol on the YPF nationalization quandary, (2) moving forward with the arrangement with the World Bank’s CIADI to address the arrears of Argentina with some international corporations, (3) moving ahead with the publication of a new inflation index in the first quarter of next year, (4) looking to reach an agreement with the Paris Club in order to open credit lines that allow for infrastructure financing, and (5) authorities are apparently becoming a bit more open to the idea of looking for ways to address the Holdout issue in a more amicable manner.
The Lingering Challenges
2014 will most likely be a difficult year for the fiscal accounts, unless the government is willing and able to meaningfully reduce spending on domestic subsidies, or unless the crop yields and international commodity prices deliver much better than expected news (would imply higher export tax receipts). In other words, the fiscal accounts will be looking increasingly complicated unless the government increases electricity, water, and transportation costs materially in 2014. The key negative issue here is the fact that following the unrest that plagued the country in the last couple of weeks (looting taking place in many provinces of Argentina following the decision of the police force to strike), and the subsequent upsized salary increase that was granted to this interest group (depending on the province, the police force received increases north of 50% y/y), it will prove almost impossible for a weaker administration like the one of President Cristina Fernandez de Kirchner to be able to keep the salary requests of teachers and other government employees at below +20% y/y nominal –as had been planned by the economic authorities.
As can be seen in the table presented, salaries weigh heavily in primary spending. Hence, if the government is not able to keep the growth of salary spending relatively controlled, it will prove quite hard to increase the primary balance of the government, unless revenues increase very fast in 2014 (pensions are “untouchable” because the increase via a formula that is tied to the pace of growth of national salaries). From the standpoint of the macroeconomic equilibrium, increasing fiscal savings is a MUST to try to reduce the pace of ARS issuance by the CB (i.e. addressing the “excess peso problem”, one that creates even more pressure over the FX rate, please see graph in the next page).
Another short-term challenge for the Republic will be trying to control the size of the energy deficit and the size of the tourism deficit. The Central Bank’s technical department estimates that 2013 will finish showing an energy deficit that amounts to about USD $3 billion, and that deficit is likely to increase further in 2014, unless domestic production increases fast. The size of the deficit itself is not large enough as to hint that a major crisis is looming, yet the real problem is that barely three years ago the energy surplus amounted to about USD $5 billion. On the side of tourism, the current deficit stands at around USD $10 billion. The decision to increase the cost of FX for tourists that use their credit card outside of the country looks to reduce the size of this imbalance, at least somewhat. Naturally, this is a short-term fix that does nothing to fix the BOP imbalance in the long-run.
The Central Bank is also looking for ways to allow grain exporters to repatriate their USD’s at this time without having to give up some of the official FX adjustment that producers obviously know is coming (it is our sense that almost everyone in Argentina is fully aware that a material adjustment of the official FX rate is coming, not least because the Blue has continued to move at +/- $9).Hence, the CB recently approved the issuance of a short-term FX-linked note that will provide exporters with an FX hedge and allow them to repatriate some of the USD’s they are holding out of the country. Local pundits believe that the size of this flow could perhaps amount to as much as USD $4 billion.
Another possible source of USD liquidity in early 2014 could be tied to some higher quality provinces and perhaps the City of BA coming to the market with new issuance, and perhaps also some higher quality corporates coming to the markets looking for new financing. As we argued before, it is clear that YPF necessitates a significant amount of resources to develop the massive Vaca Muerta field, and investors appear to be hungry enough to digest new issuance from this corporate (the recently issued USD-denominated 2018 YPF was well received and is trading some 4 points higher in the market). In addition, there is always the possibility of the Sovereign issuing bonds through the pension fund system (ANSES), in that manner helping to rebuild the stock of FX reserves somewhat.
Market Strategy
We must say that we liked what we saw and heard in Buenos Aires. Despite the material retrenchment that has taken place in the level of international reserves, such being a clear sign that the Kirchner economic model has reached its official finale, the authorities appear to be aware of such undeniable fact and seem willing to twist the model, at least somewhat, in order to try to find a more stable equilibrium in the external accounts. In our view, the recent advancements that have taken place with the international community are a good omen. Naturally, a key question remains whether it is “too late” to implement the change, or whether the critical limit on the FX stock of reserves has been crossed or not. In our view, the question of “lateness” in the apparent shift in economic policy is most likely tied to the future performance of commodity prices, and on that front we remain sanguine.
We continue to think that Argentina’s willingness to pay restructured bondholders remains very high, and we are beginning to get a sense that the government may in fact now be more prone to entertain the possibility of actually settling its lingering obligation with the holdout litigants, of course, if such a decision can in fact be sold as a political victory by the Kirchner administration, and assuming that the US Supreme Court decides against granting certiorari to the Republic’s case –such final decision will likely become known at some point in Q314. In other words, we now see at least some possibility of the government choosing to settle with the litigants ex-ante deciding in favor of changing bond jurisdiction (the famous Plan B).
We also believe that the concerns in the market with the most favored clause of the 2005 and 2010 covenants being still active once the US Supreme Court makes a decision may be overstated, because (1) performing bondholders have no real willingness to enter into a legal battle with Argentina, and (2) because the Republic could, in theory, defend a better offer on the grounds that the offer was “forced” by the US Justice System.
We continue to think that Argentina’s future capacity to pay will remain tied to the future pace of growth of Brazilian industry and the rate of growth of the Chinese economy. Despite the material depletion of reserves that has taken place this year, the amortization load of this country remains very comfortable (for example, total 2014, 2015 and 2016 amortizations to GDP amount to 2.9%, 2% and 0.3% respectively). In addition, as argued before in this piece, we think that a faster rate of depreciation of the official exchange rate coupled with some likely corporate and provincial USD issuance, will help to reduce the velocity of erosion in external reserves going forward.
We also think that the prospects of a regime change in 2015 will remain a credit positive event. Despite the still low apparent probability of the Supreme Court granting certiorari for the second part of the Argentine appeal (the first certiorari has already been denied by the US Justice System), our investment bottomline remains unchanged: in risk/reward terms, a Boden 2015 yielding north of 8.5% and a Province of BA 2015 yielding 13.2% continue to favor long exposure on this credit (our preferred trade remains the Province of BA, not least because they will finish 2013 showing a balanced budget, following the implementation of a very aggressive fiscal adjustment program).
As our clients may remember, we have always liked the USD GDP Warrants, as they have continued to trade at 50% their theoretical value. The problem that we see right now with the Warrants is that there is now a material risk that the Argentine government will publish a revised GDP time series at some point in 2014, and there is a good likelihood that that new time series will reduce the difference between the Actual GDP growth time series and the Base Growth Time Series that was included in the 2005 and 2010 bond covenants. Hence, there could be some negative pressure on warrant prices in the interim. We doubt that the difference between the old and new time series of growth will prove extreme, yet there is risk that markets will trade on that expectation.