Argentina: Chronicle of an IMF Bailout Foretold

Greetings Macro Man Community--thank you to the new contributors who have done well taking up the TMM mantle. It’s great to see that the Macro Man tradition is carrying on.

This isn’t me coming out of retirement, so much as wrapping up some loose ends. My departure coincided--nearly to the day--with a firestorm in emerging markets that hasn’t quite been put out yet. A combination of local factors, higher US rates, outright USD strength, and the subsequent reversal of portfolio flows has crushed a few EM currencies like BRL, TRY and ARS.

Argentina is an especially compelling case--it was the prodigal son of emerging markets in 2017, having not only come back to the market in style, but also plugged the market in size with the famous century bond, a 100-year issue that gets financial journalists squealing with delight every time they think about it.

Fast forward to, well, only later in 2017...and Argentina started to backtrack on inflation targeting, central bank independence, free movement of capital, and was experiencing a historic drought that was crushing soybean production--the country’s biggest source of export revenue.

It started slowly...and then as ever in EM...all at once:

Bang...in only a couple of weeks, the peso was 20% weaker and the central bank hiked three times in the space of a week, taking the overnight rate to 40% to stem the run on the currency.

Having written about the subject in the past, I feel compelled to look back at my work and see what I missed, what I got right, and what was simply a big surprise:

Back in September, I wrote this on Argentina:

“I continue to believe global trends will buy time for Macri’s agenda to work--and while an Argentine election is always a bit of a crapshoot, the trend in Latam favors center-right candidates”  

Grade: B. Global trends did NOT give Macri time for his agenda to work--but he did win a big midterm in October. So I got the theme right--Macri was engaging in a risky strategy to use cheap short-term funding and not cut spending quickly, hoping growth would eventually bail him out. It didn’t work.

“Beyond the political risk, the fiscal situation is far from healthy--and will require a bout of austerity and likely significant spending cuts. The 2017 primary balance is a nasty -4%/GDP,  which means the government is going to be running up a larger debt load for the foreseeable future. “

Grade: A-. Many real money folks were simply enamoured with the story, and didn’t really check under the hood.  Macri cut the deficit, but ignored his addiction to short-term financing.

“Either way, as the charts below show, an acceleration of public debt at this pace for a sub-investment grade credit is simply unsustainable….I expect Cambiemos will win in October, which should provide a short-term tailwind, but the medium-term is fraught and highly dependent on local and international factors that could throw the reform movement into a state of chaos.”

Grade: A.  Maybe there’s a spot for me at Hacienda when Macri finally cleans house. Or a cushy consulting gig with the IMF?

I’m feeling pretty good so far. Now, let’s talk about the currency!

“Similar to the credit, this is an attractive carry trade if you buy into “the story”, but not without its risks. I think ARS will appreciate over time, but it won’t be quick.”

Grade: D. I was clever enough to note the risks, and an abundance of evidence ARS had to weaken. Then had to add a throwaway line about about “ARS  will appreciate over time”. I blame my editor.

Then I get into the lebac/NDF cross border trade. “The lebacs and ndf hedges mature every one to three months, so you have the opportunity to get out if the fundamentals or political situation deteriorate. That is unlikely...Long story short, at 500bps this spread is well in excess of the risk that the government will again implement capital controls over the next 3, 6, or 12 months.”  

Grade: D+. In classic “crystal ball” fashion, I made the forecasting assumption that Macri wouldn’t have a real mess on his hands if the economy went south. That’s what happened. Now the IMF is in town and capital controls are most certainly on the table. It wasn't just that I was wrong, I was wrong about the downside of being wrong.

Yet, in the end, if you followed my trade here you just might weasel away with your profits intact--and I was right that you have numerous exit doors to get your money back. You’re still up TTD, and at last check this spread is in decent shape--but there’s going to be some sleepless nights and pepto-bismol between you and maturity.

To summarize, I think this shows that there are no easy routes to investing success.  TBH, I think I got more stuff right than wrong--yet the stuff I got right here was relatively tough to monetize, and the stuff I got wrong had the potential to be a first-class ticket on the fast train to EM Crazytown that ends in a smoldering pile of twisted metal and an uber to the unemployment office.

With that, a quick post-mortem on how Argentina got to this point, and where they may go from here.

First is this one--not the ARS chart, but the real effective exchange rate. I alluded to this but didn’t realize just how important it was and is.

You can see here that the deval the country experienced when Macri let the peso float in 2015 was enough to get back to a competitive level, but high inflation and *not high enough* interest rates let the real value of the currency appreciate back to unsustainable levels.

Hand in hand with that chart is this one:

When Macri won in 2015 the country experienced a huge increase in portfolio flows and FDI--enough to fund the budget deficit and start re-accumulating international reserves. But what else do you notice? A significant acceleration in the current account deficit.

That’s what came back to bite them in the back--especially after the central bank backtracked on the 2018 inflation target in December and inexplicably cut the overnight rate earlier this year--two measures that slashed real interest rates and waved a red flag in front of weary local investors that now might be the time to take their money out of the country.

Then came the unpredictable. This is a chart of global  soybean production, with Argentina on the bottom tile.

What you see there is a drop in production by roughly a third, which adds up to roughly $7 billion in lost export revenue just in soybeans alone. Add a couple more yards from corn and other agricultural products, and this is a pretty big event.

This is why EM countries build international reserves, so they can use them to fund their short-term USD liabilities when times get tough or there is an unexpected hit to export revenue. That’s where Brad Sester comes in...the High Prince of International Capital Flows (I had a short debate on Twitter on this subject last week...it was an honor getting worked over by him)

Brad noted just how inadequate Argentina’s reserves have been, owing to not only their rapid increase in short-term debt, but also the relatively small size of the local banking sector. This chart is particularly telling:    

The spread between the dark blue lines and the top of the bars are the key. Short-term external debt and the C/A deficit were accelerating much faster than net reserves. I’d add that the government was also dependent on short-term local financing in the form of t-bills and Lebacs...from foreigners!! That doesn’t show up in these figures, but Macri eliminated all restrictions on incoming and outgoing capital in early 2017...when the economic situation got sticky this year, that hot money was looking to leave as quickly as it came.

That culminates in this chart, which shows just what kind of figures were dealing with here. (the pathetic color crayon is my emphasis, not Brad’s)

With all that, an appreciating USD, a reversal in global EM flows, and a debt-gdp level approaching 50%, you can see why Macri had to call in the IMF. I’m still not convinced that is the right political decision, but would be willing to stipulate he made a sound decision to go to them, before they came to him.

Where does that leave us in the market? Would you be surprised to hear...not very far from previous levels?!?  This is a chart of the spread over UST for the Argentina 33s, a dollar bond that has been around forever. 100bps off the lows?!? 470bps over? Really?

Yes folks, that’s where we are in the global credit cycle. A low grade credit with a documented history of being “debt intolerant” rolls over and requests an IMF bailout AFTER A 100BP SELLOFF IN THE CREDIT.

Where does Argentina go from here? I don’t know. Part of me says they are going to pull a Houdini and get out of this mess. Another part says this is just the beginning of an ugly Greek-like cycle of austerity, reform, and the resurgence of leftist politics.

What do I know for sure? Given the magnitude of the global credit binge, we’re going to see a lot more of this kind of thing. To avoid tough economic measures, Argentina exchanged safety and flexibility for cheap financing and fragility. All it took was a drought, a couple of bad political decisions and a 100bp selloff and it was game over.

Argentina lost. Others will too.

Shawn

TeamMacroMan2@gmail.com @EMInflationista