Argentina | Difficult choices: reform or default

admin | August 16, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

It’s understandable that Argentina Eurobonds have discounted a high probability of default.  Indicators of cash flow stress and solvency have worsened under the assumption of a non-reformist government.  The latest treasury auction has reaffirmed restricted access to capital while the IMF program has already front-loaded funds with no other obvious lender of last resort. The Macri administration looks likely to avoid default by drawing down scarce FX reserves, running up arrears and using other regulatory measures to contain FX stress. But the intensity of the cash flow stress likely early next year should force the Fernandez administration to quickly decide among difficult options. What are the choices for the next administration? Is default inevitable?

The challenge is regaining access to funding if the Fernandez administration chooses default over economic reform.  Without access to capital, the Fernandez team would face forced austerity. The political options are difficult. The majority of population rejects economic reform, and there are ideological constraints within the coalition.  It’s a tradeoff between the political constraints of economic reform versus the cash flow constraints on restricted access to capital.   The default could be orderly via coordination of an IMF program, with debt sustainability being reassessed after the latest ARS weakness.

It’s possible the Fernandez team shifts towards responsible governance after understanding the economic realities once in office.  However, the initial signals have all been worrisome with no apparent understanding of basic economic principles showing up in the populist campaign rhetoric and no sensitivity to the recent financial stress. There is a comfortable 15% margin of voters that allows for a shift towards more moderate rhetoric.  The prospects for a more responsible approach would improve if there were an official announcement of a well-respected technocrat as economic advisor or the creation of a transition team to discuss interim policy measures. Despite the recent meeting with President Macri, candidate Fernandez lost the opportunity to name-drop a well-respected technocrat when asked about his cabinet while also discouraging any collaboration to minimize market stress.  There has also been no effort to disassociate from the more radical factions of the coalition or clarify a rational economic program. The markets assume the worst based on the interventionist and isolationist strategy of the Kirchner era, and it’s difficult to expect the best without any encouragement from the Fernandez team.

Fernandez may be forced to clarify IMF relations on the risk the fund withholds the September 15 $5.4 billion payment in potential 1:1 meetings with the IMF this coming week during the assessment of the fifth program review.  The longer that Fernandez waits to reassures markets, the worse the cash flow stress and the higher the probability of default from lower FX reserves and weaker FX rate.  It’s worrisome that the political agenda dominates the economic agenda despite these risks. It may already be too late to avoid default after the recent ARS weakness pushes debt ratios far above 87% of GDP as of the end 2018.  The next few months will be increasingly challenging on cash flow management. The risk for precarious liquidity post political transition will require huge effort for fiscal adjustment or cash flow relief on debt restructuring.

Exhibit 1: Looming debt repayments and debt service

Source: https://www.argentina.gob.ar/hacienda  (includes repos and based on latest official data and ARS 3/31/2019), Amherst Pierpont Securities

There has been increasing debate about the context of default and the obvious vulnerability of the domestic debt stock.  It’s a similar breakdown of local law at 27% versus 31% for NY law of the total stock of bonds and notes; however 2020 amortizations are more onerous for local law bonds (Exhibit 1). The selective or initial default on local debt could provide some efficient savings against the complications of external default. There has been a track record of distressed locally based exchanges at the first stage of rollover stress based on the perception that local investors are partners in crisis. However, voluntary distressed debt exchange and forced restructurings locally may not open access to capital markets or provide sufficient savings against the large gross financing needs. It’s not clear that external investors would provide fresh funds in light of reluctance to reform and enthusiasm to default. This is also true on negotiations to restructure external debt. The alternative of inward isolation, as in 2001, is not realistic based on low stock external assets, limited access to capital and still a cash flow deficit on the fiscal and external accounts.  This could eventually reconcile the alternative of IMF sponsorship for private sector involvement (PSI) that would provide the context for a more orderly restructuring.  The initial challenge will focus on managing the cash flow stress through the October 27 elections and the declining margin of flexibility on the delays to commit to a coherent economic program.

The first bounce on Eurobond prices looks more like a technical bounce after successive days of weakness with some support as bond prices converge near historic sovereign recovery value levels. The current levels on Eurobond prices would provide a clear buying opportunity if President Macri avoids default and capital controls and then the opposition delivers a positive shock with a pro-reform mandate post elections. It is too soon to say the market has reached a floor for the high correlation between ARS and solvency ratios on the 76% dollarization of the debt stock.  Modeling recovery value is challenging based on the fluidity of the macroeconomic inputs, the high sensitivity to ARS projections and the lack of firm commitment from the Fernandez administration to the current economic model and IMF program. Assuming a non-reformer bias, then this would imply no further fiscal consolidation that could constrain growth prospects and demand a haircut on external debt to maximize savings necessary for debt sustainability. The debt restructuring scenario under an IMF program could allow for an orderly process while any independent restructuring would suggest worst case scenarios and recovery value below current levels.