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Twists and turns in Ecuador and Argentina

| December 13, 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.

An appetite for yield should dominate emerging markets investing in 2020 with particular focus on high beta benchmarks, such as Ecuador and Argentina. Pricing on debt from each of those countries discounts varying probabilities of default and recovery—for Ecuador, whether it averts default, and for Argentina, whether it offers reasonable recovery value. Policy risk looks set to pick up intensity early next year with political transition in Argentina and a legislative calendar focused on economic reform in Ecuador.  On those issues, sentiment diverges. Ecuador looks likely to maintain IMF relations and lower debt rollover risks while Argentina struggles to determine a realistic economic plan for debt repayment capacity and recovery value. The right call on each of those should have significant impact on emerging markets returns.

Exhibit 1: The market’s views of Ecuador and Argentina have diverged

Source: Bloomberg Barclays EM USD total returns

Ecuador’s comeback on reform agenda

The economic team in Ecuador is still recovering from the initial shocks of failed implementation of reform. The team met defeat in the legislature on economic reform and defeat in the streets after trying to make subsidy cuts.  There is no room for failure on the second attempts. The team pushed through fast track tax reform with further momentum on labor reform, capital markets reform, budget reform and central bank and finance reform.  President Moreno also seems determined to deliver on fuel subsidy cuts with sufficient socialization to avoid a repeat of the October protests from indigenous groups and labor unions. It’s telling that a center-left administration endorses orthodox economic reform with broad-based political support to defend economic stability and dollarization. The IMF remains supportive. It has confirmed disbursement of the delayed second and third program tranches and seems flexible so long as there is progress on economic reform.  The success on a second round of tax reform reaffirms expectations of legislative support for the reform agenda into next year. This should allow for further normalization of Ecuador’s debt pricing from still-distressed levels.

Argentina’s struggle to determine growth model

Argentina is also entering a new phase after an uncertain and lengthy political transition and is often cited as an important surprise factor for 2020. The question is whether it’s a positive or negative surprise for bondholders’ potential recovery value.  There is open discussion of default from budgetary cash flow stress and almost zero liquid FX reserves.  The economy suffers from large gross financing needs, insufficient intra-government financing, informal suspension of IMF relations and chronic capital flight with almost zero liquid foreign exchange reserves.  There has already been a forced maturity extension of local treasury bills. Argentina continues to prioritize liquidity relief as the outgoing Macri administration has been forced to rely upon direct monetization from the central bank. There are huge challenges ahead for the Fernandez administration.  The new economic team will set the context for recovery value. It’s hard to expect pragmatic reform when the economic team reflects ideological loyalty to Kirchnerismo.  If Kirchnerismo discourages growth through foreign direct investment and refuses to cut back spending entitlements necessary for a primary fiscal surplus, what provides the future savings for debt repayment?

Argentina can either convince the 75% majority of bondholders to voluntarily “extend and pretend” and forfeit debt service for two years to five years or shift toward a pragmatic stance and embrace the pension reform necessary for a structural primary fiscal surplus.  Neither of these scenarios seems likely. If the IMF doesn’t endorse debt re-profiling, then it would discourage bondholder participation in re-profiling debt and discourage the IMF to re-profile their loans. The bondholders may be motivated to seek some compromise that averts a haircut on capital; however the IMF as a creditor would be less flexible and would likely insist on the debate between haircut and/or primary fiscal surplus to reassure for their own repayment.  There is still a potential compromise solution with flexibility from creditors; however this requires pragmatism from the Fernandez administration. The recovery value of 50% to 55% remains the compromise scenario under a successful negotiation. 

Third time’s a charm on relative performance?

Despite a strong start to the year for each year in 2018 and 2019, both Argentina and Ecuador have again been the worst EM performers.  The current distressed prices for Argentina provide some technical support. There is reluctance to sell near historical recovery value of $40 and expectations that the Fernandez administration will avoid a large debt haircut and likely litigation backlash. However, attractive risk/reward only starts at pricing closer to $30 in light of difficult (IMF) creditor negotiations, the large gross financing needs and the uncertain debt repayment capacity. The alternative scenarios that argue for recovery value closer to $50 to $55 are either convincing the 75% majority of bondholders to “extend and pretend” for a few years or shifting towards a pragmatic stance and embracing the pension reform necessary for a structural primary fiscal surplus.  These are low probability scenarios. The bottom line is that current market prices are vulnerable to high execution risk and pessimism that weak economic growth and weak commitment to fiscal discipline will constrain debt repayment and argue for a haircut on external debt.

Exhibit 2: Ecuador and Argentina have underperformed broader EM

 

Source: Bloomberg Barclays EM USD total returns

Prospects for Ecuador look better with solidarity for fiscal consolidation and flexibility from the IMF as progress continues on the economic reform agenda. This momentum should continue into early 2020 with submission of more reform bills, progress on fiscal consolidation, cutbacks in current spending and revenues from the asset monetization program. This should allow for normalization from the current curve inversion with 10-year benchmark bonds gradually recovering back to 10% from current levels near 12%.

The surprise risk for next year should focus on the distressed credits as an important influence for EM returns, especially considering the compressed spreads and difficulty of repeating the impressive 12.8% year-to-date EMBIG-D returns.  On the approval of tax reform, Ecuador should maintain IMF relations that are critical for liquidity and rollover risks.  Argentina looks likely to struggle in its IMF relations next year as debt negotiations commence to seek relief from cash flow stress from creditors.

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