Argentina | Bondholder skepticism looks extreme

Siobhan Morden | December 1, 2023

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. This material does not constitute research.

Financial crisis has imprinted itself on the memories of Argentina’s bondholders and policymakers, and those memories are in play again. Argentina’s recent election has lifted some of the most extreme bond market pessimism. But memory of crises past has both left bondholders skeptical about policy progress and created incentive for policymakers to avoid another one. An ideological shift in Argentina, the incoming Milei administration’s strong political capital and pragmatism and the austerity forced by constraints on credit all make current bondholder skepticism look extreme.

It seems logical with so many unknowns that Agentina’s bond prices should simply just assume the worst. Current pricing implies default in 2025 with 30% recovery. But it is early in the economic transition with high uncertainty around the success of reform. The incoming Milei administration will need to deliver front-loaded shock therapy next year. The trifecta of fiscal discipline, an independent central bank and foreign exchange flexibility is likely the only winning combination to reverse stagflation. There are huge macro imbalances with a large stock of public and corporate US dollar liabilities, no stock of US dollar reserves and an urgent need to realign prices and cut bloated spending.

Still, there are a few reasons for optimism in Argentina’s ideological shift, in the new administration’s substantial political capital and in the discipline imposed by no access to credit.

There has been an ideological shift across the society and political establishment that rejects heterodoxy of central bank deficit monetization and recognizes the importance of a fiscal anchor. The Milei victory is unprecedented with significant popular support on a pro-austerity campaign platform.

The political capital is also a clear advantage with an unexpected 12% margin of victory and an immediate shift towars pragmatism. There are prospects for a broader coalition that benefits from technocratic and political leverage across the legislature and regional governments, including Economy Minister Caputo. This should reinforce the ideological policy shift with a top-notch economic team and immediate meetings with the IMF to collaborate on the economic plan. President-elect Milei has reiterated a clear priority for spending cutbacks equivalent to 5% of GDP with de-emphasis on the unwelcome distraction of dollarization.

There is also the hard reality that you cannot spend what you cannot borrow. There is no access to external credit and only limited access to domestic credit through under-developed local markets.  This reflects the show-me attitude among external creditors and reluctance to provide any additional credit until there is some success on reducing domestic ARS liabilities.

Shock therapy may be out of vogue, but there is no other alternative. The Argentine economy needs quick results. It faces a stagflationary crisis, restricted access to credit and the approaching cycle of midterm elections in 2025, where President-elect Milei needs to rebuild legislative support. The Milei administration seems to recognize the need to quickly leverage its political capital with front-loaded austerity measures.

There is also another notable takeaway from the current economic crisis – a renewed commitment to pay bondholders.  The outgoing Fernandez administration has remained current on its debt through the extreme external and fiscal cash flow stress.  None of the candidates endorsed debt restructuring as part of their economic campaign platforms. The Milei administration is probably the most committed to the rule of law, especially to facilitate the shift from public consumption to private-led economic growth.  It’s not clear whether the high implied probability of default on bond prices discounts a unique strong willingness to repay. This willingness to repay always remains typically subordinated to the ability to repay. However, the consistent payment this year to bondholders and to the International Monetary Fund sets an important precedent. The memory of crisis and the punishment from domestic financial markets offers clear motivation for centrist policy that reinforces willingness to pay.

Stagflation fatigue remains the primary threat to effective shock therapy. Social tensions could test policy resolve. The memory of trial and error and ultimate policy failure under Kirchnerismo is sharp. There is no quick fix to the acute macro imbalances, but there is not much if any policy flexibility given the minimal financing options. The commitment to pro-cyclical fiscal discipline should ultimately determine the probability of default and recovery. However, current bond prices probably also underestimate the ideological commitment and binding constraints of credit restrictions and memories of crisis. The base case scenario has to assume some initial success for fiscal adjustment and some reasonable burden-sharing for bondholders with recovery value above historic lows.  The initial positive momentum after recent policy announcements should at least push bond prices outside of the year-to-date trading range to test post-2020 restructuring price levels.