Saturday 21 December 2019

Do Argentine bonds at 45c offer good odds for a recovery trade?

So it turned out that buying the 100 year Argentine bond, issued by 'market friendly' Macri, was a miscue at best. 

But at 45c, are Argentine external bonds a recovery trade under the new government or likely to be imminently defaulted on?

With the external bonds in the low to mid-40s, given Argentina is an index name, either they default in 2020 or the bonds have to rally over say the next six to twelve months. If a recovery trade sets in, the long onlies will have to buy in, which will start a virtuous circle of yield compression and improving solvency and business confidence.

New Government takes office

Christina Kirchner the former President, was elected as VP in October with her former Chief of the Cabinet of Ministers, Alberto Fernandez, winning the Presidential election. The new government assumed office on the 10th December and is in the process of setting out it's economic policies.

Fernandez has said publicly that their economic polices do not include debt default. This month they have been proposing new taxes and measures and asking for a programme adjustment with the IMF.

They are increasing taxes on tourism/ money going overseas (30%), on cash crop exports (so wealthy land owners), property taxes (real estate is a store of value for the wealthy) and will increase social spending including a six month freezing of utility prices, even though inflation is over 50%. There are tax breaks on asset repatriation and no income taxes on Peso denominated income, under Macri there was a lot of domestic capital flight, the repatriation of which would support a recovery trade.  

The proposals aim to increase social spending and reduce the primary balance adjustment in order to support growth and grow out of the debt problem rather than contract public spending to get out of it.

"The year 2020 is not a year in which fiscal adjustment can be made. A larger fiscal contraction would deepen the recession and aggravate the problem," Martin Guzman, the new finance minister said in his first news conference after taking office.

So they are ruling out more spending cuts and are instead going to focus on growth to change the debt dynamics and levels. A key to this is reprofiling the existing debt. They want to stop interest and principal payments for two years in order to spend money to get the economy to grow. 

Peronism, Recent History and IMF Programme

The Juan & Eva Peron founded, Justicialist Party, is a left-wing populist party that focuses on economic policies of domestic industry defence from imports, limited interest in free trade, support MERCOSUR regional trade in South America.

Christina's version of this, 'Kircnerism', is basically a policy mix that inflates the local money supply and government debt, makes industry uncompetitive and puts pressure on the current account deficit.

But it wasn't always so, under Nestor Kirchner from 2003 to 2007, Alberto Fernández, now President, but formerly Chief of the Cabinet of Ministers, during the first 5 years of Kirchnerism, they followed five tenets regarding the economy, which explained the perceived early success of the Kirchner movement:
  1. "Take no measures that increase the fiscal deficit"
  2. "Take no measures that increase the trade deficit"
  3. "Accumulate reserves in the central bank"
  4. "Keep the exchange rate very high to stay competitive and favour exports"
  5. "Pay off the external debt and do not acquire new debt"
According to Fernandez, after Néstor Kirchner died, Cristina Kirchner moved away from these five tenets, causing an economic crisis that resulted in the first political defeat of Kirchnerism in a presidential election in 2015.

The economy, similar to other EMs during the China/ commodity cycle grew well, Argentine GDP in USD $bn's saw annual growth and inflation both in the mid to high single digits for the cycle through to 2008.

GDP, total and YoY:

Inflation YoY:

With a lack of access to external debt, Argentine external debt had fallen to 28% of GDP, domestically there were capital controls and high inflation.

But in 2015 Christina Kirchner's government spent 39.8% of GDP on revenues of 35.4%, so a 4.4% primary deficit and another 1.6% on interest, leading to a 6% of GDP deficit.

In 2015, Macri was elected and inherited an economy that had seen 12 years of Kirchnerism. Reserves were low, inflation over 30%. The government had the highest taxes in Argentine history but ran a 6% deficit to GDP. FX controls had been in place since 2011.

Macri then came in with free market reforms, including cutting government taxes and spending. They settled with the bond holdouts for $6.5bn, regaining bond market access and opened the capital account. This however triggered capital flight and a 30% Peso devaluation.

The economy contracted in 2016 and rebounded in 2017. The government borrowed from abroad, even issuing a 100 year bond. But by the end of 2017 the government deficit had reached 7% of GDP and external debt had risen to 37.2% from 27.9% in 2015.

In 2018 with a drought affecting soya production, the Fed hiking rates and inflation rising in Argentina the central bank was forced to raise rates to over 80% as the currency tumbled.

Interest rates:

In May they approached the IMF for a $50bn bailout loan. Nicolas Dujovne was made combined treasury minister and president of the Central Bank.

The IMF then agreed with them a large primary balance adjustment programme. but public spending cuts drove the economy into greater recession in 2018 and 2019 and the Peso was devalued again in 2019 to 59.

In July the IMF approved the release of a further $5.4bn to Argentina bringing the total to $44.1bn, with much of those loans having been used to facilitate domestic capital outflows.

The main capital flight was domestic, with foreign portfolio investors pretty much holding all the way down and only pulling a smaller amount out over the last year. The IMF borrowings effectively replaced the domestic outflows:

Imports fell heavily but only this year have exports picked up: 

The primary balance in 2017 was -4.4% and is targeted at 1.4% in 2020 vs 0.1% projected in 2019. That's a 5.8% adjustment - quite large by historical standards: 

On a Cyclically Adjusted basis the adjustment is over 7%, and in the top 4% of adjustments: 


But things were starting to turn the corner. The primary balance and trade balance had gone positive in Q1. Inflation was starting to fall. A pick up in exports was supporting the goods trade which a fall in outbound tourism helped services. 


In the current account the net income balance remained negative as local interest rates push up the interest bill by several billions per quarter, but the goods surplus was almost enough to balance the current account in Q3: 


Current Account to GDP: 

Capital flight has also reduced and in September new capital controls were introduced. 

But the damage had been done and Macro lost the election to Fernandez and Kirchner who in December have taken office. 

New Economic Policies

So we are likely to see a return to Christina's old policies?

Probably not, they are in an IMF programme and will have to continue with most of it, most of the external adjustment has happened and the economy is expected to return to growth in 2020.

Additionally Christina from 2011-2015 had the hang-over from the busting of the China/ commodity boom to work through. Commodity prices have been lowish and Argentina has already done its external adjustment. 

We are more likely to see a fiscally disciplined Justicialist Party, similar to the one Fernandez described above when Nestor was leader. However they are looking to modify the policies and are looking to kick start a growth cycle.

Martin Guzman has been appointed Economy Minister. Guzman is a Joseph Stiglitz protege. Stiglitz and Guzman both have described sovereign debt crises as 'liquidity crises' and advocated fiscal stimulus and growth as a way of dealing with the crisis, as opposed to the contractionary austerity medicine that the IMF has often prescribed. For example, Stiglitz described European austerity as a 'suicide pact'.

Guzman has repeatedly argued for the following:
  • Growth as a way of dealing with debt crisis, not spending cut driven primary balance adjustments
  • Fixing economic problems and weaknesses
  • Streamlining debt restructurings
  • Problems should be dealt with fast to restore business confidence and return to growth, which in turn supports higher debt service
  • He has argued that most debt restructurings have not been enough and that has usually led to a second default within a few years
He made many of these points in a presentation in Geneva last month,

For Argentina he recommends delaying debt payments on capital and interest for two years, and argued against an immediate default. Argentina should set a March deadline for re-profiling its debt, he said.

Commenting specifically on the Argentina IMF programme, he argues the IMF forecasts have been wrong and the policies are not working:

Source: Martin Guzman, IMF projections

“This programme didn’t work,” Guzmán said. “If the country tries to deepen the austerity policies that have been implemented recently, that will lead to a deeper recession.”

Guzmán argued against receiving further funds from the IMF to service Argentina’s bonds. Saying the nation should only accept money from the fund if it’s invested in boosting production in the export sector.

“Argentina’s central problem is its debt,” Guzmán said in an interview with local newspaper Clarín on October 19. “If the country doesn’t solve that, there will be no way to implement a macroeconomic programme that allows for a recovery."

He has repeatedly stressed the interconnection with rapid debt restructuring, a return to business confidence and growth and in turn the level of debt that can be serviced.

One argument he has made is that most sovereign debt restructurings don't alleviate the debt enough and there is a 50% re-default rate in 3 years and 60% in 7 years.  High income countries actually have a worse re-default rate than low income.

Source: Martin Guzman

He argues that any restructuring needs to be enough to get economic growth and confidence to return.

Many of his papers are listed on his website.

Argentina with about $15k GNI per capital is a high income/ Market Access Country. So, amusingly, given they only emerged from the 2001-2016 default four years ago (as of 2020), re-defaulting and restructuring in 2020 hits the 65% redefault interval in 4 years.

So his policies are likely to raise taxes on assets and cash crop exports and be reinvested into education, infrastructure and other social spending areas. They are trying to get Argentines to repatriate foreign assets.

He has set a deadline of March to agree a re-profiling of the bonds with a 2 year interest and principal holiday.   

Guzman added last week that, in order to put public debt on a sustainable path, the government first needs to “determine a sequence of primary fiscal and trade results that are consistent with a recovering economy.”

Growth strategy

A recent article shows what Guzman thinks is the right strategy to grow the economy, driven by supply side reforms and investment.

You can see the economic stagnation that took place in the final years of Christina's government and since. Most of the 'peaks' coincided with the top of the commodity super cycle in 2011:

Qly GDP from Agriculture:

 Qly GDP from Manufacturing:

 Qly GDP from Mining:


Qly GDP from Construction:

GDP from public administration (you can see the macro retrenchment in recent years)

 Gross fixed capital formation:

So the country lost its growth strategy as the commodity boom faded and then later went through an economic crisis.

In the article he discusses economic stagnation since 2012, high poverty rates, poor employment security, stagnant export volumes leading to weak domestic demand growth and a lack of economic confidence overall.

He points to economic disruptions contributing to poor productivity growth, which in part have been driven by the commodity dominance of their exports and the cyclicality that drives. 


In terms of growth he is sceptical on unconstrained free trade, arguing it will leave them exporting commodities and importing manufactured goods. Instead he argues Argentina should focus on areas where they can grow and gain knowledge and be less dependent on commodities for exports. But also that the gains of the growth should be redistributed and less concentrated in a few hands; which explains the wealth and cash crop export taxes so far. 

He comments 40% of the working population does not have a complete secondary eduction. With such low skills levels, in turn the economy is dependent on low productivity/ labour intense industries to maintain employment, which in turn caps productivity. 

As you can see from the charts above they have tended to have large cycles in productivity growth where they gain 2-3% productivity annually in the up-cyle and them lose part of that in a recession.

For example the deflation of the commodity super cycle since 2011 has led to a lost decade for their exports. Argentine export volumes fell 12.8% from 2011 to 2018 and primary products within that fell 2.8%. Although there has been a rebound this year. High inflation and interest rates, taxes and logistical problems are viewed as having hampered the industrial sector.

As such he is sceptical that the EU/ MERCOSUR free trade agreement will do much else than destroy industrial jobs in Argentina. Their view is the agreement is designed to turn Argentina into a market for finished industrial goods, in exchange for commodity exports, so it will benefit rich land owners and hurt Argentine intermediate sector workers. 

The agreement liberalises 90% of MERCOSUR industrial products. 76% of Argentine exports to the EU and primary goods and 86% of imported manufactured goods. The 10% Argentine protected areas include some auto parts, machinery, footwear and textile products will lose tariffs in 10-15 years. The deal also opens up national government procurement contracts larger than $1.2m.

Guzman's views on debt sustainability
Guzman believes that debt should be sustainable based on the inter temporal budget constraint. Ie taking into account future growth, how much debt can be shouldered? The higher the growth and lower the cyclicality of that growth the more debt that can be carried. 

Guzman argues that a series of credible economic scenarios need to be used to identify if debt is sustainable and outstanding debt above that be written off. He comments that the IMF are usually too optimistic in their post-crisis outlooks, in part driven by the IMF's contractionary rebalancing medicines.

Assessing the Appropriate Size of Relief in Sovereign Debt Restructuring

In this paper, based on a series of assumptions and formulae Guzman finds that as a general benchmark, 60% debt to GDP is sustainable with a high (95%) likelihood for an average country that they wont redefault with in a few years. This would give a 5% probability of default and therefore allow a normalised bond yield. Debt that is higher than this needs to be haircut.

Source: Martin Guzman

Richer countries, less cyclical countries, countries with stronger business/ creditor reputations and countries with more domestic than foreign debt, stronger governments able to push through reforms and stimulate post-crisis growth are likely able to support more debt than this, and the converse countries, less.

The IMF have broadly similar conclusions in their debt sustainability analysis for Market Access Countries.

The IMF uses 50% debt to GDP as a long run cap EM countries, with the 60-80% range as a peak level after a downturn. gross financing needs in the 20-25% of GDP range also raise the default risks. 

Reinhart and Rogoff in their Growth in a Time of Debt paper found that for Emerging Markets, total debt over their 90% of GDP killed growth and in the 60-90% reduced it moderately while putting upwards pressure on inflation.

Source: Reinhart and Rogoff

If you just look at EM external debt, over half of EM external defaults have been done by countries inside the Maastricht criteria of 60% debt to GDP:

If external debt is over 60%, growth is affected markedly and at over 90% on average the economies contract, ie they default.

Argentina is now on to its 8th default. Interestingly the UK has never defaulted in 1000 years.

Source: This Time its Different.

They also found high levels of capital mobility lead to higher probabilities of crisis, when there is a reason for that capital to be withdrawn. In other words Macri opening the capital account and letting domestic capital flee, arguably set up the series of events that brought the country to where it is now.

Argentina's debt sustainability.

So based on a 60% post recovery debt to GDP and 60-80% short term level, where does Argentina stand?

The IMF has debt peaking at 77% of GDP in 2019 and then declining to 65% in 2021 under their programme:

External debt peaks at 58.7% of GDP in 2019 and then declines to 50% in 2021.

Of the projected $285bn end-2019 external debt, $107bn is owed to the official sector, so the IMF, Chinese and other bilaterals. $178.2bn is owed to the private sector.

Within this government debt is $185bn and is mostly external debt: 


 IMF dashboard:

In the IMF's downturn scenario, they have a 50% real devaluation and 25% of that inflation pass through test shows debt going to 115% of GDP. A poor growth outcome would lead to 80%.

Looking at it from another stand point, The economy is about $400bn. At a 3-4% economic growth driven by 1% population growth and a positive outcome on productivity plus a 1% primary surplus, the country could support 4-5% of GDP in debt service.

External debt is 60% of GDP, at 8% coupon rate, that is 5.2% of GDP. Its a shade too high, but Guzman doesn't want to run a primary surplus of more than 1% and these assumptions are based on a positive growth outcome.

In addition the IMF stand-by facility loan interest is between 1.96% and 4.96% depending on how much is drawn, so less than the 8% coupon used above.

Within that 60% of GDP of external debt, 70.7% is government, so 42% of GDP on a $477bn economy. That's well within the IMF, Guzman and Reinhart and Rogoff thresholds.

As long as the economy grows the debt profile is within the solvent bands and not at a level needing a significant principal haircut. But they do need to get the economy to grow as a renewed recession from here would push the numbers into restructuring territory.

As such when Guzman says the sovereign debt problem is a liquidity one and not a solvency one, believe him

 "We want to have a good relationship with the IMF but without growth we won't be able to pay," said Fernández.

“We'll do what we have always done, which is to fulfill and honor our debts, but we will not do it at the expense of our people,” Fernandez said.

One of Guzman's own measures on restructuring success is whether the PV of the new bonds is higher than the old bonds. In other words if they are lower the market is saying there is a high likelihood of redefaulting. I.e. if the bonds start to rally 9which they have done in December) as details of his proposals come out, it is effectively a market endorsement of the plan. 

Assuming a reprofiling happens 

So lets assume they get the near term (2020, 2021) maturities to agree a principal extension and they defer interest on other bonds as PDI. How this works out with collective action clauses and equal treatment of creditors is not clear, but Ill assume they can just tell the bond holders there is a 2 year deferral with PDI. In 2014 when Christina was forced to stop payments on the restructured debt by Judge Griesa, the bonds didn't move much and just accrued PDI on the basis the market viewed it as a temporary situation. 

If the economy starts to recover their balance of payments should also improve. The collapse in FDI and the rise in interest outflows has hurt their balance of payments. As things settle down the net FDI balance was about $10bn a year and has dropped to about $2bn this year, so could regain $8bn or more, almost 2% of GDP. Also the income balance would improve by $4-6bn as net interest interest flows improve as domestic inflation/ yields fall.

Foreign portfolio investors in local fixed income have seen the USD value of their holdings collapse from $140bn to $56bn.

This liability collapse via the fall in local asset values has boosted the NIIP from about $60bn to $120bn or so. Guzman wants to entice some of that money home in order to support the BoP and reduce reliance on the IMF facilities, although foreign reported portfolio holdings only total $65bn.

Commodity Price Outlook
One reason for a renewed downturn could be a surprise fall in commodity prices. Beef, grains and cereals are key exports, but none show particularly stretched prices. In fact as the Chinese try and rebuild pig herds it may support soya prices.

So if anything commodity prices are more likely to boost the country over the next few years.

The Bonds
So where does that leave us with the external bonds?

The curve is fairly flat in the low to mid-40s for most bonds, depending on the coupon level.

Coming back to the point above: Within that 60% of GDP of external debt, 70.7% is government, so 42% of GDP on a $477bn economy. Of that $202bn about $95bn is private and $107bn official.

So the $95bn at 45c has a NPV of $43bn, on a $477bn economy that is about to enter a recovery cycle and which was once a $600bn economy.

You could buy the bonds outright, either at the front end and get a pull to par, or back end to get most duration and future coupon income. While if they restructure all the bonds into a new strip, ala Greece, you want to own the lowest price bonds.

Picking a few bonds as general examples:

The Nov23s with a 4.625% coupon are trading at circa 47c up from a 39-40c low a 10% running yield.

The lower coupon 3.375% Jan 23s are at 43c up from 37/38c lows, a 7.8% running yield.

The 6.875% Jan 2048s are at 43c's mid, a 16% running yield:

The 100yr bond offers a 7.125% plus coupon on a 45c price, or a 16% running yield, plus, of course, a pull to par for your great, great grandchildren:

Curve trade
You could do a curve trade, long the front end, short a longer bond on a ratio basis. Long the Jan 23s with a 10% running yield, half hedged short the Jan 48s with a 16% yield would net a 2% bond carry plus a small short rebate. If something goes wrong and the bonds drop to 30c, with a flat curve, you would be down 17c on the long and 13c x 0.5 ratio, so 6.5c, on the short, so net down 11.5c less 2 points of carry, -9.5c over a year. But you could then lift the short and benefit from the long bond rebound, after any restructuring and moderate principal haircut.

If things go well and by the end of next year the curve rallies, the Jan 23s, lets say they get to 65c and the 48s to 55c, you gain 18c on the long (35% capital gain) and lose 12c x 0.5 ratio, so 6c on the short. Plus 2c carry. So that outcome is +12c.

Local debt
I'm not looking at the local debt here, but there could be an interest rate normalisation trade there given the level of stress.


So Fernandez and Guzman have said they will pay the bonds and want to grow the economy. On that basis the bonds are a cheap recovery play.

Question is, do you believe them?
All Ill say here is the odds being offered are much better at the bottom of the economic cycle and at 45c on face than buying a 100year bond at par...

Needless to say if the US and China go into a hard slump the bonds will likely trade with a 3x handle for a while, even if Argentina and the government deliver.

It's a shame Guzman didnt do a study on countries that triple default, as Argentina's reputation at being able to stick to the straight and narrow preceeds itself. That said if trouble only develops 4 or 5 years down the road, that's in the distant future from a 2020 markets standpoint. 

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