Argentina Might Not Default In 2013 But Its Future Is Gloomy

Includes: ARGT
by: Zugzwang Capital

The purpose of this article is to give the reader a succinct idea of the state of affairs in the Republic of Argentina (NYSEARCA:ARGT), from an economic perspective. Much has been said about a potential debt default, so we'll discuss this issue briefly, but the ultimate goal of the article is to present and evaluate economic variables that may affect the country's solvency in the future.

Talks about an imminent Argentinean default are all over the place; an updated insight on this matter can be found here. Credit default protection has skyrocketed after a hearing that didn't go well for Argentina. NML Capital and Aurelius Capital Management have been pressing hard for a long time, going as far as having the Fragata Libertad ship seized in Tema, Ghana, only to suffer a setback in December, as the ship was released due to a ruling from the UN Law of the Sea Tribunal. These holdouts, as they are known for having opted out of the debt restructuring offered by the Argentinean government a few years ago, are now close to having a New York court of law rule in their favor. The Republic of Argentina has been ordered to issue an alternative payment offer by the end of the month. Cristina Fernandez de Kirchner stated in a 3 hour and a half speech last week, that vulture funds will not be offered more than what bondholders received when they opted to exchange their old debt for new bonds. She said that, since more than 90% of the bondholders accepted the exchange, the Republic of Argentina will not favor the hedge funds. The President also promised to continue paying all restructured debts in U.S. Dollars.

It can be discussed whether Argentina's position is legitimate or not, and whether the so-called vulture funds should be given a special treatment in comparison to the bondholders that exchanged their debt. However, what will ultimately count, at the end of the day, is if these funds accept Argentina's offer and - if not - what does the New York Court rule as a consequence. The main issue here has to do with the "Ley del Cerrojo nbr 26017" ("Latch" Law), which clearly indicates that the exchange that was made in 2005 was one and final. Later on, in 2010, there was a second exceptional exchange for bondholders that had not been included, made possible through a law suspension granted by the Senate that lasted a couple of months. After that, Law nbr 26017 resumed its legality and no other exchanges were offered by the Republic of Argentina. Therefore, the Argentinean senate will have to grant an additional suspension for these holdouts, in case an agreement is settled. Jurisdiction here is a point of the debate, for the debt was issued in the United States. However, it is difficult to gauge how will the Argentinean Senate interpret a clear breach of its legislation.

In essence, the situation is so complex that trying to forecast a potential outcome for this litigation would be as flipping a coin and expecting better than 50/50 odds. Therefore, we will not attempt to forecast an outcome regarding this specific litigation, but rather discuss what variables are affecting the Argentinean economy and, thus, its ability to pay its debts in the future. This article also aims to help investors decide whether the upside of investing in Argentina is worth the risk.

There are several variables constraining growth and affecting the overall functioning of the economy. These are, basically, rising inflation, growth stagnation and an important decrease in investment and savings. Inflation has been an important source of debate between independent economists and the government policy makers. The National Statistics Institute of Argentina declares that the country's annual inflation is close to 12%, while independent analysts estimate it around 25% per annum.

We will use the independent estimates for the analysis, since public statistics from the INDEC institute are not trustworthy according to local and international sources.

GDP has grown a mere 1,9% in 2012 according to official estimates, while independent economists suggest that this percentage may be even lower, closer to zero growth. 2012 was, for Argentina, a textbook case of stagflation. The economy is currently stalled and the purchasing power of the average worker has decreased in a considerable manner, due to rising prices and no credible alternative for purchasing power protection. The currency has lost one of its most important qualities, i.e., that of reserve of value.

To make matters more complicated, employment has not improved in the last 6 quarters. The government ordered supermarkets to freeze prices for 60 days, ending on April 1, a policy that has proved to be - from a historical perspective - nothing more than an illusion. It is not clear what will happen on April 2, but one might argue that prices will soar. Asides from a hike in prices due to compensation by suppliers for this two-month price vacuum, future inflation expectations will play a decisive role as well.

Savings have decreased in the last few quarters, mainly due to the lack of confidence in the currency, the peso. Since contracts and bank certificates of deposit are indexed by the official rate of inflation, there is no escape from inflation for the average citizen other than consumption. This rationale explains why consumption has been so high, and why durable goods are being viewed as a means of reserve of value. For instance, a car bought last year is now more expensive if we compare it with the day it was purchased. This is a consumption boom built on unsustainable foundations, i.e., not derived from increase in savings, capital investment and employment.

A lower confidence in the currency, coupled with the fact that people are prohibited from buying U.S. dollars, has contributed to widen the gap between the official and the parallel (black market) exchange rate. This gap ranges, as of March 7, between 50% and 60%. One might interpret that the market is charging a ~55% premium for the risk of holding pesos. Even if the government opts to debase the currency as a means to tighten the gap between the official and the parallel exchange rates, it would still be necessary to increase tariffs that are currently being subsidized, such as transport and electricity, since important productive inputs/consumables are imported. Needless to say that tariff increases would add more gasoline to the fire. The government is running an unsustainable deficit and issuing large amounts of debt, shown by the increase in the monetary base.

Government spending with subsidies and assistance plans is at all-time highs, and the means for paying this spending has been money printing. The monetary base grew 36% last year, according to the Central Bank. The energetic deficit is pressing the currency even more, since every year the government is forced to import oil and gas from abroad. The estimates for 2013 are $ 13 billion in energy imports, according to former Finance Minister Roberto Lavagna. A huge part of this amount will be paid from export retentions charged from the agricultural exports, mainly soy bean, and will certainly exacerbate tensions between agricultural producers and the government.

Most independent economists agree that the state of affairs right now can rapidly lead to a currency and credit crisis. The consensus is that inflation can be managed, if the government takes the proper actions, such as decreasing the spending spree, adjusting the national indexes and fostering policies towards savings and investment increases. The energy deficit is most certainly Argentina's toughest challenge, and the first step was taken with YPF's nationalization. The problem is that, while Argentina needs oil and gas production to increase and sustain the country's growth, expropriating a foreign company is not the smartest decision. YPF needs foreign equipment and investing, and right now the market is not eager to lend or invest in the country.

There is not much time left for the government to take action, and that need may affect decisions related to paying its debts and avoiding default. Default is not an option and, even if the President claims that Argentina is not participating in global capital markets out of choice, the country will need foreign investment to boost energy production. It is likely that Argentina's actions will be in fact directed toward reaching an agreement with holdouts and making peace with the global capital markets. A good first step would be to reach an understanding over the price that will be paid to Repsol. Cristina Fernandez de Kirchner has almost three years in office left, and a full-blown crisis is the last of her wishes. While her speeches are tough, actions may prove to be softer. Nevertheless, extreme caution is suggested for those that wish to invest in public companies or through exchange traded funds.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.