I regard with some skepticism recent reports and articles by analysts, investors and bloggers talking up the investment opportunities in Argentine stocks. It appears that many don't have an appreciation for the high level of risk that exists when investing in Argentina. They are solely fixated on the history of high economic growth, growing year over year company performance and dividend yields that are in excess of 5%. Argentina has been politically and economically unstable for decades, with reactionary populist socialist and Peronist political parties vying for political power after the end of the military dictatorship in 1983.
This ongoing economic instability created by poor fiscal policy, high public debt, an unstable currency and spiraling inflation boiled over into riots, popular dissent and an economic collapse in 2001, causing the country to officially default on its foreign debt in 2002. Since then Argentina has seen explosive economic growth with annual GDP rates in excess of 8% from 2003 to 2008 and then over 9% in 2010. Yet despite this I believe that Argentina is a volatile and crisis prone country that is particularly risky for investors and in this article I will explain why.
The Mirage of High Economic Growth
Despite Argentina's volatile political and economic history, which ended in the 2002 debt default, the Argentine economy has grown at a rapid pace over the last decade. From 2003 to 2008 Argentina experienced an annual average GDP growth rate of 8.5%, and in some individual years it even exceeded 9%, putting its growth rate alongside China's. The only time economic growth dipped was during the global financial crisis with the GDP growth rate bottoming out at 0.8% in 2009, only to recover to 9.2% in 2010.
It is this spectacular growth that has seen many Argentine companies grow at incredible rates reporting stronger year over year revenue and income growth and paying impressive dividend yields. There are a number of Argentine companies listed as American depositary receipts (ADRs), which historically have paid dividends in excess of 10% including; Banco Macro SA (BMA), Telecom Argentina SA (TEO), YPF SA (YPF) and BBVA Banco Frances SA (BFR). All of which has drawn investors to Argentine stocks as they seek to cash in on this growth.
For 2012, Argentina's economic growth is forecast to continue with the IMF forecasting GDP growth of 4.6%, which is the fourth highest 2012 IMF forecast for South America. It is also a full percentage point higher than Brazil, which is world's sixth largest economy and Latin America's largest. This forecast is also more than double the United State's 2012 GDP forecast of 1.8%, and higher than the forecast growth rates for Canada and Mexico, as set out in table 1 below.
Table 1: IMF 2012 GDP Forecasts
2012 Forecast GDP Growth
Source: World Economic and Financial Surveys September 2011; imf.org/external/pubs/ft/weo/2011/02...
This high rate of economic growth is being driven by the growth of Argentine foreign trade, especially with MERCOSUR, the South American trade bloc composed of Brazil, Argentina, Paraguay, Uruguay and Chile. Argentina's exports for 2011 totaled $84.3 billion, with Brazil, the European Union, China and then the United States being the key export markets. The main exports were soybean products, cereals, beef, motor vehicles and parts, chemicals and medicines, oil, gas, petrochemicals, gold and copper.
Argentina is also experiencing a rapid expansion in its oil, gas and mining industries with a number of domestic and foreign companies engaged in the exploration and extraction of oil and gas, as well as base and precious metals. Some of the largest oil and gas companies operating in Argentina are YPF a subsidiary of Spain's Repsol (OTCQX:REPYY), CNOOC (CEO), Petrobras Argentina (PZE) and Chevron (CVX).
However, the Argentine oil and gas sector is heavily regulated increasing costs and reducing operational flexibility thus limiting its attractiveness to private investors. This includes significant tariffs being levied on oil exports with a tax of 100% on all oil exports above $45 a barrel. Given that oil has been trading at around or over $100 per barrel since March 2011 this creates an additional and significant cost for oil producers operating in Argentina.
Some of the major mining and metals companies operating in Argentina are Barrick Gold (ABX), Xstrata (OTC:XSRAY), Yamana Gold (AUY), Vale (VALE) and AngloGold Ashanti (AU). The mining industry while less heavily regulated than the oil and gas industry is still subject to an export tax of 10% levied on Argentine mineral exports, again creating an additional cost for mining companies operating in Argentina.
Another contributor to Argentine economic growth is capital investments, which have been growing rapidly in value. The contributor to the growth in capital investments has been a rapid increase in construction, which accounts for half of the growth in capital investments and it is being driven by the following factors;
- real interest rates are negative, as the current inflation rate of 9.7% exceeds the official interest rate of 9%;
- real assets, such as buildings and land are traditionally seen as an effective hedge against inflation; and
- the ongoing expansion of Argentina's oil and gas industry has seen a rise in demand for the necessary transport and physical infrastructure to support this rise expansion.
Argentina's economy is growing strongly with growing exports and an expanding resources sector, although it appears with ongoing and increasing government intervention this is under threat. All of which reflects a high degree of economic volatility caused by high levels of political and economic risk.
Argentina's Growing Country Risk
Many investors are unaware of the high degree of country risk that is part and parcel of investing in Argentine companies or companies that operate in, or derive a significant proportion of their earnings in Argentina. This risk has been growing for sometime as a result of the governments highly interventionist and protectionist policies. In order to fully understand this risk and the impacts it can have on investors I will evaluate the key underlying risks that form part of any country risk assessment. When assessing country risk the main underlying risks considered are:
- political risk;
- exchange rate risk;
- economic risk;
- sovereign risk; and
- transfer risk.
The degree of political risk in Argentina is quite high due to a succession of governments who see wholesale intervention in the economy and the business sector as a valid tool for economic management. Many of these governments have not only engaged in active economic intervention, but happily manipulated both the legal system and economy when it has suited their political purposes. This can be attributed to the accepted view that the economy is a tool that can be used to manage political agendas, conflict and popularity. The current government of President Cristina Fernandez de Kirchner has made it well known that it is more than willing to intervene in the economy and business sectors to achieve its political and economic goals.
Following her October 2011 landslide re-election, President Cristina Kirchner has ordered energy and mining companies to repatriate all future export revenue to Argentina. She also told insurance companies to repatriate investments held abroad, tightened oversight of the foreign exchange market, raised the amount of wheat farmers can sell abroad and applied pressure on Argentine companies not to pay dividends to their shareholders but instead reinvest earnings in Argentina. These demands were all made after Argentina saw a record flight of capital in the third quarter of 2011 due to rising fears of currency devaluation.
This hard line stance can be attributed to Argentina being unable to access international credit markets since the debt default, making Argentina reliant upon a trade surplus to bring capital into the economy. I also believe that there is a significant degree of political ideology and political opportunism that plays into these demands as they provide the government with an opportunity to distract its electorate from the real problems facing the Argentine economy. These problems include staggering levels of inflation, high unemployment and growing poverty particularly in Buenos Aires.
These demands have had a significant impact on Argentine companies with YPF, the nation's largest oil and gas company, deciding to reinvest the last two years of earnings in production and exploration instead of paying dividends to stockholders. This decision was made easier for a reluctant YPF, because when it initially failed to meet investment promises the government stripped the company of two oil field concessions.
It has also recently come to light that the government has made the decision to nationalize YPF. This can only foreshadow an upcoming change to Argentine law, making oil and gas production a matter of public interest, which is a foreboding development for the other oil explorers and producers in Argentina.
Telecom Argentina has also bowed to the pressure and agreed to withhold 2011 dividend payments. This will need to be formally ratified by shareholders at an April 27 2012 shareholder meeting, but that is merely a formality. I am also certain that many other Argentine companies will follow suit as they seek to avoid the increasing public glare that President Kirchner's demands have placed upon them and any recriminations from the government, should they not comply.
These demands are not the only cases of government intervention of manipulation of the legal system as tools for managing the economy. There are numerous other examples including the recent creation of additional restrictions on the import of foreign books into Argentina, ostensibly due to high lead levels in their ink being a health risk. This smacks of an Orwellian attempt at of controlling imports for products that can be produced in Argentina.
The Argentine government has also sent a letter to foreign banks that engage in researching, rating and capital raising for resource exploration companies operating in the Falkland Islands, stating that they will face criminal and civil action in the Argentine courts, even for writing research notes on these companies.
The Argentine government has now commenced legal action against oil exploration companies operating in the Falklands, despite the fact that they don't have legal jurisdiction over the islands. In recent days the Argentine government has been escalating the Falklands issue and it now seems to have developed into a significant political side show that is being used to distract the population from the deep seated problems within the economy. This can only lead to further political and economic problems as it endangers foreign trade with the United Kingdom and emboldens further political agitation against foreign companies.
It is also unlikely that the government's protectionist and interventionist policies will ease in 2012 despite a moderate Hernán Lorenzino, who is perceived as market friendly, being appointed as Minister of Economy. This is because the real power regarding the economy lies with the Secretary of Domestic Commerce, Guillermo Moreno, who is a hardcore interventionist. This only creates greater political risk for investors and makes the government's management of private industry and foreign investment even more unpredictable.
Overall this ongoing history of governmental intervention in the economy combined with manipulation of the legal system is a systemic problem that will never cease without significant political, cultural and legal reforms.
There are a number of ongoing economic risks faced by Argentina; the most concerning for investors being the spiraling and seemingly uncontrollable inflation, which for February 2012 was unchanged from January's 9.7%. This is further exacerbated by concerns that the government is fudging the inflation figures and they are in reality considerably higher than reported.
According to a number of private agencies Argentine inflation for February 2012 rose by 1.65% and didn't remain stable as stated by the government. Furthermore, these agencies have stated that inflation was 22.75% in the last twelve months and not the 10% officially reported.
Furthermore, research shows that consumers share private analysts' inflation assessments with the Universidad Torcuato di Tella (UTDT) survey conducted in January 2012 indicating that households believed consumer prices will increase by 25% over the next 12 months. This high rate of inflation, while creating a short-term stimulatory effect for Argentine stocks, can only create problems for investors with regard to company valuations and eroded long-term value.
Besides the inflation risk there are a number of other economic risks that could trigger an economic decline including:
- Negative real interest rates, which is driving down the buying power of lenders and is contributing to the creation of a construction bubble.
- Ongoing heavy taxation and government interference in company operations. particularly in the resources sector that will reduce direct foreign investment and see many companies leave Argentina, leading to a flight of capital.
- The impending economic slowdown of China combined with the ongoing recessionary environment in the eurozone and a slower than expected U.S economic recovery, all of which will have a direct impact on demand for Argentine exports.
The degree of sovereign risk is quite high and much of this stems from Argentina's history of debt defaults combined with weak fiscal policy, rampant inflation, high public sector debt as a percentage of GDP, large flights of capital and a devaluating currency.
In June 2011 Black Rock in its inaugural Sovereign Risk Index, rated Argentina as the 8th riskiest country out of the 44 countries rated. According to Black Rock this made Argentina less risky than Greece, Portugal or Venezuela but riskier than Spain, Mexico or Colombia.
There is also a high degree of regulatory risk in Argentina because the government frequently uses regulation as a tool to manage political issues and the economy. In addition, Argentina is in the process of ensuring that much of the regulation of its economy is brought up to international standards where required, which will see many regulatory and policy changes. This in my opinion has led to some opportunistic changes to regulatory requirements notably in the banking sector that serve to assist the government policy of preventing Argentine companies from paying dividends to foreign investors.
Recently the Banco Central de la Republica Argentina, the Argentine central bank, amended the regulations relating to the capital requirements for banks, notably with regard to the assessment of operational risk and the payment of dividends. This saw a substantial increase in the minimum capital requirements that an Argentine bank must hold before it is legally able to pay a dividend. It lifted the capital require to Argentine banks having an excess capital of 75% (before it was 30%) after the deduction of proposed cash dividends over the required capital.
This change was ostensibly implemented as part of the reforms being undertaken by the central bank to bring the Argentine banking system into compliance with international standards and Basel III requirements. However, given the timing of the announcement, which was not long after the Argentine government started applying pressure to companies to not pay dividends but rather reinvest them in their Argentine operations; it is in my opinion an opportunistic use of regulatory requirements to achieve a political goal.
As a result of this change to the capital requirements one Argentine bank Banco Macro has already stated that it will not pay a dividend. It is also highly likely that the other Argentine banks with U.S listed ADRs, which are BBVA Banco Frances and Grupo Financiero Galicia (GGAL) will not pay dividends either as they don't meet the capital requirements. However, at this time I am not aware of any statements from these banks confirming this.
Country Risk Indicators
Clearly each of the underlying risk that make up country risk are particular high for Argentina but the degree of country risk becomes even clearer when considering how Argentina is rated internationally by ratings agencies and international governmental institutions. These risk ratings for Argentina, the remainder of South America, U.S, Canada and Mexico are set out in table 2 for comparison below.
Table 2: South American Key Country Risk Indicators
Corruption Indicator (Position out of 184 Countries)
Even the high level indicators listed below do not bode well for the degree of country risk for investing in Argentina. Its credit rating of B is one of the lowest in South America and is only higher than Ecuador, one of the most impoverished countries in South America. This credit rating is lower than Venezuela's which is B+. Yet Venezuela is engulfed in a wave of nationalist fervor and nationalizations with the chaotic rule of Chavez, which has seen the breakdown of the rule law and the internal security situation becoming increasingly unstable with rising crime and corruption.
When we consider Argentina's corruption indicator as measured by Transparency International, for 2011 Argentina was rated as the 100th most corrupt country in the world from the 184 assessed. This is the fifth highest rating in South America and only behind unstable and systemically corrupt countries such as Bolivia, Ecuador, Paraguay and Venezuela.
OECD Country Risk Rating
In January 2012 the OECD assigned Argentina a country risk rating of 7, where 0 is the least risky and 7 the most risky. From this assessment Argentina is rated as the most risky South American country along with Ecuador and Venezuela. Overall this does not bode well for investor confidence when investing in an Argentine company and in fact raises many questions for investors around safety of capital invested, consistent payment of dividends and the transparency of company financials and reports.
It is clear that investing in Argentina carries a significant degree of country risk which effectively increases the likelihood of diminished returns and even significant capital losses for investors. For the short to medium-term I do not believe that the level of risk will decrease and in fact it may get worse because of the systematic degree of government intervention in the economy coupled with a protectionist agenda.
It is also likely that there will be significant changes in the oil and gas industry with the nationalization agenda now firmly established by the government. At this time the best option for investors would be to wait for the government's economic agenda to become clearer. It is also highly likely that Argentine stocks will drop in value as the degree of uncertainty rises creating buying opportunities for investors further down the track as the outcome becomes clearer. It is also worth considering alternate investment opportunities in Latin American countries that have less country risk such as Brazil, Chile and even Colombia.