Mon | Sep 25, 2017

Walter Molano | Argentina: Fair weather friends

Published:Friday | February 17, 2017 | 2:00 AM
President of Argentina, Mauricio Macri.

After being considered to be a pariah and the scourge of the asset class for more than a dozen years, Argentina is now Wall Street's top pick.

Of course, it helps that it is the most prodigious issuer in the emerging world, but then again, who's counting?

Provinces with few industries, exports or natural resources are being peddled to investors around the world. One of the big surprises is the renewed enthusiasm for the GDP warrants.

During Economy Minister Alfonso Prat Gay's tenure, the government announced that it was launching a collar for the warrants. This created a virtual floor for the instruments, despite their low intrinsic value.

Halfway through last year, the government issued almost US$3 billion in bonds to execute the operation. The transaction, unfortunately, was never completed, but the prices for the warrants remained firm.

By the end of the year, Prat Gay was gone, the ministry was reorganised, and the warrants began to drop. Now, there are rumours that the operation may be revived. Moreover, the most recent macroeconomic data showed that the economy was showing some signs of life. The level of economic activity in November was up 1.4 per cent on a month-to-month basis, but down 1.4 per cent on a year-to-year basis. The latter is the more important metric, given that it teases out seasonality factors.

Still, it was enough for the Argentine bulls to bang on their drums. Local economists are expecting GDP to grow 2.5 per cent y/y to three per cent y/y in 2017, but some international analysts are calling for a growth rate of almost four per cent y/y. They remind us that the GDP growth rate needed to trigger the payment of the warrants is three per cent.

Three conditions for payment

However, they seem to have forgotten that there were actually three conditions that were necessary to make the payment - and that is not going to happen for a long time.

The premise behind the GDP warrants was for the Argentine government to compensate creditors for accepting a large haircut during the debt-restructuring process. The government led by Mauricio Macri noted that the Argentine economy had grown at an average pace of three per cent y/y during the last 30 years, a period fraught with military dictatorships, a war with England, default and hyperinflation.

However, if the country grew at more than three per cent going forward, this would be partially attributed to the large haircut. Hence, the government was willing to share part of the upside with creditors. They established a baseline of economic activity that trended up at an annual rate of three per cent per year. The total payout was also capped at 48 cents before 2035.

Therefore, these became the three conditions that were necessary to trigger payment. In other words, the actual level of economic activity needed to be above the baseline, the pace of GDP growth had to be more than three per cent per year and no more than 48 cents could be paid out. So far, the government has paid out 18 cents. That means that 30 cents can still be recovered.

However, soon after President Mauricio Macri took office, the government reorganised the national statistics agency, INDEC, which had been destroyed by the previous administration. In the process of reviewing the GDP series, the government revised down half a dozen years of economic activity. This brought the actual level of GDP well below the established baseline.

The revision was so large that even if the country posted a growth rate of four per cent y/y in 2017, it would not be enough to trigger a payment. Indeed, our model suggests that the country would need to grow more than 7.6 per cent y/y in order to meet all of the necessary conditions. And, the payment would only be about two cents. Hence, it is hard to imagine why anyone would recommend buying the GDP warrants at current levels.

To make matters worse, it is doubtful the Argentine economy will grow more than three per cent y/y in 2017. Most of the government's major infrastructure projects were sidelined in 2016, and they finally began making progress after the departure of Prat Gay.

Nevertheless, it will take some time for the economy to take off. The level of activity was still shrinking on a year-to-year basis in November, and should move into positive territory by the end of the second quarter. Hopefully by next year, the pace of economic activity will rise above three per cent y/y.

Still, it will be a long time before the level of economic activity is above the baseline. In the meantime, the clock will continue to run down.

Maybe the new minister of the Treasury will initiate the collar, but it does not make sense. But, we can surely trust that Argentina will get a lot of positive recommendations from its new-found friends.

- Dr Walter T. Molano is a managing partner and the head of research at BCP Securities LLC.

wmolano@bcpsecurities.com