DBRS Confirms Argentina at B, Stable Trend

DBRS, Inc. (DBRS) confirmed the Republic of Argentina’s Long-Term Foreign Currency – Issuer Rating at B, and the Long-Term Local Currency – Issuer Rating at B (high). At the same time, DBRS confirmed the Short-Term Foreign and Local Currency – Issuer Ratings at R-4. The trend on all ratings is Stable.

KEY RATING CONSIDERATIONS

Argentina has made considerable progress reducing macroeconomic imbalances, but inflation remains stubbornly high and the economy remains in recession with a general election approaching in October. A combination of tax increases, reductions in public subsidies, and other efforts to streamline public expenditure are expected to produce a cumulative adjustment in the primary deficit from 4.6% in 2016 to 0% in 2019. Taking into account the remaining disbursements from the IMF program, this eliminates the need for net new financing this year. The political outlook nonetheless remains highly uncertain, as austerity measures have deepened the economic downturn just as the election campaign is about to start. This has weighed on the popularity of President Macri and could increase the risk of policy reversals by the next administration.

The Stable trend reflects DBRS’s assessment that the upside and downside risks to the rating are broadly balanced. On the one hand, policy continuity appears likely if President Macri is reelected or if a new administration broadly adheres to critical elements of the current IMF program, even if mixed with some increased interventionism. On the other hand, an administration that reintroduces domestic subsidies, price controls, and distortionary taxes would likely undermine fiscal and monetary policy discipline.

RATING DRIVERS

One or a combination of the following developments would likely put upward pressure on Argentina’s ratings: (1) continued progress on disinflation and on the establishment of a credible inflation targeting framework; (2) fiscal discipline in line with existing 2019/2020 targets, combined with efforts to strengthen the tax base and improve the quality of public expenditure; (3) continued progress on structural reforms to boost investment and enhance medium-term growth prospects; or (4) increased evidence of a political consensus around the main pillars of macroeconomic stability, including through passage of the law on central bank independence.

Downward pressure could emerge on the ratings if (1) fiscal or monetary policy discipline slips in the lead up to or following the general elections; or (2) the incoming government reneges on key policy commitments agreed under the IMF program, generating continued market pressures and limiting the availability of funding headed into 2020 and 2021.

RATING RATIONALE

Pivotal 2019 Elections Will Determine the Path of Argentina’s Economic Policies

Argentina’s national elections will be held on October 27. Voters will select the next President and close to half of Congress. If no Presidential candidate receives more than 45% of the vote (or more than 40% with at least 10% more than the next candidate), a runoff election between the top two contenders will be held on November 24. The final list of primary candidates will not be known until June 22, and the list of candidates for the general election will be finalized on September 7.

Just as the last presidential election brought about a major policy shift, voters are faced with a similarly consequential decision in 2019. Mauricio Macri came into office promising change and has, in spite of some setbacks, delivered substantial reforms to cut Argentina’s primary deficit, reduce indiscriminate public subsidies, roll back distortionary taxes and controls, and increase the efficiency of the public sector. The administration has worked to strengthen the independence of the central bank and introduce a credible inflation targeting regime. The initial gradual approach to deficit reduction and disinflation did not deliver the expected results, forcing the administration to accelerate the adjustment process in an election year. This has in turn posed a serious test to the political sustainability of the reform program.

In this context, Macri’s reelection prospects appear challenging. His vice presidential pick, Miguel Pichetto, could help to significantly broaden his appeal to Peronists. Cristina Fernandez’s earlier move to declare herself the vice presidential running mate to Alberto Fernandez, her late husband’s former chief of staff, appears to have had similar motivations. There are other moderate Peronist candidates that could declare as candidates before the campaign officially begins, but polls suggest they will have an upward climb to defeat either of these leading candidates. Given that either administration will likely need the support of Peronists in Congress, this is likely to be a moderating force for both. However, the Argentine presidency has some leverage through revenue sharing arrangements with the provinces that is usually sufficient to obtain needed legislative support for key policy initiatives.

Argentina’s institutional weaknesses and the high degree of policy uncertainty remain a key credit challenge. The fate of several recent and proposed reforms, particularly the new law on central bank independence and the continuation of the IMF program, appears to be at risk in this election. Alberto Fernandez has expressed concerns regarding Argentina’s debt burden, though he has also pledged to meet Argentina’s payment obligations. The precise policy platform of a Fernandez government remains unclear, and could be more moderate than DBRS expects, closer to the moderate Peronists than to the administration of Cristina Fernandez (2007-15). However, DBRS sees a considerable risk of prolonged market and exchange rate turmoil if the new government appears unwilling to maintain fiscal discipline and adhere to key components of the existing IMF program.

Considerable Progress on Fiscal Adjustment, but More Work to Do Following the Election

The administration has reduced Argentina’s primary deficit from a peak of 4.6% in 2016 to a projected 0% in 2019. The government will need to achieve a modest primary surplus in the months leading up to the election in order to achieve the 2019 target, as December wage payments usually result in a sizeable deficit for that month. Although there could be pressures to ease on fiscal policy in support of a weak economy, the target appears to be within reach. The government aims to achieve a primary surplus of 1% of GDP in 2020. More critically, additional efforts to improve the quality of the ongoing adjustment would help to ensure fiscal sustainability: tax reforms to broaden the tax base and rely less on distortionary export taxes; pension reforms to curb the growth of social spending, and other measures to boost the resources available for public investment.

Argentina’s public debt increased dramatically as a percentage of GDP during 2018, reflecting a major exchange rate shock combined with increased borrowing from the IMF. Debt increased from 57% of GDP in 2017 to 86% of GDP in 2018, as the peso lost 53% of its value against the US$ over the course of the year. Extensive dollarization within the public debt stock and a relatively shallow domestic market makes the government vulnerable to confidence shocks. Over one-third of public debt remains in the hands of the central bank and other public sector companies, and Argentina’s overall reserve levels (bolstered by the IMF program) appear to be adequate. Refinancing needs are limited in 2019 due to the expected primary balance and continued disbursements under the IMF program. Nonetheless, repayments to the IMF in 2021 and 2022 could be challenging in the absence of a return of market confidence or a successor program.

Having already experienced a large exchange rate-induced debt shock and benefiting (at least temporarily) from a more competitive currency, the risk of additional debt shocks appears relatively lower than in the recent past. However, domestic and international interest rates are presently at very high levels. For now, the reduced fiscal deficit and availability of IMF financing should enable the government to wait until real interest rates return to sustainable levels before tapping market financing. In the event of another adverse shock, the government will be forced to choose between additional IMF financing (likely with deeper conditionality to address structural challenges) or a return to monetization. The latter path may look easier to some policymakers in the short run, but would ultimately undermine Argentina’s ability to repay its external debts.

Tepid Economic Recovery in the Context of Strong Disinflationary Policies

Economic activity has been depressed for the past four quarters (Q2 2018 through Q1 2019), as the impact of a severe drought and broader loss of confidence in the gradual adjustment effort have dampened consumption and investment. Fiscal policy has simultaneously turned contractionary, with subsidy reductions and increased export taxes affecting real disposable incomes. Argentina’s economy is likely to stabilize and return to growth over coming quarters, supported by the agricultural sector, which is experiencing a huge increase in production following the 2018 drought. Measured on a year-over-year basis, the economy is expected to contract 1.2% in 2019. The IMF projects growth of 2.2% in 2020, close tto Argentina’s estimated potential, but DBRS sees risks as skewed strongly to the downside. Tight monetary and fiscal policies, a need for wage restraint to support disinflationary objectives, and risks stemming from global trade restrictions are likely to dampen Argentina’s growth performance this year and next. Growth could receive a temporary boost if the new government seeks to reverse some of the austerity measures enacted by the current administration, but this would likely be short-lived and ultimately counter to the objectives of restoring macroeconomic stability.

The BCRA’s disinflationary efforts have experienced significant setbacks, in spite of strong government support for the program’s objectives. Inflation has surged to 55.8% as of April 2019, driven by a combination of higher administered prices, a weaker peso, and the strong inertial effects of successive wage negotiations to compensate for past inflation. The BCRA’s policy framework was revised in October to establish a base money target, which is adjusted regularly to keep inflationary pressures in line with BCRA objectives. As of end-May 2019, base money growth was just under 30% y/y and short-term interest rates remain above 70%. Measured on a month-on-month basis, inflation appears to be slowing, and inflation expectations declined from over 40% in April to 36% in May. No further administered price increases are scheduled in the lead up to elections. Nonetheless, inflation will be significantly higher than the BCRA’s 2019 inflation target of 17%.

Financial intermediation remains limited and credit markets continue to have limited influence over Argentina’s economy and economic cycle. Funded by a limited deposit base of 21% of GDP, 37% of which is denominated in foreign currency, long-term borrowing is generally unavailable to most of the population. Credit to the private sector amounts to a mere 13% of GDP, with a similar proportion denominated in foreign currency (predominantly US$).

Reduced External Imbalances and Enhanced Exchange Rate Competitiveness Bode Well for Economic Stabilization.

Argentina’s external accounts have largely rebalanced following the major devaluation of the peso during 2018, the domestic recession, and the ongoing recovery of the agricultural sector from last year’s drought. The current account deficit fell to 1.8% of GDP in the fourth quarter, versus 5.2% of GDP for the full year, with the goods balance shifting into a surplus of 3.5% of GDP in the fourth quarter. For the first four months of 2019, exports have fallen 1.8% y/y, though the harvest season is beginning and should provide some increased support to exports in coming months. Goods imports have fallen 28.9% y/y in the same period, showing the significant impact from the domestic recession, combined with income and substitution effects. The IMF expects the current account to remain in deficit this year and then widen slightly as the economy recovers, with a small surplus in the goods and services balance (1-2% of GDP) more than offset by a deficit in the income account (3-4% of GDP). DBRS remains concerned regarding the outlook for exports, given the global environment. A recovery in Brazil combined with increased trade integration within the region could provide some needed support to Argentina’s manufacturing sector and boost growth prospects.

Reliance on external borrowing and the widespread use of the US dollar are legacies of Argentina’s lack of monetary policy credibility will remain a challenge for the foreseeable future. If the disinflationary process is ultimately successful and Argentina is able to allow for a more flexible exchange rate regime while achieving greater price stability, this could lay the foundation for growth in the domestic financial system, gradual dedollarization, and increased resilience in external accounts.

In the event of a deterioration in credit fundamentals or in the external environment, DBRS considers it likely that Argentina would face material constraints on its access to foreign exchange. This reflects the extent of foreign currency borrowing within the economy and the likely use of foreign exchange reserves to support the peso. In addition, evidence suggests that Argentina would be reasonably likely to differentiate between its local currency and foreign currency debts. Although domestic financial repression (characterized by severely negative real interest rates) has eased significantly under the current administration and new central bank leadership, the value of most local currency debt has been gradually eroded by past (underreported) inflation and is held predominantly by public sector entities and other domestic banks. Accordingly, DBRS considers the risk of a default on Argentina’s foreign currency debt to be somewhat higher than the risk of a default on local currency debt.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the BB (high) – BB (low) range. Additional considerations factoring into the Rating Committee decision included: Argentina’s limited market access, the high level of uncertainty surrounding the upcoming elections and policy outlook, and elevated risks to debt sustainability associated with domestic real interest rates and the potential for additional exchange rate shocks. The main points discussed during the Rating Committee include the potential policy implications of upcoming national elections, recent and expected progress on fiscal adjustment, inflationary pressures, the ongoing adjustment in the current account, exchange rate dynamics and prospects for stronger export growth, and risks to debt sustainability.

KEY INDICATORS

Fiscal Balance (% GDP): -5.1 (2018); -2.7 (2019F); -1.5 (2020F)
Gross Debt (% GDP): 86.3 (2018); 75.9 (2019F); 69.0 (2020F)
Nominal GDP (USD billions): 518.9 (2018); 477.7 (2019F); 515.4 (2020F)
GDP per capita (USD thousands): 11.6 (2018); 10.6 (2019F); 11.3 (2020F)
Real GDP growth (%): -2.5 (2018); -1.2 (2019F); 2.2 (2020F)
Consumer Price Inflation (%, eop): 47.6 (2018); 30.5 (2019F); 21.2 (2020F)
Domestic credit (% GDP): 22.6 (2017); 22.9 (2018)
Current Account (% GDP): -5.4 (2018); -2.0 (2019F); -2.5 (2020F)
International Investment Position (% GDP): 2.7 (2017); 12.1 (2018)
Gross External Debt (% GDP): 34.9 (2017); 60.9 (2018)
Foreign Exchange Reserves (% short-term external debt + current account deficit): 92.5 (2017); 138.2 (2018F)
Governance Indicator (percentile rank): 55.8 (2017)
Human Development Index: 0.83 (2017)

Notes:

All figures are in USD unless otherwise noted. Public finance statistics reported on a general government basis unless specified. Governance indicator represents an average percentile rank (0-100) from Rule of Law, Voice and Accountability and Government Effectiveness indicators (all World Bank). Human Development Index (UNDP) ranges from 0-1, with 1 representing a very high level of human development.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website www.dbrs.com at http://www.dbrs.com/about/methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

The primary sources of information used for this rating include INDEC, BCRA, Ministry of Treasury, IMF, World Bank, UN, Econviews, Oxford Economics, and Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This rating was not initiated at the request of the rated entity.

The rated entity or its related entities did participate in the rating process for this rating action. DBRS did not have access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

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