Argentina’s dramatic emergency actions to restore confidence in the peso have hit valuations of local currency bonds. However, barring default or a dramatic collapse of the country's currency, patient holders of securities may still make positive returns.
The Argentinian peso has seen its value fall by 18% this year. After initial rises in interest rates failed to restore confidence, the government of President Mauricio Macri introduced a drastic series of measures to stabilize the currency.
These included a 675 basis point hike to the policy rate (from 33.25% to 40%) and a cut in the primary deficit target from 3.2% of GDP to 2.7% of GDP. The latter measure was intended to restore confidence that spending would not lead to runaway inflation – the fears of which hit confidence in the peso.
Peso purchasing power vs. U.S. dollar
Source: Bloomberg, 5/9/18.
An International Monetary Fund (IMF) loan or flexible credit line should further bring stability to the market and stave off fears of a repeat of the default in Argentinian government debt that occurred in 2001. Either will increase the ability of Argentina's central bank to stabilize the currency.
Governments can draw on the credit lines at any time. The IMF offers this facility to countries it considers to have “very strong policy frameworks and track records in economic performance”. Colombia, Mexico and Poland are the only previous nations to have signed up for the credit line. None have drawn on the credit lines so far, and Poland exited the arrangement in November 2017.
Argentina’s gradualist approach to economic reforms implies an elevated reliance on funding from global capital markets relative to other emerging market (EM) economies. In the context of higher US Treasury rates, and a stronger dollar, then, it’s not unexpected that Argentine markets have seen a spike in volatility. Currency volatility, in particular, was amplified by the Argentinian central bank’s slow initial response to broader EM foreign currency weakness.
The actions of Macri’s government and the IMF shows a clear political determination to maintain economic and financial stability in the country, and also demonstrates the technical capacity to construct, and implement, effective policies in response to a fast-moving economic situation.
The recent volatility and elevated interest rates should have an impact on growth, but it is worth noting the financial sector and interest rates in Argentina still play a very limited role in driving economic activity. As a result, the impact should be much less severe than for a similar scenario in a developed economy. As a result, it is very possible that growth will remain in positive territory both this year and next. Though of course, it will be necessary to continue to watch closely the domestic political environment and global macro backdrop.
There is still a compelling case for holding local currency government bonds in Argentina. As an example, the local debt maturing in 2021 currently yields about 20%. Assuming the government does not default on its coupon payments and the Argentinian peso stays at the current levels over that time frame, then if held to maturity, the bonds should deliver an approximate return of 70%. In other words, for a 3-year bond to experience a negative return, the currency will have to depreciate more than 70%.