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Credit: Help from more realistic risk premia

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Briefing

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Box 14: Is it time to buy after the rough ride in Argentina?

Tighter financial conditions globally, rising risk aversion towards EM, and domestic policy mistakes led to a drying out of financing, sending the peso into free-fall and pushing inflation higher for Argentina in 2018. By May, authorities had no choice but to seek IMF help. Argentina has since negotiated two iterations of a three-year stand-by agreement, recently augmented to USD57bn, 90% of which is scheduled to be disbursed within the next 12 months.

The agreement with the IMF has two key pillars. First, it puts an end to fiscal gradualism, demanding that this year's expected 2.6% of GDP primary deficit be turned into a 1% of GDP surplus by 2020. To achieve this, the authorities will cut public investment, reduce utility subsidies, maintain some distortionary taxes, and tax exporting sectors more heavily (Figure 171). The second pillar is a monetary straight-jacket: zero monetary growth in nominal terms through July 2019. Given that inflation is expected to end 2018 at 47%, and that the central bank is reducing its stock of Lebac liabilities (not all of which are being turned into Leliqs held by the banks), this constitutes a monumental monetary contraction in real terms, one that will keep interest rates high (currently at 68% on seven-day Leliqs) and that will be relaxed only if the peso appreciates and tests the bottom of wide, pre-established, FX bands.

We think the Macri administration will hit the interim target of a 0% of GDP primary balance in 2019, but the commitment of the incoming government in 2020 (President Macri will face re-election in October) is more questionable, particularly given that it will have little in the way of IMF disbursements to look forward to at that point. Using these assumptions, the government projects that it will not need to issue USD debt aside from the short-term maturity LETES until 2020, for which it assumes a 50% roll-over for USD-denominated and 100% for ARS-denominated.

Our analysis (Figure 172) shows that meeting the fiscal target in 2019 (0 deficit) combined with close to a 60% roll-over for short-term private debt in USD and local currency would be enough to cover the financing needs of the government until the end of the Macri administration. However, the market will follow closely whether the government is complying with the fiscal target in an election year, and the sustainability of the monetary and exchange rate plan in an environment of higher financing costs, to assess short-term debt sustainability. Medium-term credit spreads will be subject to the market's perception of the outcome of the 2019 election, and the adherence of whoever wins to the current adjustment plan and the SBA with the IMF. The expected recession in 2018-19 could weigh on the current administration's ability to retain power. We expect to see an increase in uncertainty in this regard as the political campaign heats up by the second quarter of the year.

In short, the front-loading from the IMF serves the purpose of a co-ordination mechanism that induces private investors to roll over a higher proportion of their short-term Argentinean credit exposure and decreasing liquidity risks, but political factors will heavily influence whether the country faces another high-stress episode in the next couple of years.

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Figure 173: Hard currency securities and loans due to mature next three years (USD bn)

Source: Bloomberg, UBS. Red boxes indicate top-16 country-sectors with highest maturity as a percentage of country reserves

A modest widening amid weak growth is the base case

Nonetheless, there will be no escape in the context of weaker EM growth, which always brings pressure on fiscal positions, which have already been slowly deteriorating (Figure 174), limiting capital inflows. External metrics are likely to deteriorate incrementally, and more quickly, if EM economies begin to lose FX reserves at a time of tighter policy from the Fed and ECB.

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However, this assumes linear relationships, and things can move quicker in the real world.

Figure 176: EMBI GD fair value framework*

Source: Haver, Bloomberg, UBS *Keeping global risk premium index at 0. Based on two regression models 1) EMBI spreads regressed on MBS, log of commodity price index (75% oil and 25% BCOMIN) and global risk premium for period since Jan 2003; and 2) MBS change (y/y) regressed on EM growth (EMBI-weighted).

In 2018, the B rating segment widened the most in both absolute (Figure 177) and relative (to US corporates) terms (Figure 178). In 2019, we expect a slight widening here, but also a drift wider in the BB and BBB credits. By country, we think South Africa, Turkey, Mexico and sub-Saharan Africa are most at risk, especially if commodity prices are weaker than we currently anticipate. Amid weaker China growth, we expect a widening in hitherto stable Asian credits too. Indonesia, Russia and Brazil should perform better, relatively speaking (Figure 179).