Argentina
Default Fears
August 26, 2008

By Daniel Volberg & Gray Newman | New York

The decision by the authorities in mid-August to open a program of debt buybacks highlights one of the key investor concerns for next year – the specter of increased risk of default.   Even as many of the region’s economies have seen credit rating upgrades – Brazil and Peru have achieved investment grade, while Colombia may be next in line – in the past year the discussion in Argentina has moved in the opposite direction.   Investors appear more concerned about the risk of default in Argentina despite the wave of abundance that has swept Latin America in recent years. While Argentina’s decision to buy back debt at distressed prices is prudent, it underscores the larger investor concerns about debt sustainability. What do we think? While we acknowledge investor concerns, we doubt that the risk of default is likely during the next 12-18 months. 

Investor Concerns

Investor concerns center on three issues – Argentina’s willingness to pay down its debt, the rising size of Argentina’s debt service and the size of the fiscal surplus.  The first issue – willingness to pay – is inherently more difficult to assess.  However, the other two issues – rising debt service and projected fiscal surplus – are rooted in economic fundamentals.  We feel more comfortable addressing the latter, but do provide some thoughts on the former.

Questions about Argentina’s commitment to servicing debt have grown louder. Since the reorganization of the inflation measuring staff in the national statistical institute (Indec) last year, investors have increasingly questioned Argentina’s willingness to pay.  That is because out of the US$149.8 billion of debt, US$61.3 billion or 41% are inflation-linked.  The concern is that if inflation is being underreported, investors holding inflation-linked securities are not getting their due payments.  While we are sympathetic to this argument, we would argue that there is a distinction between the ongoing statistical controversy and a decision to outright default on a payment.  In fact, one reason the authorities cited for the debt buyback program was to show their willingness to pay.  Nonetheless, we concede that on the first issue of concern to investors – namely, Argentina’s willingness to pay – the Indec affair has clouded the debate.  In contrast, we believe that the second and third concerns of investors – which focus on Argentina’s ability to pay – are easier to assess.  And in both cases, we are more comfortable that the issues remain manageable at this time.

It is true, of course, that rising debt service obligations are set to increase Argentina’s financing needs next year.   And that, in turn, has raised questions about ability to pay debt.   Indeed, according to the Economy Ministry, financing needs are set to double from near US$6 billion this year to close to US$12 billion in 2009. Most of the increase is explained by maturing guaranteed loans – over the past three years the annual capital and interest due on these loans has been in the US$1.5-1.8 billion range, but over 2009-11 the amount is set to increase to US$2.7-4.3 billion. In fact, next year the total due for guaranteed loans is US$4.3 billion, up from US$1.4 billion this year.  For a healthy economy, such an increase may have been manageable by accessing extra funding in the markets to more evenly redistribute the payments.  However, Argentina’s policy mix has limited any significant market access and has shifted to the onus to using other resources – especially the fiscal surplus – to meet rising debt payments and avoid default.

Meanwhile, falling commodity prices and burgeoning expenditure growth have contributed to investor concerns about the sustainability of the fiscal surplus.   Last year, fiscal spending grew 47% relative to the year before, while revenues grew 40%.  And while in the first seven months of 2008, fiscal spending growth has moderated to 34%, with commodity prices falling and GDP growth projected to slow as well, the risk is that next year’s revenue growth may slow considerably from the current pace of 38%, placing the sustainability of the fiscal surplus in doubt.  That is because near 80% of federal fiscal revenues come from just four sources – value added (VAT), payroll (social security), income and export taxes.  VAT, payroll and income taxes, which together account for nearly US$32.5 billion out of the total tax take of US$47 billion year to date, are largely driven by two factors – economic growth and inflation.  And while export taxes are only US$6.2 billion so far this year, they are significantly larger than the overall fiscal surplus of US$4 billion.  Thus, with soy prices down 20% in the last month and a half and with our forecast of economic growth of 4.7% in 2009 or a consensus forecast of 4.5% in stark contrast to the 8.1% average growth in 1H08, it is not hard to extrapolate that fiscal revenues may slow in the months ahead. And with the authorities so far showing few signs of cutting expenditure growth, questions about sustainability of the fiscal surplus are adding to the concerns that the authorities may not be prepared to deal with next year’s rising financing needs.

Not as Bad as it Seems

While market jitters appear to be justified by the deterioration in fundamentals, we suspect that the situation may not be as bad as it first seems. The markets are signaling a drastic deterioration – in the past 13 months, 5-year CDS widened by nearly 600bp to the widest point in the past three years for which data are available.  Whether current market prices suggest that default is imminent is up for discussion, but we would argue that the risk of a default next year is limited.  We start with the fact that while total debt payments (buybacks, capital and interest) coming due next year are US$20.2 billion, only buybacks, bonds and guaranteed loans to the tune of US$14.7 billion are likely to be at issue – we suspect that the rest (largely multilateral and central bank debt) is likely to be rolled over without a hitch. Here are our four thoughts on why we suspect Argentina has the ability to pay its debt next year:

First, the authorities have deep pockets, having saved part of the proceeds of the past five years of abundance. According to our calculations, the federal government may have near US$10-11 billion in savings in the banking system and US$47 billion in international reserves at the central bank.  We estimate that nearly US$4 billion out of the US$10-11 billion in savings are working capital, leaving US$6-7 billion to help offset any difficulties in meeting 2009 financing needs. As for the international reserves, it is true that legally they cannot be deployed for servicing bonds or guaranteed loans, but they can be used to pay bilateral and multilateral creditors.  Of course, dipping into savings and reserves is not a good signal, nor a long-term solution to a fundamental problem, but it does buy the authorities time.

Second, local sources should help offset some of the debt service coming due next year. Local pension funds are going to have to invest part of their new funds in new public debt securities, helping cover part of the debt coming due.  Using data provided by the Economy Ministry on social security tax collection, we estimate that pension funds may be able to provide between US$1.8 and US$3 billion in new funding next year.  Using the lower estimate and not counting the savings, that leaves a total of US$12.9 billion left to cover.

Third, authorities could tighten fiscal policy to free up cash.   Subsidies are the fastest-growing item on the fiscal spending side.  In the first six months of the year, energy and transportation subsidies grew (in nominal terms) by 110% and 39%, respectively.  In fact, if subsidies continue growing at their current rate, then energy subsidies would reach US$4.1 billion by the end of 2008 and transportation subsidies another US$2.9 billion.  Together they would account for nearly 55% of all subsidies this year.  Significant increases in residential energy and public transportation prices – prices that have been largely unchanged since 2001 – would be both healthy for the overall economy and would allow for significant fiscal savings (see “Argentina: Credit Crunch or Energy Crisis”, This Week in Latin America, August 13, 2007).  While the authorities have been reluctant to take this course, we suspect that the idea of raising energy prices continues to be under consideration, even after the modest increase instituted last month.  Should the authorities decide to raise prices by roughly 30%, that could provide them with an extra US$2.1 billion.  That leaves the authorities with US$10.8 billion to cover.

Finally, we suspect that the authorities are set to enjoy a significant fiscal surplus next year. We estimated an econometric model to help quantify the effects of inflation, growth, commodity prices and other macroeconomic fundamentals on fiscal revenues.  Our finding is somewhat surprising, but reassuring – even in the event of another 30% correction in the price of soybeans, GDP growth slowing to our forecast 4.7% pace and with inflation near 23%, the primary fiscal surplus is set to be 2.1% of GDP or US$8.7 billion (assuming an exchange rate of 3.25).  This is far below the 3.4% of GDP primary surplus that is likely this year, but it is still a substantial amount of money.  That leaves the authorities with US$2.1 billion to cover, most likely by issuing debt to Venezuela or dipping into savings, in our view.

There are risks to our call for a healthy fiscal surplus.  It critically depends on the pace of expenditure growth.  We assume that fiscal expenditures would grow at 34% – the average pace of 1H08.  This assumption is also consistent with our model’s estimate of expenditure growth that is projected based on, among others, GDP growth, inflation and previous pace of spending.  Here is the risk: next year is a mid-term election year, and the authorities have seen their approval ranking tumble in recent months from near 55% in January to near 20% in July, setting up the possibility of fiscal stimulus.  Recall that last year in the run-up to the presidential election, expenditure growth accelerated to 47% from 27% the year before.  In fact, if instead of assuming expenditure growth at the pace of 1H08, we assume that spending will grow at the pace of the average of the last four quarters (3Q07-2Q08), then next year’s projected 2.1% of GDP primary surplus turns into a primary surplus of only of 0.4% of GDP (US$1.6 billion).  While we acknowledge this risk, we suspect that the authorities have a deep commitment to maintaining a fiscal surplus and continuing to rein in public spending.  Indeed, they appear to have been alarmed at the pace of expenditures engineered in the run-up to the last election, prompting public statements to that effect and a (ultimately unsuccessful) push to raise export taxes.

Bottom Line

Investors have been increasingly jittery and pessimistic about Argentina servicing its debt payments next year.  We suspect that if the reason for the rising market pessimism is a perception of Argentina’s inability to meet the rising debt obligations in a more challenging economic environment, then that pessimism may be misplaced.  Argentina may have a difficult year next year; indeed, there is even a risk of recession, but with deep pockets from the last five years of abundance and with a fiscal surplus likely intact, Argentina should be able to meet its debt service obligations in the next 12-18 months.

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Colombia
No More Hikes
August 26, 2008

By Boris Segura | New York

Despite the fact that Colombia’s central bank is unlikely to meet its inflation target this year, be ready for renewed calls for the central bank to begin cutting its policy rate. These demands are likely to come from the voices that originally were pushing for the central bank not to hike rates. And we might also get some market participants jumping onto the ‘cutting’ bandwagon.

In what follows, we will expand our reasoning why Banco de la Republica is likely to stay on hold for the foreseeable future.

Inflation Outlook Is Still Challenging

The inflation picture in Colombia is not rosy. Headline inflation has soared since April, and is on its way to reach its highest print since 2003. The central bank expects headline inflation to peak in September/October. Even when typically month-on-month inflation in Colombia is low during the current months, base effects are challenging this time around, and therefore headline inflation is likely to keep rising. According to our projections, year-on-year headline inflation is likely to peak at around 8% and then start dropping. We take this opportunity to mark-to-market our year-end 2008 inflation to 7.4%, from 6.8%. We are also revising our end-2009 inflation forecast to 5.5% from 4.5% previously.

Perhaps more importantly, ex-food inflation is not likely to roll over easily. In its latest inflation report, Banco de la Republica expresses concern about the indexation mechanisms in regulated prices (utilities, fuel and transportation) and potentially wages. Regarding non-tradables inflation excluding food and regulated prices, even when the ongoing deceleration of the economy is helping to keep it under control (more on this below), the central bank does not expect a decisive break below 5% until 2H09. In fact, the central bank qualifies its statement, stressing that the link between slower growth and lower inflation would only work if inflation expectations decrease and wages remain contained.

The recent correction in international commodity prices is likely to aid inflation. In particular, we should get some relief on food inflation. Also, Banco de la Republica expects an improved supply of local non-processed food during the first months of 2009, as its production is currently being ramped up. In terms of fuel prices, the relief should not be meaningful, as the authorities partially subsidized them during the oil crude price run-up.

Looking ahead to 2009, there is a non-trivial probability that the central bank misses its target again. Its inflation projection only foresees headline inflation reaching its 4% target in early 2010; ex-food inflation should have a hard time converging to the target in 2009 as well.

We broadly agree with Banco de la Republica’s assessment, although we are slightly more pessimistic. Given indexation of regulated prices and some contamination of inflation expectations and wages, we are revising our year-end 2009 inflation forecast. Thus, we expect the central bank to miss its target for a third-year running.

Expectations: Surveys from Mars, Breakevens from Venus?

The July 25 rate hike was a credibility-enhancing move by Banco de la Republica. As we argued last month, the deterioration in inflation expectations was increasing the risk of them becoming unhinged, and the central bank needed to safeguard the credibility of its inflation-targeting regime by hiking rates (see “Colombia: A Case for Hiking Rates without Delay”, This Week in Latin America, July 21, 2008).

The market agreed with our assessment. After the rate decision, there was a strong rally in Colombian fixed income markets. The yield curve flattened, and breakeven inflation expectations moved down accordingly.

However, inflation expectations based on surveys conducted by Banco de la Republica do not show improvement yet. Twelve-month-ahead inflation expectations have moved 100bp higher since April. However, these surveys tend to be adaptative to actual inflation. Therefore, we should expect survey-based inflation expectations to come down in due course.

The truth lies somewhere in between. Even when breakeven inflation is showing improvement, not all of it can be credited to the latest hike by Banco de la Republica. In fact, (nominal) local rates looked oversold in mid-July, and the government has not executed any more debt swap operations since the US$500 million done in May. This operation was partly behind the explosion of the cross-currency swap curve, which also dragged the local rates curve with it.

Our own diffusion index for ex-food inflation should provide some comfort. Ex-food inflation is becoming less diffused; last June’s jump actually was more of a blip.  This leaves us a little bit more sanguine about the prospects of inflation expectations going forward.

Orderly Deceleration of the Economy

Observers are worried about the sharp drop in growth between 4Q07 and 1Q08.   GDP growth went from 8.4% in 4Q07 to 4.1% in 1Q08.  We argued earlier that 1Q weakness may have been exaggerated (see “Colombia: A Case for Hiking Rates without Delay”, This Week in Latin America, July 21, 2008). In fact, Banco de la Republica published an estimate of the ‘one-off’ factors (Holy Week effect, strike at the Cerromatoso mine, change in regional authorities and car imports restrictions imposed by Venezuela) that artificially depressed the 1Q GDP reading; they detracted 1.4% from it, meaning that 1Q GDP should have been 5.5% under normal conditions.

Banco de la Republica adjusted its growth estimates downwards. In its latest inflation report, the central bank lowered its growth forecast for 2008 from a 4-6% range to 3.3-5.3%, with a most likely point estimate of 4.3% (from 5.2%).

After a sustained dose of monetary tightening, it is inevitable that the economy is decelerating.   After all, rates of growth of 8.2% like 2007’s are not sustainable in an economy whose potential GDP growth hovers around 6%. According to the central bank, the output gap is still positive, but shrinking; we expect it to dissipate by year-end.

From the expenditure side, the slowdown is likely to be generalized.   Again, we are seeing no collapses but slower growth across the board. Investment is likely to lead the charge, with exports holding in quite well this year, due to surging oil and mining exports.

From the supply side, interest rate-sensitive sectors are leading the deceleration.  For example, industrial production and retail sales have been weak throughout this year; the same has been seen in construction (mostly civil works) and financial services (credit growth is decelerating and non-performing loans are on the rise).

We expect 5% growth in the 2Q report. We expect some recovery in investment, from a depressed reading in 1Q, as well as a further drop in imports (mostly durable goods). This reading would be consistent with our full-year GDP growth forecast of 4.6%.

There is downside risk to our growth forecast.   Slower global growth could dent so-far strong export volumes and prices. Another risk factor is potential economic trouble in Venezuela, the main marginal destination for non-traditional exports, which we don’t foresee at this point. Recall that non-traditional exports are labor-intensive and their producers earn higher-than-average profitability on them. And key would be the response of foreign direct investment, not only because of its effect on overall investment but also due to its potential impact on the currency.

Monetary Policy Response

As explained above, there is a non-trivial probability that Banco de la Republica misses its inflation target for the third consecutive year in 2009.   What should be its monetary policy response? Unfortunately, its most recent inflation report does not provide us with a longer-term assessment of inflation by the central bank.

The central bank should not heed incipient voices that are now pushing for rate cuts.   We sense an orderly, soft landing of the economy. As such, there is no need for monetary stimulus to prop up economic activity. Besides, the central bank should minimize contamination of inflation expectations which, although down, are still well above its inflation target.

We expect Banco de la Republica to stay on hold for at least the rest of the year. Unless inflation and inflation expectations deteriorate, we don’t see the central bank hiking either. We feel that the central bank has done its tightening job, hiking by 400bp over the last 30 months. Its intervention rate in real terms is certainly high.

Banco de la Republica is likely to keep a hawkish discourse. We were pleasantly surprised by the reaction of monetary policymakers to the criticism of its latest rate hike on July 25. On several occasions since, the central bank has forcefully responded to charges that its policy stance is choking the economy and that “a little more” inflation doesn’t matter. Minutes of the July 25 meeting and the latest inflation report elaborate further on the reasons why the central bank is uncomfortable with the inflation outlook.

Bottom Line

We contend that Banco de la Republica has ended its monetary tightening campaign.   Headline inflation should peak soon, and cumulative tightening has all but eliminated the positive output gap in the economy.

But the central bank should ignore the siren song for rate cuts. The economy is going through a ‘soft landing’, and the inflation outlook is challenging; under these conditions, a rate cut would send a contradictory signal. Inflation expectations are still high, and the central bank should avoid the risk that high expectations can pose to faster wage growth. In our view, the battle to limit expectations from feeding through to higher wages is probably the greatest challenge facing the central bank in the coming months.

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Indonesia
Coming Interbank Liquidity Squeeze
August 26, 2008

By Chetan Ahya, Deyi Tan | Singapore & Shweta Singh | India

Domestic Demand Growth Remains Strong

Domestic demand (ex-inventories) remains strong at 6.9% in 2Q08 after recovering from the trough of 2.3% in 3Q06. Consumption as well as investment demand indicators indicate a healthy trend in 2Q08. Motor vehicle sales grew at an average of 43% during the last three months. Non-oil and gas imports grew at an average of 49%Y during the three months ending June 2008. The lagged impact of a cumulative 450bp policy rate cut between April 2006 and December 2007 is driving the credit growth and supporting aggregate demand in the economy. Credit growth accelerated to 33.6%Y in June 2008. It is likely to exceed the highest level reached post the 1997-98 crisis (33.8% in April 2001). Real policy rates at -3.1% (as of July 2008) and real prime lending rates estimated at less than 0% (as of July 2008) offer support to this trend.

Many Hurdles in Sustaining this Trend

Indonesia is facing a major price stability challenge as its domestic demand growth accelerated to 7.5% in 1H08. In the current cycle, two key factors are resulting in inflationary pressures. First, similar to other countries in the region, Indonesia is facing higher input cost pressures from rises in global commodity prices, resulting in cost-push inflation. WPI inflation has accelerated to 34.7%Y in June 2008 in Indonesia as compared with 11.9% in India and 8.8% in China. Second, weak production infrastructure also brings up added challenges. Even without the unusual cost pressures of the current magnitude, Indonesia has in the past faced hurdles sustaining 6.5-7% growth in domestic demand. The government’s inability to provide policy support to encourage a swift acceleration in capacity growth, particularly infrastructure, is a key hurdle. Administrative hurdles and poor labor laws add to the structural rigidities of Indonesia’s production capacity. Acceleration in domestic demand growth over 6% often results in inflationary pressures.

Indonesia is already suffering from one of the highest rates of inflation ex-food and energy in the region, accelerating to 8.1% from 5.4% 12 months back. This compares to the average of 3.1% for the region, excluding Indonesia. If domestic demand remains strong, we believe that there exists a high probability of increased pass-through of higher commodity prices (as reflected in the wholesale price (WPI) inflation at 34.7%) into CPI. Even as global commodity prices have started declining, we believe that the cascading impact is likely to continue for longer. Moreover, wages tend to track inflation closely. The government typically decides the minimum wage growth, which is usually in line with the trailing 12-month inflation, and private sector companies tend to follow this trend.

Low Exchange Rate Volatility Helping to Extend the Trend this Time

In the past, strong domestic demand has pushed import growth, narrowing the current account surplus. Reversals in the global risk appetite at the same time would result in exchange rate volatility. Typically, during such uncertain times, the locals have also added to the currency volatility by switching into dollar deposits from rupiah deposits. This environment could force the central bank to pursue a tightening monetary policy aggressively. The tightening could help to check the exchange rate volatility and slow aggregate demand, which reduces the inflationary pressures. However, so far in the current cycle, sharp rises in the prices of commodities such as coal and crude palm oil have meant that the current account surplus has remained reasonable at 2.3% of GDP (1Q08), ensuring that the exchange rate does not depreciate. However, sustained non-oil import growth at a time when commodity prices are declining will narrow the foreign trade balance and increase the risk of weakening the exchange rate. Non-oil import growth has averaged 49% during the three months ending June 2008. Capital inflows are also likely to slow further due to reduced global risk appetite for emerging markets.

Tightening Interbank Liquidity Will Be the Biggest Hurdle in the Current Cycle

While the CPI inflation rate has moved to 11.9% from the trough of 5.3% in November 2006, the policy rate has increased to 9.0% currently, from 8.0% in January 2008. We believe that if Bank Indonesia does not tighten aggressively, the market will take charge and force the automatic tightening on the system. We believe that the banking system is unlikely to sustain the current high credit growth, which is at the heart of the strong domestic demand trend. In June 2008, total bank credit grew by 33.6%, while deposits grew by 15.1%. Rupiah credit growth was even higher at 34.8% and deposit growth at just 14.4%. Low real rates are discouraging depositors and encouraging borrowing by consumers as well as companies. For the corporate sector, a 34.7% WPI inflation indicates higher demand for working capital.

Initially, this acceleration in credit growth did not result in a tightening in liquidity, as the bank credit-deposit ratio was low. However, at 72.7%, the bank credit-deposit ratio is now close to full capacity. Banks have to impound approximately 9-10% of rupiah deposits (which account for about 83-84% of the total banking sector deposits) in cash reserve ratio (CRR). On dollar deposits, the required CRR is 3.0%. Banks tend to invest about 20-25% of the deposits in government bonds (meeting the government’s fiscal deficit). Not surprisingly, interbank liquidity has begun to tighten as the bank credit-deposit ratio crossed into the 70-72% range. Our estimates indicate that if banks continue with the current 33% credit and 15% deposit growth, the banks’ credit-deposit ratio will likely increase to 75% in four months’ time (December 2008) and 84% by June 2009. We think this will likely do very little for funding the government’s fiscal deficit.

We believe that the banks are unlikely to be able to manage the current 30-35% credit growth as liquidity pressures will likely rise significantly. The initial signs of the tightening interbank liquidity are evident in the recent Jibor (Jakarta Inter-Bank Offered Rate) trend. The spread of Jibor over Bank Indonesia’s policy rate has increased from -27bp in August 2007 to 90bp currently. Banks with credit-deposit ratios of 90% or higher are facing constraints. Some of the larger banks with low credit-deposit ratios are now choosing to lift their credit growth, resulting in a tightening of liquidity. We believe that the 3-month Jibor will likely rise by150bp over the next 3-4 months from the current level of 9.9%. Any major decline in commodity prices (lower export income) and/or contraction of capital inflows due to volatility in global financial markets could add to the stress in the domestic banking system, in our view.

Quick Moderation in Domestic Demand Would Help to Maintain Macro Stability

We believe that the ideal outcome could have been an aggressive policy tightening by the central bank, ensuring moderation in credit growth to 20% and domestic demand to 5-5.5%. This would also ensure that the current inflationary pressures do not become vicious. The current gradual tightening approach will mean that the market forces will likely take charge and cause an automatic tightening. More importantly, it will likely increase the risk of a disruptive tightening in the case of either a major fall in commodity prices, taking away the support of current account surplus, and/or major global financial market risk-aversion, which could result in capital outflows. Indonesia’s relatively open capital account, which allows greater freedom to households in moving to dollar deposits, could accentuate the stress, in our view.

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