DBRS Confirms Argentina at B, Stable trend

DBRS, Inc. confirmed the Long-Term Foreign Currency – Issuer Rating of the Republic of Argentina at B and the Long-Term Local Currency – Issuer Rating at B (high). The Short-term Foreign and Local Currency – Issuer Ratings were confirmed at R-4. The trends on all ratings remain Stable.

KEY RATING CONSIDERATIONS

Argentina’s ratings reflect the progress made in reducing macroeconomic imbalances. Argentine authorities have begun to lower the fiscal deficit, reduce medium-term inflation expectations, and improve the business environment. These policy adjustments, if sustained, should better position Argentina to take advantage of its considerable growth potential over the medium term. Nonetheless, Argentina’s ratings suffer from its record of poor economic management as well as the scale of the near-term macroeconmic challenges. Inflation remains stubbornly high, reflecting wage rigidities, rising utility prices, and transitory shocks. The economy remains heavily reliant on external financing. Furthermore, tighter monetary and fiscal policies will likely dampen the near-term growth outlook and could ultimately jeopardize the political sustainability of the adjustment effort.

RATING DRIVERS

In spite of the near-term challenges stemming from recent interest rate and exchange rate volatility, DBRS views the administration’s policy response positively and sees potential for upward pressure on the rating within the next 18 months. The ratings could be upgraded if there is (1) continued progress on disinflation and fiscal consolidation, particularly if in combination with (2) increased evidence that reforms are bearing fruit in generating rising employment and productivity, which should in turn help to make reforms politically sustainable; or (3) continued progress in improving the quality of public expenditure and public institutions generally. Downside risks to the ratings include (1) increased political opposition that effectively halts progress on the macroeconomic adjustment program, or (2) additional external shocks that undermine prospects for a successful adjustment.

RATING RATIONALE

Multi-year Fiscal Consolidation on Track, but Increased Restraint on Current Expenditure Needed to Stabilize Debt

Argentina’s fiscal position leaves the country vulnerable to shocks, given the country’s low levels of domestic savings and heavy reliance on external borrowing. Nonetheless, the Macri administration has delivered thus far on its fiscal consolidation targets. The primary fiscal deficit (for the federal public sector) declined to 3.8% of GDP in 2017. Current expenditure declined slightly in real terms. While social benefits expanded at a strong pace, cuts in subsidies and public investment more than compensated. These trends continued in the first four months of 2018. This focus on capital expenditure cuts reflects a reduction in energy and transport subsidies in favor of better targeted income support programs.

Fiscal consolidation is expected to accelerate in 2018 and 2019, with the government seeking to reduce the primary deficit by over 1% of GDP each year. However, with elections 15 months away and the economy expected to slow, the credibility of the fiscal consolidation effort will likely be put to the test. Meeting fiscal targets will require a stronger effort in controlling current spending. Social spending continues to rise at a rate well above inflation, while public capital expenditure has declined significantly in real terms. In addition, interest costs borne by the government have increased. The IMF projects that interest costs at a general government level will rise from just under 2% of GDP in 2017 to nearly 4% of GDP in 2023. DBRS sees considerable uncertainty around these estimates, but the trend of rising interest costs only heightens the importance of a durable reduction in current expenditure.

Public debt levels are relatively low in comparison to many advanced economies, but high interest costs and Argentina’s reliance on foreign currency borrowing significantly increase the risks associated with Argentina’s public debt. Roughly two-thirds of Argentina’s public debt is denominated in foreign currency. Real market-determined yields are high and have risen significantly in the past month. With the exchange rate down nearly 25% year-to-date, the debt/GDP ratio is expected to rise in 2018. Although the debt ratio is expected to remain broadly stable after 2018, this depends on successfully implementing the fiscal consolidation plan.

The Central Bank is Aggressively Tightening to Strengthen Policy Credibility

Monetary policy has been similarly focused on restoring credibility. An increasing reliance on central bank financing under the previous administration was rapidly undermining the value of the peso. While the new Central Bank (BCRA) Governor has made progress in lowering inflation, this has proven a challenge amid cuts to subsidies, a volatile exchange rate, and negotiated wage hikes, all of which can contribute to inflationary pressures with a lag and thus create substantial inertia in price dynamics. In December 2017, the government modified the BCRA’s 2018 inflation target to 15% and subsequently negotiated 15% wage increases for most sectors. Nonetheless, YTD inflation (Jan-Apr) was 9.5% and inflation appears likely to end the year well above the target. Given the anticipated effects of recent peso depreciation, pressures are rising for a renegotiation of the 2018 salary agreements. The BCRA has increased interest rates by nearly 1300 basis points since April in an effort to fight back against rising inflation expectations.

The BCRA’s ability to slow inflation and gradually lower inflation expectations is critical to restoring confidence in the peso. In DBRS’s view, the primary risks to monetary policy objectives come from political pressures to renegotiate wage agreements and overall voter fatigue with fiscal and monetary tightening. In this context, efforts to negotiate an IMF arrangement should support the stabilization effort, but the domestic political landscape leading into 2019 elections will ultimately determine whether recent policy improvements will endure (see recent commentary, IMF Support a Potential Positive, But Not Without Risks).

Bank credit has played a limited role in Argentina’s economy since the 1990s. At 17% of GDP, credit remains at a level well below that of regional peers. The 2001 crisis undermined confidence in the banking system, and the previous administration’s misreporting of inflation statistics only reinforced residents’ tendency to save in foreign banks and in U.S. dollars. Credit growth has recently picked up, increasing 56% on a y/y basis as of March. Although U.S. dollar borrowing has also picked up as restrictions have eased (now 18% of total bank credit to the private sector), most of the growth in bank credit is peso-denominated. Increased confidence in the currency and banking system would help support continued financial deepening. However, risks associated with rapid credit growth will need to be monitored closely, particularly if foreign currency loans continue to grow as a share of the total.

Economic Performance Improving, in Spite of Expected Cyclical Slowdown

The economy returned to growth in 2017 driven by capital investment and private consumption growth. The repatriation of foreign assets combined with an easing of trade restrictions has helped fuel a sharp rise in construction and other investment. In value-added terms, the retail and wholesale trade sectors along with financial and business services have led the recovery. First quarter 2018 performance appears to have been similarly strong, but some sectors are showing signs of a slowdown and tighter macroeconomic policies are expected to cause a further deceleration in growth. Moreover, the agricultural sector has faced drought conditions. Soybean production in 2018 will likely generate the lowest crop yields in a decade.

DBRS remains of the view that Argentina has solid medium-term growth prospects. The economy should be in a strong position to rebound in 2019 and 2020. In the near term, however, weak growth could undermine support for the Macri administration and generate uncertainty regarding the future path of economic policy. Current projections show the economy slowing late in 2018 and in the first half of 2019. If this slowdown is deeper than expected or accompanied by higher unemployment and labor unrest, this could test the administration’s resolve in pursuing its agenda or simply lend greater popularity to opposition candidates.

External Vulnerabilities Elevated, but IMF Support Likely to Aid Rebalancing

Argentina’s current account has deteriorated in recent years and reached 4.8% of GDP in 2017. This reflects increased imports of machinery and other capital goods, as well as higher income payments to foreign holders of Argentine debt. Exports have also stagnated, reflecting competitiveness challenges and (more recently) a weak harvest. Financing has largely been provided in the form of portfolio inflows. FDI remains very low compared to regional peers, in spite of recent reforms to improve the business climate. The recent depreciation of the peso (down 23% YTD) should facilitate an external rebalancing, provided the authorities undertake a sustained effort to limit inflationary pressures. IMF support should ultimately bolster the government’s efforts to rebalance the economy.

Institutional Metrics Show Some Improvement, but Political Sustainability Remains in Doubt

World Bank indicators suggest that the Macri Administration is perceived to have made significant strides in improving the rule of law, government effectiveness, and other key areas of governance. 2017 survey results are not yet available, yet in the area of regulatory quality, Argentina has improved over 20 points in the percentile rankings (to a still low 34%) in just two years. Similar indicators compiled by other international organizations also show considerable strides in 2016 and 2017. At the same time, polls show the President’s popularity slipping, and some other indicators (such as the World Bank’s Doing Business Indicators) show limited or no progress. Macri appears to retain considerable support among the business community, but the losses in real disposable income felt by much of the population have weighed on his popularity.

There is little clarity at this stage regarding the most likely opposition candidates for the 2019 Presidential election. Some opposition politicians (particularly the FPV) have seized on the ongoing negotiations with the IMF as a rallying point for protests. Unions continue to agitate for higher wages as compensation for inflation, while the opposition in Congress seeks to roll back utility tariff hikes. At this point, it seems unlikely that the fragmented opposition will succeed in rolling back recent reforms or in coalescing around a single candidate, particularly one that would advocate a rapid return to monetized fiscal deficits and the reimposition of controls on trade and capital flows. However, there is ample time for candidates to come forward, and there is a possibility of a runoff election between two individuals with dramatically different economic agendas.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the BB (low) - B range. The main points of the Rating Committee discussion included: negotiations with the IMF, recent financial market volatility, fiscal and monetary policy, external imbalances, reserve adequacy, political institutions, and the outlook for 2019 elections.

KEY INDICATORS

Fiscal Balance (% GDP): -6.5 (2017); -5.5 (2018F); -4.9 (2019F)
Gross Debt (% GDP): 52.6 (2017); 54.1 (2018F); 52.7 (2019F)
Nominal GDP (USD billions): 637.7 (2017); 542.2 (2018F); 561.0 (2019F)
GDP per capita (USD thousands): 14.5 (2017); 12.7 (2018F); 12.8 (2019F)
Real GDP growth (%): 2.9 (2017); 2.0 (2018F); 3.2 (2019F)
Consumer Price Inflation (%, eop): 24.8 (2017); 23.0 (2018F); 17.0 (2019F)
Domestic credit (% GDP): 24.5 (2017); 25.8 (Mar-2018)
Current Account (% GDP): -4.8 (2017); -5.1 (2018F); -5.5 (2019F)
International Investment Position (% GDP): 3.5 (2017)
Gross External Debt (% GDP): 35.2 (2017)
Foreign Exchange Reserves (% short-term external debt + current account deficit): 64.9 (2017)
Governance Indicator (percentile rank): 55.3 (2016)
Human Development Index: 0.83 (2015)

Notes:

All figures are in USD unless otherwise noted. Public finance statistics reported on a general government basis unless specified. Fiscal and debt statistics drawn from IMF WEO (general government basis); Government fiscal performance and targets referred to in text pertain to the Federal public sector. Projections shown above are provisional and likely to be revised pending negotiation of IMF arrangement. 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 sources of information used for this rating include Ministry of Finance, INDEC, BCRA, IMF, Province of San Luis, Province of Buenos Aires, BIS, World Bank, UN, Oxford Economics, Trading Economics, EconViews, and Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating to be 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.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period while reviews are generally resolved within 90 days. DBRS’s trends and ratings are under constant surveillance.

Lead Analyst: Thomas R. Torgerson, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Chief Credit Officer, Global FIG and Sovereign Group
Initial Rating Date: September 6, 2007
Last Rating Date: June 5, 2017

Information regarding DBRS ratings, including definitions, policies and methodologies, is available on www.dbrs.com.