DBRS Morningstar Confirms Argentina’s Long-Term Foreign Currency – Issuer Rating at CCC, Downgrades Long-Term Local-Currency – Issuer Rating to CCC from CCC (high)

DBRS, Inc. (DBRS Morningstar) confirmed the Republic of Argentina’s Long-Term Foreign Currency – Issuer Rating at CCC and downgraded Argentina’s Long-Term Local Currency – Issuer Rating to CCC from CCC (high). At the same time, DBRS Morningstar confirmed the Republic of Argentina’s Short-Term Foreign and Local Currency – Issuer Ratings at R-5. The trend on all ratings is Stable.

KEY RATING CONSIDERATIONS

The confirmation of the Long-Term Foreign Currency – Issuer Rating at CCC reflects DBRS Morningstar’s view that Argentina’s acute macroeconomic imbalances leave the economy highly vulnerable to shocks. Annual inflation is 99%, reserves are at a very low level, and the unofficial peso-dollar exchange rate is about 90% above the official rate, highlighting the market’s concern with the outlook. Furthermore, Argentina has failed to regain access to international markets despite entering into an IMF program in March 2022. We expect Argentina will continue to implement the basic pillars of the IMF program in 2023, even as several key targets, including inflation and reserve accumulation, will likely be missed. The IMF projects 2.0% growth in 2023 but limited momentum at the start of the year, combined with the impact of a severe drought, tight import restrictions, and weaker external demand, suggest clear downside risks to the forecast. General elections are set to take place in October, which raise near-term policy risks. In our view, the challenging economic and political outlook presents material risks to macroeconomic stability and the government’s capacity to repay its debt to private creditors.

The downgrade of Argentina’s Long-Term Local Currency – Issuer Rating to CCC reflects the deterioration in local government funding markets. The government has shortened maturities and increasingly relied on inflation-linked and dollar-linked issuance in order to roll over maturing local-currency debt and finance the deficit. The concentration of short-term debt coming due with the elections approaching in October raises rollover risk. The downgrade reflects a weakening in our assessment of the “Debt & Liquidity” building block.

The Stable trends reflect our view that risks to the CCC ratings are broadly balanced. A credible macroeconomic policy adjustment by the next administration could potentially set the stage for stronger and more durable economic growth. Structural reforms to take advantage of the country’s abundant natural resources could further strengthen the country’s growth outlook. However, Argentina’s large macroeconomic imbalances pose significant political and policy-related challenges. It is unclear whether the next administration will be willing and able to sustain public support for tight macroeconomic policies, especially as the country faces deep social divisions and a polarized political environment.

RATING DRIVERS

The ratings could be upgraded if the government implements a credible macroeconomic program that durably lowers inflation, puts fiscal accounts on a sustainable path, and strengthens the government’s access to market financing. Reforms that increase investment and productivity growth would also be credit positive.

The ratings could be downgraded if the IMF program is suspended, or if government debt dynamics deteriorate such that the odds of a restructuring of bonds held by the private sector materially increase.

RATING RATIONALE

Tighter Fiscal Policy Is Supporting The Macroeconomic Adjustment But Policy Implementation Risks Could Intensify As Elections Near

One of the most pressing policy issues facing Argentina is the fiscal deficit. The government narrowed the primary deficit from 3.0% of GDP in 2021 to an estimated 2.4% in 2022, thereby slightly outperforming the program’s primary deficit target of 2.5%. The 2023 budget aims to reduce the deficit to 1.9% of GDP, in line with the IMF program target. Although the scale of the adjustment appears modest, meeting the target could still be difficult. The fiscal balance in 2022 included 0.3% of GDP in non-tax revenue generated from the issuance of inflation-linked debt which will not be included in 2023. In addition, the adjustment in 2023 will largely depend on cutting politically sensitive spending items, such as energy subsidies and social transfers, during an election year. We expect the government to run tight fiscal policy in the first half of 2023 but it is not clear, in our view, if the government will maintain such a restrictive stance as the October elections approach.

The next administration will face a challenging fiscal outlook. The scale of the fiscal adjustment needed to put public finances on a sustainable path is large and implementation risks are high, in our view. If the government meets its primary deficit target in 2023, the next administration will still need to tighten fiscal accounts by 3-4 percentage points of GDP. Such an adjustment is achievable, particularly if the next government wins with a strong mandate to address the country’s macroeconomic imbalances. The test will be to sustain political support for such a sizable and potentially prolonged adjustment. The challenging fiscal outlook combined with historical weaknesses in fiscal policy formulation weigh negatively on the Building Block Assessment for “Fiscal Management & Policy”.

Stress In The Local Bond Market Could Lead To Greater Monetary Financing And Potentially A Restructuring

Facing fragile market conditions, the government has shortened maturities and increasingly relied on inflation-linked and dollar-linked issuance in order to roll over maturing local-currency debt and finance the deficit. This has led to a concentration of local-currency bonds coming due in the second and third quarter. The high share of government debt held by public sector entities and the presence of capital controls mitigate rollover risk to some extent, but the government’s ability to mobilize peso financing from private creditors is uncertain, especially as the election approaches and there continue to be concerns about policy credibility. Turbulence in the local market could lead to the government to rely on central bank financing, which would add to inflationary and exchange rate pressures. It could also potentially lead the administration to forcibly amend the terms on local government bonds.

On the external front, Argentina has reduced its external debt servicing needs through 2024. In September 2020, Argentina reached an agreement with private creditors to restructure $82 billion in debt, which provided substantial FX liquidity relief through 2024. Argentina also reached an agreement on an Extended Fund Facility with the IMF in March 2022 to refinance repayments to the IMF that were largely coming due in 2022 and 2023. Despite these developments, Argentina has failed to regain market access. The next administration may seek another IMF program in early 2024, which could provide some additional net financial support in exchange for further policy conditionality.

In our view, risks to debt sustainability are elevated. The IMF program’s baseline scenario projects government debt-to-GDP to decline from 80% of GDP in 2022 to 71% in 2023 and then stabilize around that level through 2026. However, Argentina is vulnerable to shocks, including exposure to terms-of-trade and weather-related shocks, and faces material policy implementation risks. This, combined with the high share of debt denominated in foreign currency (66%), pose significant risks to public debt dynamics. Moreover, Argentina’s capacity to repay will depend on strengthening domestic market conditions and eventually regaining access to international markets. The considerable risks to debt sustainability combined with Argentina’s weak liquidity position lead DBRS Morningstar to make a negative adjustment in the Building Block Assessment for “Debt & Liquidity”.

Inflation Is Elevated And Unanchored, Complicating Any Adjustment By The Next Administration

Inflationary pressures moderated slightly in the second half of 2022 but intensified in January 2023. Monthly headline inflation declined from its peak of 7.4% (m/m) in July 2022 to 5.1% in December 2022. The slowdown appeared broad-based but also driven partly by voluntary price agreements. However, headline inflation increased 6.0% (m/m) in January 2023, which raises some concerns about whether macroeconomic policies are sufficiently tight to moderate price pressures. On a year-over-year basis, headline inflation hit 99% in January. The IMF’s updated projections from the Third Review assume that annual inflation will decline to 55-65% by the end of 2023. In DBRS Morningstar’s view, the target looks very ambitious. While weak domestic demand should support disinflation, upward price pressures will remain strong due to further adjustments to utility rates, faster currency depreciation in order to maintain competitiveness, and growing wage pressures. According to the February Survey of Market Expectations by the central bank, the median forecast for CPI inflation was 98% for December 2023 and 80% for December 2024. The challenging outlook for inflation leads DBRS Morningstar to make a negative adjustment to the Building Block Assessment for “Monetary Policy and Financial Stability”.

The central bank has lifted real policy rates into positive territory in order to strengthen demand for peso assets and reduce inflation. The nominal effective policy rate was raised from 45% (on the 28-day LELIQs) in December 2021 to 107% in September 2022. That puts the nominal monthly policy rate at 6.3%, which is above recent reports of monthly inflation as well as expected inflation over the next 12 months. Durably reducing inflation will likely require a sustained commitment to tight macroeconomic policies and the phasing out of monetary financing. The government’s use of short-term measures to combat inflation, such as price controls and import restrictions, could end up exacerbating underlying economic imbalances, leading to a further deterioration in the investment climate and an acceleration of inflation down the road.

Argentina’s financial system remains small in size. State-owned Banco Nación is the dominant player in the banking sector. While profitability has suffered due to low net interest margins and limited demand for credit, the banking system has high levels of liquidity and is well-capitalized. Non-performing loans remain at low levels and net FX exposure is modest. However, exposure to the public sector has increased to over 50% of local currency assets.

Low Reserves And A Sizable Exchange Rate Gap Signal Currency Vulnerability

Despite foreign exchange controls and balanced current account dynamics, reserve accumulation efforts have been hobbled policy credibility concerns. The current account balance shifted from a surplus of 1.4% of GDP in 2021 to a deficit estimated at 0.3% in 2022. Although higher global grain prices boosted export receipts, the trade balance deteriorated due to higher natural gas and fertilizer import prices, as well as strong underlying demand, which drove capital and consumer import volumes higher. The current account is projected to shift to a small surplus in 2023 on the back of weaker domestic demand, although agricultural export losses due to the drought raise downside risks to the forecast.

At the same time, Argentina has been unable to attract net capital inflows. While foreign direct investment into Argentina picked up in 2022, capital inflows have been largely offset by private sector debt repayments and Argentine savers’ accumulation of hard currency assets. From Q3 2019, when capital controls where imposed, to Q3 2022, currency and deposits held abroad by Argentine residents increased by $29 billion, thereby lifting the stock to $247 billion (41% of GDP). As a result, Argentina maintains a sizable net international asset position, amounting to $113 billion in Q3 2022 (19% of GDP).

Low reserves and a widening exchange rate gap could put pressure on the currency. Gross reserves amounted to $40 billion in mid-February, but net foreign exchange reserves (calculated as gross reserves minus dollar deposits from financial institutions, central bank currency swaps and credit lines, and gold) amounted to about $3 billion. Complicating reserve accumulation is the spread between the official ARS/USD rate and the unofficial rate, which is close to 90%. Concerned about reserve levels, the government has implemented on a series of foreign exchange controls. We expect the Fernandez administration to aim to avoid a sharp depreciation of the currency prior to the election. We anticipate that the next administration will be compelled to accelerate the crawl in order to weaken the real exchange rate and reduce the FX spread. Overall, we continue to see considerable external risks that, despite Argentina’s balanced current account dynamics and positive NIIP, warrant a sizable negative adjustment to the Balance of Payments building block.

Argentina Rapidly Recovered From The Pandemic But Growth Prospects Are Weak Without Policy Credibility and Structural Reforms

The economy recovered rapidly from the shock of the pandemic. Output in the third quarter of 2022 was 7.4% above the fourth quarter of 2019. However, the Argentine economy was already suffering from a two-year recession prior to the pandemic, and real GDP is still slightly below the fourth quarter of 2017 when GDP peaked. Notwithstanding the recovery in 2021 and 2022, we expect the economy to slow markedly in 2023 due to deteriorating external conditions, tighter macroeconomic policies, and the ongoing drought. The IMF projects GDP growth of 2.0% in 2023 and 2024; however, we view risks to the forecast as clearly skewed to the downside.

Poor macroeconomic management, an unpredictable and onerous regulatory environment, and limited global integration have contributed to Argentina’s poor growth performance. In the eight years prior to the pandemic, GDP growth contracted on average by 0.3% per year. During this time, investment averaged 16.8% of GDP, one of the lowest rates among emerging markets, and the number of private sector jobs created was close to zero. The IMF program primarily aims to address macroeconomic imbalances, and leaves most of the necessary structural adjustments to the next government. Absent a plan that restores policy credibility and enacts structural reforms, we expect medium-term growth prospects to remain weak, with Argentine policymakers having limited room to stimulate growth without exacerbating macroeconomic imbalances.

The Government Will Aim To Keep The Economy Treading Water Until The General Election in October

The field of presidential candidates has not yet been defined. Primaries for the two main coalitions (Frente de Todos and Juntos por el Cambio) as well as for a libertarian coalition (La Libertad Avanza) are scheduled for August. The governing Peronist coalition (Frente de Todos) faces an uphill battle. Perceptions of economic mismanagement have driven the government’s popularity close to its lowest level since 2010. In our view, the government’s near-term objective will be to get to the October elections without generating hyperinflation, devaluation, or a default, but also while also avoiding taking any corrective policy actions that have might incur high political costs. As a result, we expect the next administration will take office under difficult economic and financial conditions.

DBRS Morningstar views the broader issue of institutional quality in Argentina as a credit challenge. In many respects, Argentina’s democracy is quite strong: competitive and fair elections are regularly held, basic civil and political freedoms are protected, and an active civil society is engaged in the democratic process. According to the Worldwide Governance Indicators, Argentina scores relatively well compared to regional peers in terms of Voice & Accountability. However, a key governance challenge is the Rule of Law. Public confidence in the integrity of the judiciary and other branches of government is generally low. In addition, we view policy predictability as weak, with frequent and significant changes to policy settings and frameworks over the electoral cycle. The heightened policy-related risks weigh on the Building Block Assessment “Political Environment”.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

Social (S) Factors

The Human Capital and Human Rights factor affects the ratings. Similar to other emerging market economies and many of its regional peers, Argentina’s per capita GDP is relatively low, at US$13.6k (US$26.1k on a PPP basis). This reflects the low level of labor productivity. This factor has been taken into account in the Economic Structure and Performance building block. In addition, labor and social conflicts have at times been a source of economic volatility in Argentina.

Governance (G) Factors

Two governance factors affect the ratings: (1) Bribery, Corruption and Political Risks, and (2) Institutional Strength, Governance, and Transparency. According to Worldwide Governance Indicators, Argentina ranks in the 35th percentile for Rule of Law and 38th percentile for Control of Corruption. Argentina ranks in the 38th percentile for Government Effectiveness and 29th percentile for Regulatory Quality.

There were no Environmental factors that had a significant or relevant effect on the credit analysis.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (May 17, 2022).

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/410504.

Notes:
All figures are in U.S. dollars unless otherwise noted. Fiscal data refers to the federal government. Other public finance statistics are reported on a general government basis.

The principal methodology is the Global Methodology for Rating Sovereign Governments https://www.dbrsmorningstar.com/research/401817/global-methodology-for-rating-sovereign-governments (August 29, 2022). In addition, DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-andgovernance-risk-factors-in-credit-ratings (May 17, 2022) in its consideration of ESG factors.

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. DBRS Morningstar’s outlooks and ratings are monitored.

The primary sources of information used for this rating include the Ministry of Economy, BCRA, INDEC, Dirección de Estadística y Censos San Luis, International Monetary Fund, World Bank/NRGI/Brookings, Bank for International Settlements, Ambito, World Bank, and Haver Analytics. DBRS Morningstar 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 not participate in the rating process for this rating action. DBRS Morningstar 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.

This is an unsolicited credit rating.

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