Morningstar DBRS Confirms Argentina at CCC, Stable Trend

DBRS, Inc. (Morningstar DBRS) confirmed the Republic of Argentina’s Long-Term Foreign and Local Currency – Issuer Ratings at CCC. At the same time, Morningstar DBRS 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 CREDIT RATING CONSIDERATIONS

The confirmation of the credit ratings at CCC reflects the significant economic and political challenges facing Argentina as newly-elected President Javier Milei aims to correct the country’s large macroeconomic imbalances and strengthen medium-term growth prospects. Argentina’s economic situation has deteriorated over the last year, in large part due to policy mismanagement by the previous government in the run-up to elections. In November 2023, annual inflation was running at 161%. Net international reserves were depleted. The informal exchange rate was 2.5x the official rate. Since taking office on December 10th, President Milei has moved quickly to implement an ambitious macroeconomic stabilization plan, consisting of a large and front-loaded fiscal consolidation, the elimination of central bank financing, an external adjustment to foster reserve accumulation, and measures to gradually restore price stability. However, the relationship between President Milei and congress will be critical to the success of the stabilization plan. In that regard, the political outlook remains highly uncertain and, in our view, there are still considerable risks to macroeconomic stability and the government’s capacity to repay its debt to private creditors.

The Stable trends reflect our view that risks to the CCC credit ratings are broadly balanced. President Milei won 56% of the run-off vote after campaigning on the need for a sharp change in policy direction. In its first two and a half months, the new administration has taken policy actions in areas under executive control while aiming to build legislative backing for the broader stabilization plan. Early results are positive: the fiscal balance was in surplus in January, reserves have increased, and monthly inflation appears to be moderating. In our view, the planned reforms could help restore macroeconomic stability and potentially set the stage for stronger and more durable economic growth.

However, governability risks are high. President Milei will need to build alliances in congress since his party only holds a small number of seats in both houses. Building a congressional coalition is already proving difficult, especially as the stabilization plan entails significant near-term economic costs. The IMF projects GDP will decline 2.8% this year. The contraction is even more severe if the strong recovery expected in the agricultural sector is excluded. Congress and the courts have already pushed back on proposed tax and labor reforms. If Milei cannot build congressional support for the stabilization plan, the result could be paralysis and dysfunction even as the economy sinks deeper into crisis.

CREDIT RATING DRIVERS

The credit ratings could be upgraded in the near term if (1) the Milei administration is able to garner and sustain political support while making clear progress on the main objectives of the macroeconomic stabilization program, and (2) the government is able to reduce rollover risks in the local bond market. Over time, policy actions and reforms that lower inflation, strengthen the government’s access to international markets, and improve medium-term growth prospects would also be credit positive.

The credit ratings could be downgraded if government debt dynamics or funding conditions deteriorate such that the odds of a restructuring of bonds held by the private sector materially increase.

CREDIT RATING RATIONALE

A Large And Front-Loaded Fiscal Consolidation Anchors The Macroeconomic Stabilization Plan

Following significant policy slippage by the previous government in the run-up to the election last year, the Milei administration aims to implement a large and rapid fiscal consolidation. The planned adjustment in 2024 is equal to 5% of GDP and would be consistent with running an overall balanced budget for the year. The consolidation plan is primarily expenditure-based, composed of cuts to energy and transport subsidies, reductions in the public wage bill, lower transfers to provinces and state-owned enterprises, and a decline in capital spending. On the revenue side, the government plans to reverse the personal income tax cuts that were implemented last year and temporarily increase import and export taxes. The end of the drought should also support export-related tax receipts. Almost all of the adjustment will take place in 2024, with very little additional tightening expected during the remaining three years of the President Milei’s 4-year term. The scale and front-loaded design of the fiscal adjustment could significantly improve the outlook for public finances and act as an anchor for macroeconomic stabilization.

However, implementation risks are very high, in our view. The government recently withdrew planned tax increases and spending cuts in the face of congressional opposition. While the administration was still able to reach a surplus in January 2024, congressional backing will eventually be required to implement the fiscal adjustment. There are also policy-related hurdles to overcome. For example, plans to wind down trade-related taxes at the end of the year will need to be offset by permanent and higher-quality measures in order to underpin the durability of the adjustment. The challenging fiscal outlook combined with Argentina’s historical weaknesses in fiscal policy formulation weigh negatively on the Building Block Assessment for Fiscal Management & Policy.

Debt Sustainability And Liquidity Risks Remain Elevated

Argentina’s capacity to repay private creditors will depend on regaining access to international markets. Argentina’s agreement with private creditors to restructure $82 billion in debt in September 2020, combined the IMF agreement on an Extended Fund Facility in March 2022, provided the government with substantial FX liquidity relief through this year. Since these agreements, however, Argentina has depleted its reserves and failed to restore market access. Government external debt servicing needs are relatively modest in 2024 but will increase to about $18 billion in 2025 and 2026, of which roughly half is to service FX obligations to private creditors. In January 2024, the IMF completed its Seventh Review of its Extended Fund Facility for Argentina, which enabled planned disbursements this year under the program but provided no new net financing. If the stabilization plan progresses well in 2024, the IMF and Argentina could potentially agree to a new program to bolster market confidence. Under the current program, Argentina is assumed to raise $1.5 billion in the international market next year.

The Milei administration is committed to ending its reliance on central bank financing and rebuilding the domestic bond market. Macroeconomic instability and policy uncertainty in 2023 put considerable stress on the local market, with the previous government shortening maturities and increasingly relying on inflation-linked and dollar-linked issuance to rollover maturing local-currency debt and finance the deficit. The government’s fiscal consolidation strategy, combined with plans to extend the maturity profile of local currency bonds, should help reduce financing pressures in the near term. Recent developments have been encouraging. In January, the Argentine Treasury successfully issued debt and used the proceeds to rebuild cash buffers and buy back debt from the central bank, thereby strengthening the central bank’s balance sheet.

Risks to debt sustainability are elevated, in our view. Government debt-to-GDP jumped to 155% in 2023 as the step devaluation in December led to a sharp decline in nominal GDP in USD terms. Under the IMF’s baseline scenario, the debt-to-GDP will decline to 86% in 2024 as the overshooting of the real effective exchange rate reverses. The ratio subsequently continues on a downward trend – reaching 60% in 2027 – on the back of sizable primary surpluses. However, uncertainty around the outlook is very high, primarily because Argentina is in the early stages of a large macroeconomic stabilization program. Risks include delays in the planned fiscal consolidation, a weaker-than-expected global economic conditions, and potential international court rulings against Argentina (compensation payments could total $17 billion). The considerable risks to debt sustainability combined with Argentina’s weak liquidity position lead us to make a negative adjustment in the Building Block Assessment for Debt & Liquidity.

Fiscal Tightening And Exchange Rate Realignment Aim To Rebuild International Reserves

Argentina’s external imbalances worsened over the course of 2023 due to expansionary macroeconomic policies, declines in agricultural exports, and an overvalued real effective exchange rate. Despite foreign exchange controls, the current account deficit reached 3.5% of GDP and net reserves (gross reserves minus FX bank reserve requirements, swap lines, and other FX obligations) declined from approximately $11 billion at the end of 2022 to -$9.5 billion by the first week of December.

However, an external adjustment is underway. Three days after taking office, the Milei administration implemented a 54% devaluation (in ARS/USD terms), which reduced the spread between the official ARS/USD rate and the unofficial rate from about 150% prior to run-off election to about 25% in the third week of February. We expect a sizable shift in the external accounts this year on the back of the currency devaluation, weaker import demand, and a recovery in export volumes. The policy mix should help the central bank rebuild reserves and eventually remove capital controls and unify the exchange rate. In the near term, however, the ability to accumulate reserves will depend in part on maintaining a competitive real effective exchange, which is a challenging task in the context of high inflation and a desire to anchor expectations around a disinflationary path. The central bank has set a monthly crawl rate of 2% on the ARS/USD to support early disinflation efforts, but the crawl rate may need to accelerate if the real effective exchange rate strengthens to the point that it jeopardizes the external adjustment.

In the financial account, limited capital inflows have been offset by private sector debt repayments and Argentine savers’ accumulation of hard currency assets. From Q2 2019, just before capital controls where imposed, to Q3 2023, currency and deposits held abroad by Argentine residents increased by $60 billion, thereby lifting the stock to $257 billion. As a result, Argentina’s holds a sizable net international asset position amounting to $91 billion, although it largely reflects a lack of confidence in the local market. Notwithstanding the positive net IIP, we continue to see considerable external risks that warrant a sizable negative adjustment to our assessment of the Balance of Payments building block.

Establishing A Credible Monetary Policy Regime Will Be Critical To Taming Inflation

When the new administration was sworn into office in early December, inflation was running at 161% year-over-year and 12-month ahead inflation expectations reached 227%, reflecting the reliance on central bank financing and expectations of a currency depreciation. As the Milei administration quickly devalued the currency, inflation surged in December with month-over-month inflation doubling to 25%. The January print was slightly better at 21% (m/m). We expect rising regulated prices will keep monthly inflation running at a double-digit pace for a few more months, but then price pressures should start to moderate as the fiscal consolidation gains traction and domestic demand weakens. The IMF projects annual inflation of 149% by December 2024 (equal to average monthly inflation of 7.9%) and 45% by December 2025 (3.1%).

As part of its efforts to revamp the monetary policy framework, the central bank created a new overnight policy rate, which was initially set at 100% (equal to 8.7% on a monthly basis). Durably reducing inflation presents significant policy challenges. A shift to positive real rates will be required at some point to better anchor inflation expectations and increase peso demand. The uncertain inflation outlook and significant monetary policy-related challenges lead us to make a negative adjustment to the Monetary Policy and Financial Stability Building Block Assessment.

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. The government is reviewing banking regulations and credit subsidies scheme to strengthen credit allocation and monetary transmission.

Argentina’s Growth Performance Has Been Poor; Reforms Could Strengthen The Medium-Term Outlook

Over the last ten years, real GDP per capita in Argentina declined by 11%. This poor growth performance has been due to macroeconomic mismanagement, an onerous and costly regulatory environment, and limited global integration. Investment averaged 16.9% of GDP over the last decade, one of the lowest rates among emerging markets. Labor market conditions have also fared poorly. The cumulative number of salaried private sector jobs created was 350,000 at a time when the economically active population increased by nearly 3 million, signaling that jobs increasingly shifted towards public and informal employment.

The government aims to increase investment and productivity by removing market distortions and regulatory barriers. The IMF estimates Argentina’s potential growth at 2.3%, which is slightly better than its historical performance (growth averaged 1.8% over the last 30 years). We see risks around the IMF’s forecast as balanced. The Emergency Decree and Omnibus bill aim to deregulate a wide range of sectors, foster greater market competition, and increase investment. Another source of upside risk to growth comes from the energy and mining sector, which could rapidly expand if investment conditions are strengthened. However, absent macroeconomic stability and structural reforms, the Argentine economy could underperform the baseline growth outlook.

Milei’s Victory Raises The Prospect Of Reform, But Also Raises Governability Risks

Javier Milei defeated Sergio Massa in the presidential run-off election on November 19, 2023, after campaigning on the need for a rapid macroeconomic adjustment, widespread deregulation, and reduced state intervention in the economy. Although the election results signaled that many Argentines were ready to take their country in a different direction, the victory of an anti-establishment candidate with a limited track record in government raises governability risks. Milei’s party, La Libertad Avanza, only holds 38 seats out of 257 in the lower house and 7 seats of 72 in the Senate. To advance the reform agenda, the Milei administration needs to build political alliances and sustain social support. This is already proving difficult: the Courts suspended a part of the Emergency Decree in early January, and Congress recently sent the proposed Omnibus bill back to committee after hitting opposition from lawmakers. At the same time, the economic and social stress stemming from the macroeconomic adjustment could spark protests and strengthen the opposition. If Milei cannot build and sustain a congressional coalition to pass legislation, governability challenges will likely intensify, potentially leaving the country vulnerable to social unrest and macroeconomic instability.

Morningstar DBRS 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 Political Environment Building Block Assessment.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS

ESG Considerations had a significant effect on the credit analysis.

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

Social (S) Factors
The following Social factor had a significant effect on the credit analysis: Human Capital and Human Rights. Similar to other emerging market economies and many of its regional peers, Argentina’s per capita GDP is relatively low, at US$13.3k (US$26.5k on a PPP basis). This reflects the low level of labor productivity. In addition, labor and social conflicts have at times been a source of economic volatility in Argentina. This factor has been taken into account in the Economic Structure and Performance building block.

Governance (G) Factors
The following Governance factors had a significant effect on the credit analysis: (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 37th percentile for Control of Corruption. Argentina ranks in the 42nd percentile for Government Effectiveness and 26th percentile for Regulatory Quality. These factors have been taken into account in the Fiscal Management & Policy building block and the Political Environment building block.

A description of how Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (23 January 2024) https://dbrs.morningstar.com/research/427030/morningstar-dbrs-criteria:-approach-to-environmental,-social,-and-governance-risk-factors-in-credit-ratings

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/428817.

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

The principal methodology is the Global Methodology for Rating Sovereign Governments (06 October 2023) https://dbrs.morningstar.com/research/421590/global-methodology-for-rating-sovereign-governments . In addition Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://dbrs.morningstar.com/research/427030/morningstar-dbrs-criteria:-approach-to-environmental,-social,-and-governance-risk-factors-in-credit-ratings in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://dbrs.morningstar.com/about/methodologies.

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

The primary sources of information used for these credit ratings include 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. Morningstar DBRS considers the information available to it for the purposes of providing these credit ratings was of satisfactory quality.

The credit rating was not initiated at the request of the rated entity.

The rated entity or its related entities did not participate in the credit rating process for this credit rating action.

Morningstar DBRS did not have access to the accounts, management and other relevant internal documents of the rated entity or its related entities in connection with this credit rating action.

This is an unsolicited credit rating.

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