Article:
What went wrong in Argentina?

by Chloe Hayward

In August the markets rocked and, in turn, Argentina was dumped. Chloe Hayward goes to Buenos Aires to find out why.

September 2007 – “THIS IS THE worst day in four years,” is the greeting given to Euromoney at the start of a meeting in Buenos Aires on August 4. As the markets in Argentina tumbled it is apparent that, despite the success stories that have come out of the country in the last four years, it is still highly vulnerable.

The August turbulence was the first true test that Argentina has faced since the 2001 crisis and, in many ways, the market didn’t fare well – investors dropped Argentine investments before those anywhere else in the region, even Venezuela. What is Argentina doing to deserve this investor reaction?

This question becomes yet more intriguing when you start talking to bankers in Buenos Aires. “Argentina has been a big opportunity since the 2001 crisis,” says Luis Caputo, chairman of Deutsche Bank in Argentina. “Several banks have come back and expanded operations in the past 24 months, the opposite to what happened in 2001 when they all shrank their operations here.”

Fabio Saraniti, head of fixed income and products for Santander Rio in Argentina, agrees: “Argentina has been a success story, with good economic growth in the last five years since the crisis,” he says. “We are heading to the fifth consecutive year of fiscal surplus and overall economic growth – that has never been seen here before.”

With Argentina recording growth rates of an average of 8.8% for four years, and growth of 7% predicted for 2007, it would seem the figures reflect a booming economy. The financial sector also looks more healthy, with solid balance sheets and carefully managed assets and liabilities. “This country and its financial system is in a much more solid position to face a market episode than we were back in 2001,” says Sebastián Palla, president of the union of retirement and pension fund administration in Argentina.

On August 21 Merrill Lynch released a report that considered how investors’ perceptions of Argentina are deteriorating. Investors are concerned about remaining financial needs, inflation reporting and fiscal slippage, as well as a lack of financial products and deep capital markets. “The country has been unable to secure a solid investor base, as its new bonds are not part of the major indices (they are issued under local law),” says Merrill.

Regardless of the positive fundamentals in Argentina, the country is still highly exposed to market movements – on August 16 the yield on Argentina’s 8.28% 30-year bonds rose seven basis points to 10.45%, according to JPMorgan. “Lack of investor appetite for Argentine bonds has left the offshore peso rate depressed,” says Vladimir Werning, economist for Argentina at JPMorgan.

Economists are still positive – they hope it is just a short-term crisis. But Argentina has suffered the most among Latin American countries in the recent storm – it even underperformed Venezuela in the first two weeks of the turbulence. “It is very clear that Argentina has been penalized a lot more than the other countries in the region and this just highlights that sooner or later we all pay for our mistakes,” says Caputo.

Inflation, corruption and wine

From an investor’s point of view, some mistakes, such as fiddling inflation figures, which the national statistics agency has been accused of doing in recent months, are too big to forgive. “Investors have lost interest because they feel they have not been treated properly over the past few months. The manipulation of the CPI and the lack of investment in the energy sector were the most worrisome for the markets’ stability,” says one banker. Simon Treacher, bond manager at BlueBay Asset Management, even went so far as to call the effect of these figure changes “a haircut” on the CPI-linked bond prices.

New economy minister, Miguel Peirano, says that the country’s inflation statistics are “trustworthy” and, in turn, the national statistics body Indec (Instituto Nacional de Estadistica y Censos) continues to report surprisingly low figures each month.

The July figures, provided by Indec, imply an annual inflation level of 8.6%. But market participants think the rate should be closer to 12%, and the IMF predicts an annual inflation level of 10.3% for 2007. The high predictions are because of fiscal spending of more than 25% of GDP in the past 12 months, and salary increases of 16% for 2007. “I would say that fiscal and wage policy have had a critical impact on inflation,” says Martin Redrado, central bank governor of Argentina. “If you consider Chile, they took 12 years to bring inflation under control – it takes time, especially if you are trying to maintain social tranquillity along the way.”

But the Indec dispute raises another point that was succinctly made to Euromoney in Buenos Aires by a vineyard owner. “This country is corrupt,” he says.

On July 16, Felisa Miceli, the economy minister, resigned under a cloud after $63,300 of unexplained cash was found in her ministry office. She denies any wrongdoing. President Néstor Kirchner has since appointed Peirano as the new economy minister. Then, less than a month later, Kirchner dismissed Claudio Uberti, an Argentine official, after a suitcase with $800,000 in cash in it was found on a plane he was flying on with Venezuelan officials. Eduardo D’Orazio, senior director of Fitch in Argentina agrees with the vineyard owner: “When the new administration is sworn in on December 10 the first thing they should deal with is corruption.”

There are even more fundamental questions than corruption, though. Many investors have raised the question, how independent is the central bank? The bankers in Buenos Aires are positive about how the central bank has responded to the market turbulence but Moody’s is worried. In a market report on whether Latin American economies were overheating, released on August 21, the credit rating agency said: “Inflation has been close to 10% in the past few years. [This] can be explained by factors such as the lack of credibility in monetary policy given the absence of an independent central bank, and also by distortions created by supply shortages of some products subject to price controls. In this sense, the Argentinean economy surprisingly does not qualify as an overheated economy.”

One banker says: “It’s not so much a question of how independent the central bank is, as how independent is anything under this government.” The central bank governor says: “On certain tissues, such as the exchange rate, there is not doubt there is coordination between us. But in terms of basic independence then each side should focus on its own job.”

Despite president Kirchner’s government getting dragged through the mud in the last two months, Kristina Kirchner, the wife of the current president, is still over 20 points ahead of the nearest competition in the run-up to the presidential elections due on October 20.

A new era?

Whether it is well-founded or not, there is a belief that the future is still bright for Argentina. “We hope that government spending will be better managed after the election – at the local elections in the City of Buenos Aires in July the newly elected deputies have already curbed spending,” says Santander Rio’s Saraniti.

Investors also hope that finally an action plan to tackle the energy shortage is being developed. Bankers and companies realize that this problem is likely to be solved by a combination of foreign investment with local management. But the foreign investment is not going to flow into large-scale, five-year to 10-year projects if the long-term horizon for Argentina is not clear.

“From our perspective we have found the government very inconsistent in the way they have dealt with the private sector,” says Ernest Bachrach, chief executive, Latin America at Advent International. “It seems they manage the economy on a day-to-day basis depending on how popular the president is at the time.” Advent just closed a $1.3 billion fund for Latin America but only 5% to 10% of the fund is going to Argentina. Pre 2001 this would have been nearer 20% to 30%, says Bachrach.

“Argentina historically changes the rules a lot,” says D’Orazio. “For the next stage of growth to start, the big companies need rules in place but here the rules are generally manipulated by the government and so it is difficult for companies to plan for the future or project prices.”

Redrado also feels that long-term projections of salaries would encourage long-term investment: “One thing that the government should do to encourage investors is give pluri-annual targets for the next four years, in terms of fiscal, monetary and wage policy. They should give specific targets that they are committed to. This would really level the playing field and bring Argentina out of the short-term horizon that we are in at the moment.”

This is particularly important for energy companies because of the tariffs on energy that the government introduced.

Money flies in

Banks that have expanded operations in recent months include Credit Suisse and Merrill Lynch. “We made a decision nine months ago to significantly increase our presence in Argentina,” says Daniel Gonzalez, country head of Argentina and Chile at Merrill Lynch. “We have hired in all areas and stated that we intend to deploy our own capital through our principal investments. Obviously we see an opportunity or we wouldn’t be investing, but it’s challenging – it’s Argentina.”

Strategic money inflows have been slow to return to the market post crisis.

“Strategic money is the one that takes the longest in coming back after there has been a crisis in a country,” says Deutsche’s Caputo. “But in contrast, the speculative money smells a good business and flies in.” In the past 18 months, there has been a huge increase in the number of private equity deals in Argentina by private equity funds and banks as they start to put their money were their mouth is.

These moves include Citi partnering with Sadesa, an Argentine power utility, in March, and putting $101 million of its own capital into buying two generators, CT Mendoza and CT Ensenada. Similarly, Merrill Lynch has made two passive investments in power generation companies CT Puerto and Piedra del Agila, as well as partnering with Pegasus Capital, a Boston private equity firm, to raise funds for real estate.

“Money is flowing into the country, and it’s real assets this way,” says Caputo. “I think private equity has been driven by the scarcity of financial assets and in Argentina in particular for the huge growth potential in many areas such as real estate, energy and agro-industrial business.” In July 2007, investment had reached 22% of GDP – an impressive level for a country with macro problems – but investors are wary: “Compared with countries like Brazil and Mexico, we are a lot more cautious in Argentina, the macro situation makes us more conservative because an exit will be much harder,” says Bachrach.

So far only about 5% of the private equity investments that have been made in Argentina have used an IPO as their exit strategy. Most investment is in smaller companies that are not ready to go to market, and exit is through private deals. Strategic investors are either realizing they have landed on a good story and have continued to take the dividends while waiting for the market to mature or they have sold on the company in another private deal. “Recently we have seen the regional multinationals, such as Brazilian and Chilean companies, wanting to open up across the region. Argentina is an obvious country for them to enter.

This trend is providing an excellent exit strategy and encouraging new short-term private equity investments into smaller companies that can now see a good exit option,” says Bachrach.

The equity market has been slow off the mark since 2001. There have been only six IPOs by Argentine companies, and only three of these went on to the Buenos Aires stock exchange. Out of these three placements, two came in early 2007 – Edenor and Banco Patagonia. Edenor was a private equity exit, with a $376 million IPO in April. “For the equity market to grow, and for equity to sell, then a company – and the country it operates in – need a good story. The current administration has done a lot to discourage investment in the large, more established companies. Most investment has gone into smaller companies that are being sold on and not made public,” says one source.

A growing bond market has also increased interest as it offers private equity investors more diverse financing opportunities.

In 2006, $1.69 billion of peso-denominated bonds came to market, a strong contrast to the $2 million that came to the market in 2003. Growth in the peso-denominated market has, in part, been explained by the increase in currency hedge and swap instruments on offer from Santander Rio. Also, in the first seven months of 2007, $2.94 billion of non-peso denominated bonds were placed in the international capital markets, again a strong contrast to the $99 million that came in 2003.

But now the market needs a long-term benchmark as the sovereign is still to return to the markets. As Walter Molano, head of research at BCP Securities, said earlier in the year: “The Argentine provinces are becoming the sovereign’s window to the international capital markets.”

In October 2006, the Province of Buenos Aires issued a vanilla bond deal for $475 million. Mendoza and Neuquen provinces also issued global bonds in the last year bringing the total placed to over $600 million.

Redrado confirms that longer-term currency issues are high on the agenda: “Two months ago there was the first five-year issue in pesos. Now we are working with multinationals to help them issue in Argentina in domestic currency and then sell it to our institutional investors. We are also working with the IDB on a structure that will issue seven-year paper.” These are all steps towards what Palla thinks is holding back Argentina at the moment: “The biggest challenge for the new government will be to develop a long-term currency.”

One area of the capital markets that has benefited from the recent rocky times is the credit derivative market. “Argentina is known for its volatile nature and this is creating a good opportunity in the credit default market,” says Caputo. “The stable presence of a CDS market is one saving grace for Argentina during the recent market turbulence – investors in Argentina know that parties don’t last for ever and they need a back-up. The challenge will now be to develop further the credit derivative market to make investment in companies more stable as investor interest in Argentina increases. I think once this market grows, and there are options beyond straight investment, so investors will look at Argentina more.” Saraniti says: “The derivatives world is growing nicely in Argentina. This will also give room for further growth in the debt area.”

Growth in the securitization market, through the local trust law, has also been important. “It is a great way for the small and mid-sized companies to finance themselves and I think that will continue to grow,” says D’Orazio. “Especially as the local institutional investors, and buyers of last resort, are starting to look at these structures.” As of mid-2006 it became law for pension funds in Argentina to invest a certain amount of their portfolio in local construction and infrastructure projects. This obligation initiated the idea to securitize future receivables of these projects. Santander and HSBC have been named as two banks that could be involved in one such deal that might enter the market before the end of the year.

Despite bankers working hard to give investors what they want, from securitization, swaps, hedging as well as straight financing options, yet again the government has been blamed for countering their efforts. The administration is concerned about allowing hot money in and therefore has put in place preventative measures. Any funds entering the country have to deposit 30% with the central bank for one year, interest-free.

This is also penalizing Argentine money that was moved offshore just before the crisis – now these funds can’t return easily, and so aren’t returning. “If this obligation to deposit money was removed it would help the market develop a lot quicker. The central bank aims to maintain the exchange rate as it is and I am sure these capital restrictions are important for that objective,” says Merrill’s Gonzalez. It is this fear of hot money that has also deterred the central bank from increasing interest rates, though Redrado also notes that Argentina is still a 90% cash economy and so the transmission mechanisms between interest rate increases and the economy are weaker than in other countries.

Engine for growth

Despite Argentina growing at an average of 8.8% for the past three years, having a trade surplus of 6% of GDP, and holding a current account surplus of 3.5%, the market is still pricing in risk that isn’t reflected in these measures. Even if inflation is 12% or 8%, this isn’t at a level that is out of control. The big question is – what will make prices reflect the fundamentals better?

Several people answer this question the same way. “We need to gain investor confidence – investors need to believe that regulations will be for the long term, inflation figures are trustworthy, and the central bank is independent,” says one. Combined with this the country needs to market itself better and normalize relations with the international community by clearing the holdouts and its Paris Club debt. However, as banks come back and invest capital and time in assets and product innovation the future is probably bright.

“Investors are waiting to see what happens after the elections,” says Cate Ambrose, executive director of Lavca.

But, as Gonzalez succinctly puts it: “There’s not going to be just one trigger that will open the door to this market.”