What is happening in Argentina?

Argentina’s primary elections over the weekend of 10-11 August surprised the market by delivering a huge victory for opposition presidential candidate Alberto Fernandez, who managed to garner 48% of the votes, above the 45% threshold necessary to win directly after the first round and thus avoiding the need for a runoff. In the province of Buenos Aires, María Eugenia Vidal, the incumbent ally of President Mauricio Macri, lost with only 33% of the votes while Cristina Kirchner’s former finance minister Axel Kicillof won with 49% of the votes.

By way of background, Argentina’s primary election, called PASO – held ahead of the presidential election (scheduled for 27 October 2019) – is a compulsory election (all Argentines between 18-70 are required to vote) where all parties’ candidates are on the same ballot and voters can vote for any candidate. In other words, this is a “real situation” test and poll for the upcoming presidential elections. And President Macri failed that test spectacularly.

At the time of writing, Argentine assets have reacted sharply, with the Argentinian Peso (ARS) down close to 18% on 12 August alone, and trading at 53 at the time of writing, up from below 40 at the beginning of the year.

Why are markets reacting so sharply in Argentina?

Essentially because the Argentinian government is currently on life support with an International Monetary Fund (IMF) package allowing the country to service its extremely high public debt by emerging market standards (80%+ of GDP), roughly 80% of which is denominated in foreign currency (mostly USD).

This IMF package comes with strict conditions and fiscal discipline, basically forcing the Argentinian people to “tighten their belts”, an obvious source of unease and popular discontent. And this is not over. As stated by the IMF in its fourth regular review of progress under the “stand-by arrangement” on 12 July 2019, “steadfast implementation of the policies underlying the IMF-supported program will be critical for continued progress”.

However, it is yet unclear what Mr Fernandez’s intentions are regarding his plans to approach the IMF. He might be more moderate than his running mate and former president Cristina Kirchner, well known for her anti-IMF views, but he has indicated several times that he intends to renegotiate the deal with the IMF should he be elected. This could entail a prolonged renegotiation period leading to possible funding interruptions, or worse, a breakdown of the relationship between Argentina and the IMF and potential debt default. We will know more in the weeks to come as he and his team outline their economic plans in more detail, but the situation will surely remain volatile.

In the meantime, the sharp weakening in the peso puts the country’s debt sustainability at risk, and limited firepower from the central bank makes powerful intervention to support the currency both difficult and unlikely. The collapse in the peso will also push inflation up, forcing central bank tightening, and almost surely drive the country back into recession, weighing further on President Macri’s very slim chance of re-election.

What is our core scenario in Argentina going forward?

In this context, the likelihood of a sovereign debt default in Argentina has gone up significantly, and we keep the negative stance we have been holding on the country over the past year.

What about our views on the rest of emerging markets (EM)?

From a macroeconomic standpoint, the direct fallout from Argentina’s crisis on the rest of the emerging world should be limited, since Argentina’s economic footprint has diminished and it is a relatively closed economy. Brazil will likely be the most affected, as Argentina is one of its top three trading partners.

However, we note that emerging countries are already in a fragile situation, with GDP growth at historical lows ex-crisis periods (i.e. 2001, 2009 and 2015) in a context of intensifying trade tensions between China and the US.

For now, little domestic inflation and US Federal Reserve easing has led to a wave of rate cuts across the emerging world, with an eye-watering 12 out of 18 of the largest emerging central banks having cut rates so far this year. In Latin America: Chile, Peru, Brazil (and Mexico could follow), in Asia: India, Philippines, Malaysia, Indonesia, Korea, Thailand and in Eastern Europe the Middle East and Africa: Russia, Turkey, South Africa.

Lower policy rates should be able to offset some of the external shocks facing EM in the short term, but we caution that sharp and/or prolonged currency weakness would limit central banks’ ability to ease and even force them to reverse course, especially in countries with high foreign currency (FX) debt or unanchored inflation expectations (e.g. Turkey, Indonesia, Mexico, Brazil, Colombia…).

Overall, this is an environment where caution is required on emerging markets, and it is difficult to be optimistic about growth prospects without a clear resolution of trade disputes.

As such, any external or idiosyncratic shock – such as the one experienced in Argentina today – should not be taken with complacency.