Reform-minded Argentina holds key to South America’s future

In November, Argentina elected its first non-Peronist President in more than 20 years when pro-business candidate Mauricio Macri capped a stunning rise by defeating former Vice President Daniel Scioli in a runoff. Macri, member of an elite Argentine family, campaigned on a message of “Let’s Change,” a rebuke to the country’s failed protectionist and socialist economic policies. Just a month into his term the former mayor of Buenos Aires hasn’t shied away from following through on his promise of bold reform. Even though the country’s transition to a more free-market economy is expected to be painful in the short-term, Argentine financial markets rallied sharply leading up to and after Macri’s electoral triumph. With a rightward shift currently taking place in Latin American politics, the outcome of Argentina’s economic experiment could go a long way toward determining the future of the region.

The following Episode Feature appears in the January 24, 2016 issue of the Wall Street Week Newsletter. Subscribe – it’s free.

Argentina, the third most populous country in South America, experienced a deep depression from 1998 to 2002 in which Gross Domestic Product (GDP) shrank by nearly 30%. Poverty and unemployment declined sharply from 2003 to 2007 under President Nestor Kirchner, but the economy never truly recovered from a record-setting $95 billion sovereign debt default in 2001. The government reached restructuring agreements with 93% of creditors by 2010, most for about 30% of par, but “vulture” U.S. hedge funds that gobbled up Argentine debt post-default continue to demand full re-payment.

Kyle Bass characterized the vulture funds as “holding Argentina hostage” due to the fact a country cannot re-enter global credit markets, i.e. sell sovereign bonds to finance government spending, without reaching agreements to restructure all defaulted debt. In 2014, U.S. federal courts ruled in favor of the hedge funds. Argentine President Cristina Kirchner, who succeeded her husband in 2007, reiterated her government’s willingness to negotiate, but equated vulture funds’ hardline demands to extortion.

Macri swept into power promising deep economic reforms that would help Argentina reintegrate into the global economy, including a more serious and urgent approach to paying its debts. However, even after the election those representing the holdout vulture funds have shown little willingness to budge. In order to shore up dwindling reserves and gain at least a sliver of bargaining power in negotiations, Macri reportedly secured a $5-10 billion loan from several global banks including by JP Morgan and HSBC. The loan has been criticized by the vulture funds as “business as usual” for the Argentine government, and by economists because of its unfavorable interest rate of 12-20%. Macri, though, insists he wants to get the deal done sooner rather than later. He plans to bring a proposal to the table as soon as next week, sooner than most economists expected. While the previous government refused to compromise from its offer of 30 cents on the dollar, in Davos new finance minister Alfonso Prat-Gay said Argentina was now offering 120 cents on each dollar owed. 

In what proved to be a defining issue of the election, Macri also campaigned on his view the Argentine peso should be allowed to float freely. Previous populist Argentine regimes put in place strict capital controls preventing cross-border flows of money and assets, creating a messy dual currency system in which the peso had different values on public and private black markets. The costly decision to support the peso also drained cash reserves to dangerously low levels. Despite concerns over a potential economic shock, Macri followed through on his promise to lift capital controls on his first day in office (December 17). The result was a nearly 30% devaluation of the peso that brought short-term economic pain to the country in exchange for hope of a better future.

The devalued currency reduced consumers’ real buying power on imports, but made Argentine exports and labor more attractive. Because of unfavorable exchange rates, Argentina, which is traditionally a major exporter of grains, had seen farmers stockpile soybeans and other crops. With export tariffs lifted and distortions removed from currency markets, farmers reached a deal to liquidate $400 million in produce per day over several weeks in December. Although economists generally consider it dangerous to remove capital controls in the face of strong economic headwinds such as high inflation, sluggish growth, budget deficits and low reserves – all conditions present in Argentina – Barclays has called the currency devaluation “perfectly orchestrated.”

Since the initial drop, the peso has strengthened by about 2% against the dollar, a sign of growing confidence in the new government’s ability to execute necessary structural reforms. While Argentina’s credit rating remains deep in junk territory, all recent moves are broadly credit positive. Bank of America Merrill Lynch even recently upped its recommendation for Argentine bonds to overweight. The ultimate goal is for Argentina to become more attractive for foreign investment, and votes of confidence from hedge fund managers like Bass are a sign of progress on that front.

The currency devaluation represents a risky political move for Macri in a region not known for the stability of its governments. The last peso devaluation, which took place in December 2001, brought the financial system to its knees, caused violent social unrest and forced President Fernando de la Rua to flee the presidential palace by helicopter. Non-Peronist Presidents are afforded even less patience, with none having completed a single term in office for more than 50 years.

In addition to economic reforms, Macri is determined to root out excess and corruption within the public sector. During the Kirchners’ tenure, the government hired nearly 25,000 employees loyal to the Justicialist Party in moves characterized as repayment of political favors. Macri has already laid off around 10,000 state workers and plans to review a $5.7 billion proposed hydroelectric dam to be built with Chinese funding and named for the late Nestor Kirchner. He also declassified documents and pledged to reopen investigations relating to the 2015 death of prosecutor Alberto Nisman, who was mysteriously killed a day before he was scheduled to testify in court about corruption charges against President Cristina Kirchner.

The new regime, in another effort to restore global credibility, is also tackling the corrupt reporting of economic data. As inflation spiraled out of control under Kirchner, she directed officials at Indec, Argentina’s national statistics institute, to alter data to paint the picture of an improving economy. Long-tenured, well-respected employees who refused to doctor data were summarily fired and slapped with large fines. Privately-calculated statistics showed inflation growing at double the government-reported levels. Under Macri, corrupt employees are being removed from Indec, with those previously fired for insubordination reinstalled to their previous positions. Indec plans to launch a new Consumer Price Index (CPI) in September.

While Macri has been cast in a positive light on the global stage, he still does not enjoy overwhelming popularity and a universal mandate at home. He only narrowly prevailed in the Presidential election and still must navigate a Peronist-dominated Congress. Critics have accused Macri of having an authoritarian streak for his frequent use of executive actions, about which he has been unapologetic. His decision to strike down a 2009 law preventing media conglomerates from gaining too much power was met with particular anger, with the opponents accusing him of rewarding the influential publications that covered him favorably during the Presidential campaign.

Understanding the need to build greater consensus, Macri has extended an olive branch to his ideological counterparts. He invited influential opposition leader Sergio Massa to accompany him to last week’s World Economic Forum in Switzerland. While in Davos, Macri, the first Argentine President to attend the conference in 13 years, met with several Fortune 500 CEOs and heads of state, including U.S. Vice President Joe Biden, Israeli Prime Minister Benjamin Netanyahu and Mexican President Enrique Pena Nieto as part of his campaign to improve his country’s relations with the developed world. He has sought to open more constructive dialogue with Great Britain over the disputed Falkland Islands, which has been a point of contention between the two nations since the bloody Falklands War in 1982. He also has sought to thaw relations with neighboring Uruguay, with which Argentina has long been at odds.

On the other side of the coin, Macri has stepped up his condemnation of habitual human rights violator Venezuela. The socialist country’s controversial President, Nicolas Maduro, has frequently jailed political opponents and aligned himself with the Russian-Iranian geopolitical bloc. Recently, though, his party has faced crippling defeats in parliamentary elections. The Venezuelan people will be closely monitoring the fortunes of Argentina, with an economic turnaround potentially accelerating the right-center political movement. Argentina’s resurgence has also coincided with Brazil’s decline, where deep corruption in President Dilma Rousseff’s far-left Workers’ Party has seen the former emerging market darling’s credit rating downgraded into junk territory by S&P and Fitch. Rousseff faces a single-digit approval rating and possible impeachment. Brazil’s rise began in 2002 when pro-business candidate Luiz Inacio Lula da Silva won the presidency on promises of economic reform, although his efforts were aided by a commodities supercycle while Macri faces a difficult macroeconomic environment.

President Macri has gotten off to a fast start, with many hedge fund investors hyping Argentina as the next great investing frontier, but skepticism remains about his ability to sustain an economic turnaround in the midst of weak global growth. Emerging markets face especially uncertain times as commodity prices tumble and the U.S. Federal Reserve tightens monetary policy. Argentina is starting to keep its promises, and investors no longer feel the need to keep their distance. No pressure, Mr. Macri, but the fate of a continent is in your hands.