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Latam Weekly Report July 10, 2013 Argentina, beyond 2015: Capital needs TO CONTACT PUENTE PUEN <GO> +54 11 4329 0000 We believe Argentina’s challenges beyond 2015 will concentrate in three main areas: 1) economic growth 2) external sustainability and capital inflows 3) competitiveness and local costs (tax rates). We analyze each of those challenges, and conclude attracting capital inflows will be a main priority beyond 2015. Growth rates above 3% will require capital inflows to finance investment needs, in particular in the energy sector. But attracting foreign investment could potentially require a more competitive environment, both in terms of real exchange rate and local costs, with changes in taxes for instance. In the external sector, and even when a 1% deficit in the CA seems sustainable for an emerging economy, international reserves will drain unless capital inflows increase. With imports going up, the import coverage ratio, currently around 6 months, could go down to 3 by 2015 and 1.8 by 2018, leaving the country considerably exposed to terms of trade variations, unless capital inflows provide a cushion. We remain cautious on medium-term prospects, but believe the situation can still be handled under a mild inflow of foreign capital. In that scenario, not only default chances would be diminished, but also potential growth could double, leaving the country in a comfortable situation looking forward. Head Strategist Alejo Costa [email protected] Strategy Cristian Antuña [email protected] What lies beyond 2015? Mostly an investment need While we wait for a final ruling on the pari-passu case, we look at the main challenges for Argentina beyond 2015, after a few years of high growth, in a context of two-digit inflation, high direct taxes, and a deteriorating external balance, which are now constraining growth prospects. In our view, it all comes down to higher investment needs, which can only be funded through foreign inflows. Foreign inflows will be needed to boost growth and investment, in particular in the energy sector, and to alleviate the external constraint. In our view, the need for foreign inflows will also condition tax and foreign policy, as a more favorable environment, particularly regarding import and foreign exchange restrictions, will be needed to attract those flows. Growth: from consumption-driven to capital-driven The last ten years have been dominated by a consumption-driven view of growth. Government policy has boosted consumption through expansive monetary and fiscal tools, in a context where the external environment, in particular Brazilian demand and favorable terms of trade, have done the rest. Slack capacity, a competitive currency, and a lower debt burden were also fundamental to boost initial growth during the period. But with inflation at two-digit levels and the external front deteriorating, government policies seem to have faced a wall, where higher investment is needed to maintain momentum. Despite reaching high growth rates, growth during the last decade has been driven mostly by a recovery in the capacity utilization. The reduction of slack capacity has been mostly explained by lower unemployment, one of the pillars of Kirchner’s popularity. A fraction of growth has been driven by higher productivity, suggesting that, while foreign demand and government policy have boosted labor demand, Total Factor Productivity (TFP) contributions have mostly mean-reverted after the 2001 crisis, and capital has remained stagnant as a fraction of GDP (see Figure 1). Please see important disclaimer information on page 11 -2- In our view, keeping momentum in growth will require higher capital accumulation. Employment gains seem to have reached a limit, and the trend in TFP (growing at an average 1.2%) is too weak to sustain growth on its own. Future policy needs to encourage capital accumulation, in particular through foreign investment. Domestic savings are not enough to sustain growth rates above 3%: according to our estimates, unless foreign capital funded investment, current trends in employment, TFP and capital accumulation would lead to a meager 2% potential growth. Figure 1. Decomposing growth: A mean-reversion in TFP that run its course? 20 15 10 5 0 -5 Projected growth (potential) Labor -10 Capital Projected growth (potential) TFP -15 GDP 2020 2019 2017 2018 2016 2015 2013 2014 2012 2011 2010 2009 2008 2007 2005 2006 2004 2003 2001 2002 2000 -20 Source: INDEC, own projections. We believe foreign inflows are needed to boost investment and reduce the external constraint, in particular those arising from energy needs. In our view, the country will need to either tap foreign markets or increase FDI incentives, which are currently subdued under current policies, mostly focused on domestic demand. According to our calculations, growth rates above 4% could be sustained should capital accumulate at a faster pace. We follow Hayashi and Prescott (2002, see appendix), and compute Argentina’s potential GDP under different scenarios of capital accumulation. We also disentangle growth in the last decade among capital, labor and productivity (TFP) changes, and Please see important disclaimer information on page 11 -3- find trends for each component under current policies. We conclude that both labor and TFP trends are too weak to sustain high growth in the next years, leaving capital as the only input that can boost growth. But the current trend is flat: foreign capital inflows will be needed to reach potential growth rates above 4%. The external constraint: in need for capital Following our update of Argentina and Brazil’s growth1, we put our external sector projections up to date, and extend it to 2018. According to our projections, the current account deficit will revolve around 1% of GDP, with energy imports peaking around 2016. With gross international reserves currently sitting at USD37bn, we believe international reserves will slowly drain, falling by additional USD14.4bn by 2015, and USD6.9bn more by 2018, assuming no policy adjustments are introduced. However, a change in policies that attracted capital inflows could modify that scenario, particularly if those inflows are destined to investment in the energy sector, currently absorbing a large fraction of reserves. Table 1. A deteriorating external sector 2013 2014 2015 2016 2017 2018 Current Account Balance (in bn of USD) -4.742 -5.875 -3.920 -5.058 -2.007 -2.319 Current Account Balance (in % of GDP) Exports Agriculture exports Industrial exports Importaciones Energy imports (nets) -1,0% 86.582 35.174 18.145 75.463 6.877 -1,3% 89.097 34.440 20.407 81.756 10.210 -0,9% 97.273 35.490 26.487 88.114 13.492 -1,1% 102.538 37.093 30.161 94.890 17.287 -0,4% 110.418 37.737 36.917 99.730 17.871 -0,5% 117.753 38.492 42.879 107.387 18.913 Change in Reserves -5.636 -5.933 -7.363 -2.761 -1.173 -3.000 * Includes warrant payments in 2014. Public debt payments are only included up to 80%. In our view, post-2015 policy will need to make capital inflows a priority. Even when a 1% deficit in the CA seems sustainable for an emerging economy, and looks relatively low in international comparisons, international reserves will drain unless capital inflows increase. With imports going up, the import coverage ratio (coverage of reserves in months of imports), currently around 6 1 Argentina’s growth for 2013 updated to 3.7% (triggering GDP warrants) and Brazil’s to 2.5%. Please see important disclaimer information on page 11 -4- months, could go down to 3 by 2015 and 1.8 by 2018, leaving the country considerably exposed to terms of trade variations. Local costs and competitiveness The real exchange rate has appreciated in the last few months, and taxes have steadily increased in the last ten years, leaving the country with a less competitive environment. We believe policies beyond 2015 will need to address those issues, either through taxbreaks for certain sectors, a more competitive real exchange rate or a combination. The real exchange rate has appreciated in the last few months, mostly as a result of a weaker BRL. As US rates increased, a weaker BRL has come down to a weaker Brazilian real exchange rate. Argentina’s central bank has responded increasing the depreciation pace of the crawling peg a few notches. But the policy, if sustained in time, could overshadow inflation-control policy through exchange rate pass-through. Figure 2. Bringing up fiscal pressure (share of GDP) 40,0% Provincial Taxes* 35,0% Federal Indirect Taxes 30,0% Federal Direct Taxes 25,0% 20,0% 15,0% 10,0% 5,0% 0,0% 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 *City of Buenos Aires, Provinces of Buenos Aires, Cordoba and Santa Fe Source: Ministerio de Economia Tax rates have rapidly increased to developed-country levels, with fiscal pressure around 35%, up from 24% in 2003. The increment has been focused on direct taxes, with social security and income taxes explaining 9% of the hike. The government has used taxation Please see important disclaimer information on page 11 -5- as a method to re-distribute income, in a highly unequal country. But the measure could backfire, as higher labor costs could reduce work incentives and reduce competitiveness relative to peers, where tax-rates are in general lower. Strategy We remain cautious on medium-term prospects, but believe the situation can still be handled under a mild inflow of foreign capital. In that scenario, not only default chances would be diminished, but also potential growth could double, leaving the country in a comfortable situation looking forward. Considering the high premium in Argentina’s debt, we believe good scenarios are fairly priced, and recommend being market-weight on Argentina’s long-end of the curve, though only after the Pari-Passu case is settled. Current volatility around the case will likely redound in mark-to-market losses, as we remain negative on the outcome of the case. Please see important disclaimer information on page 11 -6- Latam news and views Argentina: vehicle sales and production, mixed data Domestic vehicle sales increased 3.4%mom and 22.1%yoy, a positive print for the overall economy. However, production of domestic vehicles (-20.3%mom; 19.8%yoy) and external vehicle sales (-14.1%mom; 42.6%yoy) underperformed analysts’ estimates. Argentina: Appeals Court issued a purely administrative order On July 9th the Second Circuit Appeals court issued a purely administrative order, rejecting a set of Argentine appeals that had been brought for protective/tactical reasons. Basically, there was a first set of appeals that was later consolidated in a second set, so the court has decided to dismiss the first set of appeals, in a purely administrative decision. Uruguay: inflation accelerated to 8.2% yoy Following a 8.1% yoy (0.3%mom) in April, Uruguay’s prices rose less than expected according to its mom figure (0.4% Vs 0.5%mom), but similar than expected according to its yoy print (8.21%yoy). Inflation during the first half of the year was the highest since 2008. Most economists believe that measures announced by the Central Bank the previous week will not have a significant impact to reduce inflation. Uruguay: unemployment fell unexpectedly The unemployment rate fell to 6.3% in May, from 6.7% in April, significantly lower than expected (6.6%). Unemployment rate in the Montevideo stood at 6.6% and in the rest of the country was 6.0%. Peru: tax revenue grows 2.7% in June Peru's tax revenue rose 2.7 % (YoY) in June due to the improved performance of the primary sector according to the government. The Peruvian government tax revenue totaled PEN 6.530 M soles in June, said the tax collection agency (Sunat). Please see important disclaimer information on page 11 -7- APPENDIX Appendix 1: Methodology We follow Hayashi and Prescott2 who use a neoclassical growth model to deconstruct GDP growth rates between two main factors, capital and labor, and its total productivity. Departing from a simple Cobb-Douglas production function, they derive a formula for the per worker product as: where y is the per worker product, A the total factor productivity, e is the ratio between occupied workforce and total working-age population and x is the capital over GDP ratio. For a more detailed explanation about the data used and its treatment see the Data appendix below. Having series for the observable variables, i.e, capital, product and labor, it is possible to construct a TFP series as a residual from the formula above. We constructed a historical series for the production inputs and, based on those, forecasts for labor, TFP and capital, allowing us to compute potential GDP. We assumed that unemployment would converge in 2020 to a 5% steady state level. So the occupation ratio would rise gradually, and end in .95 at that time. Similarly, we supposed that the capital over product ratio would catch up with the Chilean one in 2020, assuming this last one continues to grow at its present trend. Finally, we took the historical growth rate trend of the TFP and assumed that it would follow this path. We constructed an out of sample series for labor, capital and TFP, and compute the path for GDP shown in our analysis. This was accomplished simply by solving for it in the stylized Cobb-Douglas equation. 2 Hayashi, F. and Prescott, E. “The 1990’s in Japan: A Lost Decade”, Review of Economic Dynamics, 2002. Please see important disclaimer information on page 11 -8- Appendix 2: Data We used INDEC database to find series for: Total capital stock at constant prices GDP at constant prices Also, we used the Labor Ministry’s BEL database to find series for: Total working age population Total employed population Variables used in our model were treated the observable variables with these formulae: “y” is the ratio between real GDP and the total working age population. “e” is the ratio between employed people and total working age population. “x” is the total capital stock to GDP ratio. Table 1: Economic Calendar Date Event 07/10/2013 07-11-2013 07-12-2013 07-12-2013 07-12-2013 07-12-2013 07-12-2013 07-12-2013 07-12-2013 07-12-2013 07-15-2013 07-15-2013 15-19 JUL 07-19-2013 07-19-2013 Trade Balance (INEI) Reference Rate Industrial Production (YoY) Consumer Price Index (MoM) Consumer Price Index (YoY) Wholesale Price Index (MoM) Wholesale Price Index (YoY) Consumer Price Index (MoM) Consumer Price Index (YoY) Mercosur Summit Unemployment Economic Activity Index (YoY NSA) Budget Balance Economic Activity Index (YoY NSA) Economic Activity Index (MoM SA) Please see important disclaimer information on page 11 -9- PE PE UR AR AR AR AR PN PN AR PE PE AR AR AR Country Period Survey Prior Peru Peru Uruguay Argentina Argentina Argentina Argentina Panama Panama Argentina Peru Peru Argentina Argentina Argentina Jun Jun Jun Jun Jun May Jul May Jun Jun Jun Jun Jun Jun Jun 0.50% 8.20% ----4.25% -0.7% ------- 0.32% 8.06% 85.646 79.590 49.594 -$378M 4.25% 12.10% 0.7% 10.3% 1.2% 13.1% 0.4% 3.7% 5.7% Table 2: Argentine Debt Table 2: Statistics for sovereign USD bonds Security Yield Carry Roll Vol Total Ratio Bonar '13 Price 103,00 3,01% 73 79 805 152 0,19 0,48 49,4 Boden '15 88,75 14,65% 343 154 803 497 0,62 2,26 200,6 Bonar '17 79 15,70% 366 144 838 510 0,61 3,37 266,2 Global '17 76,25 18,00% 417 144 1470 561 0,38 3,10 236,4 57 16,30% 379 21 1308 400 0,31 7,50 427,5 32,5 12,60% 297 -202 1122 95 0,08 13,15 427,4 Disc NY Law Par NY Law Duration DV01 (1MM) Table 3: Statistics for provincial USD bonds Security Yield Carry Roll Vol Total Ratio BUEAIR15 BUEAIR17 101,00 86,75 12,15% 15,33% 287 358 32,0 20,0 527 786 319 378 0,61 0,48 Duration DV01 (1MM) 1,80 3,28 181,8 284,5 BUENOS15 BUENOS17 86,00 90,00 20,75% 16,10% 476 375 27,3 24,1 703 758 503 399 0,72 0,53 2,17 1,89 186,6 170,1 BUENOS18 BUENOS21 69,00 70,00 19,90% 20,05% 458 461 -17,5 -20,9 1154 1209 440 440 0,38 0,36 3,98 4,28 274,6 299,6 BUENOS28 65,00 16,70% 388 -27,3 888 361 0,41 6,86 445,9 *Vol refers to autocorrelation-adjusted 2012 volatility, under a GARCH(1,1). Total refers to pure carry plus roll. Ratio refers to the ratio of total carry over volatility. All statistics are computed with a 3m of data. Carry and roll computed for 3m horizon. Table 4: Statistics for corporate USD bonds Sector Maturity Next Payment Frequency (months) Coupon Residual Value Banco Hipotecario 2016 Banks 27-Apr-16 27-Oct-13 6,0 10% Banco Macro 2017 Banks 1-Feb-17 1-Aug-13 6,0 9% Banco Galicia 2018 Banks 4-May-18 4-Nov-13 6,0 Banco Galicia 2019 Banks 1-Jan-19 1-Jan-13 Banco Macro 2036 Banks 18-Dec-36 18-Dec-13 Transener 2016 Electricity 15-Dec-16 Hid. Piedra del Águila 2017 Electricity 11-Jul-17 Edenor 2017 Electricity Edenor 2022 Electricity Petrobras Argentina 2013 Oil and Gas Petrobras Argentina 2017 Oil and Gas Capex 2018 Outstanding Parity 1,0 102 88% 15,7% 2,3 B- - 104 95% 2,11 3,87 88,0 1,0 95,1 10,4% 2,9 - B3 105,6 9% 1,0 102 85% 1,73 86,0 13,1% 3,6 B- B3 300,0 6,0 6,0% 1,0 107 93% 2,35 100,1 17,0% 4,0 - Caa1 229,3 6,0 10% 1,0 101 72% 0,72 72,0 12,1% 7,9 - Caa3 149,1 15-Dec-13 6,0 8,9% 1,0 101 48% 0,74 47,6 79,5% 0,9 CCC - 53,1 11-Jan-14 6,0 9% 1,0 100 84% 0,10 83,8 18,4% 2,0 B- - 98,8 9-Oct-17 9-Oct-13 6,0 11% 1,0 103 47% 2,80 48,0 37,8% 2,9 CCC- Caa1 /*- 24,8 25-Oct-22 25-Oct-13 6,0 9,8% 1,0 102 50% 2,17 50,7 23,9% 4,5 - Caa1 /*- 300,0 30-Oct-13 30-Oct-13 6,0 9% 1,0 102 100% 1,95 100,1 9,1% 0,3 B B1 200,0 15-May-17 15-Nov-13 6,0 6% 1,0 101 103% 0,98 104,0 4,8% 3,4 BBB A3 300,0 Oil and Gas 10-Mar-18 10-Sep-13 6,0 10,0% 1,0 103 68% 3,47 70,0 21,2% 3,1 B- - 200,0 Pan American Energy 2021 Oil and Gas 7-May-21 7-Nov-13 6,0 8% 1,0 101 97% 1,49 97,0 8,6% 5,1 - B1 500,0 YPF 2028 Oil and Gas 2-Nov-28 2-Nov-13 6,0 10% 1,0 102 101% 2,03 103,5 9,8% 7,7 - - 100,0 TGS 2017 Oil and Gas 14-May-17 14-Nov-13 6,0 7,9% 1,0 101 89% 1,33 90,2 13,4% 1,9 B- B3 374,0 Arcor 2017 Food and Beverage 9-Nov-17 9-Nov-13 6,0 7% 1,0 101 107% 1,33 107,0 5,5% 3,7 - B1 200,0 Arcos Dorados 2019 Food and Beverage 1-Oct-19 1-Oct-13 6,0 7,5% 1,0 102 104% 2,17 106,8 6,3% 5,0 - Ba2 308,6 IRSA 2017 Real Estate 2-Feb-17 2-Aug-13 6,0 8,5% 1,0 104 88% 3,85 91,5 11,8% 2,8 B- - 150,0 Alto Palermo 2017 Shoppings 11-May-17 11-Nov-13 6,0 7,9% 1,0 101 88% 1,40 89,7 11,6% 3,1 B- - 115,0 Paper 9-Jun-17 9-Dec-13 6,0 6% 1,0 101 108% 0,64 109,1 3,9% 3,4 BBB- Baa3 270,0 200,0 Alto Paraná 2017 Accrued Interest Credit Rating Mod. Duration S&P Moody's Technical Value Company Price YTM ( in millio n o f USD) 224,6 Tarjeta Naranja 2017 Financials 28-Jan-17 28-Jul-13 6,0 9,0% 1,0 104 89% 4,18 93,0 12,7% 2,1 - - Raghsa 2017 Real Estate 16-Feb-17 16-Aug-13 6,0 9% 1,0 104 86% 3,52 89,0 13,3% 2,6 - B3 100,0 Airport 1-Dec-20 1-Sep-13 3,0 10,8% 0,9 91 94% 1,18 95,5 12,7% 3,2 B- B3 300,0 Aeropuertos Arg 2000 2020 Autopistas del Sol 2020 Highways 1-Jun-20 1-Dec-13 6,0 6% 1,0 101 70% 0,73 71,0 16,0% 4,1 - - 155,7 IRSA 2020 Real Estate 20-Jul-20 20-Jul-13 6,0 11,5% 1,0 106 94% 5,59 99,4 12,0% 4,4 B- - 150,0 IMPSA 2020 Industrial 30-Sep-20 30-Sep-13 6,0 10% 1,0 103 74% 3,03 76,0 16,7% 4,9 B - 390,0 Please see important disclaimer information on page 11 - 10 - Important disclaimer This document is for distribution only as may be permitted by law. 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