Strong economic recovery in Argentina

Argentina’s economy is booming. However, questions remain about the sustainability of the economic recovery in Argentina, which has benefited substantially in recent years from a strong commodity cycle and favourable international economic conditions. In spite of this, Argentina offers opportunistic plays to those who are willing to take high risks for potentially high rewards.

Last year was the third consecutive year of strong economic growth in Argentina, with GDP expanding by a staggering 9.3%. This is welcome news for the country, which suffered a financial crisis in late 2001 that forced it to make the largest sovereign debt default in history. And so far in 2006, the economy continues to show strong growth.

But that could be short-lived. According to a July 2006 release by the London-based Economist Intelligence Unit, Argentina’s annual rate of GDP growth is expected to fall in 2006 and 2007 to 7.5% and 4.5%, respectively, and to taper off to around 3% a year thereafter.

“Argentina is coming off a low base” following its economic collapse, which was preceded by three years of recession, says Patricia Perez-Coutts, vice president of Toronto-based AGF Funds Inc.and portfolio manager of AGF Emerging Markets Fund. She argues that the real strength of Argentina’s economy cannot be judged on recent short-term growth; average growth over a longer period is not as healthy.

To put this into perspective, the Argentine economy grew by an average of 5.8% a year between 1991 and 1998. However, it declined by an annual average of almost 5% in the five years that followed.

Argentina’s recovery from “very depressed levels” is largely because “it was able to take advantage of favourable international economic conditions, mainly high commodity prices, by putting the correct economic policies in place and preserving a fiscal surplus,” says Mark Mobius, portfolio manager of Templeton Emerging Markets Fund at Franklin Templeton Investments Inc. in Hong Kong. “Most of the recovery was driven at the beginning by the export sector and later by domestic absorption.”

Incidentally, Argentina is one of the world’s leading producers and exporters of agricultural products such as sunflower and soybean oil, corn, soybeans and honey. In 2005, processed agricultural products accounted for a third of its total exports, which rose in value by 16% in 2005, resulting in a trade surplus.

In addition, a February 2006 EIU report states, Argentina’s industrial sector has retained strength because of high prices for processed foods, aluminum, plastics and other products, which have stimulated exports. The report adds: “At the same time, there has been strong pent-up internal demand for durable goods following four years of recession.”

As a result, production has recovered to its previous peak in the second quarter of 1998, before the economic downturn of 1999-2002.

Another factor allowing the country to recover so quickly was the strong investment that took place during most of the 1990s, says Mobius. However, he is “particularly concerned” about the current low level of investment in infrastructure and energy.

Argentina’s fiscal situation has improved mainly because of massive restructuring, writedown of the country’s foreign debt and strong growth of receipts from export taxes, states the EIU report. In restructuring some US$100 billion in sovereign debt, domestic pension funds and foreign creditors were required to take “haircuts” of 30% and 66%, respectively, on their outstanding loans and accept extended maturities of between 30 and 40 years, souring relationships between foreign investors and Argentina.

However, thanks to Argentina’s economic recovery, it was able to repay the International Monetary Fund US$9.5 billion in January, allowing the country’s total foreign debt burden to drop to 61.7% of GDP in 2006 from 77.7% in 2005. Nonetheless, the EIU cautions, this ratio is still high compared with most emerging-markets borrowers.

The decline in Argentina’s debt burden has led Standard & Poor’s Corp. ’s rating service to raise its long-term sovereign credit rating to B from B-minus and its short-term sovereign credit rating to B from C.

In its March 2006 research update, S&P says external debt bur-den “is expected to decline by 100% of projected current account earnings, almost one-third its level in 2004.”

S&P, however, cautions that the country is constrained by several problems, including weak public institutions; poor relationships with privatized utilities; acrimonious relations with creditors; rising inflation; weak monetary flexibility; and strained ties with the IMF.

But experts question whether it will be sustainable over the long term

More important, it says: “Despite the impact of debt rescheduling, a public-sector debt burden at around 60% of GDP in 2006 is similar to the level prior to the country’s sovereign debt default in 2001.”

Mobius contends it is unlikely Argentina will face a sovereign debt problem over the short term, but warns: “History is against Argentina, and the surplus evidenced in the past two to three years is a novelty. The fiscal surplus is supported by sources of income that are not viable over the long term, such as taxes on exports and on financial transactions. On the expenditure side, devaluation has depressed the wages of workers, who have not been able to recover their purchasing power.”

He adds that the government has not restructured the public sector for the long term and, if union pressures for wage increases are effective, the problem of fiscal deficits could re-emerge.

Perez-Coutts believes the political will is not there yet. “The government has moved to a ‘socialistic’ environment, which for now is muddled in uncertainty and contradiction,” she says. “Argentina could be at the top of the high risk/high return area.”

In the one- and three-year periods ended July 31, the MSCI Argentina index was up 47.5% and 54.4%, respectively, in U.S.-dollar terms, indicating the Argentine market is mirroring the buoyancy of the country’s overall economy. The market performance, says Mobius, “is a combination of recovery from crisis levels and positive performance of some names.”

Perez-Coutts believes that the Argentine market is small and inefficient, but offers “opportunistic plays.” She says selected opportunities exist in the banking and industrial sectors.

Mobius says the banking sector has cleared the road to grow its intermediation business in a profitable manner and has also restructured to resume lending activities.

Companies such as Grupo Fi-nanciero Galicia SA (which engages in banking and financial investment activities) and Tenaris SA (a manufacturer of seamless steel pipes for the oil and gas industry) are two investment opportunities.

Although both Mobius and Perez-Coutts prefer to invest directly in the domestic market, which is more liquid, the average retail investor would find it more convenient to invest in Argentine American depository receipts trading on U.S. stock exchanges. The Bank of New York ADR index lists 23 Argentine ADRs; over the one-year period ended Aug. 8, it has risen 43.5%, vs the S&P 500 composite, which has gained only 4%.

In addition to Grupo Financiero Galicia and Tenaris, Petrobras Energia Participacoes SA (a holding company engaged in oil and gas exploration, production and refining) and Telefonica De Argentina SA (a holding company that provides telephone and Internet services) trade as ADRs in the U.S.

The Argentine government believes robust growth is sustainable as long as it can avoid the problems of the past. However, says Mobius, “The strong growth rates of the past three years are not repeatable if investment as a share of GDP does not rise.”

He adds that a significant increase in interest rates and lower commodity prices could impact negatively on Argentina.

Perez-Coutts adds rising inflation, political risk and unfavourable government policies to the list of underlying problems.

The EIU sees capacity constraints, which are beginning to have an impact on Argentina’s economy, and the erosion of purchasing power (because of rising inflation) as barriers to continuing growth.

Dwarka Lakhan

Dwarka Lakhan is a pioneer in emerging markets journalism in Canada. His first emerging markets article, “Africa Joins Ranks of the Emerging,” appeared in Investment Executive, Canada’s leading newspaper for financial advisors, in September 1994. Since then he has written hundreds of articles on the full spectrum of emerging markets and has conducted more than two thousand interviews with emerging and frontier markets investment professionals.

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