News & analysis

Riots and civil unrest predominantly due to the austerity measures has been a key driver for LATAM markets over the past few weeks as government’s attempt to restructure their fiscal liabilities.

Governmental policies aimed at shoring up fiscal accounts to promote foreign investment and regain favour in the eyes of global institutions such as the IMF has come at the cost of significant erosion of political capital.

While Argentina has grabbed the global media’s attention due to the resumption of capital controls, the unilateral extension of short-dated liabilities, and the return of former President Cristina Kirchner to office as Vice President, political risk is not isolated to Argentina and shows no signs of subsiding any time soon.

The electorate’s distaste towards austerity measures was most notable when Argentina took to the polls with the electorate handing the populist candidate Alberto Fernandez, and his expansionary manifesto, the keys to the palatial mansion. However, without elections to voice their concerns, austerity measures have prompted widespread political unrest in Chile and Ecuador recently, with both countries officially declaring a state of emergency.

Chilean Finance Minister Felipe Larrain summarised the current problem hamstringing many LATAM economies right now when speaking to journalists in Washington when he stated, “reforming the economy is tough – you can win the argument and lose the elections”. Economic reforms are key, however.

The IMF revised its growth projection for LATAM to 0.2% from the 0.6% level where growth for the region averaged for the last five years. The deteriorating economic outlook has been shared by domestic central banks and in some instances by financial markets too. However, despite the region being broadly tarnished with slowing growth, civil unrest and roadblocks to fiscal reforms, there remain some standout economies.

Brazilian real

Brazil is exactly that – one of the standout economies in the LATAM space

While the Brazilian economy is slowing and the BCB is forced to cut rates further, despite the Selic rate currently at a record low of 5%, progress has been made on addressing the structural budget deficit without civil opposition following the approval of the pension reform bill.

Markets have reacted to the news favourably too. Credit default swap pricing, which insures investors against default on government debt, has fallen to levels not seen since 2013, back when Brazilian government debt held investment grade.

Last week President Bolsonaro unveiled a further bundle of reforms aimed at reducing the size of the budget deficit, following from the approval of the pension reform bill in September. The proposals are wide-ranging and include another push by Bolsonaro to privatise parts of Brazil’s largest state-run electricity provider Electrobras.

The plans also included constitutional amendments aimed at alleviating Brazil’s public sector liabilities, such as decentralising budget resources, easing non-discretionary spending rules, and cutting public sector salaries and job security.

Public sector pensions and payrolls currently account for a large proportion of Brazil’s non-discretionary liabilities, which in itself makes up 95% of tax revenue spending annually. With debt-to-GDP levels ballooning from financing the structural budget deficit, investors welcomed the announcement. Brazil’s current debt-to-GDP level sits at 79.8%.

In markets, the real rallied below the 4.00 level, which we have argued is the lower bound for the USDBRL exchange rate in Q4, bond yields plummeted and the largest Brazilian equity ETF hit a 3-month high.

Market optimism has moderated since the announcement on Monday, predominantly due to the poor investor uptake in the world’s priciest oil auction held on Wednesday for Brazil’s Buzios field.

While President Bolsonaro and Economy Minister Guides sounded optimistic when announcing the new proposed reforms, suggesting they may be passed before year-end, political commentators suggest this may not be as easy as it sounds.

That being said, the political challenges needed to be navigated are far easier than neighbouring countries, with opposition to fiscal restructuring limited to the legislature. The release of former President Lula from jail adds an extra layer of potential resistance to the proposed reforms as he is considered able enough to untie the disjointed leftist parties.

 

Chart: Brazil’s CDS pricing retraces to 2013 lows as reforms seek to adjust ballooning debt-to-GDP levels

Argentine peso

On the other end of the spectrum sits Argentina

The sound electoral win by Alberto Fernández in Argentina has given voice to the popular demand for the end of stringent austerity in the country. Under the IMF bailout conditions negotiated by the Macri administration, a fiscally neutral budget was the target for 2019. Macri aimed to achieve this by means of a sharp increase in public service fees, the reduction of state employment and taxes on exports. Alongside the austerity measures, Argentina has also fallen into short-term default and inflation has doubled to above 50%.

Compounded by a sharp devaluation in the currency and a collapse in economic activity, with one in three Argentinians now living in poverty, conditions were prime for an expansionary fiscal stance to win the election.

The reaction in the Argentine peso has been muted despite the shift in the balance of power towards a fiscally expansionary government.

There are two reasons for this; the market has already priced in the negative consequences of a Fernandez administration after the primaries and the BCRAs strict capital controls minimised FX volatility. Following the primaries, where the Argentine peso depreciated by a third, the BCRA imposed capital controls to reduce volatility in markets, allowing only $10,000 dollars to be exchanged monthly.

This is key not only for market speculators but also for domestic savers, who hold US dollars as a natural hedge against high levels of inflation in Argentina. However, after the election the BCRA tightened its grip, allowing savers access to only $200 via bank account transactions and $100 in cash until December.

The newly elected president hinted that the capital controls would remain in place beyond December in order to avoid a wider pass-through effect on inflation from currency devaluation, while preventing reserves from draining further. With 80% of domestic liabilities denominated in USD, any further peso sell-off would sink the economy into a larger pile of debt.

The restoration of capital controls, however, poses significant challenges to the Argentine economy…

By virtually closing official capital markets for a longer period, supply-chain disruptions could erode investor confidence, thus increasing the already tight external financing conditions for the economy.

The artificially overvalued real exchange rate will impact the competitiveness of domestic exports, which are already subject to taxes, limiting prospects for a growth rebound further. Moreover, the increasing spread between the official exchange rate and the currency value in the parallel “blue” markets will increase inflation expectations, rendering the implementation of capital controls ineffective in the long-run by undermining the government’s ability to control price dynamics.

During the recent tightening of capital flows, the gap between official and informal markets has widened up to 20%. While the spread may seem large in nominal terms, it is muted when compared to the period under Cristina Fernandez’s government. During the time of Peronist control, where tight capital controls were implemented, the spread widened to around 80%.

A larger gap between both markets perpetuates Argentina’s inability to lift capital controls in the near future, imposing further constraints to GDP growth.

The prospects of longer capital controls combined with potential monetary and fiscal stimulus by the incoming populist administration adds further concerns on the terms of the debt restructuring. Markets and the IMF will be on the edge of their seats in the following weeks to assess whether the new economic program and the cabinet to be appointed are convincing enough to invest in Argentina. For now, the country is still deemed as a defaulting creditor by investors, as suggested by CDS markets.

Mexican Peso

Mexico’s secular violence already priced in

Current political unrest in Mexico, like in Bolivia, doesn’t focus on austerity measures, however. A new round of violent events have taken place in Mexico in a crossfire between government forces and drug cartels.

In an attempt to capture the son of “El Chapo” Guzman, the world’s most notorious drug dealer, AMLO’s government was overpowered by the criminal organisation. The president then aborted the operation in order to prevent further violence.

The release of Guzman Lopez sends a message of weakness within the Mexican government in the face of terrorist-like attacks by narco groups. This incident marks the biggest security challenge to Mexico. Markets have yet to react significantly to the developments, however.

President López Obrador promised to solve a decade-long war against drug gangs in the country, for which he has deployed thousands of security units along with increased spending in education and financial support for younger generations. Although AMLO’s approval rate in polls has kept above 60% thus far in his short tenure, homicides in the country are on pace to break last year’s record.

The Mexican Peso has barely reacted to the heightened domestic security threat with the spread between long and short-dated bond yields mostly trading in positive territory.

The reason for this apparent calm among investors is simple: violence in Mexico is largely priced in. This is also the view of the Standard & Poor’s rating agency, which considered that the recent violent events will not affect the sovereign grade as the insecure environment in the country is already accounted for in the risk indicators.

The agency categorises Mexico’s sovereign debt two notches above investment grade at BBB+ with a negative outlook. The low domestic growth prospects along with the heavy burden of the state oil company Pemex in the public finances are the main concerns in the Mexican overview.

GDP growth in 2019 is forecast in the 0.2%-0.7% range, down from the 2.85% average annual growth rate in the last 5 years.

Fiscal stimulus is blunted by the negative outlook attributed to Mexican sovereign debt, with next year’s budget showing little room for menouvre. Trade stimulus is also clouded by the US-China trade war, suggesting monetary policy loosening will be the best tool for growth stimulus in the short-run. With inflation readings matching Banxico’s target for five months in a row and Fed cuts providing ample degrees of freedom, monetary policy accommodation is set to remain in play in Mexico.

Banxico has already eased interest rates by 50 basis points in the last two meetings and is expected to ease further this week.

Markets are pricing another 180 basis points of cuts in the next 12 months. Despite eroding the carry trade attractiveness of the peso, the rate cuts have boosted the currency as they relieve domestic growth con. For the next Banxico meeting on Thursday 14th, a 25 basis point cut should be a guarantee. However, two concerns might prevent Banxico from delivering on its dovish forward guidance. Namely, upside inflation pressures from the non-core component and the potential downgrade of Pemex or the sovereign rate could compromise further monetary efforts to stimulate economic growth.

Chilean peso

The Chilean peso joins the Argentine peso at the bottom of the EM currency rankings for the last three weeks, with both currencies highlighting investor’s distaste for domestic political instability. While Argentina’s problems revolved around credit default due to the high levels of debt and stagnating economic growth, Chile’s is a little more unique.

Chile is one of the richest LATAM countries as measured by GDP per capita, but slowing economic growth coupled with social unrest following fuel price increases has sent the Chilean peso to lows not seen since 2002.

The fact that the slowdown in economic activity and the fall in inflation pressures occurred prior to the protests only increased investor’s concerns and exacerbated the peso’s decline.

The Chilean peso paints a very clear assessment of domestic economic and social conditions at present, but the visual is made even more dramatic when compared to the rally in copper prices – Chile’s main export. Last Tuesday, the peso hit a 16-year low despite copper hitting a 3-month high.

The disconnect is telling and highlights the impact domestic unrest is having on investor sentiment. The protests have already cost Chile between $2bn and $3bn according to Finance Minister Ignacio Briones, with the cost of damage only expected to increase with the period of civil unrest showing no signs of abating in the short-term. Unrest in Chile hit the front-pages after this week’s APEC meeting was cancelled. The summit had increased market attention as Presidents Trump and Xi were expected to sign the narrow trade deal on the side-lines.

The peso is currently trading at a 16-year low and today’s release of October’s monetary policy minutes will likely confirm the central bank’s easing bias is set to remain. The October 23rd decision to cut rates by 25 basis points to 1.75% was in line with the Bloomberg median estimate.

The central bank highlighted the first few days of civil unrest in its monetary policy statement and today’s release of the minutes may give markets more guidance on the MPC’s initial assessment of the events and the impact they believe it will have on the trajectory of the economy. The length of the unrest and the economic impact, as projected by Finance Minister Briones, is likely to be deemed deflationary in the medium term.

While October’s minutes will only highlight the early stages of the protests, it will prove a good guide for future monetary policy.

Current forward contract pricing suggests market participants are predicting 50 basis points of cuts in the next 6-months to counteract the economic impact of the protests, despite the recent uptick in core inflation.

 

Chart: The Chilean peso hits a 16-year low despite copper prices rallying, highlighting investor’s distaste for the currency embroiled with political unrest

 

 

Authors:
Simon Harvey, FX Market Analyst at Monex Europe
Olivia Alvarez-Mendez, FX Market Analyst at Monex Europe in Spain

 

 

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