DBRS, Inc. (DBRS Morningstar) confirmed the Republic of Argentina’s Long-Term Foreign Currency – Issuer Rating at CCC and Long-Term Local Currency – Issuer Rating at CCC (high). At the same time, DBRS Morningstar confirmed the Republic of Argentina’s Short-Term Foreign and Local Currency – Issuer Ratings at R-5. The trend on all ratings is Stable.
KEY RATING CONSIDERATIONS
The confirmation of the ratings at CCC/CCC (high) reflects DBRS Morningstar’s view that Argentina faces deep-seated economic and policy-related challenges. While Argentina reached an agreement with the IMF in March 2022 for a $44 billion Extended Fund Facility that included an economic stabilization program, spillover effects from the war in Ukraine and domestic political uncertainties have aggravated the country’s macroeconomic imbalances. Rising global commodity prices have added to inflationary pressures and complicated deficit-reduction and reserve accumulation efforts. Moreover, open divisions within President Fernandez’s administration over the direction of economic policy raise implementation risks. The rift between factions of the governing coalition could deepen as elections approach in October 2023.
Argentina has recovered from the shock of the pandemic, but the economy’s acute imbalances have not been addressed. Output in the first quarter of 2022 was 4.4% above the fourth quarter of 2019. This is a relatively strong performance compared to other large economies in the region. However, fiscal consolidation plans are in jeopardy due to a sharp increase in spending in the first half of the year. Inflation is now running above 60% year-over-year, and the pace will likely accelerate due to greater monetary financing, faster currency depreciation, and growing wage pressures. Furthermore, reserves remain at very low levels, despite capital controls, and the unofficial peso-dollar exchange rate is about 100% above the official rate, which highlights the market’s increasing concern with the credibility of the currency. In our view, Argentina’s challenges, if unaddressed, pose material risks to macroeconomic stability and the government’s capacity to repay its debt to private creditors.
While policy risks are rising, we expect Argentina will continue to implement the basic pillars of the IMF program in the near term, even as several key targets will likely be missed in 2022. Due to deteriorating external conditions, rising inflation, and slightly tighter macroeconomic policies, we expect the economy to slow markedly through the rest of the year. The IMF projects GDP growth of 4.0% in 2022 and 3.0% in 2023. The statistical carryover from the first quarter is 4.1%, so the forecast implies no growth over the next three quarters. In addition, Argentina’s weak fundamentals make it highly vulnerable to downside risks, including weaker-than-expected global demand or material policy deviations from the program.
DBRS Morningstar rates the Long-Term Foreign Currency – Issuer Rating one notch lower than the Long-Term Local Currency – Issuer Rating to reflect additional risks that stem from Argentina’s limited access to foreign exchange and the high share of government debt denominated in foreign currency.
The ratings could be upgraded if the government implements a credible macroeconomic program that durably lowers inflation and puts fiscal accounts on a sustainable path. Reforms that increase investment and productivity growth would also be credit positive.
The ratings could be downgraded if the IMF program is suspended, or if government debt dynamics deteriorate such that the odds of a restructuring of bonds held by the private sector materially increase.
Spending Growth In Early 2022 Risks Derailing Fiscal Consolidation, And Concerns Mount About The Political Commitment To Adjust
Arguably the most pressing policy issue facing Argentina is the fiscal deficit. The government pledged to narrow the primary deficit from 3.0% of GDP in 2021 to 2.5% in 2022, but fiscal results year-to-date and uncertainty around the government’s commitment to the adjustment suggest that even this modest tightening is at risk. In the first five months of the year, real primary expenditure increased 15% y/y, while revenues (excluding property income) grew by 2% y/y. The sharp increase in expenditure partly reflects rising energy subsidies, as energy costs have increased much more than tariffs, but spending growth was elevated across expenditure categories. The government reaffirmed its commitment to the 2022 primary deficit target of 2.5% during the IMF’s First Review. However, achieving the target will require substantially tighter policy in the second half of the year. In our view, it is not clear that the government is willing to implement such a restrictive fiscal stance, especially in light of the recent cabinet changes within the Fernández administration.
The IMF program calls for the fiscal consolidation to continue through 2024, when the program ends. The primary deficit target is 1.9% in 2023 and 0.9% in 2024. In our view, implementation risks are high, as reducing the deficit will require reforming politically sensitive spending items such as energy subsidies at a time when poverty levels are elevated and general elections are approaching in October 2023. Moreover, additional consolidation will need to continue in the post-program period to put public finances in a sustainable position. The challenging fiscal outlook combined with historical weaknesses in fiscal policy formulation weigh negatively on the Building Block Assessment for “Fiscal Management & Policy”.
Fiscal Slippage And Shallow Local Bond Markets Will Likely Lead To Greater Monetary Financing
The reluctance of the domestic bond market to rollover government debt jeopardizes the government’s plan to reduce its reliance on central bank financing. According to the IMF program, the government aims to increasingly meet its financing needs in the domestic peso-denominated bond market while capping monetary financing at 1.0% of GDP in 2022 (and fully eliminating monetary financing by 2024). The shift to market financing would be supported by a lower primary deficit, a shift to positive real rates, and improvements in market infrastructure. In the first quarter of the year, the government was able to issue peso-denominated debt, as planned, with high rollover rates. However, market conditions deteriorated in the second quarter, with short-term bond yields surging in June despite central bank intervention. Fragile domestic market conditions could lead the government to increase its reliance on central bank financing, thereby surpassing the ceiling set in the IMF program and adding to inflationary and exchange rate pressures.
On the external front, Argentina has reduced its external debt servicing needs through 2024 but policy implementation slippage could lead to tensions with the IMF. In September 2020, Argentina reached an agreement with private creditors to restructure $82 billion in debt, which provided substantial FX liquidity relief through 2024. Argentina also reached an agreement on an Extended Fund Facility with the IMF in March 2022 to refinance repayments to the IMF that were largely coming due in 2022 and 2023. Despite these developments, Argentina has failed to regain market access, and disbursements from the IMF and other official creditors could be in jeopardy if policy implementation materially deviates from the IMF program.
In our view, risks to debt sustainability are elevated. The IMF program’s baseline scenario projects government debt-to-GDP, which was 80% at the end of 2021, to gradually decline over the medium term. However, deteriorating global conditions and policy implementation concerns, combined with the high share of debt denominated in foreign currency (70%), pose significant risks to debt dynamics. The considerable risks to debt sustainability combined with Argentina’s weak liquidity position lead DBRS Morningstar to make a negative adjustment in the Building Block Assessment for “Debt & Liquidity”.
The Inflation Outlook Has Materially Deteriorated Due To Global Shocks And Domestic Political Uncertainties
Headline inflation increased to 61% y/y in May 2022. Higher global food and energy prices, largely due to the war in Ukraine, have contributed to rising inflation since February, but upward price pressures are broad-based, reflecting strong aggregate demand and a recent acceleration in the pace of currency depreciation. The IMF’s First Review under the EFF projected that year-end inflation would be 14 percentage points higher than previously assessed (52-62% from 38-48%). In DBRS Morningstar’s view, risks to the revised inflation outlook are still clearly skewed to the upside. Greater monetary financing, further adjustments to utility rates, faster currency depreciation in order to maintain competitiveness, and growing wage pressures will likely lead to an acceleration in inflation in the second half of the year. Uncertainties around the direction of macroeconomic policy could also increase inflation expectations and contribute to inertial forces. Inflation expectations remain unanchored. According to the June Survey of Market Expectations by the central bank, the median forecast for CPI inflation in December 2022 is 76%. The upside risks to the inflation outlook lead DBRS Morningstar to make a negative adjustment to the Building Block Assessment for “Monetary Policy and Financial Stability”.
The central bank has started to tighten monetary policy in order to strengthen demand for peso assets and dampen inflationary pressures. In the first six months of the year, the central bank raised the effective annual policy rate from 45% to 67% (on the 28-day LELIQs). That puts the nominal monthly policy rate at 4.3%, which is still below the monthly rate of inflation for every month since February. We expect the central bank to tighten monetary policy further so as to deliver a positive real policy rate. In addition, the interest rate floor on deposits and ceiling on credit have been raised to facilitate the transmission of monetary policy. We view these actions positively. However, other short-term measures to combat inflation, such as price controls and import restrictions, will likely end up exacerbating underlying economic imbalances, leading to a further deterioration in the investment climate and an acceleration of inflation down the road.
Argentina’s financial system remains small in size. State-owned Banco Nacion remains a dominant player in the banking sector. While profitability has suffered amid the pandemic, the banking system has high levels of liquidity and is well-capitalized. Exposure to the public sector has increased over the last year, but net FX exposure is modest.
Low Reserves And A Sizable Exchange Rate Gap Signal Currency Vulnerability
Argentina has recently undergone a significant adjustment in its external accounts. The current account shifted from a deficit of 5.0% of GDP in 2018 to a surplus of 1.4% in 2021. The adjustment was led by import compression in 2019 and 2020, as the pre-pandemic recession and Covid-19 shock led to a massive cutback in imports. Imports rapidly recovered in 2021 but were outpaced by strong export growth, which benefited from higher volumes and favorable terms of trade. Lower primary income payments, as a result of the debt restructuring agreements, also contributed to the adjustment in 2020 and 2021. The current account is projected to remain in a modest surplus position in 2022, but the outlook is somewhat uncertain due to spillovers from the war in Ukraine. Higher global grain prices are boosting Argentina’s export receipts, but the positive effect on the trade balance is being offset by higher natural gas and fertilizer prices, as well as strong underlying demand, which is driving capital and consumer import volumes higher.
Despite running a current account surplus and incrementally tightening capital controls, Argentina has not been able to rebuild external buffers. Capital outflows have continued because of private sector debt repayments and Argentine savers’ preference for hard currency assets. The latter has led Argentina to build a considerable stock of external assets. From Q3 2019, when capital controls where imposed, to Q1 2022, currency and deposits held abroad by Argentine residents increased by $25 billion, thereby lifting the stock to $244 billion (47% of GDP). On the other side of the ledger, Argentina has been unable to attract meaningful inflows. As a result, Argentina has maintained a sizable net international asset position (NIIP), amounting to $119 billion in Q1 2021 (23% of GDP).
Low reserves and a widening exchange rate gap could put pressure on the currency. Gross reserves amounted to $43 billion at the end of June, but liquid net reserves (calculated as gross reserves minus dollar deposits from financial institutions, central bank currency swaps and credit lines, and gold) amounted to about $5 billion (supported by a $4 billion disbursement from the IMF in June). Concerned about reserve levels, the central bank added new restrictions on importers’ access to foreign exchange in late June, which may support reserve accumulation but will likely damage growth prospects and contribute to inflationary pressures. Moreover, the spread between the official ARS/USD rate and the unofficial rate increased from 65% in early June to 100% in mid-July, highlighting the market’s increasing concern with the credibility of the currency. Overall, we continue to see considerable external risks that, despite Argentina’s current account surplus and positive NIIP, warrant a sizable negative adjustment to the Balance of Payments building block.
Argentina Has Rapidly Recovered From The Pandemic But Medium-Term Growth Prospects Are Weak
The economy has recovered rapidly from the shock of the pandemic. Output in the first quarter of 2022 was 4.4% above the fourth quarter of 2019. However, the Argentine economy was already suffering from a two-year recession prior to the pandemic, and GDP is still 2.9% below the fourth quarter of 2017 when GDP peaked. Notwithstanding the strong recovery in 2021 and early 2022, we expect the economy to slow markedly through the rest of the year due to deteriorating external conditions, rising inflation, and tighter macroeconomic policies. The IMF projects GDP growth of 4.0% in 2022 and 3.0% in 2023. The statistical carryover from the first quarter is 4.1%, so the forecast implies no growth over the next three quarters.
Poor macroeconomic management, an unpredictable and onerous regulatory environment, and limited global integration have contributed to Argentina’s poor growth performance. In the eight years prior to the pandemic, GDP growth contracted on average by 0.4% per year. During this time, investment averaged 16.9% of GDP, one of the lowest rates among emerging markets, and the number of private sector jobs created was close to zero. The IMF program primarily aims to address macroeconomic imbalances, and leaves most of the necessary structural adjustments to the next government. Absent a plan that restores policy credibility and enacts structural reforms, we expect medium-term growth prospects to remain weak, with Argentine policymakers having limited room to stimulate growth without exacerbating macroeconomic imbalances.
Deteriorating Macroeconomic Conditions And Domestic Political Considerations Increase IMF Program Implementation Risks
Congress approved the IMF program with large majorities in both houses, including near-unanimous support from the opposition coalition. However, more than one-third of the governing coalition, led by Vice President Cristina Fernández de Kirchner, voted against the program or abstained. In our view, implementation risks are high. The government’s popularity is at its lowest level since 2010, and public support for the IMF could erode amid accelerating inflation and weakening growth prospects. With elections approaching in October 2023, intra-government divisions generate uncertainty over the government’s willingness to fulfill its commitments under the program.
DBRS Morningstar also views the broader issue of institutional quality in Argentina as a credit challenge. In many respects, Argentina’s democracy is quite strong: competitive and fair elections are regularly held, basic civil and political freedoms are protected, and an active civil society is engaged in the democratic process. According to the Worldwide Governance Indicators, Argentina scores relatively well compared to regional peers in terms of Voice & Accountability. However, a key governance challenge is the Rule of Law. Public confidence in the integrity of the judiciary and other branches of government is generally low. In addition, we view policy predictability as weak, with frequent and significant changes to policy settings and frameworks over the electoral cycle. The heightened policy-related risks weigh on the Building Block Assessment “Political Environment”.
ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS
Social (S) Factors
The Human Capital and Human Rights factor affects the ratings. Similar to other emerging market economies and many of its regional peers, Argentina’s per capita GDP is relatively low, at US$10.7k (US$23.6k on a PPP basis). This reflects the low level of labor productivity. This factor has been taken into account in the Economic Structure and Performance building block. In addition, labor and social conflicts have at times been a source of economic volatility in Argentina.
Governance (G) Factors
Two governance factors affect the ratings: (1) Bribery, Corruption and Political Risks, and (2) Institutional Strength, Governance, and Transparency. According to Worldwide Governance Indicators, Argentina ranks in the 34th percentile for Rule of Law and 50th percentile for Control of Corruption. Argentina ranks in the 43rd percentile for Government Effectiveness and 31st percentile for Regulatory Quality. These factors have been taken into account in the Political Environment building block.
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.
For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/399984.
All figures are in U.S. dollars unless otherwise noted. Fiscal data refers to the federal government. Other public finance statistics are reported on a general government basis.
The principal methodology is the Global Methodology for Rating Sovereign Governments https://www.dbrsmorningstar.com/research/381451/global-methodology-for-rating-sovereign-governments (July 9, 2021). Other applicable methodologies include DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (May 17, 2022).
The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. DBRS Morningstar’s outlooks and ratings are monitored.
The primary sources of information used for this rating include the Ministry of Economy, BCRA, INDEC, Dirección de Estadística y Censos San Luis, International Monetary Fund, World Bank, Bank for International Settlements, Ambito, and Haver Analytics. DBRS Morningstar considers the information available to it for the purposes of providing this rating was of satisfactory quality.
This rating was not initiated at the request of the rated entity.
The rated entity or its related entities did not participate in the rating process for this rating action. DBRS Morningstar did not have access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.
This is an unsolicited credit rating.
For more information on this credit or on this industry, visit www.dbrsmorningstar.com.
140 Broadway, 43rd Floor
New York, NY 10005 USA
Tel. +1 312 696-6293