Chile
Heading for the Exit
April 15, 2010

By Luis Arcentales & Daniel Volberg l New York|

Chile's central bank seems to be heading for the exit.  At least that was the message contained in the March Monetary Policy Report (IPoM) published last week.  Despite a fair amount of uncertainty about the growth and inflation outlooks caused by the tragic February 27 earthquake, the central bank informed that in its projections it was assuming that the pace of monetary policy normalization would take place "somewhat faster" than currently assumed in its monthly survey of expectations, even if on a two-year horizon the policy rate would "converge to a level similar" to the survey's 5.50%.  This new hawkish guidance - which caught markets off guard - caused a sharp re-pricing of expectations for near-term tightening, with 6-month swaps approaching the 1.0% mark.

Given the heightened uncertainty regarding growth and inflation after the earthquake, is the central bank's apparent willingness to normalize policy misplaced?  We don't think so, even if we were surprised by the urgency of the central bank's message. In the aftermath of the earthquake, we thought that the negative shock to growth would push the central bank to err on the side of caution and thus stay on hold for longer, despite potential near-term pressures on inflation (see Global Monetary Analyst: Risks in the Policy Mix, March 17, 2010).  However, the central bank is right to point out that up until late February, the economy was expanding at a very rapid pace and that inflation was normalizing against a backdrop of a very stimulative policy stance and expanding bank credit.  Importantly, Chile's comfortable fiscal position - with public sector savings worth near 10% of GDP - gives the government ample maneuvering room to kick-start the rebuilding efforts and thus limit the negative impact from the earthquake on activity (see "Chile: In a League of its Own", This Week in Latin America, February 17, 2009).  In light of the central bank's new guidance, we are pushing forward our expectations for tightening, with policy rates ending the year at 2.75% from 2.0% previously, reaching 5.0% by December 2011.  

Firing on All Cylinders 

The Chilean economy was firing on all cylinders in the first couple of months of the year, following very strong activity figures in late 2009.  Importantly, the recovery was more than just a reflection of the impact of better global demand on export activity or a swing in inventories after massive destocking last year; instead, it has been characterized by strong consumption and improving fixed investment as well.  Indeed, had it not been for the earthquake, the central bank indicated that it would have upgraded its 2010 GDP growth forecast by one full percentage point to as high as 6.5% .

A sharp turnaround in consumption - particularly in durable goods - has been a key driving force in Chile's recovery.  By 4Q09, consumption of durable goods was just 1% shy of the historical high levels from 2Q08; meanwhile, our calculations based on the narrower survey from Chile's retail chamber, CNC, show that sales of durables, as well as non-durables, are running well above pre-crisis levels.  And though the impact of the earthquake on confidence and employment should eventually translate into slower consumption, available data from March showed momentum: imports of consumer goods came to a near standstill in the first week of March but by the third week of the month they were 58% higher than during the period of March 1-23, 2009.  Given the low comparison base, if we extrapolate for the full month the growth rate seen in the first three weeks of March, seasonally adjusted data suggest a very strong monthly expansion.

The upturn in consumption reflects a very favorable consumer backdrop.  First, Chileans have experienced strong real wage gains in great part thanks to the sharp decline in inflation, including a six-month long bout of annual deflation between August and January.  Second, the economy has been steadily creating jobs since last June, with employment growth accelerating to almost 4% annualized in the December-February period.  Put together, at the end of last year our calculation of wage mass was rising at annual rates comparable to previous peaks.  Last and probably more relevant for the monetary policy outlook, credit conditions were normalizing.  The central bank's survey showed that in 4Q a net 26% of participating banks reported easing loans standards, while 37% reported improved credit demand.  Similarly positive trends were also evident in loans to business and mortgages as well.  

Beyond the boost to construction from the forthcoming rebuilding efforts, the outlook for investment remains positive, in our view.  In the very near term, weekly data of capital goods imports yield similar results to those for consumer imports: after dipping in early March, by the third week of the month they were 40% higher from the same period in 2009, consistent with a seasonally adjusted sequential gain.  And looking ahead, the March IMCE survey showed that Chile's captains of industry remain constructive, even after the earthquake: in March the diffusion index of capex intentions stood firmly in expansionary territory, retreating modestly to 69.1 points from 75.9 in February.  The positive trend in investment - beyond near-term noise caused by the earthquake - should be reinforced by a powerful inventory cycle after last year's massive destocking, which knocked off some 3 full percentage points from annual domestic demand growth last year.  Indeed, though March's IMCE inventory gauge dipped sharply to 43.6, implying insufficient stocks, even pre-earthquake the index suggested that the destocking process had run its course, with figures around the 50 neutral threshold (50.9 in January-February).

Taking into account available data for February and March - which provide some indication of the near-term impact of the earthquake - we are trimming our 2010 GDP forecast modestly to 4.3% from 5.0% previously, while boosting our 2011 outlook to 5.0% from 4.4% previously. 

Heading for the Exit

While Chile watchers - ourselves included - were surprised by the central bank's hawkish message, the shift in guidance seems justified, in our view.  This change in tone seems to reflect what we consider to be a fundamental shift, as the underlying monetary policy stance has begun to move out of synch with the cyclical backdrop.  While the economy had been showing strong momentum up until the earthquake, the gradual normalization in the real interest rate - measured as the policy rate deflated by headline inflation - appears to have faltered.  The ex-post real interest rate peaked in 4Q09, after effectively moving towards a neutral level over a period of some eight months on the back of falling inflation. 

However, as deflation began to subside and annual inflation moved into positive territory, real rates moved back to levels consistent with a stimulative stance: while our work suggests that the neutral real rate may be in a range of 1-3.5%, the actual real rate has hit 0.2% in March.  Against this backdrop, central bank authorities may have become uncomfortable as surveys and breakeven measures suggested that inflation was moving towards 3.5% by end-2010, even as medium-term expectations remained well-anchored near the 3.0% central target. In turn, this suggested that the real interest rate would have been on its way towards deeply stimulative levels.  Such a move, in our view, would have put the authorities in the uncomfortable position of allowing an effective ratcheting up in monetary stimulus even as the economy's cyclical rebound continued to gain ground, with exceptional strength in credit-sensitive areas like durable goods sales amid signs of normalizing credit conditions.  When viewed in this light, the shift in the central bank's guidance appears to have coincided with an inflection point in the underlying trend in the stance of monetary policy. 

The outlook for near-term inflation is likely to be noisy, but we see risks skewed to the upside.  To be fair, March's surprisingly low 0.1% monthly gain in headline and flat core readings, though they failed to include the areas most affected by the earthquake, suggested that underlying price pressures remain muted.  Still, even if future readings come in on the low side, a very low comparison base should push annual inflation higher over the course of the year.  Indeed, we suspect that, given the evidence of the past few years of surprisingly rapid pass-through from swings in commodity prices into inflation, this is a risk that cannot be dismissed.  Moreover, though 2010 inflation expectations remain well within the central bank's tolerance band of 2-4%, pricing power seems to be staging a comeback, at least as suggested by business surveys.  After hovering near neutrality until December of last year (49.5), the diffusion measure of selling prices from the IMCE survey spiked to 60.9 points in March.  This move is relevant, in our view, because costs moved above the 50 neutral threshold back in June of 2009 but only since January of this year have selling costs broken above the 50 level.  

Bottom Line

Chile's central bank seems to be heading for the exit. The central bank's guidance that it will likely start tightening at a faster pace than most Chile watchers had expected seems to reflect a fundamental shift as the underlying monetary policy stance has begun to move out of synch with the cyclical backdrop.  Despite uncertainty in the near term related to the impact of the earthquake, the economy had been showing strong momentum while inflation and credit conditions were normalizing.  Against this backdrop, central bank authorities may have become uncomfortable as expectations for rate hikes and inflation suggested that the real interest rate would have been on its way towards deeply stimulative levels. 

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Argentina
Managing Through
April 15, 2010

By Daniel Volberg l New York|

When the authorities announced that they plan to open the debt restructuring this week, they raised expectations of Argentina regaining access to international capital markets and managing through the next two years.  Argentina lost access to international markets after defaulting on its debt in 2001.  In 2005, the authorities opened a debt restructure that ended up successfully exchanging near three-quarters of the outstanding defaulted debt for new, performing bonds.  But the holders of near a quarter of the original defaulted debt did not participate and are commonly known as the holdouts.  Since then, Argentina's access to international capital markets has been challenged by the threat of legal action as some of the holdouts seek to attach Argentine assets in order to pay off past due debts.  The upcoming restructuring is meant to remedy that situation by exchanging defaulted bonds for new, performing debt.  Still, some investors may opt out of the restructuring in order to continue with their legal action.  That begs the question: if the participation in the restructuring falls short of 100% - as is widely expected - would the remaining threat of legal action continue to hamper Argentina's access to international markets?  We suspect not.  Indeed, in our view, Argentina may be able to regain access to international capital markets, helping it to manage through the next two years despite fiscal slippage and rising debt service obligations.

Debt Restructuring

Argentina is seeking to restructure the remainder of its defaulted debt.  The authorities are hoping to restructure the US$20.1 billion in notional defaulted debt and a further US$9.7 billion in past due interest payments.  Virtually all - 98% to be exact - of the defaulted debt and past due interest are in foreign currency.  The authorities have been signaling that of the US$20.1 billion in default, they expect anywhere between US$8 billion and US$11 billion to be restructured this year.  This guidance is based on the authorities' view that holders of near US$9 billion in defaulted debt who have sued and received judgments in their favor may not participate in the restructuring.  Rather than restructure and take a haircut on the face value of their debt holdings, these investors may continue to seek to attach Argentine assets to recoup the face value of the defaulted debt.

While the terms of the upcoming restructuring have not been finalized, the broad parameters may include an exchange of defaulted debt for a package including three items.  According to press reports, in exchange for their defaulted bonds investors may receive: a) a new Discount or Par bond at around 32-35 cents on the dollar, b) a new seven-year bond to compensate for the interest these investors would have received had they participated in the 2005 restructuring, and c) GDP warrants.  One source of uncertainty is whether past payments on GDP warrants will be included.  That may be an additional sweetener for the investor community.

The authorities hope that a successful restructuring would allow them to regain access to international debt markets.  Argentina is again set to issue international debt as part of the upcoming restructuring.  But the authorities have signaled that they may try to go beyond issuing new debt in exchange for defaulted bonds.  Argentina may now attempt to raise capital in international markets - the so-called ‘new money' part of the debt exchange.

Back to International Capital Markets?

But if a core of investors who have legal judgments in their favor stay out of the exchange and pursue legal action against the Republic of Argentina, would that restrict the country's access to international markets?  That is fundamentally a legal question and the answer is not fully knowable. 

We suspect that there may be ways for Argentina to gain access to international markets despite outstanding judgments and threats of attachment.  Here are a few thoughts on the issue.

Argentina's authorities may be hoping to push courts to set aside existing judgments and attachment orders if the restructuring succeeds in reaching a critical participation threshold.  According to a research document prepared for the US Congress, there is historical precedent for sovereign debt workouts with at least 90% participation to translate into courts setting aside attachment orders and existing judgments.  Given the near US$82 billion in debt that was defaulted on in 2001 and the near US$62 billion that participated in the 2005 restructuring, the holders of near US$11.5 billion or near 60% of the outstanding notional defaulted debt would have to take part in the debt exchange for Argentina's restructuring to be successful in achieving the 90% participation threshold. 

At first glance, this threshold seems achievable. After all, the authorities need to convince only 60% of the holdouts to participate.  However, remember that out of a total of US$20.1 billion in remaining defaulted debt, the holders of near US$9 billion have already received judgments in their favor and another US$4.4 billion are in arbitration.  Hence, the goal of reaching US$11.5 billion participation in the exchange seems extremely difficult to achieve, in our view.

One way for the authorities to achieve the 90% threshold is to convince some creditors to voluntarily give up on their efforts to recoup their losses through the courts.  There appear to be two camps on whether the authorities will be successful in convincing investors to set aside their legal claims.

The first camp argues that creditors have an incentive to restructure since while the law applicable to international bonded debt makes it relatively easy for creditors to obtain judgments against a defaulting sovereign, those judgments may be difficult to enforce.  That is because under the "commercial activity exception to execution immunity", property sought for attachment in the United States must be "used for the commercial activity upon which the claim is based".  This rule makes it difficult for investors with judgments in their favor to actually attach Argentina's assets.  The difficulty in enforcing judgments may be a powerful enough incentive to convince some creditors with judgments in their favor to participate in the restructuring. 

The second camp counters that creditors have a strong incentive in staying out of the restructuring as they may be on the verge of an opportunity to attach assets as Argentina decides to tap international capital markets with new debt issuance.  This camp argues that it is after the exchange, when Argentina tries to issue new debt, that the authorities will find their access to capital markets blocked by the courts.  After all, the Southern District Court of New York had ruled in the past that bonds exchanged as part of a debt restructuring should be immune from attachment.  But this immunity may not apply to new debt issuance, potentially allowing the holders of defaulted debt to attach any cash that investors would transfer in exchange for Argentina's newly issued debt.

We suspect that even if the restructuring does not result in courts setting aside creditor judgments, Argentina's authorities may have a way to reduce the threat of attachment in new debt issuance by making the critical transaction within Argentina.  One element frustrating international creditor attempts to attach Argentina's assets is that the local court system does not provide the necessary support.  While the Argentine courts have recently begun taking a more independent line, we suspect that it may be some time before international creditors could successfully sue the Republic of Argentina in Argentine courts.  If that's the case, then we suspect that the authorities may be able to issue new international debt by setting up a trust within Argentina that receives the cash from those subscribing for the new issuance.  Therefore, the cash for debt exchange would be made within Argentina, not across borders, and so any decision to attach the cash would lie within the jurisdiction of an Argentine court. 

Alternatively, the authorities may issue local market debt with an option to switch into international law bonds.  Such a transaction would have investors obtain international law debt as part of a two-step process.  In the first step, the authorities would raise the capital under local law, reducing the risk of attachment.  In a second step, the local law bonds now held by the investors would be exchanged for international law bonds.  The local law bonds that the authorities would receive would then be cancelled.  In order to reduce attachment risk, the critical element for the transaction would be that both steps would have to take place within Argentina.

Manage-Through Scenario

Given our view that Argentina may be able to regain capital market access, we suspect that it will manage through the next two years.  Manageable financing needs, potential for improvement in policy direction, a cyclical rebound this year and relatively solid economic fundamentals underpin our view that Argentina should have a relatively strong performance over the next two years.

The key medium-term catalyst in Argentina may be the potential for a change in policy direction post elections next year.  The main issue in Argentina has been continued policy deterioration, but there is increasing enthusiasm that we are nearing an inflection point with presidential elections in October 2011.  The authorities have overseen significant policy slippage.  To name some of the most visible examples: data quality issues after the independence of the statistical agency was compromised in 2007, nationalization of the pension fund industry in late 2008, significant regulatory deterioration in the agricultural exports sector since 2008 and the naming of government-linked board of directors to most large Argentine corporations after the authorities obtained large equity stakes through the pension fund nationalization.  But the current administration suffered a significant loss in midterm Congressional elections last year and there is a growing expectation that we may see a change in policy direction post elections next year.  A more prudent macro management team may be the biggest catalyst for Argentina in the medium term, in our view.

And in the near term, Argentina is in a cyclical rebound. The drivers of growth are basically a rebound in agricultural production due to better weather (last year was the worst drought in half a century) and Brazil's recovery is pulling up demand for Argentina's industrial exports.  We expect to see 4.6% growth in 2010.  This growth may not last however - we expect 2.4% growth in 2011.  Looking ahead, we don't see these drivers continuing into 2011 as Brazil's demand slows on the back of monetary tightening and agricultural production upside seems limited given that the main crop - soybeans - is expected to post record volume this year.  Meanwhile, domestic drivers for growth may be limited by the continued risk of policy heterodoxy and rising inflation.  The risk to our call is that we see domestic demand growth in anticipation of a new administration taking hold next year.

But beyond the cyclical issues and given the potential for a more prudent economic policy within the forecast horizon, it is important to note that Argentina's macro fundamentals are relatively solid.  Last year the economy posted a current account surplus of 3.4% of GDP and we expect near 3% surpluses this year and next.  However, we estimate that inflation may be running around 16%Y and inflation expectations suggest that it may rise to 25% by year-end.  Still, given Argentina's history of elevated inflation, we suspect that even at these levels it remains manageable.  The weakest point on the macro front may be fiscal slippage, but even there the numbers are manageable.  We expect an overall fiscal deficit of around 1.1% of GDP at the federal level in 2010 and 2011, and a consolidated deficit of 2.5% of GDP in 2010 and 2.6% in 2011.  And the good news is that the fiscal deficit may be distorted by subsidies to public services and energy sectors where prices remain well below international levels.  Under these conditions, a fiscal adjustment in Argentina may be growth-augmenting, as it may spur investment and improve sentiment.  Last, but not least, while the markets are concerned about Argentina's debt service, we see manageable financing needs even without market access.  Indeed, though the near US$22.2 billion in financing needs may seem like a high burden, the authorities may count on significant internal resources: part of a hard currency cushion with near US$48 billion in international reserves as well as a fraction of the near US$18 billion in public sector deposits.  And the drive to restructure debt may mean Argentina regains market access already this month.

Bottom Line

Argentina may be able to manage through the next two years.  The authorities may be on the verge of largely putting the 2001 default behind them and regaining Argentina's access to capital markets.  In addition, Argentina is in the midst of a strong cyclical rebound.  Despite better growth, we suspect that fiscal slippage remains the principal challenge, but the deterioration may be less alarming - especially after regaining market access.  Still, we would caution against confusing an externally driven cyclical bounce with long-term sustainable growth.  From fiscal deterioration to inflation to continued deterioration in the business climate, Argentina's challenges remain significant.  The positive note, however, is that in the interim between now and 2011 when investors continue to expect an end to policy heterodoxy (coinciding with a new administration), the economy may be in better shape.

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