Argentina Investment Focus: Part III - Sector Policy

Sector policy has influenced valuations by affecting relative prices and income through at least three tools: Exchange Rates, Taxes and Regulated Prices.

Reforming the status quo of sector intervention creates clear winners and losers, even if it generates an overall rising tide, making it particularly challenging to modify. Unlike asset price dislocations based on the restrictions of capital detailed before, most of this sector dislocations are partially built into asset prices. However, some sectors combine both the characteristic of having limited access to capital markets and being well poised for a shift in sector policy. 

The real exchange rate of Argentina is at its lowest level in more than a decade, driven by high inflation and an intervened nominal exchange rate. As a result, exporters have been severely hurt by rising costs and falling volume. Producers for the local market that would have been hit by falling real prices of competing import products have been protected by import restrictions.

A normalization of the exchange rate at a higher rate is probably a prerequisite for the liberalization of the capital account. Given how important this is to foster foreign investment,I believe there is a good probability that this policy shift will indeed take place.

Argentina Multilateral Real Exchange Rate

Source: Elypsis Web

The sector that has suffered the most because of government tax policy has been farming where exports pay a steep 35% levy on FOB prices. Reforming the tax code to benefit farming as a whole would be a very bold move with little positive short term effects and a high financial cost for the government. Consequently, I do not believe that the reduction of export taxes across all crops will be part of the reform package for at least a few years, although some of them might get a reduction.

On the other end of the spectrum, the electronic goods industry has received significant government assistance in the form of subsidies, tariffs, restrictions on imports and an impulse to internal demand. The industry creates a lot of jobs and would be very sensitive to external competition, so radical reform could only happen on the back of a very strong economy. However, a wind-down of some of its many perks or on some of its products (i.e. computers) is likely as it would have immediate positive effects for consumers.

Pampa ADR Stock Price (US$)

The government has also kept the regulated prices of some sectors, like energy generation and distribution, below market prices. In generation, this has come coupled with a two-tier system whereas "new" energy (not clean, just new) is rewarded with a higher rate than "old" energy. The government pays old energy just the marginal cost to guarantee continuing production while promising new projects higher rates to justify the initial investment. Rates for new energy are higher than they would be in a one tier country and vice-versa. Given Argentina´s need for an increase in electrical generation investment, new energy prices will probably remain in place, but the unification of the market would be costly for the government without much short and medium term benefit, but that of the symbolical value of a "normalization".

In the distribution side, households have been subsidized by a mix of low prices by distribution companies and government subsidies. Subsidies have resulted in a higher electricity demand and will probably be diminished to both reduce that demand and save the government some cash. The low prices charged by distribution companies would also come up since there is no two tier system and investment in the sector is much needed, but will probably not be priority in the short term with rate hikes already in place.

In summary, sector policy will probably change, but those who expect an immediate change of all government policy are minimizing the short term effects of such reforms. We expect a normalization of the FX market, little changes to taxes and a reduction of subsidies but not a total "normalization" of tariffs.

Conclusion

Irecommend investments in

- Sovereign Fixed Income
- Large land plots
- Large Block Real Estate (i.e. Shopping Malls)
- "New" Energy Generation; very opportunistically old
- Exporters, though not soybean farms: food, software, mining, bpo

Argentina Investment Focus: Part II - Capital Controls

Capital controls were enforced in Argentina with full force 5 years ago restricting the transfer of funds abroad (the "cepo cambiario"). This measure has had the double effect of inhibiting foreign investors from entering the Argentine market and restricting Argentine investors and firms to investing their savings at home or accessing the illegal or contado con liqui markets.

Unlike a settlement with the holdouts, a freeing of the capital account is not an easy task since it would require the realignment of many macroeconomic variables that, if not approached in a smart, programmatic manner, could lead to a severe currency run or rampant inflation. Furthermore, some of these measures are not sector neutral and would suffer from much opposition from jeopardized actors (i.e. fx and its effect on importers and exporters). The probability that these measures will be implemented is high, but far from guaranteed.

The withdrawal or reduction of capital controls would have a significant impact in FDI and would serve as a driver for investment in private assets in a similar fashion as a settlement with the holdouts would for investment in publicly traded assets: investments would start actually yielding to foreign investors. For exactly the same reason as before, this reform would drive an increase in valuations across the board.

However, these restrictions have also created severe price dislocations because of the difficulties of the local Financial System to direct capital efficiently. Since capital has been forced to stay within the country, these dislocations have been amplified.

The Financial System in Argentina is very ineffective at articulating savers and investors.  As an example, private debt represents only 15% of GDP against 69% in Brazil and mortgages are close to nonexistent. Coupled with capital controls that restrict foreign capital and a lack of liquidity events for local groups, this has restricted investors to direct retail investments that make it very hard to finance big and long projects.

Sources: Central Bank of Colombia, Central Bank of Chile, Central Bank of Brazil, Central Bank of Argentina

Consequently, capital has flooded the markets where individual investors can atomize their investments and access liquidity relatively easy (i.e. residential real estate), but stayed away from investments which are sizeable, (i.e. infrastructure, utilities) and long-term with low current yield (i.e. significant land plots).

Empirical data is consistent with this hypotheses. Residential real estate is yielding Cap Rates of ~4%, similar to New York City with small studio apartments yielding even less, while big shopping malls are acquired at ~5pp spreads to similar assets in the US for a total return in the low teens.

The return of Argentina to global capital markets where significant pools of capital are easier to articulate would result in higher demand for big-scale, long repayment, hard to atomize assets. Furthermore, a gradual reform of the Financial System would also favor such a focus.

Argentina Investment Focus: Part I - Sovereign Risk

On December 10th Argentina will have a new president. We do not know yet with certainty who will be sitting on the “sillón de Rivadavia", but we do know it will be someone new. A lot of investors have been betting on the new policies that will come along with this change, rallying with the increasing prospects of politic and economic reform: Massa running for parliament in 2013, Macri coming close second in the first round or Scioli showing his willingness to negotiate with holdouts.

So, if one believes that Argentina will effectively undergo reforms that will make its economic regime converge to that of its neighbors, where should then investors focus their capital?

The bullish view for Argentine assets is based on the fact that a new more market-friendly government would take the steps that would lower the country´s sovereign risk spreads and eliminate current capital controls; both things would have an immediate impact by reducing discount rates that would boost multiples and valuations. However, capital controls have come coupled with an array of local sector measures and realities that have not only diminished the value of asset values, but also generated severe price dislocations that make some assets more attractive than others under the light of foreseeable reform.

Since there are very few publicly traded assets and recent relevant transactions, the search for value needs to be pursued based on the general conditions that generate attractive investment opportunities in a sector, rather than a standard valuation approach..Through a series of 3 articles I will analyse the big forces in play for the Argentine valuations' recovery story and the best strategy to invest in it:

i)Sovereign Risk
ii) Capital Controls
iii) Sector Policy

Sovereign risk has been high due to successive hostile measures towards investors: default, cheating on inflation-linked bonds, hard nosed hold-out negotiations, nationalizations. A settlement with the holdouts and a change of the economic policy team would very likely immediately reduce spreads as Argentine bonds start actually yielding to investors worldwide and the prospect of further reform starts looking more likely to investors.

There is very little short-term economic cost for reaching an agreement with the holdouts since it would allow the government to access fresh financing at lower rates and the cost of the settlement will very likely be due in kind, generating only a minor uptick in the total debt level. Someone might debate whether a settlement is economically beneficial for the country in the long term since its cost is very material, but it is very hard to argue against the positive economic short and medium term effect for the new administration.

However, it does come at a political cost since the current administration has portrayed the standoff with the holdouts as a patriotic gesture that generated a lot of empathy with the electorate and will fight any agreement that does not include a significant reduction in the total debt.

Recent comments by Daniel Scioli, the candidate that was perceived as the least likely to settle, confirmed his willingness to negotiate a deal with the holdout debtors. There is a very high probability that a deal will be promptly reached by the next president and this is already partially built into valuations.

All assets would be boosted by such an outcome, both because of its impact in the cost of capital of any Argentine asset and the indirect implications about further reform, but private assets will be boosted less without a softening of capital control restrictions. Were further reform not to happen, the biggest winner of this seldom measure would be sovereign fixed income, since it is the asset that best captures the isolated effect of the settlement.

Investments focused on a change in sovereign risk are an Argentina risk-on/ risk-off bet, and do not aim to profit from dislocations among asset classes within the country. Capital Controls, presented in our next delivery, are a bit more complicated.