|Mohamed A. El-Erian|
What a difference 18 months can make. The consensus market view at the beginning of last year was bullish on Latin America. Brazil was growing again, having overcome its January 1999 crisis. Higher oil prices were supporting Colombia and Venezuela. Even market sentiment towards Argentina was improving, reflecting the hope that the newly elected government of Fernando de la Rúa would decisively overcome years of stagnation and deteriorating debt dynamics.
Today, market perceptions are far different. Argentina faces a significant probability of default and/or protracted economic stagnation. Other countries in the region are trying to cope with Argentine contagion. In Brazil, exchange and interest rates have overshot, and there is a growing risk that this deviation may get embedded in the country’s debt structure, complicating an outlook already adversely impacted by the domestic energy crisis.
Meanwhile, Colombia and Venezuela face more challenging prospects on account of their socio-political circumstances and, given the synchronized slowdown in the global economy, an uncertain outlook for international oil prices. And to top it all, some polls are suggesting that popular support for democratic governments is declining throughout Latin America.
This downbeat view of the region is impacting risk appetites for emerging markets as a whole. Indeed, reflecting concerns about Argentina and, to a lesser extent, Brazil, some analysts are arguing that the very foundations of the asset class are at risk. Some are even warning about the end of the asset class.
In its simplest form, this argument runs as follows. The continued threat of an Argentine default will carry on pushing capital out of the asset class. This results in a generalized increase in interest rates faced by emerging economies. Debt servicing costs rise and access to new market funding declines. Growth dynamics are thus undermined further, aggravating the risk of a vicious debt cycle. As reformist governments seek to compensate through fiscal cuts, they experience an erosion in popular support and, eventually, are voted out of office. This leads to further outflows from the asset class. In sum, not a pretty sight. So, where should the balance be struck?
Despite the traditional academic work on perfect markets, it is not unusual for investor sentiment to swing wildly between exuberance and gloom. Markets operate on the interaction of fear and greed, spiced by bouts of herd behavior. And, in the process, contrarians can be rewarded.
What about this time around? Is the market overplaying the gloom? The answer is yes, and no.
Any assessment of the outlook for Latin America, and emerging markets as a whole, must start with Argentina. The country’s policymakers are hard at work trying to overcome the damaging combination of poor growth, a growing debt burden, and accelerated erosion of the foreign investor base. This daunting challenge is being compounded by Argentina’s worsening regional and international environment. And, to top it all, the country has congressional elections in October at a time when the internal cohesion of the ruling coalition is coming under pressure.
No wonder residents have been pulling their deposits out of the banking system, contributing to a sharp drop in the country’s international reserves. There are no painless solutions to Argentina’s predicament. Indeed, the message from the last few years is a clear one. Given the country’s socio-political situation and its external environment, the country’s policy stance is over-determined. Or, to use economic jargon, there are too few instruments for even the limited number of stated policy objectives. Substantial borrowing from official creditors such as the International Monetary Fund could theoretically buy some time. But the impact will be limited in the absence of a more sustainable policy regime.
No wonder Argentine economy ministers have given the impression of repeatedly changing policy course. Fiscal adjustment have been frustrated by their negative impact on growth. But when the policy emphasis is altered to put the primary emphasis on growth, the financing constraints kick in. In the process, the country loses more of its already limited degree of policy independence – either by design (witness the recent “zero-deficit” law) or by force (witness the shrinkage in the investor base and deposits).
Default Plus Stagnation?
Such considerations are fueling the emerging consensus that, in the absence of forceful policy intervention and additional external funding, Argentina faces a significant probability of default, protracted stagnation or both. Accordingly, lobbying efforts are increasingly aimed at supplementing the $40 billion Argentina package announced at the end of last year. Yet the medium-term policy component is yet to emerge beyond the extension of pro-cyclical policies.
There is an active debate regarding the wisdom and feasibility of such a course of action. Should the official community intervene again? If so, should it insist on a change to Argentina’s policy regime? And, what about private sector creditors; should they be bailed in or bailed out?
The answer will no doubt reflect a blend of economic judgment and political expedience. Considerations will include not only Argentina’s economic and political outlook (the “what are we bridging to” question), but also a judgment about systemic effects (specifically, Argentine contagion versus moral hazard issues).
While both willing and able to join this debate, leaders of other Latin American countries have to deal with the day-to-day impact of Argentine volatility. While they no doubt hope for the best in Argentina, they are advised to plan for a choppy regional outlook.
To some, the issue of Argentine contagion risk is a peculiar one. After all, the country is relatively small in global economic terms. Moreover, its trade links are limited. Even its largest trading partner, Brazil, has only a small part of its GDP that is sensitive to Argentine demand.
The root of contagion risk is technical in nature. Specifically, it is the combination of the behavior of money managers of the “closet-index” variety and a 20% weight for Argentina in the most widely followed market index, JP Morgan’s EMBI+.
The hypothesis is that default-induced Argentine losses lead investors to sell other holdings to gain liquidity ahead of a possible wave of redemptions. This type of behavior occurred during the 1994-95 Mexican crisis, the 1997 Asian one, and the 1998 Russian debacle. The sell-off in 1998 was made worse by excessive leverage that, among other things, was reflected in the headline-grabbing demise of Long Term Capital Management.
The major systemic risk is that the outflows of funds knock countries into a series of unstable equilibria fueled by the combination of deteriorating debt and growth dynamics. This further erodes confidence in the asset class, which is why some analysts have gone so far as to predict the end of the emerging market asset class.
An intensification of Argentina’s problems would most likely disrupt the asset class as a whole. But the nature of the disruption and its evolution could well be different from both the consensus view and from what we have seen in previous emerging market crises.
Moreover, it might lead to a fundamental change, for the better, in the way the asset class is approached by international investors. Accordingly, from a medium-term perspective, we could end up with a more robust flow of international capital to countries deserving such flows.
The view that contagion could well be short-lived is a recognition of the progress that most emerging economies have achieved. The resulting “self-insurance” is constructed on the basis of four elements: tighter fiscal policy and the adoption of more flexible exchange and interest rates; stronger institutions and the adoption of transparent and market-compatible rules and frameworks; improvements in debt profiles and responsible use of liability management; and the accumulation of considerable international reserve cushions.
Determining the Speed
The combination of these four factors – which varies from country to country -will determine the speed with which most of the Latin American countries rebound from possible Argentine contagion. And provided that an Argentine “muddle through” scenario is not a protracted one, most countries could bounce back rapidly.
For the asset class as a whole, the recent period of Argentine contagion has been accompanied by a development that is supportive for the asset class over the medium term: a considerable degree of differentiation among credits. As the end of July, only three of the 17 country components of the EMBI+ had experienced negative returns year-to-date (Argentina at -26.3%, Turkey at -4.9% and Brazil at -3.8%). The other 13 registered positive returns – and significant ones at that, ranging from 6.9% to 25.1%.
Such differentiation could be even more pronounced in the event of an Argentine credit event. In the process, this would further discredit the “closet index” approach to emerging market investing in favor of one driven more by considerations of economic and political fundamentals. By enabling these countries to aspire legitimately to a more respected place in traditional fixed income platforms, such a development could ensure a wider, deeper and more stable flow of funds to emerging economies. LF
Dr. Mohamed A. El-Erian is a Managing Director of Pacific Investment Management Company. He was formerly with the International Monetary Fund and Citigroup.