Argentina's Economic Sins Come Back to Bite

Editor's Note: This assessment is part of a series of analyses supporting Stratfor's 2020 Annual Forecast. These assessments are designed to provide more context and in-depth analysis on key developments over the next quarter and throughout the year.

When he takes office on Dec. 10, Argentina's new president, Alberto Fernandez, will quickly find his hands tied, having raised expectations of simultaneously increasing government spending while lowering inflation. But while those campaign promises may have earned Fernandez the seat, the International Monetary Fund (IMF) and the many other foreign creditors who keep Argentina's lights on won't tolerate such visions of grandeur. Without a long-term program to solve the country's economic crisis, or the cash to make good on its heaping pile of IOUs, Buenos Aires will likely be forced to once again default on a large part of its debt next year, sending the already impoverished country even deeper into a tailspin. 

Old Economic Habits Die Hard

Argentina is again up to old tricks that led to eight previous defaults in the country's 200-year history. After settling in 2017 with holdout creditors from its most recent default, President Mauricio Macri's administration began borrowing heavily in foreign currencies to help finance government budget deficits — a dangerous move economists refer to as "original sin." As a result, the country's external debt grew by $100 billion to $285 billion between 2016 and 2018, nearly doubling as a percentage of gross domestic product (GDP) to 54 percent. The debt incurred by Argentina's government and public sector to finance its domestic budget deficits, meanwhile, rose from less than 53 percent of GDP to 77 percent in the same period. 

Given this growing twin debt burden, the country's current financial obligations extend far beyond Buenos Aires' ability to pay. In June, the IMF estimated that Argentina would need $92 billion in external financial support to make good on its scheduled repayments in 2020. In contrast, available resources are insufficient, making both the external debt and the public debt, including domestic obligations, unsustainable. For at least the next three to five years, Argentina is expected to lack either the resources or the ability to earn sufficient funds needed to make repayments, while also financing necessary imports, such as refined oil and parts for domestic industrial production. Of the Central Bank of Argentina's $43 billion in foreign currency reserves, the bank's usable net reserves likely don't exceed $10 billion — less than 15 percent of the total loan repayments Buenos Aires will owe in 2020 alone.

Amid the uncertainty, investors have started pulling their assets from the country. And this, combined with Argentina's meager domestic savings and soaring inflation, have continued to stymie economic growth. The private sector's distrust of the local currency has also made the Argentine economy highly dollarized, with people seeing U.S. currency as a haven for saving and inflation protection. Nearly 80 percent of the government's domestic debt, for example, is owed in U.S. dollars. Unsurprisingly, as Argentina's economy continues to spiral, both poverty and unemployment levels have skyrocketed. And while intended to fight inflation, the prohibitively high interest rates set by the Central Bank of Argentina rates have only appreciated the exchange rate for the peso even further, another obstruction to the economic growth needed to grow incomes and avoid greater social unrest.

A Return to Populism 

Macri had initially opted for a gradual approach to the reduction of the country's deficit and accumulation of debt. But financial markets started to catch on that the country was up to its old habit of racking up foreign currency debt without fixing its domestic economic problems. Macri resorted to IMF support in 2018, but a program front-loaded with money was back-loaded with unpopular fiscal cutback measures that ultimately led to his political demise.

Fernandez will step into this economic maelstrom amid great uncertainty over his leftist economic policies. Fernandez's recently unveiled Cabinet includes Martin Guzman, a professional economist but severe critic of Macri’s economic policy, who will serve as an economy minister. A former official of the Fernandez de Kirchner government, meanwhile, will serve as the head of the country's central bank. Fernandez's repeated vague assertions that the debt will be paid, caveated by the need to avoid further "austerity," have fueled anxiety among financial markets. More recently, Fernandez also said public finances were in a "deplorable state" and that Argentina would repay debt only when the economy is growing. But if and when that growth will occur, of course, remains fair from certain.   

In turning Argentina's economy around, Fernandez also has the added challenge of minimizing the role of radical Peronistas, including his vice president-elect, the former president Cristina Kirchner de Fernandez and former Economy Minister Axel Kicillof, whose hard-line push for more social spending increasingly resonates among the country's impoverished citizenry. Both have taken confrontational approaches toward creditors in the past and will probably do so again if given the opportunity.

Implications for the IMF Loan

With Argentina's debt selling at distressed prices in secondary markets, many creditors are probably steeled at least to extend their maturities. But they won't agree to be scalped by accepting large value reductions of their debt, or acting without assurances that Argentina will eventually pay most of what it owes. The IMF's endorsement of Argentina's economic policies would provide such an assurance by signaling that Buenos Aires will not repeat its past mistakes ad infinitum, and will thus be key to ensure creditor cooperation.

To salvage its $57 billion agreement with Argentina (its largest-ever loan), the IMF will probably accept some increased social spending in the short term and may potentially even allow the country to rack up a small fiscal deficit to boost domestic goods and services spending for at least the next year. It will not, however, accept a program built on unrealistically optimistic economic projections. Instead, the IMF will demand a credible long-term plan consistent with the path Macri's administration initially promised. In addition to addressing fiscal and structural economic imbalances that impede debt sustainability, such a plan would also likely demand reining in public spending to an amount that can be financed without assuming "immaculate" economic growth with fantasy projections of increased tax revenues. 

Fernandez's vision of long-term higher spending and, by implication, increased primary budget deficits will thus prove unacceptable to the IMF. Other, potentially problematic policies that Fernandez and his advisers have suggested include: 

• Increasing wages while extending price controls, and relying only on "social pacts" to discourage further wage and price increases. This would encourage black-market activities by ignoring pent-up inflation, further discouraging domestic investment.
• Promoting exports to improve the exchange rate of the peso without a hard peg to restrain inflation. The IMF would view this as currency manipulation, which is prohibited by its Articles of Agreement. Such a move would also result in further flight from pesos into U.S. dollars or euros, increasing the risk of a government default since the majority of its debt obligations are in dollars (with its revenues mainly in pesos).
• Financial repression by artificially lowering interest rates. This would threaten the health of the country's banking system, much of which is funded in U.S. dollars. It's possible Fernandez would reinstate a Kirchner-era requirement for banks to buy government debt, regardless of the return.
• A permanent tax on exports to raise revenue. Macri's export taxes were intended to be only temporary. While easy to administer, a permanent tax would not only further discourage exports but also create multiple exchange rates that the IMF usually opposes. 

A Dangerous Domino Effect

Fernandez does not have the luxury of time. The budget he'll inherit from the Macri administration is currently in near balance, but not for long. Many debt payments since September are past-due and new ones will follow quickly, including a massive $570 million interest payment owed in January. Some hedge funds in New York and London are already suing Buenos Aires to recover unpaid claims connected with the country's last debt restructuring in 2005. And further action to seize Argentine assets in the coming year is likely. 

But despite these risks, Fernandez and his political allies are unlikely to have a sudden change of heart that puts the IMF program back on track in the medium term. Instead, Fernandez is more likely to break decisively with his business-friendly predecessor and reinforce his populist credentials by substantially increasing social spending and subsidies, killing any potential IMF deal — and with it, any hopes for increased cooperation with other foreign creditors. As a result, the new president risks leaving Argentina with budget deficits that can't be financed without default or other disruptive actions, such as forcing banks to buy government debt or forcing conversion of private dollar bank accounts into pesos. 

A default could shut Argentina out of international financial markets for the foreseeable future by reinforcing its reputation as an unreliable debtor. It could also have regional spillovers at a time when Latin American growth is among the most sluggish globally. Argentina's increased default and credit risks could spill over into higher borrowing costs and added budget expenses for countries such as Brazil that are already facing tight domestic constraints amid heightened social unrest. Moreover, with Argentina's trade policies becoming more protectionist, added tensions within the South American trade bloc Mercosur could cause the already troubled union to collapse entirely, and inhibit interregional trade even further.

But if there's one lesson Fernandez and his fellow Peronist populists have learned from Argentina's never-ending cycle of debt defaults, it's that it's easier to force creditors to bear the burden of economic adjustment, than it is to make the tough political choices needed to actually address the country's perennial economic weaknesses. And while that lack of political will might prove convenient in the short term, a looming return to the disruptions of the Kirchner years could very well throw Argentina right back into financial chaos.