The most remarkable aspect of Argentina’s latest financial meltdown is the feigned surprise expressed by economists and investors. The truth is that Argentina’s crisis largely repeats the steps of previous ones, including economic mismanagement, dysfunctional politics, too much debt, and a terms-of-trade shock caused by a plunge in grain prices.
As happens after every crash in asset prices, scalded investors claim the outcome was unforeseeable. In the days following the collapse of Argentina’s financial markets financial newspapers quoted investors referring to “black swans” and “6+ sigma” events, implying the improbability of the event was so great that no investor could possibly have foretold it. Given that Argentina undergoes financial crises on a routine basis — every decade or so — this claim seems ingenuous.
Famed economist Paul Krugman, seeking an explanation for this crisis, generated an interesting exchange on his Twitter feed (@paulkrugman).
Krugman noted that President Macri was vulnerable from the start, as he was dealt a hand of elevated fiscal and current account deficits, the infamous “twin deficits,” which always should raise concerns for emerging market investors. According to Krugman, the recommended course of action for Macri at the launch of his administration in 2016 was to cut the deficit and devalue the currency. However abetted by yield-hungry foreign investors enthused by his pro-market reform agenda, Macri opted for foreign borrowing.
As economist Brad Setser noted in a response to Krugman, Macri’s policy option resulted in a sharp rise in foreign debt, which, given Argentina’s precarious export base, dramatically increased its vulnerability.
For the first two years of Macri’s term (2016-2017) the strategy seemed to be working, and Argentine asset prices boomed. In July 2017 Argentina successfully issued a $2.75 billion 100-year bond which was highly oversubscribed and appreciated sharply during the rest of the year. But, as Krugman notes, the fundamental issues were not addressed and Argentina succeeded only in digging itself into a bigger hole.
Unfortunately for Macri, the global economy turned down in early 2018, resulting in a strengthening dollar and falling commodity prices. As they are wont to do, fickle foreign investors suddenly cooled on Argentina, and by the summer Macri had agreed to an $56 billion bailout from the IMF aimed at supporting “expansionary austerity.” According to Krugman, time ran out on Macri and his final desperate measure to bring the situation under control by drastic interest rate hikes and last-minute austerity created a nasty slump and a loss of popular support.
Krugman blames the crisis on “neoliberalish reformers” and a naïve IMF. Krugman’s followers on Twitter responded in different ways. Some took offense to Macri being labeled a “neoliberal,” arguing that, if anything, he was a shy on reforms. Most commentators expressed a fatalistic anguish, stating that because of political polarization and a high dependence on fickle foreign savings these crises will routinely recur no matter who the leaders are. Most everyone seemed to agree that the IMF blundered, though perhaps only because it was pressured by a pro-Macri Trump Administration.
So, what really happened in Argentina?
A good place to start is to review the history of emerging market blow-ups and recognize the patterns. Ray Dalio’s Principles for Navigating Big Debt Crises (Link) provides a good template to do this, as it analyses 23 emerging market crises since the 1980s and identifies commonalities.
The chart below shows the macro characteristics of each country-specific crisis at the time of maximum vulnerability.
Dalio identifies six primary indicators that appear repeatedly.
- Expansion of the Debt to GDP Ratio of at least 5%
- Foreign Debt to GDP of at Least 30%
- Fiscal Deficit at least 2% of GDP
- GDP Output Gap of at least 5% (GDP 5% over trend growth)
- Currency at least 10% overvalued
- Current Account Deficit over 3% of GDP
Not every crisis is identical, but by-and-large they follow the same pattern, meeting the criteria over 80% of the time. Russia, with its structural current account surplus, is the only anomaly, with both booms and busts dictated by oil-driven terms-of-trade shocks.
When a country meets most of these criteria its economy is considered very overheated and vulnerable to a serious downturn. A crisis is usually triggered when a slow-down in GDP growth unnerves investors.
How does Argentina’s present collapse fit into this framework? To begin, we note that Argentina has had three crises since 1980, all of them fitting nicely into the template. As discussed by Krugman and his Twitter-followers, Argentina’s twin deficits, debt accumulation and reliance on foreign debt put it at high risk. A near-doubling of the country’s debt/GDP ratio from 2015-2018 and a heavy reliance on foreign debt were reckless. The following charts illustrate the deficits and debt profiles.
Twin Deficits
Total Debt and Foreign Debt
Moreover, as shown below, when Macri assumed office the Argentine economy was overheated. After years of irresponsible populist policies, Argentina’s GDP was well above trend and the current account deficit was elevated, meaning that cautious austerity measures were in order.
Where Argentina breaks the template is with regards to the valuation of the currency. As shown in the chart below, both in terms of its REER (Real Effective Exchange Rate) and the Big Mac Index, the peso was cheap relative to its history and in comparison to EM currencies.
Macri may have seen the cheap peso as his trump card, and it may well have been if the global economy had not weakened and if grain prices had risen. Unfortunately, the global economy did turn down and grain prices went into free-fall. Moreover, Brazil’s endless recession also weighed on Argentina’s manufacturing sector which depends heavily on this border trade
As the chart below makes clear, investors should have heeded the warning from falling commodity prices. By the time Macri took office, grain prices had already plummeted and they continued to fall, so that today they lie 60-70% below the 2012-2015 period.
What lessons can be drawn from the latest Argentine fiasco? First, in retrospect Macri’s task was probably thankless. With the mess left by the previous administration and collapsing farm prices his best strategy would have been to follow Krugman’s advice and bite the austerity bullet early. But in Argentina’s fractious political climate that may well have been a suicidal option. Instead he took the risky bet that favorable markets would sustain a gradual economic transition. Unfortunately, Macri’s luck ran out.
Trade Wars
- The great decoupling (Oxford Energy)
- KKR sees opportunity in China decoupling (KKR)
- Banning technology will backfire on the U.S. (FT)
India Watch
- India’s digital transformation (McKinsey)
China Watch:
- Expected returns in China (UBS)
- China-Russia: cooperation in Central Asia (AsanForum)
China Technology
Brazil Watch
EM Investor Watch
- Naspers strategy to create value (FT)
Tech Watch
- Investing in Asian Innovation (Oppenheimer)
- Trends in battery prices (BNEF)
Investing
- The age of wealth accumulation is over (FT)
- An investment thesis for the next decade (Gavekal)
The chart shows clearly the downward trend in infrastructure and real estate development spending between 2012 and 2018. This has been an intrinsic element in Beijing’s effort to control debt levels and redirect spending towards consumption. In mid-2018 this trend was reverted, and further data points to a strong upsurge under way (shown in the chart below). 
However, this upsurge in fixed assets investing is most likely of an emergency nature. Once Xi and Trump sign their trade deal and a modicum of normality returns to China-U.S. relations confidence will return. At that time authorities will be able to recalibrate and adjust policies, and it is likely they will seek to return to the previous path of managing the transition to a more consumer and service-driven economy.
