Despite Upcoming Elections and Potential Reform, Argentina Can Provide Investors Little Near-Term Confidence

Concerns over a Moody's downgrade of Argentine debt and a possible Fed hike are keeping investors in the country cautious.
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While the expected election of reformist candidate Fernando de la Rua as Argentina's next president on Sunday may help the country's economy over the long term and even spark a mini-rally in its capital markets, international investors aren't getting ready to plunk a lot of cash in the near term.

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Sure, Argentines will be freed from the frenzy of politicking and have time to concentrate on the task of putting South America's second-largest economy on the mend. But with

Moody's Investors Service

downgrading Argentine debt two weeks ago and the

Dow Jones Industrial Average

signaling the U.S. bull market may be coming to an end, few think the country's route to recovery will be easy.

Argentine investors got another reason for pessimism when the latest election polls showed Eduardo Duhalde, the governor of Buenos Aires province and a presidential hopeful, gaining ground on de la Rua, jumping to 12 points behind from 19. Last summer, Duhalde spooked investors in Argentina and the U.S. with promises of tax cuts, layoff bans and renegotiations of the country's external debt. While he is not expected to win the presidency, Duhalde's party, the protectionist

Peronists

, may win more seats in the house, senate and provincial governments than analysts have predicted.

Already the nation's stock market is reflecting the expected short-term angst. Since Oct. 6, when Moody's cut Argentina's debt to the decidedly junk rating of B1 from Ba3, the benchmark

MerVal

index has given up nearly 5%. It now trades at 515.15, a three-week low.

To be sure, part of that performance has been dictated by the volatile U.S. markets. And not all the news is bad. Two weeks ago, Argentina raised $1.5 billion in special

World Bank

-backed bonds. If Argentina pays the World Bank back in 60 days, then the guarantee on the first series rolls over to the next series, which is spaced out over five years.

Standard & Poor's

gave the issue an investment-grade rating.

But even this development carries with it an unsettling element. Miguel Kiguel, Argentina's undersecretary of finance, acknowledged that his nation opted for this structure because the country had difficulty selling ordinary dollar-denominated bonds. And Argentina hopes to raise another $500 million to $1.5 billion before Dec. 10, when the new government takes office.

As if Argentina's domestic woes weren't enough, the new government is also at the mercy of the U.S.

Federal Reserve

, which may raise interest rates by 25 basis points come November. While a quarter-point hike may have only marginal effects, any rise will put pressure on Argentina to raise domestic rates as its economy contracts from capital outflows to higher-yielding, less risky U.S. Treasuries.

The Argentine peso is pegged one to one to the dollar, meaning that each peso in circulation needs to be backed by one dollar in reserve. In addition, Argentina has a currency board, thus money supply only changes with inflows and outflows of dollars into the country.

Outflows will, in turn, hamper Kiguel's proud prediction that foreign domestic investment will reach a record of $6 billion by the end of the year. If investors continue to have faith that Argentina will not devalue, foreign direct investment may return if Argentina raises rates in the wake of a Fed hike. Argentina's total external debt is estimated at $140 billion, or nearly half of the total GDP and roughly five times its level of exports.

"Recovery in debt financing inflows is vital to the growth outlook," wrote Vladimir Werning of

J.P. Morgan's

economic research team.

Excepting a surprise victory from Duhalde, the Argentine long-term growth outlook is positive, with J.P. Morgan forecasting 3% GDP growth in 2000. But how quickly reforms lead to growth, and thus to restored investor confidence, depends upon actions taken by both the outgoing and incoming governments over the next three months.