Argentina and Venezuela: The weakest link

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This post is a guest contribution by Daniel Volberg of Morgan Stanley.

Faced with the risk of a global downturn, we have argued that starting points matter and that Latin America is for the most part better prepared for a downturn than in the past. But the improvements in the region’s balance sheets have not been uniform; indeed, two economies in the region, Argentina and Venezuela, stand out as most vulnerable to a severe external shock. A track record of policy heterodoxy, relatively weak balance sheets and high reliance on elevated commodity prices mean that Argentina and Venezuela are likely to be Latin America’s weakest link. However, while neither is well equipped to weather a prolonged slowdown in global growth, we are concerned that Venezuela is far more vulnerable than Argentina. We highlight three concerns:

First, the balance of payments in Argentina and Venezuela may be vulnerable to deteriorating global macro dynamics. At first glance, it may seem that the starting points for both Argentina and Venezuela are strong. After all, in the four quarters through June both countries ran current account surpluses, putting them in an exclusive club with only Chile as the other regional economy with a current account surplus. Argentina posted a 0.3% of GDP current account surplus while Venezuela’s surplus was a massive 8.4%. But this image of a strong starting point belies very challenging dynamics.

If commodity prices were to simply remain flat at the levels reached in mid-2011, both Argentina and Venezuela could face balance of payments reversals. Whether we use twelve- or six-month growth trends in import and export volume to project forward the current account balance, we find that Argentina’s and Venezuela’s balance of payments could reach unsustainable levels within a year. For Argentina, using the six-month trend results in the current account balance falling from 0.3% of GDP surplus in the four quarters through June to a 3.9% deficit by December next year. For Venezuela, a similar calculation results in the current account slipping from an 8.4% of GDP surplus to a 6.4% deficit. And while this exercise for the rest of the region suggests that Argentina’s current account dynamics are in line with the regional average (Venezuela, though, is one of the worst performers), we suspect that both Argentina and Venezuela may be more vulnerable than the rest of Latin America to a reversal in the current account. After all, in both countries, foreign direct investment – which tends to be the most sustainable form of financing current account deficits – has been limited (and in Venezuela’s case negative). This suggests an important vulnerability since both countries appear to be reliant on steadily rising commodity prices in a global economy where downside risks to commodities have risen sharply.

Second, the fiscal accounts appear stretched and vulnerable to a downturn. In contrast to the current account balances, on the fiscal side both Argentina and Venezuela are starting from a position of weakness.

Argentina’s fiscal balance is already in the red, although admittedly it is difficult to be too alarmed about a consolidated fiscal deficit which we estimate reached 0.5% of GDP through August: the federal budget balance posted a deficit of roughly 0.3% of GDP in the 12 months through August and we estimate that the provincial fiscal deficit was likely at least -0.2%. After all, many developed and emerging economies are facing double-digit shortfalls. But it is worth noting that the deficit comes despite what had been a very favourable global environment that had prevailed in the first half of this year. And for a country with no access to international capital markets, managing any deficit may be challenging.

Meanwhile, Venezuela’s fiscal condition is likely even more worrisome than Argentina’s. A key challenge in assessing Venezuela’s fiscal health is that the fiscal results that really matter – the consolidated fiscal balance – are available only through 3Q10. Back then, in the four quarters through September 2010, Venezuela posted a -9.0% of GDP consolidated fiscal deficit. To gauge how that result might have changed, we look at the more up-to-date central government fiscal results. At first glance, these suggest a dramatic improvement. After all, we estimate that the central government posted a 0.3% of GDP surplus in the year through May. However, the overall central government balance tends to be largely uncorrelated with the consolidated fiscal results for Venezuela that really matter. A much stronger link appears to be between the so-called ordinary central government balance – the balance between so-called ordinary revenues (excluding public credit and bond issuance) and ordinary expenditures (excluding short-term debt buybacks) – and the consolidated fiscal results that ultimately determine Venezuela’s fiscal health. And on this front the numbers are far from strong. The ordinary central government balance posted a deficit of roughly 4.7% in the year through May, only slightly better than the 6.6% deficit in the year through September 2010. Therefore, if the ordinary balance is any guide, we suspect that there will be only limited improvement (close to -7.5% of GDP) in the consolidated fiscal results from the 9.0% deficit.

In sum, both Argentina and Venezuela are starting from a position of weakness on the fiscal front, despite what has been – until very recently – a favourable global backdrop. Neither Argentina nor Venezuela appears to have the room to pursue counter-cyclical fiscal policy to mitigate the impact of a potential external shock.

Third, international reserves may be insufficient to deal with the potential stress. Despite losing US$3.7 billion since July, Argentina still has a significant international reserve cushion – at US$48.2 billion as of October 14. However, a rapidly appreciating real exchange rate (via high inflation) has fueled fears of a more pronounced currency depreciation that may prompt outflows. The risk is that Argentina is largely a cash-based economy – roughly US$30.7 billion in local currency is in the hands of the public – so a shift in the money demand towards dollars could potentially prompt meaningful reserve losses. In addition to the risks of dollarisation in times of stress, the authorities are already planning to use US$5.7 billion of reserves (down from the US$7.5 billion allocated this year) to make external debt payments next year.

Meanwhile, while Venezuela has maintained a steady cushion of international reserves, currently at US$31.0 billion, the composition has steadily deteriorated, with only US$6.7 billion left in liquid instruments, US$4.1 billion in IMF lines and US$21.1 billion in gold. Indeed, Venezuela has increasingly relied on the revaluation of the stock of gold to maintain international reserves at a steady level during the past few years. Given potential liabilities of up to US$27 billion in pending arbitrations with oil companies that could hit Venezuela this year or next, Venezuela’s reserve cushion appears weak (see “Venezuela: Leaking Dollars”, This Week in Latin America, May 2, 2011).

Argentina versus Venezuela

While both Argentina and Venezuela may be ill-prepared for a global downturn, we are more constructive on Argentina’s ability to navigate the downside risks in an orderly fashion. This appears to be at odds with the view from some that contrast Argentina, which defaulted on its external debt obligations in 2001, with oil-rich Venezuela, which has remained current on its debt obligations. And recent market moves suggest that that view has been gaining ground: Argentina’s risk premium has widened much faster than Venezuela’s. We remain concerned that the risks in Venezuela are greater than in Argentina for three reasons.

First, Argentina’s balance sheet is stronger than Venezuela’s, whether we look at balance of payments, fiscal or debt dynamic. While the balance of payments in both countries is sensitive to commodity prices, Venezuela appears to be much more vulnerable. Our simple exercise of using recent import and export trend growth with only one change (holding commodity prices constant) produces a much more dramatic swing from surplus to deficit in Venezuela. Venezuela’s current account balance would move from a surplus equal to 8.4% of GDP at mid-2011 to a deficit equal to 6.4% at end-2012, while Argentina’s deterioration would be milder – moving from a 0.3% surplus to a deficit of 3.9%. And financing the current account shortfall during financial market stress is also likely to be more challenging for Venezuela, where FDI has been negative since 2008. Argentina, by comparison, has consistently maintained inward FDI inflows of 1-2% of GDP since 1Q09. While this is below the regional average of 2.8% of GDP, it should still provide some flexibility for the authorities in Argentina to deal with a temporary current account reversal.

Venezuela may also be more vulnerable than Argentina on the fiscal front. After all, as we had highlighted earlier, we estimate that the current consolidated fiscal deficit in Argentina is roughly -0.5% of GDP. In contrast, we estimate that Venezuela’s consolidated fiscal deficit may be as large as -7.5% of GDP.

And Venezuela’s debt dynamics may be more challenging than Argentina’s. While debt ratios look similar in both countries (Argentina’s total debt/GDP ratio stands near 46.3%, versus 40.5% for Venezuela’s external debt), Argentina is less vulnerable to any disruption in international capital markets for one simple reason: it has had virtually no access to international markets since its debt default a decade ago. Venezuela, in contrast, has been increasingly reliant on external debt – averaging US$15 billion in net new debt per year during the past three years – to boost the supply of goods (via imports) and maintain economic growth (see “Venezuela: Leaking Dollars”, This Week in Latin America, May 2, 2011). While some have highlighted that Venezuela’s access to international markets puts it in a privileged position relative to Argentina, our concerns are two-fold. Venezuela’s continued reliance on new debt despite strong oil prices in recent years suggests that its model is under significant pressure. And it is worth noting that any disruption or interruption in access to capital markets would likely be much more costly for Venezuela.

Second, Argentina has a stronger growth engine than Venezuela. Argentina has had a much stronger track record in generating economic growth in the last few years. The average GDP growth for the last five years was 6.8% in Argentina, more than double the 3.0% growth in Venezuela over the same period. While there has been some concern regarding Argentina’s reported statistics – including GDP – we doubt that this alone explains the wide gap between the reported figures in Argentina and Venezuela. We suspect that Argentina’s advantage on the growth front is due to its much more diversified economy with agriculture, energy and industry as key drivers compared to Venezuela’s almost exclusive reliance on oil. An additional issue that likely underpins the difference in economic growth rates is that while both countries have pursued heterodox policies, Venezuela’s business environment – exemplified by the frequent expropriations – has been much more challenging. And we suspect that Argentina’s stronger economic growth engine puts it in a more favourable position to weather the global downturn without a major disruptive event.

Third, recent actions from policy-makers suggest that the risk of a disruption may be higher in Venezuela. We are watching to see if there are changes in the direction of policy in Argentina following the October 23 general election: we suspect that the risks are two-sided. We suspect that there is an internal debate within the administration – that is widely expected to be re-elected – which could lead to either positive or negative policy changes in exchange rate and fiscal management. By contrast, the signals from Venezuela’s policy-makers have been much more challenging. The announcement by Venezuelan authorities in August of plans to bring gold reserves from banks in OECD countries back to Caracas, followed by the September announcement that Venezuela will leave the International Court for the Settlement of Investment Disputes (ICSID), raise the spectre that the authorities may be preparing to disregard an arbitration ruling against them. Of course, the recent moves may simply reflect rising uncertainty about how to respond in the event that Venezuela’s president’s health continues to deteriorate. While it is certainly possible to build a scenario of a more business-friendly policy framework in Venezuela, we are concerned that the near-term risks of a disorderly transition and the potential for disruptive events have risen.

Bottom Line

While the prospects for Latin American growth in 2012 continue to be largely driven by risks from abroad – the state of the US economy, the sovereign crisis in Europe and the uncertainty over China’s policy response – the region does have pockets of home-grown vulnerability. Nowhere in the region do those vulnerabilities appear to be greater than in Argentina and Venezuela. That may not come as a surprise to most Latin America watchers. But it may surprise some to learn that there is a growing view that Argentina’s model is more vulnerable than Venezuela. While we believe that both models are likely to face serious challenges in the coming years with or without a global downturn, we remain concerned that Venezuela’s balance sheet leaves it more vulnerable today.

Source: Daniel Volberg, Morgan Stanley, October 18, 2011.

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