It may be 148 years since their troops last fought each other in combat and nine years since they buried their economic differences to form Mercosur, but rivalry between Argentina and Brazil still runs deep. These days South America’s two superpowers fight proxy wars over credit ratings, GDP growth rates – and of course football.
Brazil’s latest victory over its southern rival came in the international debt markets, in the form of basis points. Last month it was able to issue a euro-denominated bond at a cheaper rate than Argentina’s debt was trading. This is unexpected: Argentina, after all, is rated one notch higher than Brazil by all the credit-rating agencies.
Brazil’s e750 million five-year bond issue, led by Credit Suisse First Boston and Salomon Smith Barney, was priced to yield 417 basis points over French treasuries, a little less than Argentina’s outstanding Five-year euro bond. And this is not a one-off. Casper Melville Murphy, strategist at Dresdner Kleinwort Benson, calculates that several of Brazil’s dollar bonds are trading through the Argentine yield curve, especially at the short end.
Investor sentiment towards Brazil has changed dramatically since last year’s currency crisis. In the wake of the real’s forced devaluation, Brazilian interest rates touched 40% and most economists predicted a rapid rise in inflation and a sharp recession. For most of last year the sovereign found it difficult to issue internationally at any price. For the most part it was forced to borrow at short maturities, with several two- and three-year bonds in euros for example.
In fact, Brazil’s economy escaped recession in 1999, growing by a modest 0.8%, and inflation has remained under control. The currency has also bounced back: after falling by as much as 60% on its pre-crisis value, the real has appreciated by some 10% this year and economists now worry that it is too strong.
Even at a time when many emerging-market credits have suffered, spreads on Brazil’s bonds have remained solid this year and at some maturities they have even tightened in recent months. Spreads on Five- to 10-year Argentine paper, by contrast, moved out by some 100bp between April and June.
What is going on? In part, Argentina’s problems have more to do with technical factors than credit fundamentals. The market has had to absorb a lot of Argentine debt, and oversupply has pushed spreads out. This year Argentina needs to borrow a total of $17.5 billion. Brazil needs to issue no more than $6 billion worth of international bonds and it has already raised more than $4 billion.
Brazil has also become much more clued-up in its borrowing strategy, issuing more liquid benchmarks and working to build a yield curve.
Argentina, long-regarded as the star borrower of the emerging markets, has had to issue frequently in a volatile and often hostile market.
But, according to the rating agencies, these technical factors have little impact on the fundamental creditworthiness of the two countries. Fitch IBCA upgraded Brazil’s foreign currency rating in February. But the other two agencies, having downgraded the sovereign after the devaluation, have not yet raised its rating (although Standard&Poor’s rating is on positive outlook). Brazil is now rated B2 by Moody’s, B+ by S&P and BB- by Fitch IBCA. (Argentina is rated BB by S&P and Fitch IBCA, and B1 by Moody’s.)
The agencies point out that Brazil’s total debt burden, including domestic debt, remains huge. The country has for decades run a big fiscal deficit. Both the 1994 anti-inflation real plan and the 1999 devaluation have added to the debt burden. The big difference between Brazil and Argentina is that the former can finance most of its debt domestically, whereas Argentina, with its less developed capital market, depends more on outside funding. “The average maturity of Brazil’s domestic debt is less than one year,” points out Fitch IBCA analyst Richard Fox. “That creates obvious dangers. Brazil’s foreign currency rating may be only one notch below Argentina’s, but the three-notch difference for local-currency debt speaks volumes.”
Many observers believe that the rating agencies are simply being slow to take note of new realities reflected in the market.
According to Melville Murphy, technical factors such as Argentine oversupply cannot on their own account for the narrowing spread differential between the two sovereigns. “If investors really believed the agencies’ view of Argentina, they would be willing to absorb the supply,” he argues.
Rather, the agencies have been slow to respond to two changes in Brazil’s fortunes. First, the Brazilian authorities have been keeping the Fiscal deficit under control and managing monetary policy. Second, abandoning Brazil’s currency link to the dollar has given the economy flexibility and boosted exports, particularly to Argentina. Strong exports have allowed the central bank to lower interest rates without weakening the real. With interest rates still high there may be plenty of room for the virtuous circle to continue.
Argentina’s currency board, which pegs the peso at one-for-one to the US dollar, has long been seen as positive for its foreign-currency debt obligations. It virtually eliminates the risk of currency crises and makes it difficult for the government to run a budget deficit.
Says Fox at Fitch IBCA: “Central bankers love currency boards because they impose discipline on the politicians.”
But as Argentina’s economy continues to groan under the weight of an overvalued currency, the market seems to be taking a different view of its merits. “To some investors the currency board is a positive, to others it’s a negative,” says Gavin. “On balance, investors have bought into the view that rigid exchange rates make it difficult for a country to adjust.”
Argentina’s sudden loss of competitiveness has been compounded by the recent strength of the dollar. And that, rather than the currency board system itself, may be the root cause of the country’s problems. “If Argentina had tied its currency to the euro it wouldn’t have had as much of a problem,” says Melville Murphy.
