Country risk: Brazil and Mexico will avoid going the way of Argentina

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By:
Jeremy Weltman
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Analysts assess the relative merits of Latin America’s heavyweights and argue that while sovereign defaults are unlikely, the risks have increased.

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Argentina’s repayment difficulties are legendary.

The country has defaulted eight times since its independence and it is threatening to do so again, as it extends, until May 22, negotiations over a $65 billion debt restructuring proposal after the initial deadline passed.

The country is mired in recession, made worse by the debilitating and possibly long-lasting impact of the global coronavirus pandemic, which is one of the worst – if not the worst – crisis in modern times.

Creditors are being asked to accept a three-year grace period, a reduction from the current bond coupon average from 7% to 2.3%, and an extension to 2030.

“The involved parties should be able to agree on a financial structure that gives Argentina additional time,” says Jose Miguel Infantozzi, an investment banking associate at The Network Company and one of Euromoney’s more than 300 risk survey contributors.

“This will include a minimum grace period and a sustainable coupon rate adjusted to the country’s economic performance … avoiding chaos for a weakened economy to support 45 million people adapting to a pandemic environment.”

Invariably, with its problems mounting, Argentina’s risk score plummeted in ECR’s Q1 2020 survey. Venezuela is still struggling, too, along with Ecuador, but they are not the only countries showing heightened risks.

Dire outlook

The outlook for the entire region “is profoundly negative”, says survey contributor Sergio Guzmán, director and co-founder of Colombia Risk Analysis.

Latin America is dependent on foreign investment and commodity exports, including oil, copper, soybeans, and other metals and agricultural produce.

However, efforts to control the virus outside the region will have lasting consequences, and the fact it was vastly underperforming, with high social-instability risks before the pandemic struck, should be raising alarm bells.

Euromoney’s survey nevertheless shows a disparate bunch of sovereign borrowers across the region, ranging from top-rated Chile, still a very low risk despite copper price volatility, lying 14th in the global risk rankings, to Venezuela still in crisis in 167th place:

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In the Q1 2020 survey, not only was Argentina heavily downgraded but so too were Brazil, Chile and Mexico, alongside Bolivia, El Salvador, Colombia, Guatemala and Paraguay to a lesser extent.

Given the timing of the survey and the delayed spread of Covid-19 to the continent, it seems reasonable to expect risk scores to deteriorate further, for most if not all Latin American borrowers. Several analysts have indicated this will be the case.

“Something over 25% of real GDP in the G7 economies has been lost from the initial effects, according to the OECD, and the recovery process appears likely to be much more drawn out than initially hoped, even when the risk of a possible second wave is excluded,” says Johan Krijgsman of Krijgsman & Associates, another survey participant.

“Commodity prices have weakened, investors have pulled back their capital and responses to Covid-19 in Latin America have not been either resolute or successful in containing the outbreaks.”

Consequently, the IMF is predicting deep recession for 2020, with all of the region’s economies contracting in unison. Argentina’s real GDP is seen declining by 5.7%, making it a third consecutive year of contraction, and one of the worst performing besides Venezuela and Nicaragua, though other countries will struggle.


Since the onset of Covid-19, however, China appears to have moderated its ‘a stick, then a carrot’ lending diplomacy into the softer ‘a carrot, then maybe a stick’ position 
 - Constantin Gurdgiev, Middlebury Institute of International Studies

The crisis will put huge pressure on already strained fiscal resources and on central banks that are tempted to reduce interest rates to provide liquidity at the risk of generating inflation as their currencies slide.

“The only consolation for some of the region’s well-performing economies in 2019, such as the Dominican Republic, Bolivia and Colombia, is that they will not contract as much as others in the region are expected to,” says Guzmán of Colombia Risk Analysis.

Citibank is even more pessimistic than the IMF. It expects GDP to plummet by 9% in Mexico, 7.5% in Argentina, 4.5% in Brazil, 2.7% in Peru and 2.5% in Chile.

“Despite these inauspicious figures, what will perhaps matter most in the current juncture is the credibility that monetary and fiscal policy authorities carry with capital markets,” adds Guzmán.

“In the specific case of Colombia, government tax revenues will continue to be under pressure in 2020, due in part to falling oil revenues, reduced exports and falling domestic demand. This trend could exacerbate in 2021 when some other tax deductions in the economic growth law come into force.”

The crisis will also have political risk implications, exacerbating tensions for political leaders who have been less responsive to the crisis, namely president Jair Bolsonaro of Brazil and Mexican president Andrés Manuel López Obrador.

Regime change remains unlikely at this point – only a handful of the region’s countries are slated to have elections in 2020, many of which have been postponed due to Covid-19 – but opposition leaders and public opinion more generally will be a factor going forward, warns Guzmán.

“It is expected that as food prices increase and quarantine measures are extended in different countries, we will experience a significant rise in protest movements that will embolden opposition groups,” he says.

Brazil

The two biggest economies in the region have undergone substantial downgrades by risk experts reassessing the investor outlook.

Daniel Wagner, CEO of Country Risk Solutions, says: “Argentina and Ecuador have already defaulted on bond payments, a number of the region’s bonds remain under pressure and the ratings agencies have downgraded numerous countries throughout the region.

“At greatest risk of additional default are Brazil and Mexico, whose economies will remain under severe strain.”

Brazil has fallen 13 places in the survey, to 73rd, but Ruetger Teuscher, senior economist at DZ Bank, retains a sense of guarded optimism.

“Brazil’s share of foreign currency denominated (public) debt is simply just too small to ignite such a default scenario,” he says.

However, he cautions: “Further erosion of the government´s political authority, along with rising unemployment, upcoming social unrest and inconsistent political decision-making will raise the risk premium for the country.”

Krijgsman also warns of inflation, fiscal and political risks down the line for Brazil.


Resistance to widening the tax base and reducing the informality of the economy, in addition to declaring no new taxes until 2021, have made public finances precarious 
 - Johan Krijgsman of Krijgsman & Associates

The present effects of the Covid-19 pandemic are deflationary, and Brazil’s inflation rate has been brought down to 2.4% in March, but he notes the sharply weakening exchange rate associated with strong capital outflows earlier this year, and the central bank recently lowering the Selic target rate to 3% and able to add quantitative easing to its arsenal.

“This raises a medium-term inflation risk that should be monitored,” he says.

Krijgsman also says confusion in politics is back.

“The reformist platform of Bolsonaro seems to have stalled as emergency aid to deal with the economic crisis takes priority,” he says. “The $223 billion package announced in April was roughly the same size as 10 years of savings from the pension reform enacted last year.

“The president’s denial about the Covid-19 virus dangers caused the loss of health minister Luiz Henrique Mandetta [fired in April] and has meant that the virus has spread faster than otherwise [more than 12,000 deaths by mid-May].”

He adds: “This stance has proved to be politically divisive locally with state governors and municipal leaders, as well as attracting international medical concerns in an editorial in The Lancet on Saturday."

The president has lost his highly respected justice minister Sérgio Moro over interference accusations, which may be investigated by Congress, and concerns have been raised that his well-regarded finance minister could be next.

“Oil market developments risk another disaster associated with Petrobras and the failure of the Boeing-Embraer deal flags that we are in a different world,” Krijgsman adds.

“Recent reports that some foreign borrowing has been reported as foreign direct investment ($36 billion in Brazil’s case) is a cause for concern."

Mexico

In Mexico’s case, bets on the oil industry have been misplaced, Krijgsman believes.

“Resistance to widening the tax base and reducing the informality of the economy, in addition to declaring no new taxes until 2021, have made public finances precarious,” he says.

“Government reliance on revenues from [state-owned oil company] Pemex (4.2% of GDP in 2018) mean it will have to find at least half that this year from somewhere else.”

Tourism, accounting for more than 8% of GDP, is another weak spot, Krijgsman points out.

“With 80% of exports focused on the US (one third of these being auto related), short-term prospects are not good, assuming a cautious consumer there,” he says.

Long-running issues such as Mexico’s North/South divide, violence and the corruption that the new president was elected to address, remain, adds Krijgsman, while longer term the Mexican dream must be to replace China as the manufacturing hub for US imports, but this will not occur overnight.

Crucial support

Survey contributor Constantin Gurdgiev is associate professor at the Middlebury Institute of International Studies and adjunct professor with Trinity College Dublin.

He believes that despite the unprecedented macroeconomic shocks triggered by the pandemic, and the already weak fiscal and sovereign debt positions of emerging markets (EMs), such as those in Latin America, the probability of sovereign defaults in the short term is falling, rather than rising.

There are three main reasons for this.

First is the fact the IMF and other lenders have substantially expanded their emergency support programmes. For EMs, they include a range of debt-restructuring instruments, including the IMF’s removal of economic conditionalities and expansion of its grant programmes.

Secondly, aggressive intervention by the US Federal Reserve and other G7 monetary authorities has allowed for monetary easing in EMs, reducing both domestic and foreign debt-service pressures in the short run. The G20 declaration of suspension of debt and interest repayments by emerging economies during the pandemic will also help.

Third, there is less pressure on many emerging economies from the geopolitical risks relating to their maturing debt rollovers.

“China is one of the biggest net lenders in the emerging markets and especially in the markets for lending to more financially challenged sovereigns,” says Gurdgiev. 

“Prior to the onset of Covid-19, China used the maturity of its loans as a tool for extracting geopolitical concessions from the borrowing states, leaving their governments between a rock and a hard place: either face default or move closer to an alignment with China."

He adds: “Since the onset of Covid-19, however, China appears to have moderated its ‘a stick, then a carrot’ lending diplomacy into the softer ‘a carrot, then maybe a stick’ position. This removes a lot of latent default risk for countries like Venezuela.”

The default risk, therefore, is not a short-term problem, but a medium-term one, he believes. While defaults are unlikely to occur within the next two to three months, beyond this horizon the risk of EM defaults will rise, and this rise will be broad and sharp.

However, Brazil and Mexico have one factor in their favour, Gurdgiev points out. One of the key reasons for defaults is that EMs borrow in US dollars both in the sovereign and corporate debt markets.

A wave of private-sector defaults is likely to trigger a notable drawdown of domestic currency reserves in economies with close ties to US dollar-denominated trade and commodities markets.

Although this, in turn, can lead to a foreign-reserves crisis, as the majority of the emerging economies have no access to Fed swap lines, Gurdgiev notes the fact that this excludes Brazil and Mexico.