Don't Let Milei's Mania Blind You: Argentina's Economy Faces Critical Challenges
There is a lot of global excitement around Milei’s strong rhetoric and policies. This is, in part, driving Argentinian debt and equities higher.
Argentinian securities have been rallying since 2021. I recommended several of them for Seeking Alpha in energy, utilities, and banks, which proved profitable. In cases like CEPU (April 2021, 470% return since) or VIST (October 2021, 568% return since), I consistently maintained a Buy rating over the volatility of post-pandemic Argentina. I also recommended others like TGS, PAM, BBAR, and LOMA.
But this time, I’m not optimistic about the country; I'm wary. In this article, I explain why I believe Milei’s government will disappoint investors. I am no macro or political trader, but given that I have recommended several Argentinian stocks, I want to provide my view after a spectacular Argentinian bull market and consider the risks ahead.
I believe Argentinian asset prices are rising beyond their fundamentals. Expectations of an Argentinian renaissance drive this. The bullish thesis argues that the new government will be able to reign on inflation, reach fiscal surplus, and introduce sustainable reforms that promote investments.
My thesis is that these long-term expectations are unsustainable because of the crisis looming in the short and medium term. Two forces can derail the opening and reform process initiated in Argentina: the deep recession caused by government spending cuts and the collapse of the monetary policy applied by the Central Bank.
Argentina has passed through similar cycles in the past. The current cycle sounds a lot like the 2016-2017 bull market. Then, investor excitement around Macri’s long-term reforms led to unsustainably high asset prices. The ensuing recession and financial collapse ended in significant losses for local and foreign investors.
Recession and political risk
Argentina’s economy is in a deep recession, and I believe it is going to get worse. The government’s view is that by reaching a budget surplus, reigning down on inflation, and changing the agents’ expectations, the economy will recover in a V shape (i.e., a quick fall followed by a quick recovery). My interpretation is that this will not happen, but rather, the economy will spiral down. The reason is simple Keynesian economics: in an environment with low savings, a sudden (negative) change in aggregate demand can cause agents to radically reduce Consumption and Investment, leading to a wider fall in Income.
The recession is significant as a short—to medium-term dynamic because it diminishes the government’s political capital and makes long-term reform unsustainable. The Argentinian people gave a vote of confidence to the new government to apply market-driven reforms. They understand that these reforms could lead to short-term pain and are willing to tolerate it. However, if the recession is too long or intense, people can change their minds and ask for a counter-reform. Again, this is not new in Argentina’s political history, where populist governments have been replaced by pro-market governments, only to see their political capital disappear, the populists return to power, and the reforms undone.
The data from the first quarter that we have access to shows a severe recession: retail sales fell 22% YoY in Q1 (CAME), and cement dispatches fell 30% YoY (AFCP). This was part of the government’s forecast, as Milei recognized in his famous ‘There is no more money’ (no hay plata) inaugural speech: the primary goal is to quickly eliminate the fiscal deficit, which requires reducing spending and rising taxes, inevitably leading to a recession. In simple economics, G spending falls, and so does Y aggregate demand.
The problem is that a wide and unexpected fall in aggregate demand decreases people’s willingness to invest and consume. This then leads to lower aggregate demand, which spiralizes in a downward trend. Therefore, governments are advised to treat aggregate demand imbalances carefully. This is contrary to what the government did, suddenly cutting 5% of the GDP in the fiscal deficit. Three factors in Argentina aggravate this.
Exports account for only 18% of the GDP, so the health of the domestic market plays a big role in demand. We will treat the role of export-oriented investments below, but their size is small compared to that of the domestic market.
SMEs, most of which are not very well capitalized, represent 40% of GDP and 65% of employment. Many will go out of business quickly if the situation does not improve. This is especially true for smaller businesses in services.
Finally, in a country where savings generally find their way into foreign currency and assets, an increase in capital profitability does not lead to higher investment without higher demand. Many local and foreign investors might welcome the market reforms, but wait for clarity and a growing economy before investing.
Then we have the problem of inflation, which accumulated 92% from December 2023 to March 2024, plus a liberalization of certain non-discretionary services like fuel, telephony, health and car insurance, and private schooling. Inflation is not neutral in the economy, and several micro-dynamics are at play. However, for all winners and losers (exporters vs importers, capital vs labor, some portions of the supply vs another), the question for aggregate demand is the same: does the increase in Consumption or Investment from the winners compensate for the loss in those categories from the losers?
Starting with exporters, there is optimism that the market reforms and the higher FX rate will lead to higher investment. I believe this will not be the case. Argentina’s export sectors are heavily oriented to factor and capital-intensive raw materials (OEC data). These sectors were already profitable, depended on commodity prices for investment decisions, and had limitations on how much they could increase production. Investments in capital-intensive sectors take time and need sustainable policies, the exact aspect that is put in doubt because of the recession. The higher profitability from a higher FX rate does not necessarily lead to more investment.
For services, the biggest export account is tourism, and Argentina is now twice as expensive for foreigners. They calculated costs at the blue-chip rate, which has not increased, while peso prices moved up 92%.
Between capital and labor, I do not believe the former compensates for the latter. Workers have a higher propensity to consume than capital owners. At the same time, capital owners are watching demand shrink and, therefore, would be ill-advised to increase investment. The price liberalization announced in telephony, fuel, and other essential services was necessary but is probably putting the cart ahead of the horses. These sectors will not increase investment in a falling demand market, and the people affected will heavily restrict their consumption.
A risky monetary scheme
The second factor contributing to instability is a typical carry trade scheme of currency appreciation paired with high domestic interest rates, which, if added to opening the capital account and ‘sustaining’ the currency by selling debt-originated reserves, will lead to financial collapse. The foreign debt and opening of the capital account components are not yet present in Argentina’s current situation, but there are indications that we could go in that direction.
This scheme is called the Argentinian ‘bicicleta financiera’ (financial bicycle). It has been applied several times in Argentinian history since the 1970s, even by today’s Minister of Economy, Luis Caputo, during the Macri administration. It is as Argentinian as football, asado, and mate.
Its origins lay in recurrent deficits paired with an obsession for currency control. Argentinian monetary thinking has been plagued for almost a century by the belief that to stop inflation, the Central Bank has to sell reserve currency and pay interest on its currency. This belief is shared by all sides: peronists, radicals, liberals, and military dictatorships. The omnipresent topic in the Argentinian spectrum is the lack of reserves to control the FX market.
But, the bicycle needs two other factors: foreign debt and a liberated capital account, which are not always present. Peronist governments tend to impose capital controls (something called the ‘cepo’ or pillory in Argentina) and do not have access to foreign credit to intervene in the FX markets.
This carry trade requires an open but intervened capital account. Because it is open, speculators can purchase back foreign currency after the trade. Because it is intervened, the rate is fixed much more strongly, and the carry trade has a higher chance of profitability.
The intervention is financed via foreign debt. The government can pay high nominal interest rates in pesos, issue dollar debt, open the capital account, and sell the dollars to peso speculators to ‘protect the currency.’
It tends to end in catastrophe and default when credit is gone, and reserves are exhausted. The country is then more indebted, creditors defaulted, and the (recession) economy does not have access to credit anymore. Generally, at this point, a populist or peronist government wins the elections, capital controls are reinstated, debt is restructured, the exchange rate is devalued, and the Argentinian cycle starts again (tip: buy here).
Interestingly, this happened very recently and was made possible by the current Minister of Economy. Luis Caputo, the current Minister of Economy, carried out this policy first as Minister of Finance and then as president of the Central Bank of the Macri administration. Argentina’s foreign public debt went up from 52% to 84% of GDP in three years (2016-2018), for a net total of $100 billion, including the IMF’s largest disbursement of more than $40 billion. The IMF loan was almost enough to net out the debt contracted during the first three years of government. Instead of doing that, Caputo defrauded foreign creditors by selling the IMF dollars to carry traders. By 2019, it was all gone. The losses in stocks and bonds exceed 70% between 2017 and 2020.
Under Milei’s government, though, this scheme is not yet complete because the pillory is closed (capital controls), and the government does not have access to debt (yet). Without debt, the Central Bank can’t sell dollars to intervene in an open capital account. That is why I am worried by Milei's statement that he is seeking new credit from the IMF ($15 billion) to open the pillory.
Interestingly, if Milei gets credit and proceeds to open the capital account, it will probably generate maximum elation in the markets. How long the scheme can last depends on how big the loans are, but it will eventually end in tragedy.
What’s ahead
I have presented a negative (albeit, I believe, sincere) view on these two fronts. However, things could work out differently, although the chances are slim.
Could this story end differently? Yes, and I hope so.
On the real economy front, the question is how long and intense the recession will be compared to how deep and patient popular support for Milei is. He is a charismatic figure, and maybe he struck a cord in people’s hearts, leading to extraordinary support against difficult circumstances. His plan would have worked if the people still supported him through this recession.
On the financial front, Milei could decide not to open the capital account and sustain the FX rate selling debt dollars. In that case, the government has two choices: if it wants to maintain a controlled FX market to avoid fueling inflation, it can’t open the capital account; if it wants to open the capital account, it must abstain from selling reserves and let the market determine the FX rate, with unknown consequences on inflation.
If this is the case, we can discuss long-term reforms and their effects on the desirability of different sectors as investments. However, the short-term dynamics prevail in the meantime because they make the long-term process unsustainable.
I might be wrong and resign some profits. However, if Argentina stabilizes and grows, we can hopefully enjoy decades of prosperity, under which I will have plenty of time to buy stocks and bonds. As Buffett said, there are infinite throws; there is no need to swing at all of them. But if I’m right, holding some Argentinian assets, especially sovereign bonds and some sectors’ stocks, will probably lead to significant losses.