Living on the edge

IFR Americas Review of the Year 2014
11 min read
Davide Scigliuzzo

Despite the negative headlines, citizens of Venezuela and Argentina are considerably happier with their lot than citizens from more developed countries, according to the results of a detailed global happiness survey published at the end of October by Pew Global Research. The Washington-based think-tank found satisfaction levels of 74% and 66%, respectively, above those in the US, Japan and all members of the EU.

The satisfaction of life clearly has little to do with financial well-being, as the economies of both countries are among the most troubled in Latin America. These woes have been aggravated by the recent collapse in the oil price, which will make Venezuela’s effort to cover funding gaps that much more difficult.

“Political risks are more difficult to evaluate because they are inherently qualitative assessments,” said Michael Gomez, head of emerging markets portfolio management at Pimco. “This would be particularly true in Argentina and Venezuela … where political leadership has been a source of market uncertainty in the past.”

Argentina’s default was prompted by a New York court order in 2012 that did not allow Argentina to pay any bondholders who accepted the country’s 2005 and 2010 debt restructurings without simultaneously fully paying back anyone who rejected the deal. Argentina ended up paying neither, and as a result has slipped into technical default.

“[Argentine President] Cristina Fernandez de Kirchner is in a real corner on this. This is a huge political issue. Many want it resolved,” said Stuart Culverhouse, global head of research at Exotix, and there is a distinct soap opera quality to the back and forth. It reached its peak (so far) in early October when central bank governor Juan Carlos Fabrega resigned.

There certainly appears to be little good news for the country. Inflation is at about 40%; the Argentine peso touched an all-time low of 15 to the US dollar in the black market (double the official rate); and foreign reserves slipped from US$30.6bn to US$28bn in October, and could be as low as US$22.5bn by the end of the year.

Key to the issue, however, is politics. As Erich Arispe, director at Fitch in New York, pointed out: “Argentina has the prospect of a real change of power next year.” Thanks to term limits, Fernandez de Kirchner must stand down and there are presidential elections scheduled for October 2015. Together with her late husband Nestor Kirchner, she has ruled the country since 2003 and there is now a real sense of transformation.

The faithful and the vultures

Kirchner has divided the world into the faithful and what she calls “vulture funds”, the bondholders who did not accept the debt restructuring. Not only has this given her a lift in the opinion polls (she has an approval rating in the 40s) but it makes it difficult for any of the presidential candidates to speak in favour of debt restructuring.

Although many would like to believe that the government will resume negotiations with holdout creditors in January, some reckon that Kirchner is playing a long game.

“There is also concern that President Cristina Kirchner would not be willing to pay the political costs associated with settling with holdouts if an agreement could not be finalised in time to access international capital markets by mid-2015,” said Daniel Chodos and Casey Reckman, Latin American strategist and economist respectively, for Credit Suisse in New York.

Were she to hold out until her term runs out, some suggest, then the issue becomes what one New York banker calls “the next guy’s problem”. This would allow her the option of standing again in 2019 when she could present herself as the candidate who didn’t give in.

Put crudely, the challenges that Argentina has are the result of temper tantrums rather than systemic economic problems. They are eminently fixable. This is why Argentina sovereign bonds are trading considerably better than the headlines might suggest. At the beginning of December the country’s US dollar-denominated Bonar bonds due 2015 and 2017 were trading in the mid-90s.

“Argentina is in a technical default at the moment. But there is no doubt at all that if President Kirchner does not solve it, the new government will,” said Alejandro Grisanti, head of Latin America economics research for Barclays.

Venezuela: falling foul

In Venezuela, meanwhile, a spiralling economic crisis and the breathtaking drop in oil prices (from US$110 to US$70 in the past six months to US$67 at time of going to press) have the country struggling to cover financing gaps.

Some attempts at addressing fiscal shortfalls may allow the government to muddle through in the short term, but there are concerns that President Nicolas Maduro’s administration will delay unpopular, albeit essential, policy changes ahead of national assembly elections late next year.

Rodolfo Marco Torres, Venezuela’s minister of finance, has been quick to jump on any suggestions that the country was planning to renege on its debts – normally via Twitter and using the hashtag #VenezuelaSeRespeta, or Respect for Venezuela. He did so in early October when there were rumours about difficulties of honouring a US$1.5bn government bond payment that was due and again later in the month, ahead of a US$3bn bond payment for state-owned Petroleos de Venezuela (PDVSA).

While all bonds issued by PDVSA require unanimity to modify the terms of interest and principal payments, the bulk of the debt issued by the sovereign contains collective action clauses allowing a 75% majority to agree to a restructuring that is binding on all holders of a particular series. The distinction, however, might not matter much in the event of a disorderly default.

The market is already pricing in higher default probabilities going into 2017, when the country faces a spike in debt maturities. This is reflected in both state-owned oil company PDVSA and Venezuela’s inverted curves, where yields stand in the low 30s in 2016 and 2017, only to drop to the 20s and the teens in year 10 and beyond.

“If present policies are held unchanged, the market sees the height of default risk in two years’ time,” said Michael Roche, emerging markets fixed-income analyst at the Seaport Group.

Venezuela’s Expected Default Frequency – Moody’s market-based measure of credit risk – hit new highs in the beginning of December, of 11.61%, putting it well ahead of other distressed sovereigns such as Puerto Rico (7.1%), and Ukraine (4.6%). It was also above the 7.75% seen for Argentina just before it defaulted this summer.

Signs that markets are preparing for a restructuring scenario are also becoming more abundant.

Investors can be therefore forgiven for believing the worst. Over the next three years, Venezuela has more than US$28.2bn in debt due – US$4.7bn of it in 2015 – inflation stands at about 65%. In mid-September, S&P downgraded the sovereign to CCC+ and said “the downgrade is based on continued economic deterioration, including rising inflation and falling external liquidity, and the declining likelihood that the government will implement timely corrective steps to staunch it”.

The most immediate challenge for the country is the declining price of oil – and this has now become a stark reality for the country. “Anything below US$90 means that Venezuela will have to take some tough decisions,” said Erich Arispe, director at Fitch in New York.

Oil prices are certainly weighing down on Venezuela. “This is one reason why the market is pricing in risk for Venezuela,” said Barclays’ Grisanti.

It may, however, be too soon to start writing obituaries. Although lower oil prices will continue to strain government finances, the country does have some room to manoeuvre.

In a recent report, political risk consultancy Eurasia stated: “Venezuela can continue to meet its debt obligations and minimum import demand with average prices between US$75 and US$80 per barrel.”

The reason for such flexibility is that dollar revenues at the moment not only prop up the price of petrol domestically, they also subsidise oil exports to Caribbean nations such as Cuba. Few analysts believe that if it came down to a choice between default or friendship, Venezuela would choose the former.

More to the point, there is China. Since 2006, it has taken on US$50bn of oil-backed Venezuelan debt, and in late October it was announced that loans that used to have tenors of three years have been extended indefinitely. With the Chinese government clearly taking a longer-term view and not bashing on the door and demanding repayment, immediate pressure has been released.

At current oil price levels, the country faced a shortfall of about US$18bn for imports and debt service, which could be covered in part by one-off solutions, said Jorge Piedrahita, CEO at broker Torino Capital. These include Petrocaribe securitisations, recent agreements with China over loan terms, the reduction of imports and the sale of PDVSA’s US operations CITGO.

“I don’t think they are at the point where the discussion is: ‘Do I pay the debt or feed the people’?” he said. “I think they can do both. They are probably more than a year away from that discussion.”

Patrick Esteruelas, a sovereign analyst at emerging markets asset manager Emso, took a similar view. “The risk of Venezuela defaulting in 2015 remains manageable and very low. It is certainly below the 45% default probability implied by one-year credit default swaps. I would say it is less than half of that.”

What has also helped is a limited devaluation of the bolivar, which has affected PDVSA in that the oil company can collect more in exchange for its dollar inflows. Although this does not bring in any extra foreign currency, it has limited FX demand and reduces the public sector deficit.

“The key difference between the two countries is that for Argentina there is light at the end of the tunnel. With Venezuela there is little sense of that yet,” said Culverhouse.

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Living on the edge