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Within months of its January 2002 default and devaluation, Argentina’s economy began a remarkable recovery, which was only reinforced by its brutal, but largely successful, international debt exchange offer two years ago. After the offer closed that year, this column predicted that the recovery would be stopped by electricity shortages, probably in late 2006.
I was off by about six months. Two weeks ago, Argentina was hit by a series of blackouts, which were attributed to unusually cold weather. In truth, the Argentines have been unusually lucky with their weather in the course of the current recovery. They’ve had enough rain to keep their hydroelectric generators running at a high rate, and basked in cool summers and warm winters. Predictably, their leadership had projected this good luck, and a large inheritance in the form of past foreign investment, into a future of unending prosperity.
Guess not. Magical thinking produces great literature but poor governance. The Argentine miracle, which has paid a lot of emerging market traders’ children’s tuition bills, is about to go poof. Fortunately for those traders in Argentina (no one invests in it, surely?), the country’s penchant for overcomplex finance led to the creation of a useful instrument for playing the electricity shortage: the Argentine GDP warrant.
International bondholders staggered out of the Argentine exchange offer as if they’d been through their first prison shower. Many of the shattered holders sold off their bonds without taking serious notice of a provision under which Argentina offered to pay them 5 per cent of the excess of the country’s GDP growth above a two-decade trend line, in any particular year between 2006 and 2035. There was a cap on total payments of 48 per cent of the warrant’s notional amount.
Initially, the warrants were valued at about 2 cents on the dollar (or euro). Understanding them required a knowledge of history, finance, and macroeconomics that was beyond most of today’s generation of emerging market traders and portfolio managers, but that came naturally to Argentine speculators. So the dumb people sold the warrants to the smart people.
From mid-2005, the warrants have risen in price from 2 cents to more than 15 cents, as EM portfolio managers noticed the extraordinary Argentine growth rates. A 700 per cent return in two years; not so bad, really. Did your EM strategist notice this one?
That was the upswing of the roller coaster, though. Astute students of Argentine history will recall that there is a downswing in the country’s economic cycles. Even so, as of last week, one sell-side firm was valuing the warrants at 17.1 cents, based on 2008 GDP growth of 3.75 per cent, another at 16.5 cents, based on 4.6 per cent GDP growth in 2008, and yet another thinks they’re worth 19.8 cents, based on 5 per cent GDP growth in that year.
Just one question: where is the electricity going to come from to power these future years of high growth? Anybody with an Excel programme can draw a trend line, and the same person with Powerpoint can create a sales pitch, but actually finding and producing natural gas, and building and operating generating plants, is more difficult.
There is a close correlation between electricity consumption and GDP growth. Along with good weather, Argentina has benefited from the 68 per cent increase in generation capacity between 1992 and 2001, most of it paid for by those foreign creditors who are now reviled by President Nestor Kirchner. Most of that new capacity was gas-fired, and the liberalised gas market of the 1990s led to substantial gas production and reserve additions.
Since then, electricity prices were devalued along with the peso, then frozen, then partially unfrozen. Gas prices were also strictly controlled, and exports cut back. The result has been no new private investment in generation, and rapidly declining reserves. A country whose energy use is 50 per cent gas-based now has only about seven years of proven reserves.
Sergio Fuentes, a Buenos Aires-based director of Standard & Poors, points out that: “Today in Argentina a megawatt-hour sells for about $25; in Chile it’s $73. There are no important private investments in the sector because of low prices and high political and regulatory risk.”
The Argentine government will point to two 800 megawatt gas-fired generators being built under its sponsorship, a projected improvement in the Yacyreta hydroelectric station, and a new nuclear station. The two gas-fired generators are supposed to be finished next year, in time for the Argentine winter. But as Mr Fuentes points out: “The schedule is very tight, and I don’t know if they will be in place in time for next winter.” And when they are completed, they will account for a little over one year’s increase in demand.
The Yacyreta capacity additions depend on Paraguay’s agreeing to flooding more of its territory, and as for nuclear projects happening on time …well …paging Father Christmas.
The situation could even now be saved if the Argentine government agreed to fully liberalise gas and electricity pricing, which would cut back on runaway demand growth, while creating the incentives to produce energy. That would need to happen quickly, because the country is dangerously dependent on highly variable hydro power, and there are long lead times, and difficult financing, involved. In any event, such a policy is just a fantasy, particularly ahead of this October’s elections.
Remember those GDP warrants? They can be borrowed at a cost of 5.15 per cent, and trade close to general collateral in the repo market. I think such a short position is a good bet.
As Steve Landis, a portfolio manager with FH International, tells me: “There’s been a great technical bid for Argentine paper. But people have forgotten these are bonds, not magic beans.”