Are Argentina's Messi days in the past?
The power of carry
Is it worth investing in a currency plagued by high inflation, with a history of continuous depreciation and numerous large devaluations?
Argentina has been in a bit of a financial mess for decades. The period since the millennium has been no exception, with Argentina twice defaulting on its debt, and being locked out of financial markets as a consequence. It was forced to turn its twin deficits (in the fiscal budget and the current account) into surpluses, as foreign currency reserves were depleted quickly. With no financial buffers and economic mismanagement by a populist president, Argentina has been plagued by high inflation and an ever weakening currency, although not quite to the extent of its previous episodes of hyperinflation.
However, the tide for Argentina changed when Mauricio Macri defied expectations by winning the 2015 presidential run-off, beating the Peronist candidate who was supported by the then incumbent president Christina Fernández de Kirchner.
Inflation is still at high levels and the twin deficits have reappeared. However, thanks to its more sound economic and monetary policy, it appears that investors are giving Argentina the benefit of the doubt, resulting in renewed access to international capital markets. The central bank has started to rebuild foreign currency reserves and announced its intention to accumulate reserves until it has reached 15% of GDP (see chart). We agree with this positive sentiment and favour long exposure in the Argentine peso. A positive view on Argentina is not raising too many eyebrows today, but has the Argentine peso actually been a bad investment historically?
To answer this question we need to look at currency returns, not spot prices. The Central Bank of Argentina has kept interest rates at high levels to fight high inflation, to stop the currency from collapsing (further) and to avoid foreign currency reserves vanishing completely. A currency investor in the Argentine peso would earn the interest rate differential (i.e. carry), as reflected in forward prices, on top of the typical loss in the spot exchange rate. The carry plus the move in the spot price together determine the return on holding the currency. As the chart below shows, this has historically been a profitable investment (against the US dollar).
Of course, given the shaky fundamentals of Argentina for many years, this investment came with a fair amount of risk, as the next devaluation was always around the corner and a return to the hyperinflation of the 1980s could not be ruled out. However, the large positive carry has enabled long-term investors to reap the risk premium. We still like being long the Argentine peso today, but for this position to pay off, Argentina's 'Messi' days need to stay in the past.