Over the last decade, Latin America’s economic growth has been grounded on favourable trade terms and ample global liquidity. With commodity prices on a downwards trend, growth drivers will need to shift. For Argentina, Paraguay, and Uruguay – part of Latin America’s Southern Cone – the shift represents an opportunity to diversify their economies and to move up in the value chain beyond the primary sector.
Economic activity has been ignited in the primary sector across different industries, yet for many in Latin America, productivity still lags relative to the agriculture and livestock farming sectors. To lever up on the decade’s momentum, those sectors will need to garner productivity gains through capital accumulation and innovation. Capital-intensive growth, however, will require funding. Some emerging market Latin American countries – such as Chile, Mexico, and Brazil – have well-oiled financial sectors that can intermediate between investors and companies, and others such as Colombia and Peru are following suit.
However, for Latin America’s Southern Cone, deeper financial markets are part of the ‘to-do list’ for the 21st century. This is where Puente’s expertise and local presence in these markets comes in. Puente’s regional coverage, in-depth research and knowledge of local players provides investors with a sold link to companies looking to exploit attractive opportunities. At Puente we have a team of more than 250 highly qualified and specialised professionals who are prepared to generate value in our clients’ businesses by offering a superior customised service based on our expertise and knowledge of both local and international markets.
The lack of capital markets development denotes a weakness, but also an opportunity
Though Southern Cone countries have successfully tapped international markets at the public sector level, most private companies have not followed suit, unlike their counterparts in Peru, Colombia, Chile, and Brazil. Corporate issuances are a small fraction of bank loans, and IPOs are rare events. Market capitalisation represents less than 10 percent of GDP, compared to an average of 36 percent for their largest Latin American neighbours.
Looking forward, financial depth will need to increase, hand-in-hand with the development of new drivers for growth. At Puente, we believe our expertise and human capital can make a contribution towards this leap. Our main areas of business are capital markets, corporate finance, wealth management, sales and trading, and asset management – leveraged by solid strategy and research areas that provide strategic, timely and forward-looking information to optimise our clients’ decision making.
Sustaining emerging markets
In Latin America, emerging markets have performed well over the last decade. Favourable in terms of trade, an expansive global monetary policy and a constructive view from foreign investors has boosted demand and inflows. The Southern Cone countries have enjoyed rapid economic growth, with soybean and beef prices as the instigators of that trend. Still, their economies are lagging behind their notable neighbours in two aspects: productivity gains have not fully spilled over the value chain; and capital markets remain mostly untapped.
The primary sector remains the main driver of foreign inflows on the goods side. Uruguay is the only partial exception, with FDI flowing towards other sectors, such as paper mills. For the three countries, the banking sector remains the main channel for financial intermediation. Corporate debt issuances are secondary in Paraguay and Uruguay, and mostly local for Argentina. IPOs are rare, and the number of listed companies is less than 150 for the whole group.
The lack of capital markets development denotes a weakness, but also an opportunity. For these economies to sustain a growth momentum, financial intermediation will need to blossom. It’s an interesting time for Argentina – after several years of mismanaged economic and monetary policies that drove investments away from the country, the situation is changing. There are several things that make both us at Puente and investors very optimistic.
Superior sovereign ratings will spill over to corporate issuances, reducing borrowing costs. Uruguay is already an investment grade country, with Paraguay looking to become one in the next few years. Argentina has the most to gain, following a credit event in 2014 amid a conflict with holdout creditors from the 2005 and 2010 exchanges, which most analysts expect to be resolved by 2016. Lower borrowing costs will increase competitiveness for sectors currently protected or in infant stages.
Uruguay will need to face the challenge of finally taming inflation pressures, as well as returning fiscal accounts to a sustainable path. Its monetary policy has been safe for a long time, only becoming slightly hawkish since last year, with inflation now at 8.5 percent, remaining above the target during the last five years. The Central Bank still faces a challenge to regain credibility by anchoring inflation expectations. Fiscal accounts have deteriorated in the last decade, with increasing social assistance programmes, public employment, and public utility companies’ tariffs growing below inflation, driving the fiscal deficit above 3.5 percent of GDP. Still, a favourable and stable institutional framework and growing credibility in authorities have allowed Uruguay to attract the highest ratio of FDI in Latin America, above four percent of GDP recently, (see Fig. 1), behind only Chile.
Infrastructural change
Paraguay started its path towards the investment grade rating introducing a set of fiscal reforms, and improving governance and institutional strength. The country has also introduced a fiscal responsibility law (FRL) that keeps expenditure bounded by a cap on the structural deficit. Looking forward, the government will need to abide by the limits imposed by the new law. This constitutes a challenge, but also an opportunity to demonstrate its commitment with the FRL, and its efficiency to approve several infrastructure projects.
In the monetary sector, the adoption of an inflation-targeting regime in 2011 has kept it under control, within the target range of 6.5 percent to 2.5 percent throughout the last five years, anchoring inflation expectations around the 4.5 percent target. This predictability of monetary policy – which has helped to reduce currency and interest rate volatility – was an important driver behind the rating upgrade. Beyond these efforts, the country will also need to reach a more diversified growth path, reducing the volatility that has characterised its economic activity, mainly as a result of climate events.
For Argentina, regaining market access is expected to reduce borrowing costs for both the public and the private sector, unlocking medium-term opportunities for growth. Reaching a settlement with holdouts from the 2005 and 2010 exchanges (following the 2001 default) will remove obstacles for the government to issue external debt in deeper markets. In turn, this will allow the next administration, taking office by the end of 2015, to build a buffer of external savings to correct macroeconomic imbalances – giving the private sector more space to function.
Argentina’s public and private sector leverage is among the lowest of the region, after declining steadily over the past decade. Increasing the availability of external savings will likely lead the government to remove some controls on its current account situation (see Fig. 2) and encourage investment, which is lagging behind its potential (see Fig. 3). This will unlock the full potential of GDP growth, estimated to be 4.5 percent. In this context, low-developed financial and capital markets are expected to face an increased demand. Foreign inflows and higher revenues would take pressure off central bank transfers to the treasury, mitigating inflation, and opening space to reduce fiscal pressure.
The country has a reputational problem that generates lack of credit, which is translated into bond and equity prices. There’s not a solvency problem. As we get closer to the change in the administration, equity prices will probably rise along with an interest in Argentine assets. We recommend investors to become positioned in Argentine bonds and equities as we think they are paying a very high premium over their real risk. There are already some investors that are getting ahead of the market by investing in real economy and financial assets.
The reduction in borrowing costs should open opportunities across different sectors where growth drivers will need to shift from commodity prices and cheap funding to investment and productivity gains.
In Paraguay, economic diversification has been improving along initiatives from both the government and the private sector. In particular, light manufacturing industries have been developed and value-added in agricultural manufactures has increased.
Mind the gap
The expansion is likely to continue due to Paraguay’s competitive advantages over Brazil, including lower labour and energy costs, and a more favourable tax environment. Paraguay’s salaries are among the lowest in the region, and currently most of its energy production from Itaipú and Yacireta is exported to its partners Brazil and Argentina. Another challenge for Paraguay is to close the infrastructure deficit gap, as it is the highest among the Southern Cone countries.
Authorities took on this issue by approving the Public Private Partnership (PPP) law, generating a proper environment to develop infrastructure projects by allowing mixed funding from the public and private sector. Three projects are expected to start the construction stage by the end of 2015 under the PPP programme, for a total investment of around $1.4bn, representing 40 percent of the last five years’ average investments. In addition, the public sector is expected to carry out investments in infrastructure for $1.8bn.
Uruguay’s investments have been concentrated on agro-businesses and the construction sector. Soybean-led agriculture productivity is at a record-high, and the exports profile is changing, with production diversifying to other activities, such as the forest industry, where the country is expected to become a main global player. Following the construction of a second-cellulose pulp plant last year and the potential installation of a third-one, cellulose exports will be among the three main exports – around 15 percent of total exports –together with soybean and beef.
Pulp exports will amount to more than 2.5 million tons per year ($1.5bn, around 2.5 percent of GDP), and will represent around four percent of global cellulose production, above Uruguay’s share of global soybean and meat production, which is around one percent of the global output.
But in this context, infrastructure investments have not accompanied the highly-dynamic growth of the last decade. Authorities, who estimate an infrastructure deficit of $3.6bn, are conscious that an investment shock is required to safeguard growth. Considering the need to reduce fiscal deficit, private investment is required to finance the construction of roads and railways, so the government is auctioning projects via PPP agreements. Part of the funding will come from local pension funds, allowed to invest up to 50 percent in productive projects ($5.5bn), but foreign savings will need to also contribute.
In Argentina, two sectors that have great growth potential are infrastructure and the oil and gas industry. With gross fixed capital formation having contracted in real terms since 2011, Argentina has an infrastructure deficit in key sectors, particularly in energy distribution, transport and technology. Electricity shutdowns and low quality of communication services are evidence of some of the infrastructure bottlenecks in the country. In the case of utilities, this is mostly a consequence of years of frozen tariffs, which have vanished utility companies’ profits in a backdrop of two-digit inflation.
It’s expected the next administration will allow tariff increments to boost investments in the sector, increasing the quality of the services. Improved utility services, transportation and communications will in turn improve efficiency in most sectors, particularly manufacturing and a whole array of services, for which infrastructure bottlenecks have been an obstacle to operate at full potential.
Argentina’s oil and gas sector (see Fig. 4) is also expected to have a game-changing role in the future, particularly in the hand of rich unconventional shale resources in the region of Vaca Muerta. This is the second-most extensive shale gas resource and the fourth-largest shale oil resource in the world, with a potential output of 27 billion barrels of unconventional oil and 802 trillion cubic feet of unconventional gas. The reservoir is seen as the main magnet to attract FDI in the long-term, with high potential to boost growth and domestic demand, and reduce balance of payments risks. Fully exploiting Vaca Muerta would require investments for over $20bn per year (around five percent of GDP), which would spill over into steel and transportation.
Lower expected energy prices have made profitability of the reservoir more uncertain, although at least for shale oil – for which productivity is lower than for gas – expected inflows could be postponed to the reservoir until price expectations increase. Vaca Muerta’s average break-even price is estimated to be around $84 per barrel of oil, which is above both current domestic regulated prices, as well as international prices.
Growth potential is bound to boost demand for consumer goods, particularly those targeted at the middle class, which amounts for 50 percent of Argentina’s population. Production of consumer goods should be increased once currency overvaluation is corrected, boosting exports and, once consumption rebounds, bringing higher growth (see Fig. 5.1 and 5.2). The manufacturing industry and commercial activity represent 30 percent of GDP, two sectors strongly dependent on consumer sales.
Competing local markets
Other promising sectors include agribusiness and financial sectors; however investors are looking at opportunities in all industries. Argentina shows asset prices at significant discounts compared to those in the rest of the region. And if expectations change following this recent period of volatility, there is a high potential for foreign investment. This is not only reflected in the financial markets; the local investment climate’s view of real assets has also started to change. Investors are no longer buying liquid assets from their offices abroad, but are increasingly visiting the country to understand how economics and politics work in order to make long-term investments in the real economy.
Both the public and private sectors present very low levels of leverage (current foreign debt to GDP stands at 47.8 percent), which will provide high flexibility for the new administration to face these challenges, once access to international financial markets is regained. At Puente, we saw these opportunities several years ago, and we have positioned ourselves as the leading investment bank in the country, ready to take advantage of the significant opportunities we see for Argentina in the coming years. This is a key aspect of our regional expansion plan to become the leading investment bank in the Southern Cone.
We believe the Southern Cone can sustain the last decade’s momentum through a more diversified economic structure, which will require financial intermediation as a key ingredient. At Puente, our expertise in the region can become an essential link in the value chain, to exploit opportunities in up-and-coming sectors that will become an integral part of these economies over the next few decades.
