Gentlemen,

Conditions in Argentina have improved slightly overnight as government and opposition forces have agreed, in principal, to reduce the budget deficit (Gwyn's fourth bullet point).  However, I'm concerned about Gwyn's third bullet point that bank deposits are being converted to dollars as well as being withdrawn from the banking system.  I've heard market rumors supporting this latter point.

Regards,

Gary

 -----Original Message-----
From: 	Hickerson, Gary  
Sent:	Monday, July 16, 2001 9:29 AM
To:	Hannon, Kevin; Lavorato, John; Fastow, Andrew
Cc:	Buy, Rick; Shankman, Jeffrey A.; Mcconnell, Mike
Subject:	FW: ENA Research: Argentina default and devaluation risk rises.  Brazil feels the effects of the contagion 

Gentlemen,

This is a good review about the financial risks in the Southern Cone.  Thoughts in the market last week involved a special Fed meeting about Argentina but no information was provided to the public.  Brazil's currency is the second worst performing currency thusfar this year, right behind Turkey.

Regards,

Gary

 -----Original Message-----
From: 	Koepke, Gwyn  
Sent:	Friday, July 13, 2001 2:52 AM
To:	Hickerson, Gary; Shahi, Pushkar; Stuart III, William; Port, David; Gorte, David; Zipter, Rudi; Buy, Rick; Kaminski, Vince J
Cc:	Raymond, Maureen
Subject:	ENA Research: Argentina default and devaluation risk rises.  Brazil feels the effects of the contagion 

Date: 12 July 2001

From: Maureen Raymond-Castaneda
         Gwyn Koepke

We believe that the risk of an Argentine debt default has increased and peso devaluation risk has also risen substantially in the last several days.

Due to recent economic and fiscal developments in Argentina, we believe:

Argentina lacks the fiscal and monetary maneuverability to lift itself out of a 3-year recession (exacerbated by a global slowdown) and a strong peso.  Argentina's fiscal position has weakened substantially due to economic weakness that limits government revenue receipts needed to balance the fiscal deficit and pay off the country's debt service.  A loss of investor confidence has caused spreads to widen despite Argentina's need to rollover about $8bn of short-term Letes (Argentine government debt) by the end of the year.  Yields paid at this week's Treasury auction are at levels that are not sustainable over the medium-term.  Three-month Treasury yields are 14.01% (versus 9.1% paid at auction on June 26 and 7.89% on June 12).  In addition to suffering from widening yields, Argentina was forced to shorten the tenor of debt from a mix of 6-month and 1-year bonds issued previously to only 3-month securities at this week's auction due to increased risk aversion to longer-term government paper by local investors (pension funds and banks).  The sharp increase in Letes yields, and the inability to issue longer maturities, is highly indicative of the difficulty the Argentine government will have in rolling over $8bn in short-term paper over the remainder of the year at sustainable rates, which further weakens its fiscal position due to higher interest payments.  
The recession has been exacerbated by the strong peso caused by the persistently strong US dollar, which has hurt Argentina's export competitiveness especially vis-a-vis the Brazilian real that has depreciated about 25% relative to the USD since the beginning of the year.  As a result to these factors, we believe the risks of Argentine debt default and peso devaluation are mounting.  
Argentina is increasingly vulnerable to a run on the banking system.  Argentines are switching from peso to dollar deposits.  Argentina's limited forex reserves constrain the central bank's ability to support the peso, if private sector deposits are withdrawn or converted into U.S. dollars.  Private sector deposits of $74bn are 33% peso-denominated, or $25bn, and 67% are foreign currency-denominated deposits, which dwarf Argentina's official forex reserves of $25bn.  Total private sector deposits fell about $5bn (from $77.5bn to $72.4bn) between February and end-April this year before stabilizing at $74bn as of July 6th.   
Political uncertainty is very high and throws into serious doubt Economic Minister Cavallo's ability to win opposition support for a new fiscal austerity program announced late yesterday.  Cavallo needs to win approval for his fiscal agenda not only at the national level, but also at the provincial level, which will not be easy considering the 3-year contraction.  Failure to gain this support to cutback spending will worsen Argentina's fiscal woes, and cause a further deterioration of investor confidence.
These external and internal pressures leave the exchange rate vulnerable to speculative attack and threaten the 1-to-1 dollar peg, especially in light of the country's limited foreign exchange reserves.  Today, Argentina's 1-month NDF traded at P1.15, implying risk of a 15% devaluation, while yesterday, the 1-month NDF traded at P1.05 (implying an increased probability of devaluation since yesterday).  Also today, the 1-year NDF traded at 1.25, implying a 25% devaluation.  As a result of these above internal and external pressures, we believe the risk of peso devaluation has increased substantially.
The danger of a steep devaluation is that private sector firms that hold dollar-denominated debt and are long pesos and short dollars will suffer from sharply higher debt payments.  This could cripple an already tenuous economic situation by causing a further deterioration in government revenue through lower tax receipts.

Developments in Argentina impact Brazil through 3 main channels:

Currency Volatility: Contagion from Argentina has lead to a substantially weaker Brazilian real.  Triggered by a general sell off of Argentine stocks, bonds and currency, the real has depreciated 24% since the beginning of the year to close today at R2.55.  To stem the real's recent decline, central bank President Fraga hiked interest rates 150 bp and simultaneously intervened in the forex market June 22, which stemmed the real's depreciation for about one week (see GMM, 29 June).  Recent currency volatility could result in further central bank intervention by drawing on Brazil's forex reserves.  Fraga has indicated the central bank will intervene to support the real's value.  A weak real will also translate into higher inflation expectations in Brazil.
Emerging market credit spreads: Argentina represents about 25% of total emerging market debt traded.  Current investor concern about Argentina has consequently widened emerging market debt spreads.  Wider spreads put upward pressure on overnight rates in Brazil, reducing liquidity and increasing costs of debt service in Brazil.
Trade mechanism: Further downward pressure on economic output in Brazil (already aggravated by the drought-induced energy crisis) brought on by weaker export market growth to Argentina.  Also, the weaker Argentine peso would reduce Brazil's export competitiveness within the Mercosur trade bloc.

This week's GMM will contain more details on the contagion effects on Brazil as well as Argentina's disappointing Treasury bill auction, the trend in private sector deposits, Cavallo's new fiscal measures to cut spending, Argentina's heightened political risk associated with the need for fiscal austerity amid concerns over provincial political support and S&P's debt downgrade to "B-", which is one notch below Moody's rating of "B2". 

The link to the GMM website is: http://enaresearch.corp.enron.com/research/framework/default.asp, pull down Sovereign and FX Risk, Global Markets Monitor. 

Recent issues of GMM with coverage on Argentina and Brazil:

GMM, 29 June ---------- Brazil's COPOM intervenes in the forex market to stem real's decline and bolsters reserves to defend currency in future
GMM, 22 June ---------- Argentina introduces new exchange rate system for traded sector. Impact on the peso discussed.
GMM, 15 June ---------- Brazil's energy crisis and its impact on the growth outlook
GMM, 8 June ------------ Argentina completes its successful debt swap
GMM, 8 June ------------ Brazil energy rationing mandate and its impact on output of key Brazilian commodities