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Juan B Alberdi 431 Piso 4 of. 404 - B1636DSR – Olivos – Provincia de Buenos Aires

República Argentina – www.capitalagroindustrial.com

Argentina: 2016 Year in Review (with Fourth Quarter Commentary) & Outlook for 2017

Executive Summary

2016: A Challenging Transition Year At the beginning of his term, President Macri pushed through a series of measures to address a host of legacy issues and imbalances, thereby stemming an imminent economic collapse and laying the groundwork to pursue a gradualist path to “normalizing” the economy. Yet, product of many factors, including some of the medicine itself, high inflation and tight monetary policy were drags on the economy throughout the year. The recessionary back-drop (and one in locally-relevant Brazil) combined with concerns about the country’s deficit spending, commitment to reforms, and overall competitiveness, led to a ‘delay’ in private capital investments -- the government also under-executing in this area. Thus, the vaunted investment-driven recovery proved elusive.

Fourth Quarter: Signs of Having Reached Bottom Inflation, which had spiked in the first half of the year – principally due to currency devaluation pass-through, farm export inflows, expiration of mispriced FX futures, and tariff adjustments – since trended down because of aggressive Central Bank action, stabilizing close to next year’s target during the last months of 2016. During the fourth quarter, wage and consumer loan growth finally began outpacing inflation, and several economic sectors looked to have found their bottom, with evidence of certain green shoots. Importantly, after successive declines throughout the year, commercial lending spiked in December, signaling inventory build-up in anticipation of better times. In short, the patient seems to have stabilized. Additional good news came by way of the year-end announcement of very promising results of the (still ongoing) fiscal amnesty front, with associated benefits to be felt going forward. Yet, a legislative showdown during this period served as a reminder of the penchant for populist policies and Macri’s small margin for error. While diffused at a relatively low cost, it highlighted the political need for a renewal of the President’s coalition’s mandate in the October 2017 mid-term elections -- which will largely be contingent on the prevailing sentiment, itself tied to the health and prospects of the economy.

2017: Projected Economic Recovery, Key to the Sustainability of Macri’s Gradualist Program We are cautiously (but increasingly) optimistic about the economic outlook for 2017, and thus, for Macri’s electoral prospects and chances for continuing to execute his “normalization” project. We think that growth will at first be driven by consumption, followed by government infrastructure spending, and finally, by long-awaited private sector investments. Our forecast calls for growth of 3.5% (in line with government projections), inflation of 22% (vs. government projections of 17%), and an exchange rate ending at ARS 18.80 per USD by year-end (a devaluation of 15.5%). Deficit spending will continue to remain high at about 4.5% of GDP (on a primary basis), but a still relatively low foreign net debt level (of about 25% of GDP at year-end 2016) should assure continued federal government access to international capital market funding, which remains the underpinning of a politically viable project. Yet, federal deficit spending will continue to draw attention, as will provincial finances, on an increasing basis. Government-controllable risks to our 2017 scenario include: a worsening case of the “Dutch Disease” (i.e. lack of competitiveness, consequence of an over-appreciated currency) or an inflationary outburst – two sides of the same coin, a challenge as both are largely rate sensitive; a lack of real and directional progress in reducing the costs of hiring and doing business in the country, including a plan to reduce government drag; overzealousness in adjusting tariffs; and, continued delays in executing public sector works. Risks outside the purview of the Administration include: an interruption in the ability to issue and/or rollover foreign denominated debt – which is being mitigated by the early execution of the year’s issuing activities; and, irresponsible actions by the opposition and unreasonable union demands – which should not be discounted.

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Av. Del Libertador 2442 Piso 3 - B1636DSR – Olivos – Provincia de Buenos Aires

República Argentina

The Year in Review (with Fourth Quarter Commentary)

“Now this is not the end. It is not even the beginning of the end.

But it is, perhaps, the end of the beginning”.1

By the time 2016 figures are finally tabulated, we expect that the year’s inflation will come in circa 40%, the primary national fiscal account will have registered a deficit of about 4.8% (or about 7.3% bottom line – figures which exclude provincial imbalances not financed by the central government), and GDP will have contracted some 2.5%, marking the fifth consecutive year of economic malaise. Figures through October show construction activity falling 15%, consumption declining close to 7.5%, and industrial production sliding 5.4%. For the first three quarters, capital investments were down about 4.6%.2 For the year, wages lost about 6% of purchasing power. Year-end unemployment will stand around 8.5%, and 32% of the population of one of the world’s bread-baskets will be deemed to live below the poverty line by the now more credible national statistics institute, the INDEC. All things considered, not a bad year … Seriously!

No reasonable person should have anticipated an easy journey for the Macri Administration, as it set about the daunting task of taking the helm of an institutional wreck (without a working dashboard) which had all the potential for a hyper-inflationary meltdown and socio-political mayhem. The precipice was avoided thanks to quick action on a host of fronts, including: Disactivating a quagmire of ruinous, booby-trapped policies and regulations; owning-up to a laundry list of “social net” entitlements (some of which hastily activated by the outgoing administration); returning from diplomatic and financial isolation by re-engaging spitefully broken relations – including with OECD governments and foreign investors; and, concomitantly facing grave fiscal and monetary imbalances – all these niceties (and others), legacies of the Kirchner era. To boot, many if not most of these matters required acquiescence and/or cooperation from voracious unions and “social movement” organizations, as well as the support of certain sectors of the opposition in Congress, where the President’s Cambiemos coalition -- itself sometimes unruly -- is a minority in both chambers. We would be remiss in not also throwing-in the challenges posed by a politicized, social-justice leaning judicial branch – vassal under the previous regime, now feeling its independent oats.

A review of some of the most salient aspects of the year follows:

Crisis Free Liberalization of the Exchange Rate and Currency Controls

The cornerstone step to Macri’s program was the liberalization of the foreign exchange rate in mid-December 2015, resulting in an immediate 30% devaluation, the ARS rising 60% from the beginning of the year to end at 13.7 per USD the day of the change. Since then, the rate experienced a relatively steady evolution (from ARS 13.00 per USD at YE2015 to ARS 15.85 per USD at YE2016) – a devaluation of 18%, well behind the year’s inflation of 40% -- for a roughly 20% loss in competitiveness in USD-terms. The impact was less pronounced on a trade-weighted basis (a loss of competitiveness of about 11%), as Brazil’s 2016 currency appreciation weighed-in favorably on the equation – the ARS gaining 7.8% in exchange-related competitiveness in relation to the BRL. The

1 Sir Winston Churchill in a 1942 speech at London's Mansion House, just after the British routed Rommel's forces at Alamein, driving German troops out of Egypt. The battle marked a turning point in the war, leading Churchill to write in his memoirs, "Before Alamein we never had a victory. After Alamein we never had a defeat." 2 A note on monthly and yearly comparisons between 2015 and 2016: Throughout this document, we have adjusted comparisons for inflation. Yet, we cannot find the basis to adjust for the extraordinary stimulatory measures taken by the previous Administration and by many provincial and municipal authorities throughout 2015 in anticipation of the year’s general elections. Thus, said year’s activity was “electorally” stimulated above base-line levels, a common local practice which has led to the following adage: “Growth in odd years, stagnancy in even years.” In addition, those companies having the wherewithal to do so, tended to build-up stocks as an inflationary hedge. This practice was even more pronounced in 2015 in anticipation of the expected post-election currency devaluation (an inflationary measure), also stimulating activity. Taken together these factors accentuate most of the 2016 declines.


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sustained need for foreign capital inflows to fund future deficit spending will continue to exert (upward) pressure on the exchange rate and inflation, and is a matter of concern, highlighting the need to find alternate means to enhancing competitiveness.

Having liberalized foreign currency controls, follow-own measures were adopted to liberalize capital flows, including the elimination of de jure and de facto restrictions on foreign currency purchases and remittances, as well as on imports. We note that the foregoing measures required a degree of courage, as more than one analyst warned that there would be a speculative attack on the currency and a rush on the country’s almost depleted foreign reserves. In this regard, the Government’s intelligent decision to simultaneously announce the elimination of export duties on most agricultural products – which induced the quick liquidation of stocks and export receipts for the entry of some USD 8.8 billion – was a key factor in this transition. At YE 2016, the country’s international reserves stood at USD 39.8 billion, up nearly 60% from the prior year’s end.

Elimination of Export Duties (“Retentions”) on Agricultural Products

By some estimates, the agricultural sector directly and indirectly bears on about 30% of Argentina’s economy when factoring for labor, machinery, fertilizers and agrochemicals, etc. During peak agricultural prices, the Kirchners instituted export duties on agricultural products as high as 30% on sales, leaving farmers with few returns, if any – a situation which turned to despair when agricultural commodity prices declined. Said policies (along with internal price controls) also impacted the nature of the business, with unhealthy shifts in activity and crop concentrations (mainly favoring the production of soy, even in areas not best suited for it), a 25% decline in livestock (with Argentina importing meat), and dairy industry decimation, amongst others. President Macri’s decision to lift almost all the retentions (except for those on soy beans, slated for a gradual phase out) resulted in foregone fiscal revenue of approximately USD4 billion for 2016. While this amounts to approximately 17% of the deficit, pent-up demand for equipment modernization and greater use of crop enhancing products will mobilize industry and consumption. Furthermore, sector investments stand to duplicate crop output in the years ahead.

Successful Return to the International Capital Markets:

Another key component to the economic plan was the re-engagement of the foreign investor community. In mid-April, the Republic returned to the world markets after an absence of 15 years with an aggregate issue of USD 16.5 billion3, which was more than 4X oversubscribed. Shortly thereafter, approximately USD 9.5 billion was paid in a settlement with a great majority of the holdouts who had not participated in two Kirchner era restructurings), thereby officially opening the international markets for the country and lowering country foreign borrowing costs – the country risk at 455 (EMBI) at year-end. Provinces and corporations were eager to make use of the window, issuing USD 6 billion and USD 5 billion, respectively throughout the year.

Principally discounting the holdings of social security fund (the Fondo de Garantía Sustentable) and the Central Bank, Argentina’s net federal government foreign exchange-denominated debt levels stand relatively low, at about 25% of GDP - a metric that should allow for continued international capital market access. As repeated throughout this document, continuing access to the international capital markets to fund fiscal imbalances remains the underpinning of a politically viable, gradualist project.

3 It sold $2.75 billion worth of 3-year notes at 6.25%, $4.5 billion of 5-year bills at 6.87%, $6.5 billion of 10-year bonds at 7.5% and $2.75 billion of 30-year bonds at 7.62%.


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The War Against Inflation: Collateral Impacts, Rewards & Sentiment

We consider Central Bank Head Sturzenneger’s steadfast handling of a potentially hyperinflationary situation one of the year’s principal achievements. Numerous factors – many of which having to do with corrective policy measures to legacy imbalances -- led to inflationary pressures throughout the year:

The translation to prices of the devaluation upon the liberalization of the exchange rate at year-end 2015. An inherited monetary overhang – further exacerbated by the expiration of greatly underpriced FX contract

futures irresponsibly – perhaps criminally -- written by previous Central Bank authorities. Public services tariff adjustments – despite which, some still only covering a third of costs. An accommodative fiscal policy required for sustaining a politically viable process. High inflows related to agricultural sector exports. Foreign capital inflows from debt issues and a trade surplus, amongst others.

The Central Bank has followed a very disciplined approach to tackling inflation, which peaked at 4% per month in May, thereafter largely trending downward and recently stabilizing at a monthly rate in line with the 2017 target of 17%. December’s general consumer price index posted a 1.2% (relatively small) increase, much welcome as a precedent for upcoming sectorial salary re-negotiations (where the Government is aiming for 18% increases).

As this piece is being written, Central Bank reference rates are still elevated (currently at of 24.75% p.a. on 35-day on LEBAC’s), yet have been trending down from a high of 38% in the first semester, when already referenced factors heightened the need for sterilization.

Sources: Underlying data which was elaborated by Capital Agroindustrial was sourced from the Central Bank of Argentina.

Not surprisingly, inflation and the Central Bank’s monetary policy combined to weigh on overall economic activity throughout the year, there being no easy trade-offs. For the year, GDP was estimated to have contracted some 2.5%. Data through October shows construction activity falling 15%, consumption declining close to 7.5%, and industrial production sliding 5.4%. Positively, the monthly economic cycle activity indicator (the “EMAE”) is trending favorably.

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Evolution of Indicative P$ Market Interest Rates (Annualized)

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Sources: Capital Agroindustrial elaboration of data sourced from the country’s National Institute of Statistics and Census (INDEC).

Another positive signal has been the financial sector’s willingness to lend and borrower willingness to contract obligations in response to declines in inflationary levels (and interest rates). As seen in the chart below, consumer lending activity picked up in the fourth quarter. Commercial lending was slow in recovering, but posted its first year-on-year pick-up during the last month of 2016. We attribute this to rising expectations amongst companies as to continued consumer demand and government infrastructure outlays in 2017, finally leading to an inventory re-stocking.

Sources: Capital Agroindustrial elaborated data was sourced from: Central Bank of Argentina (in the case of loan data); and the University of the Province of San Luis and the country’s National Institute of Statistics and Census (INDEC) for monthly inflation.

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Monthly Evolution of the Economic Activity Estimator (% Change)

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Monthly Inflation (Left axis) & % Real Monthly Changes in ARS Bank Loan Outstandings (Right axis)(Loans were inflation adjusted by SL consumer price index through November - INDEC CPI for December)

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Underlying the improvement of consumer proclivity to contract debt has been the stabilization of consumer confidence levels starting in mid-third quarter and continuing in the fourth.

Source: Capital Agroindustrial elaboration of data sourced from Universidad Torcuato DiTella’s Centro de Estudios Economicos.

Yet, underlying sentiment indicators point to dissonance between perceptions of an improvement in general and personal well-being in relation to the past vs. future expectations on one hand, and the outlook for the economy at large on the other:


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Election Cycles & the National Consumer Confidence Index: Months Pre & Post Presidential

Elections

CFKII 2011 Macri 2015

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External Front Challenges: Beyond the gracious words extended by world leaders, the stabilization of most agricultural prices, and a hearty welcome by yield-hungry financial investors upon Argentina’s decision to return from self-imposed exile, the external front presented its share of headwinds, mainly by way of Brazil. Argentina’s largest trading partner and principal importer of the country’s industrial output continued to languish, contracting an estimated 4% this past year, following a similar decline in 2015. Reduced exports to said country (down 35% from 2014) have continued to significantly impact local industry, a paradigmatic example being the motor-vehicle sector – where exports to Brazil are down 50% on a running rate basis. Given that well over 70% of Argentina’s vehicle-manufacturing had in recent years been destined to its large common-market partner, one can appreciate the local adage: “When Brazil

sneezes, Argentina gets a cold”. Fortunately, Brazil’s influenza seems to have run its course, but only marginal relief should be expected by way of its stabilization and recovery over the coming year, as nationalistic and protective Brazilians will likely first favor local industry.

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Elusive Capital Investments and Stimulus: Undoubtedly, this proved to be the most disappointing aspect of the year. The stagflationary, high interest rate environment back-drop combined with concerns about the country’s deficit spending, commitment to reforms, and overall competitiveness, led to a “delay” in private capital investments, particularly in areas with extended pay-back horizons -- the government also under-executing in this area. Thus, the vaunted investment-driven recovery proved elusive.

During the first three quarters of the year, capital investments registered a real decline of about 4.6% in relation to the previous year, contributing to the already cited fall in construction activity. Underlying dynamics evidence a pronounced drop in investments by local industries (many of which small and mid-sized business with no access to cheaper, dollar funding, and thus faced with prohibitive local borrowing costs), in part compensated by higher outlays by larger domestic and foreign companies. By mid-year, foreign direct capital investments totaled USD1.3 billion, already surpassing total 2015 levels. While definitive figures for full-year foreign capital investment are not available, we would be surprised if they exceeded USD4 billion -- very shy of the Administration’s pre-election expectations of USD20 billion, and small in relation to the nearly USD60 billion in announced private sector and public-private projects to be executed in the 2016-2019 period:

Announced Private & Public-Private Sector Investments

For Execution in the 2016 – 2019 Period – In Millions of USD SECTORS PRIVATE

PUBLIC- PRIVATE

TOTAL

Mining USD 9,979 USD 4,085 USD 14,064 Manufacturing 11,487 1,155 12,642 Public Services 2,316 9,807 12,123 Transportation, Logistics & Communications 7,499 3,996 11,495 Real Estate & Related 3,211 7 3,219 Financial Intermediation 2,206 - 2,206 Construction 1,080 532 1,611 Commerce 815 - 815 Hotels and Restaurants 727 - 727 Agriculture, livestock & forestry 472 51 523 Education & Social Services 81 - 81 Fishing 7 - 7 Total USD 39,879 USD 19,632 USD 59,511

Source: Argentina’s Investment and Trade Agency.

The Government was also slow to the starting gate on own and sponsored Keynesian infrastructure initiatives as projects conceived under the previous administration were vetted and re-assessed. By its own admission, the Government only executed 89% of the amount budgeted for this area, some of which on cleaning up inherited past-due bills – rumored to have been substantial – rather than on new spends. Funding may also be an issue for some of the larger state-sponsored infrastructure projects, as many of the largest (principally hydro-electric projects) are backed by Chinese state-company financing. The re-work on some of the accords reached by the previous Administration almost certainly prompted the end-of-year trip to China by Minister of the Interior Rogelio Frigerio (whose suite also includes Public Works by political design) to smooth over their impact and reinvigorate relations – in the hopes of perfecting funding from this source, expected to eventually reach USD30 billion.


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On a positive note, the government was highly successful in its Renovar (#1 and #1.5) alternative energy projects auctions, awarding 57 projects (totaling 2,420 MW of power) supported by power purchase agreements with CAMMESA (the entity which clears the wholesale electricity market), with a state backstop. Continuing investments in generation (and transmission) are critical after more than a decade of neglect, as current installed capacity (of about 33,700 MW) cannot be reliably counted on to meet current peak demand levels, never mind future growth requirements, and is thus viewed as a serious potential bottle-neck by industry. Over and beyond already planned additions principally related to hydro projects (which will begin to come on line starting in 2019) and those awarded under Renovar #1 and 1.5# auctions, in order tend to rising demand while covering system losses and maintaining a minimal 30% capacity reserve (its current level), at a very minimum some 1,500 MW in additional generation capacity must be installed during the next 4 years. There is no time to spare in getting capacity online.

While on the topic of energy, low levels of investments in the oil & gas sector greatly contributed to the disconnect between projected and actual investment levels for the year, with paltry activity related to the “Vaca Muerta” formation proving especially disappointing. Said geology is estimated to hold the world’s second richest shale gas reserves, or about 11% of world unconventional resources. During 2013, with oil prices at over USD 110 per barrel, estimates called for some USD20 billion in yearly development and exploitation investments over twenty years.4

Yet, Macri assumed after a two-year decline in prices (with pronounced drops on the eve of his election) to then recent lows of below USD30 per barrel. At said level, the government felt obliged to continue the policy of subsidizing conventional exploitation activities, with little margin left to cover exploration and development – never mind in the unconventional space. Fortunately, hydrocarbon price increases during the year have finally reached a level allowing the Administration to begin to wean conventional producers off subsidies, while also setting the stage for a multi-sectoral agreement on long-awaited Vaca Muerta investments: During the first week of January 2017, a number of oil companies agreed to USD5 billion in investments in the unconventional space during the year, after agreements were reached with the Province of Neuquén and the unions representing local oil & gas workers which effectively lowered operating costs.

The Fiscal Amnesty Initiative The year ended with a ministerial change in the economic suite (more on that later), and the announcement of very strong results in the fiscal amnesty initiative. Said ongoing program provides Argentines the ability to declare assets not yet declared to the local authorities, with only minimal penalties. Of the estimated USD400 to USD500 billion in undeclared assets (principally held abroad), year-end tallies registered the declaration of USD100 billion, with expectations that by the program’s end in the first semester of 2017, an additional USD30 billion will be registered. While this good showing (compared to a similar Kirchner era effort yielding USD3 billion) had more to do with tax information sharing agreements reached in Uruguay and the United States than underlying confidence in the program (as 90% of the amount was kept outside of the country rather than being repatriated under more benign terms), it represented extraordinary tax revenues for the year (helping the administration to meet its deficit goals)

4 Regrettably, during Peak Oil, the most propitious time for its development, sectoral investment interest in Vaca Muerta was stymied because of government price-caps and the expropriation of YPF from Repsol. Chevron was the only IOC to have committed minimal investments under special terms -- essentially representing the purchase of an option. Since then, the Peak Oil window vanished, as oil prices halved to about USD 55 per barrel by year-end 2014, and again in 2015 to about USD30 per barrel, the previous government seeing itself forced to turn on its previous price cap policy to one of subsidization to merely maintain conventional sector activity (never mind replenishing reserves or realistically expecting much on the unconventional front) in its efforts to preserve run-down international reserves: By the end of the Kirchner era, its price-cap policies had turned the country from being largely energy self-sufficient to requiring imports to the tune of USD11.5 billion and USD 7 billion for 2014 and 2015, respectively. Thus, the Kirchner’s bequeathed the following perverse legacy: Low hydrocarbon prices reduce the import tab, require sector subsidization to merely maintain production, but entail lower subsidies to generators (as electricity tariffs are subsidized). Higher prices would draw investment interest in the sector, but in the short term represent a drain on foreign reserves, and require higher subsidies to generators. The difficult job of unwinding the mess is in the hands of Energy Minister Aranguren, whose measures have at times been controversial, as they have necessarily touched the pockets of multiple constituencies.


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and will provide for a stream of future governmental revenues based on income and asset taxes. The approximately USD8.0 billion which has already been repatriated to date should eventually find its way into the economy.

End of Year Signaling: Transitioning from the Urgent to the Important A recurring criticism to Macri’s economic program is the absence (at least from the public’s eye) of an integral, substantiated, medium-term, fiscal-economic program. On this last matter, we believe it was as untimely as impractical to have heretofore expected a detailed fiscal-economic program, as it would have been tantamount to requesting a recovery ward therapy regime from an emergency room doctor in mid-surgery. However, product of the Administration’s own success in achieving relative stability, we now empathize with those who seek greater visibility: More specifically, a road-map delineating how the Administration intends to reach its 1.5% primary deficit goal by 2019. 5 While the country’s low net federal foreign debt (at 25% of GDP) – one of few positives aspects of the isolationist Kirchner era -- provides for substantial borrowing capacity that can bridge fiscal imbalances and allow for the continuation of a socio-politically viable, gradual approach to change, there is an increased call for insight into the end-game – particularly by decision-makers holding the purse strings on investments having long-term pay-back horizons. Lost on few is the risk that the country will again go down the road of living beyond its means, borrowing irresponsibly from tomorrow to live for the day.

A credible plan to close the budget gap while mitigating a noxious tax structure and burden (comparatively high at 35% of GDP considering no semblance of corresponding benefits) is increasingly viewed as the cornerstone of a broader set of initiatives required to enhance economic competitiveness through structural reforms – in lieu of the oft used, but self-defeating mechanism of contrived currency devaluation – which nimble Argentines quickly transfer to price (with an overshooting bias).6 The year-end jettisoning of two high-profile members of the Administration’s team -- Minister of Treasury & Finance, Alfonso Prat-Gay, and the CEO of the state-owned airline (Aerolineas Argentinas), Isabela Costantini -- are widely viewed as signaling the Administration’s recognition of this issue.

Speculation as to the real underlying reasons for Prat-Gay’s demise aside, it provided a politically expedient way to: i) convey the administration’s ‘commitment to results’ – Prat Gay having miscalled the timing of the recovery and been assigned the blame for the income tax bill showdown; ii) directionally mark the end of a period of economic contraction (and beginning of an expected virtuous cycle); and, iii) signal the intent to shift focus in the manner outlined in the foregoing paragraphs.

In this last regard, as important as Prat-Gay’s removal was the selection of Nicolas Dujovne as his replacement to head Treasury (not Finance)7. Dujovne has the reputation of being a technically competent economist and is an effective public communicator. Based on his published articles and TV commentary, his specialization while in the Presidential party’s (PRO’s) Pensar think-tank, the wording used upon his designation, as well as follow-up statements by administration officials, Dujovne’s focal areas are expected to be on the cost side of the fiscal equation (quality at first, eventually transitioning to quantity after the mid-term elections), as well as the overhaul of the tax

5 The primary deficit fiscal goals being as follows: 4.8% (2016); 4.2% (2017); 3.0% (2018); & 1.5% (2019)

6 While we do not see dramatic moves on the exchange rate front, it is an area which deserves heightened monitoring and will be subject to policy tweaks to try to quell and/or alleviate a case of the “Dutch Disease” – a situation in which strong capital inflows into a country lead to an appreciation of the currency, inflation, and a loss of international competitiveness. Recent policy moves to mitigate such tension (while also reducing Central Bank need of further sterilization, thus allowing for further interest rate easing) include: lifting of selected banking sector dollar deposit limits; permitting cash purchases of foreign currency; and, doing away with the requirement of remitting and locally clearing foreign source service income. Yet, these are band-aids considering the size of deficit related international debt issues.

7 On a passing note, we would mention that Luis Caputo will stay-on and continue his work as head of the country’s finances, albeit at a higher pay-grade, as Finance was broken out and elevated to a ministerial role.


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regime – including anticipated action on the VAT, social contribution charges, and transaction (Debit/Credit) tax fronts.

Ms. Costantini’s induced resignation – prima facie more surprising than Minister Prat-Gay’s turn in fortune -- is also viewed as content-rich signaling: The move is believed to: i) serve as a signal for a “less gradual” approach to reaching Administration goals; ii) anticipate a predisposition to confront unions – a courageous move given upcoming mid-term elections; and, iii) demonstrate a commitment to private sector free enterprise and foreign investment. As to the first: While operating and financial performance at the airline had much improved under her tenure, it continued to bleed cash. Taken in aggregate, state-owned enterprise deficits account for 12.5% of the 2016 budget gap, with Aerolineas at the top of the list. As to the second (and related to the first): Six unions are active in the airline, and all benchmarks point to too many people who are paid too much. Thus, there is no innocence in a senior Administration’s statement that ‘the lack of labor conflict was a sign that dealings with the unions had been too lenient.’ As to the third: In public hearings, Costantini was set to argue against the opening of Argentina’s skies to low-cost foreign carriers. And while a private sector executive (her background) with a dominant position can’t be blamed for trying to protect the status quo, the Administration understood that such an inclination should not be espoused by the head of a state-enterprise in a country seeking foreign investments – particularly in light of a sub-optimally served market segment.

While on the topic of the recent shuffling: In accordance with Macri’s vision of “normalizing” Argentina, including the movement away from the Super-Ministers of yore and the emphasis on (‘my’) team-work, the suite of areas most directly impacting the economy is now spread across eight ministries: Finance, Treasury, Production, Labor, Competitiveness, Public Works (a sub-secretary under the Interior), Energy & Mining, and Agroindustry. Thus, the responsibility of overall economic policy and coordination is in the hands of the President and his trusted Troika: Chief of Staff Peña, and Vice-Chiefs Lopetegui and Quintana. Yet, perhaps heeding calls for a more unified approach to the economy – while diminishing the load on band-with at the top –Mr. Dujovne has been tasked as the Administration’s spokesperson for all suites on matters impacting the economy. In practical terms, this should also set him up as the “gatekeeper” of the economic suite – something Prat-Gay was unable/not permitted to achieve. We would view this as highly positive, while keeping in line with President Macri’s vision.

(RESUMES ON NEXT PAGE)


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Summarizing 2016: All things considered, ending 2016 on a stable but improving, stag-flationary note, with an encouraging set-up for next year, is a decidedly positive achievement. In a recent interview, Macri self-graded his first term in office as an “8” over 10. Weighing the outcome vs. the backdrop, we judge the President’s to be about right. We highlight the year’s principal successes:

PRINCIPAL SUCCESSES OF THE FIRST YEAR

• NOT BLOWING UP! • Return of relative autonomy to the Central Bank • Effective diffusion of a potentially hyper-inflationary time-bomb caused by sizeable, below-market futures contracts issued by previous

Central Bank authorities • Effective continuing sterilization of monetary overhang, product of continuing fiscal deficits and FX inflows • Resolution of the default overhang (with an accord with almost most holdouts) • Re-engagement of foreign investors and a return to the international markets • Reduction in country risk spreads and foreign financing costs • Replenishment of FX reserves • Significant progress in unravelling foreign capital flow control regime • Stability of the FX market after flotation • Progress made in setting the course for adjusting public service tariffs – a continuing challenge going forward • Progress made at unwinding distortionary oil and gas subsidy regime – with a more definitive regime pending • Successful launch of the push to solve the power generation bottleneck through renewable energy PPP’s (Renovar) • Elimination of most of the confiscatory farming sector export retentions • Elimination of the mining sector export retentions • Reconstruction of the shell that had become the national statistics bureau (the INDEC) • Re-engagement with world-leaders, OECD member economies, and with the IMF • Passage of a law encompassing Public Private Programs • Fiscal Amnesty regime results

Undisputed discounts from a perfect score (on controllable matters) were by way of: i) The jolt felt by many households due to the brusque introduction of tariff increases in early in the year -- leading to a court-ordered roll-back, public hearings, and a re-calibrated start of the needed adjustments, but not before producing a major hit to consumer confidence; ii) the surprise IVQ hi-jack of an income tax bill in the House which – in one swoop -- signaled the end of the honeymoon period, kicked-off the mid-term electoral season, bared the country’s continuing propensity to be seduction by populist fanfare, and exposed a lapse in political adroitness 8; iii) & iv) a number of well-intended but pre-mature pronouncements as to expected foreign capital investment flows and the timing of the economic recovery; v) internal dissonance within the Administration as to certain aspects of economic decisions – related to degree and timing, not overall direction; vi) delays in public-led infrastructure spends; and, vii) the absence of an integral, substantiated, medium-term, fiscal-economic program.

8 The bill introduced by the Administration essentially represented a tweak to the income tax code, principally to reduce individual tax burdens by adjusting scales to compensate for more than a decade’s worth of inflation. Upon arrival at the House, said bill was scrapped, and an alternative project (having ex-Minister of Economy Kiciloff as one of its principal authors) was summarily passed by members of Peronist factions (Massa’s Frente Renovador and Kirchner’s Frente para la Victoria), under the guise that the Administration’s bill did not reflect his campaign promise of doing-away with individual income taxes - which is accurate. Under the revised House bill, the proposed elimination of individual taxes was offset by a series of measures having the potential to derail the Administration’s economic program, such as: the reinstatement of mining export duties (which had been removed only months prior, by the same House) and other taxes jeopardizing the in-progress tax amnesty program (such as a tax on ‘unproductive assets’), amongst others. By the time the House-passed bill reached the Senate, it became evident that it was not only damaging to the President’s program, but also mathematically flawed -- yielding a hole much larger than originally advertised (to the tune of 3X). But perhaps more politically relevant to its ultimate demise was its ruinous impact on Provincial finances, as federal revenue sharing is partly funded through income tax revenues. Mercifully, moderate Peronists in the Senate (led by Majority Leader Pichetto) bowed to the logic of the evidence and provincial pressure, successfully orchestrating rounds of around-the-clock negotiations amongst congressional leaders, union bosses, and members of the Administration, resulting in an acceptable compromise bill, which eventually became law. So, while the political costs of a potential Veto were avoided, it was largely due to ‘own-goals’ of a fragmented opposition.


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Other criticisms more subject to debate include: i) the foregone opportunity for a larger currency devaluation upon initial flotation; ii) the foregone opportunity for a sincerer accounting of the mess inherited; iii) the manner and timing of the lifting of FX restrictions and export retentions; iv) the degree of gradualism being applied; v) the Keynesian nature of some of the measures; and, vi) the strict monetarist discipline adopted by the Central Bank, among others. As the expression goes: “Can’t please everybody all the time” – a particularly fitting saying in a country as skittish and pundit-ridden as Argentina.

(RESUMES ON NEXT PAGE)


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Outlook for 2017

“Keep calm, but hurry up man!” 9

We are cautiously (but increasingly) optimistic about the economic outlook for 2017, and thus, for Macri’s electoral prospects and chances for continuing to execute his “normalization” project. Yet, like Borensztein, we sense the urgency of seeing sustainable green shoots over the course of the next semester, lest the October 2017 mid-term legislative elections turn into a negative referendum, throwing a wrench into Macri’s program – with unforeseeable consequences. The lag in sustained economic reactivation to date combined with increasingly evident post-honeymoon political jostling, highlights the distance which separates Argentina’s present from its potential, and the difficulties in getting from here to there. There is little margin for error – and that which remains is largely attributable to a hopeful (but increasingly impatient) citizenry and a still divided Peronist camp.

We think that growth will start to consolidate during the second quarter, first driven by the continuing uptrend in private consumption (which is about 65% of the local economy), followed by government infrastructure spending (principally benefiting construction), and finally, by the long-awaited private sector investments. Our forecast calls for growth of 3.5% (in line with government projections), inflation of 22% (vs. government high side projections of 17%), and an exchange rate ending at ARS 18.80 per USD by year-end (a devaluation of 15.5%, signaling a further drop in competitiveness).

Deficit spending will continue to remain high at about 4.5% of GDP (on a primary basis), but a still relatively low foreign net debt level (of about 25% of GDP at year-end 2016) should assure continued federal government access to international capital market funding, which remains the underpinning of a politically viable project. Yet, federal deficit spending will continue to draw attention, as will provincial finances, on an increasing basis.

Key Drivers of Growth for 2017: The two principal pillars of growth will be the agricultural sector and government own and led infrastructure projects (principally favoring the construction industry). Spillovers from these activities to other areas of the economy largely account for projected growth.

Agricultural Sector: As mentioned, the sector directly and indirectly bears on about a third of the country’s economy, and is into its second year of relief from most of the weight of the noxious export retention regime. Investments made throughout 2016 (of about USD4 billion, the same as the fiscal relief to the sector) are projected to yield an 11% increase in grains and oilseeds production, which will rise to 120 million tons in 2016/2017 campaign. Continuing increases in sector activity will spillover into consumption and capital goods sectors – benefits to especially be felt by the automotive, machinery, and chemical & fertilizer sectors.

Government-led Construction: This sector languished in 2016 (down some 15%) and accounted for about half the 100+ thousand loss in declared private sector employment. Next year will be different, however, as activity will be boosted by federal, provincial and municipal execution of projects in anticipation of the mid-term elections. Sector representatives expect a 10% increase in activity. The federal government’s own budget for public works (USD4.0 billion) is nearly 40% higher than was executed in 2016 – with a similar percentage increase off a larger base projected for federal government transfers to political sub-divisions for the same purposes (reaching USD 8.3 billion). The federal government’s transfer of USD1.5 billion to the electorally important Province of Buenos Aires

9 Alejandro Borensztein’s “message” to President Macri on his first anniversary in office from one of his trademark weekly treatises published on 12/4/2016 in the Clarín newspaper, entitled: “(Let’s) Change Really Starts Now!”, a play of words alluding to the President’s ruling coalition party Cambiemos (Let’s Change). Borensztein is a political pundit & humorist, renowned for his wit and insight. He is a worthy heir to his father, ‘Tato’ (Mauricio) Bores (1927-1996). Taken together, the Borenszteins have explained Argentina to the Argentines some 70 years.


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in the first weeks of the year is deemed indicative as to the strategy to spend what and where must be spent to improve its chances of a good showing in mid-October.

Another area of increased activity will be in energy, with an estimated USD10 billion in projected investment outlays. Investments in the sector are largely accounted for by ongoing hydro-generation projects, the execution of the recently awarded Renovar projects, and recently re-launched development work at the Vaca Muerta formation – as described before.

Risks Government-controllable risks to our 2017 scenario include: a worsening case of the “Dutch Disease” (i.e. lack of competitiveness, consequence of an over-appreciated currency) or an inflationary outburst – two sides of the same coin, a challenge as both are largely rate sensitive; a lack of real and directional progress in reducing the costs of hiring and doing business in the country, including a plan to reduce government drag; overzealousness in adjusting tariffs; and, continued delays in executing public sector works. Risks outside the direct purview of the Administration include: an interruption in the ability to issue and/or rollover foreign denominated debt; and, irresponsible actions by the opposition and unreasonable union demands.

On the topic of financing, given its importance to the government’s ongoing program, authorities are mitigating potential international market interruption risk through the early execution of its financing program – virtually having already closed on half of 2017’s projected international market funding needs.

To finance the 2017’s projected deficit (equivalent to USD 23 billion) and capital maturity and service requirements (USD 20.2 billion and 8.6 billion, respectively), net of projected Central Bank transfers and other offsets (of USD 11.5 billion), the Government will need to source the equivalent of USD40.4 billion during the year. Of this amount, half will be sourced from private international investors.

PROJECTED SOURCES AMOUNTS

(USD BILLION EQUIV.)

Multilaterals & Bilateral Sources: USD 3.9 Private International Bank Facility 6.0 T-Note Refinancing 4.5 Local Market Issues 14.0 International Market Issues 10.0 Public Entities 2.0 Total USD 40.4

Source: Ministry of Finance As we write this paper, the Ministry of Finance has already closed on the bank facility of USD 6.0 billion (with a 180-day maturity, but with relative refinancing ease), and is in mid-closing of a USD 7.0 billion bond placement (3X oversubscribed) – thus halving the exposure to risks associated with international market access.

Even factoring for the projected borrowings during the year, net hard-currency Government debt (i.e. backing out Central Bank and the country’s social security fund holdings) will remain low at 30% of GDP, thus, barring an unpredictable market shock, the country should not have a problem in attracting investor appetite through the year. In fact, countering the impact of expected US interest rate increases, market appetite for sovereign Argentine paper should rise in the coming year with the country’s expected re-entry in the MSCI Emerging Market index – upon reclassification from “frontier”. Entry into said index will spur buying by funds that are benchmarked against it.

(END)


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About Capital Agroindustrial SA: Capital Agroindustrial S.A. (CASA) provides investment banking services catering to domestic and international companies with interests in agribusiness and natural resources in Argentina, as well as to investors and lenders in those and other sectors.

The firm specializes in structuring and arranging domestic and international short and long-term financing, mergers and acquisitions, debt restructuring, private equity, and in strategic advisory.

CASA creates value for its Clients through a multi-disciplinary team of professionals and by combining local presence and global reach.

For further information about CASA, please visit www.capitalagroindustrial.com and/or contact us directly.

Buenos Aires: Diego Temperley Managing Director

+54 (911) 6273-2127 [email protected]

New York: Mark A. Chlapowski Senior Advisor

+1 (347) 449-1877 [email protected]



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