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Car-wash scandal sends Brazil debt slumping vs. Argentina

The biggest corruption scandal in history has pushed Brazil's borrowing costs toward the highest levels relative to Argentina's since South America's second-largest economy returned to world debt markets. But the Argentine advantage may be short-lived.

Brazil's President Michel Temer survived his most critical test since coming to power following the impeachment of Dilma Rousseff in 2016 when an electoral court ruled June 9 that he could not be forced out of office over alleged illegal funding. The 76-year-old lawyer still faces, though, a criminal investigation that could undermine his efforts to pass major economic reforms including an overhaul of the pension system.

Evidence of up to $5 billion in illegal payments, reportedly the most of any similar case in history, has been unearthed by investigations into the "Lava Jato," or "car wash" scandal which has already cost Rousseff her job and now threatens to engulf Temer, potentially throwing Brazil's economic management into reverse after years in which it had outperformed Argentina. Brazilian dollar per capita GDP rose from only 40% of the Argentine level in 2001 to more than 100% a decade later. In contrast, Argentina spent most of the first decade of the century as an international market pariah after defaulting on its debt in 2001.

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A street performer juggles knives for tips at a bus station where graffiti reads in Portuguese "Death to Temer" in Brasilia June 12, 2017. Source: Associated Press

The yield on Brazil's 6% 2026 dollar bond spiked 17 basis points to a more-than-two-month high 5.11% May 18, when a newspaper reported that executives from giant meatpacking firm JBS had provided evidence Temer okayed bribing the politician who initiated the impeachment of former President Rousseff. The spread with Argentina's 2026 dollar bonds tumbled 40 basis points by the next day to 96, only the third time it had fallen below 100 since the bond was sold in April last year and down from a year-high of 200 in February. The spread was just 11 basis points higher June 13.

But, while confidence in Brazil is wavering, investors are also awaiting clarity on the situation in the country's southern neighbor, where the party of center-right President Mauricio Macri will compete in midterm congressional elections in October. While Macri, the scion of a wealthy industrial family, has won plaudits from analysts since he took over in 2015, inflation still running at above 20% means living standards remain under pressure despite the end of a recession.

Risk of a panic

"I think it's a time to lighten up, and for different reasons in each case," said Jorge Piedrahita, CEO of Torino Capital, referring to assets from both of South America's two largest economies. In the case of Brazil, Temer's fate is key, he said, now that the chances of passing reforms, including raising the pension age to 65, are hanging in the balance.

"The risk there is that the reform does not happen, or it happens in a very watered down version," Piedrahita said. "There could be a moment where the market panics."

His stance on Argentina is also cautious, although Piedrahita expects Macri to make gains in Congress.

"For investors, this would be a sign that Argentines really are embracing change," he explained.

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Argentine President Mauricio Macri meets Donald Trump in April. Source: Associated Press

Macri has repaired relations with international investors since his election ended 12 years of populist government under the late President Nestor Kirchner and then his wife Cristina Fernández, liberalizing trading in the peso and raising $16.5 billion on international markets in April 2016 in the country's first international debt sale since its default. Buenos Aires' Merval stock index has risen 25% so far this year, while Brazil's Bovespa, which surged 14% from the end of 2016 until May 16, has since slumped 10%.

"In Brazil, if we look at the micro side, and if we look at only the fundamentals of companies, the fundamentals are improving, especially in the side of the economy focused on domestic consumption," said Tiago Souza, an equities analyst at NCH Capital Brazil. "But prices are high already, so if we don't have a fiscal reform … investors will have to revise growth prospects for the future and even costs of capital estimates. It's appropriate to have a more defensive approach at this time with the risk involved in the political turmoil in Brazil."

A measure of expected potential movements in the exchange of the Brazilian currency, the real, spiked to the highest levels since the financial crisis after the JBS story, hitting above 40%. It has since eased to around 20%, still roughly twice levels in February, according to GARCH volatility data from New York University's Stern School of Business. Argentine peso GARCH was around 10%.

Carry trade trap

But, while currency statistics seem to provide more evidence of investors leaning toward Argentina over Brazil, relatively low peso volatility may actually be a trap, according to Pablo Cairoli, CEO of Epic Capital Securities, which focuses on Latin American securities.

With the Argentine central bank's official interest rate at 26.25%, volatility has been suppressed by a carry trade which has driven flows into peso assets in order to take advantage of high yields. Any sudden end to this play could trigger depreciation and a sharp rise in volatility, Cairoli said.

"I think it would be a very good moment to get out of the carry trade and capture that extra volatility," he said, although he acknowledged that successful legislative elections for Macri would be positive.

"If the government has a good election in October," he said, "that will mean a confirmation that all the long-term investments that were promised, especially the foreign investment…are going to come, and that’s going to boost the activity."