Friedberg Gives A Lesson In Speculation Under A Currency Board Regime
Over a week ago when Argentine Economy Minister Domingo Cavallo warned Argentine congressional candidates and union leaders of the dangers of a devaluation of the Argentine peso he was making a reasoned argument that represents a core principle of classical economics, that if followed, could keep Argentina's economy from falling into a condition of virtual disrepair. But when Steve Hanke, a regular columnist for Forbes magazine, President of Toronto Trust Argentina in Buenos Aires and Chairman of Friedberg Mercantile Group, Inc. in New York,(which manages $1 billion) made the same argument in late July, he not only echoed age-old economic arguments, he also made a fortune for his firms' clients, and others, who followed his advice.
The manner in which Friedberg accumulated profits from the deployment of its financial capital in Argentina, consistent with Hanke's persistent advocacy for sound money, is a case study and indicative of why Canada's The Globe And Mail has recognized Friedberg as one of the top performing investment groups in the world.
For the better part of the summer, Argentina's investment environment has been one too volatile for most investors. Falling commoditities prices, and bad advice from the IMF, in conjunction with some questionable tinkering by Cavallo have all contributed to near economic chaos. But if ever there existed positive proof of the saying that there lies quiet within the eye of a storm, it was in the manner in which Friedberg reacted to the worsening situation in Argentina.
In June, after IMF-mandated tax increases began to tear away at economic growth in Argentina, the then-newly appointed Minister of Economics, Domingo Cavallo, began to undermine market confidence in the peso. First, Cavallo began to informally tell members of the Argentine business community and the international financial media of possible strategies for exiting Argentina's currency board like-convertibility standard which mandates that 1 U.S. dollar exchange for 1 Argentine peso. Then Cavallo actually got behind the idea of a dual exchange system and introduced a regime whereby all exports, with the exception of oil, are transacted with a devalued peso while all imports take place with a revalued peso. The remaining transactions are made to take place at a 1 to 1 peso-dollar exchange rate. In addition Cavallo helped to advance a euro-dollar basket law through the Argentine Congress that mandates that a basket of 50% euros and 50% dollars will replace the current sole dollar anchor, once the euro reaches parity with the dollar.
The combination of these decisions and changes by Cavallo eroded domestic and international market confidence in Argentina and were viewed as a precursor to an eventual devaluation of the peso and its exit from the current convertibility law.
Hanke and Friedberg thought otherwise and in the midst of the storm, reflected over the lessons of history. Friedberg, in addition to being contrary investors by nature felt confident that the past record of how currency board regimes have fared against speculative attacks would hold true. Of little concern to the rest of the market but of major import to Friedberg was the fact that since the very first currency board was installed in 1849, there has never been an instance of a country where a currency board regime was in effect, that was forced to devalue as the result of a speculative attack. As a result, Friedberg rest assured in the sturdiness and self-adjustment mechanism of currency boards and bet against an exit from convertibility - not only because of the traditional strength of the currency board but also because of Friedberg's recognition that because of Argentina's large dollar-demoninated debt (90% of its sovereign debt is denominated in foreign currencies) and other factors, the country's policy-makers would not be willing to accept the devastating effects of a devaluation. So, while other investors were taking their capital out of Argentina, Friedberg poured fresh cash in, purchasing one month peso forwards that had an annualized implied yield of between 90% and 150%, receiving "a very high-return for holding contracts that in our view don't carry too much risk.", as Hanke put it.
Hanke and Friedberg came to a very unorthodox conclusion, contrary to the prevailing view of most in the marketplace. They realized that the markets had exaggerated the risk of currency devaluation and were demanding a risk premium that was unjustified, in light of all available information - past and present. By investing in the high-yield currency, Friedberg recognized that the returns were greater than the risk of decline.
Indeed Hanke laid out that argument in no uncertain terms in an August 17, 2001 interview in the Buenos Aires Herald. In response to two questions Hanke lucidly outlined Freidberg's high-yield investment philosophy and its implementation in Argentina:
Question: What about your views on the floating rate bonds issued by Argentina?
Answer: We purchased some of those when the price was 63 and the yield to maturity was 36% . This was among other things, an application of advice my old friend Sir John Templeton imparted during a trip we took to Mexico: the time of maximum pessimism is the best time to buy. The problem is discipline and temperament. It's hard for most people to oppose what appears to be the general drift of public opinion. That's never posed a problem for me. As Winston Churchill said on his return from the Boer War, "Nothing in life is so exhilarating as to be shot at without success." In addition, I like high-yielding bonds because you start earning the high-yield the day you buy the bonds, whether or not anyone else thinks they are a wise investment. Moreover, you will continue to earn that yield until the bonds mature, even if the market never accepts your judgement about valuation. And, of course, in the event that the market accepts your judgement - that the bonds are grossly undervalued - you have the option of shortening the holding period to something less than maturity and selling the bonds at a capital gain.
Stocks don't have the same features as high-yielding bonds. If I buy a stock that I think is grossly undervalued, I will not make big money until the market accepts my judgement about valuation. That could take years. And while waiting for market sentiment to change, I will probably lose money.
The risk in the high-yielding bond story is default risk. Although this is a real possibility in Argentina, I believe the risk is lower than the markets do. Under the present plans for refinancing letes and the zero deficit program, Argentina's financing gap for the remainder of 2001 will be positive, and while the gap will be negative in 2002, it won't require too much effort to fill.
Question: Are there other features of the Argentine markets that make you bullish?
Answer: Yes. Usually when your portfolio is very liquid and you are in cash, you don't get paid too much. That's not the case in Argentina. Indeed, at Toronto Trust Argentina, we have a relatively large cash position in peso deposits at international banks in Buenos Aires, and we are being paid a lot to hold those liquidities that are ready for redeployment. Consequently, I am very comfortable with our overall portfolio and anticipate a very good performance in the coming months, one that is based on our understanding of the workings of the convertibility system. At the end of the day, we are betting that there are only two realistic scenarios for Argentina: either it will stick with convertibility or it will officially dollarize.
Many analysts, financial reporters and economists, in our view, are erroneously interpreting Argentina's recent election results, which will bring into power, parties and factions in opposition to President Fernando De La Rua and Domingo Cavallo, as a no-confidence vote in the current tie between the U.S. dollar and Argentine peso. Nothing could be further from the truth. Argentina's electorate and business community still credit Cavallo with effectively fighting Argentina's hyperinflation of the early 1990s. No one in Argentina wants to return to those days. What members of the opposition are most opposed to in Argentina is not the country's monetary policy, but rather, its fiscal policy. The dissatisfaction is being clearly aimed at the IMF-mandated spending cuts and tax increases. It is these measures that political opposition parties have in their crosshairs. As the new Senator-elect Eduardo Duhalde said over the weekend "We're governed by a model that's hurting the Argentine people... This model, of structural cuts, has had an enormous defect of shrinking the economy." As a result, Duhalde and others are speaking of enacting tax rebates and reducing social service cuts, as opposed to floating the peso.
For those who take a deeper look it is obvious that fiscal austerity and not Argentina's currency board-like monetary regime is the primary target of the political newcomers. Since that is the case we look for Cavallo's voice against devaluation to prevail and Friedberg's strategy of profiting from excessive risk premiums in currency and bond markets to continue to be a successful one, particularly in the immediate post-election environment where market participants are increasingly swayed by those who believe a devaluation of the peso is imminent.
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Tuesday, October 16, 2001