Daniel Scioli leads the race to the presidency in October, but a runoff with Mauricio Macri in November is likely.

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1 Latam in Depth Wednesday, September 09, 2015 ARGENTINA The day after Daniel Scioli leads the race to the presidency in October, but a runoff with Mauricio Macri in November is likely. The new administration will receive an economy in stagflation and will have to address several economic distortions. There are three possible strategies: i) shock, ii) gradualism, and iii) continuity. A worsening external environment makes the successful implementation of a gradual approach more challenging. Our scenario for the next year lies between shock and gradualism. A deal with the holdouts and access to external markets is likely. Despite adjustments in the exchange rate and tighter policies, the peso will likely remain overvalued and the removal of controls will take longer than we expected. As a consequence, the economy will remain stagnant in Presidential race Daniel Scioli continues to lead the presidential race. According to the latest polls (Poliarquía) Daniel Scioli (from the ruling Frente para la Victoria) leads the presidential race with 38% of voting intention, followed by Mauricio Macri (Frente Cambiemos) with 29% and Sergio Massa (Frente UNA) with 19%. Despite Scioli s advantage, a runoff on November 22 is still likely, because a candidate needs more than 45% of the total votes, or 40% with a 10% advantage over the second-place candidate, to become president. Macri and Massa cannot form an alliance for the first round due to legal constraints, but this option is open for the November runoff. Political analysts are now more convinced that Scioli if elected will be able to govern independently from Kirchnerism. Unlike the situation in Brazil, Scioli won t need congressional support to implement fiscal adjustments, as most of the deficit results from subsidies that can be removed without approval from Congress. While it is true that the next president will need the lawmakers support to get rid of the legislation that constrains the negotiations with the holdouts, Kirchnerism in Congress is likely to be less present than previously estimated. In fact, politicians and economists close to Scioli are now giving more signs of independence, openly discussing the removal of exchange-rate controls, faster exchange-rate depreciation, higher interest rates and an agreement with the holdouts to unlock access to the international capital markets. Where do we stand? The fiscal deficit continues to widen as the presidential elections approach. The 12-month fiscal deficit rose to 3.6% of GDP in June 2015 from 1.3% in 2011 (or to 5.1% from 1.8%, respectively, if we exclude transfers of central-bank profits). The increase in expenses was led by a ballooning subsidy bill, oriented mostly to energy and transport, which reached 5.2% of GDP in The central bank remains the main source of financing for the treasury. Besides the profit transfers from the central bank (that is, the money printing corresponding to the valuation gains on international reserves as the peso depreciates) the central bank also lends to the treasury. Because the resulting money supply is not fully sterilized, the monetary base is growing at 36%, keeping the real interest rates in negative territory. Currently, the benchmark Badlar rate is around 21%, below the inflation rate (estimated by the private sector at 27%). Please refer to the last page of this report for important disclosures, analyst and additional information. Itaú Unibanco or its subsidiaries may do or seek to do business with companies covered in this research report. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the single factor in making their investment decision.

2 Amid lax policies, the central bank continues to use the nominal exchange rate as an anchor for inflation. The exchange rate has depreciated 8.7% during the first eight months of the year, while inflation accumulated in the same period is 16%. We expect inflation to reach 27% by the end of this year (from 38.5% in 2014). To control the exchange rate, the central bank continues to rely on controls and reserve depletion. Although gross reserves stand at USD 33.5 billion, we estimate reserves net of foreign currency obligations of the central bank (China lending, dollar reserve requirements of commercial banks and blocked payments of restructured bonds) at USD 13.0 billion. The net figure will likely fall to USD 6 billion by the end of this year, due mostly to the sizable repayments of sovereign and provincial foreign-currency debt in October. 35 billion Two sides of the same coin billion Gross international reserves Net international reserves (rhs) Aug-14 Feb-15 Aug-15 Source: BCRA, IMF e Itaú The positive impact of the real exchange-rate appreciation on real income is bringing modest relief to activity. The IGA (the GDP proxy estimated by the private sector) grew 1% yoy in 2Q15, after falling 0.6% in the previous quarter. We expect the economy to grow by 0% this year (-2.6% in 2014). What needs to change and how politicians are planning to implement the changes As highlighted by the path of reserves, the macro-policy framework in Argentina needs to change. The next government will likely need to depreciate the real exchange rate and tighten macro policies to keep inflation from going into an upward spiral. For that, the government will have to reduce the fiscal deficit and, consequently, the monetary expansion to finance it (raising the real interest rates). A deal with the holdouts could open the international capital markets to Argentina, smoothing the necessary adjustments somewhat. Removal of capital controls is also important, both because it will be hard to attract capital inflows to the private sector (through FDI, for example) with restrictions on getting dollars out of the country, and also because their removal will help improve activity (through confidence and higher imports of intermediate and capital goods). The removal of controls has better chances of success (that is, not triggering sizable capital outflows) if the exchange rate is closer to a fair value and the new government enjoys market confidence. There are three possible strategies for the next administration: i) shock, ii) gradualism, and iii) continuity. A shock approach means that the changes would come fast. A sharp one-off depreciation and complete removal of exchange-rate controls would be accompanied by a spike in interest rates. Tighter fiscal policy would also help to fight inflation. The government would try to reach an agreement with the holdouts as soon as possible, to increase the dollar supply to Argentina. 14 Page 2

3 The gradualism approach means increasing the pace of nominal devaluation, allowing a gradual weakening of the real exchange rate. Exchange-rate controls and the lax monetary policy would be removed slowly, while the government would try to increase access to capital markets (mostly through an agreement with the holdouts). Finally, in the continuity scenario, the government would try to maintain the current policies, remaining in default and repressing the real exchange-rate market further, deepening the relative price distortions. The presidential candidates are leaning toward the gradualist approach. The short-term activity and inflation costs associated with the shock approach are too high. Continuity would not last long without an unlikely major change in the external scenario. However, the deterioration of the key external variables for Argentina puts the successful implementation of a gradualist adjustment at risk. Against the Brazilian real, the Argentinean peso has already appreciated 28% in real terms this year, to the strongest value since December Furthermore, internal demand in Brazil is also weakening and soy prices have dropped 10% year-todate. In the end, the new government may well avoid a shock, but the adjustments may have to come faster than currently planned Strong real exchange rate against main trade partners Dec 2001= USD BRL EUR 0.50 Dec-01 May-05 Oct-08 Mar-12 Aug-15 Source: Itaú The outlook for 2016 Our scenario for the next year lies between shock and gradualism. We expect the new administration to settle the debt with holdouts next year, to regain access to debt markets. We forecast a real depreciation of the currency of around 20%. The nominal exchange rate will likely hit 15.8 pesos to the dollar by December 2016 (from 10 by year-end 2015). However, we note that due to the deterioration of the external environment, the peso will likely remain overvalued, so exchange-rate controls would not be fully removed, at least in The adjustment of the exchange rate and tariffs will likely push inflation to 35% next year. Positive real interest rates will be necessary to prevent inflation from rising above that level. The Badlar rate would reach 36% by year-end, but will probably peak above that level during the year. As the adjustment hits real wages and the presence of exchange-rate controls continues to weigh negatively on production, the economy would remain weak next year. Furthermore, considering the recent deterioration of the external scenario, we now see GDP growth at zero next year (from 0.5% in our previous scenario) and see downside risks to this forecast João Pedro Bumachar Juan C. Barboza Diego Ciongo Page 3

4 Forecast: Argentina F 2016F Economic Activity Real GDP growth (Private Estimates) - % Nominal GDP - USD bn Population (millions) Per Capita GDP - USD 9,432 11,423 13,688 14,721 14,932 12,858 14,169 13,634 Unemployment Rate - year avg Inflation CPI (Private Estimates) - % Interest Rate BADLAR - eop - % Balance of Payments ARS / USD - eop Trade Balance - USD bn Current Account - % GDP Foreign Direct Investment - % GDP International Reserves - USD bn Public Finances Nominal Balance - % GDP Gross Public Debt - % GDP % 0.0% 0.0% 0.0% 0.0% 0.0% Source: IMF, Bloomberg, BCRA, Haver and Itaú % % Macro Research Itaú Ilan Goldfajn Chief Economist Click here to visit our digital research library. Page 4

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