Argentina's economy minister Nicolás Dujovne meets with IMF MD Christine Lagarde on Thursday
The slow pace of Argentina’s fiscal reform programme finally caught up with its government last week and, compounded by an error in monetary strategy at the end of last year and a deteriorating risk environment for emerging markets, the country is firmly into emergency reaction mode.
Meanwhile, the banks that had been changing their funding mix and business strategy to anticipate economic growth and credit demand face tough operational questions: do they continue with their path to normalization or hunker down and see how long and fierce the storm will prove to be – and what damage it will do?
There are three main impacts to the banking sector from the recent economic drama in Argentina, which saw the central bank intervene three times and increase its policy rate by 1,250 basis points in three inter-meeting decisions to 40%.
This was an attempt to stop a run on its currency – the peso fell by 12% last week – and prevent the central bank burning through billions of dollars of FX reserves to fight the peso's depreciation – followed by the politically risky decision to negotiate a line of credit from the IMF.
The first impact is short term, mixed and related to the new reality of the financial system.
The banks should benefit from the higher interest rates through higher net interest margins (NIMs), according to UBS financial analyst Frederic de Mariz. He thinks the recent fallout to Argentine banks’ valuations – Argentine bank ADRs have suffered – leads to a buying opportunity as “higher rates will impact NIMs positively, via higher securities income.
“We currently expect NIM to compress from 10.7% in 2017 to 10.6% in 2018, and now we see upside risk to 2018.”
De Mariz estimates that every 50bp increase in NIM would translate into about 9% in earnings per share.
The Argentine central bank (BCRA) also moved to cut the permitted level of foreign currency held as part of banks’ tier-1 capital, from 30% to 10%. However, despite the short deadline for compliance (May 7), a report from BTG Pactual said that the impact on the private banks would be minimal.
“According to February data, only public banks were close to the 30% limit (at 29%) as private banks were around 2%,” it states, although that low figure could have increased if banks had increased their hard currency positions since March.
Rating agency Moody’s believes the main financial impact will be negative, with higher interest rates hurting the system’s delinquency ratios.
“The rate of non-performing loans was a low 1.6% of gross loans as of year-end 2017,” it states. “However, with interest payments on variable-rate loans [which on average constitute roughly one third of banks’ portfolios] set to increase by nearly 50%, we expect impaired loans to increase.”
Although Argentina’s banks are relatively insulated from the drop in the exchange rate, the steep and sudden increase in interest rates is credit negative for them- Maria Valeria Azconegui, Moody's
According to Moody’s senior analyst Maria Valeria Azconegui, this will more than offset any positive returns from securities income.
“Although Argentina’s banks are relatively insulated from the drop in the exchange rate, the steep and sudden increase in interest rates is credit negative for them, because it will increase delinquencies and credit costs, and squeeze lending margins over the next two months,” says Azconegui.
However, the second issue for banks’ management teams, and their investors, is the degree to which higher interest rates and higher inflation – Morgan Stanley predicts that every 10% fall in the peso will lead to an extra 1.2 percentage points of inflation – will lower economic and credit growth.
The banks had been enjoying the start of a strong positive credit cycle – BCRA data for April revealed system loan growth of 56%, accelerating from 53% in May.
Many banks had been changing their operating models and had raised capital to capture market share to support rapid loan growth and sustain profitability. The leading private banks were increasing credit volumes to offset lower margins.
The shift to this model is now in doubt. Economists for banks and consultancies are either emphasizing the risk is now firmly to the downside of their earlier estimates, revising growth targets down or in some cases predicting a recession – which is “now looking likely”, according to Edward Glossop, Latin America economist for Capital Economics.
The third and related issue that the banks will need to navigate is the longer-term political risk.
President Mauricio Macri’s decision to secure IMF support is a huge political gamble and one that could undermine the comfortable assumption that he will win next year’s presidential election, which formed after his strong showing in last year’s mid-term elections.
Reports suggest that the Argentine government will request a standby arrangement (SBA) from the IMF, updating the initial suggestion from the government that Argentina would seek to negotiate a flexible credit line (FCL) or a precautionary and liquidity line (PLL).
Such a strategy would be more realistic – as qualifying conditions for countries applying for FCLs and PLLs are defined by the IMF – and quicker.
However, SBAs do come with conditionality and this could be the government’s hardest challenge. Macri’s political opponents will be quick to attribute any acceleration in the fiscal adjustment to its agreement with the IMF – and economy minister Nicolás Dujovne has already been forced to quicken the “gradualist” fiscal adjustment.
The pain needed to quicken the fiscal adjustment and help take the burden of inflation-fighting from monetary policy is now going to be higher than anticipated. The ability of Macri’s opponents to attribute that to the IMF’s involvement in the economy weakens his chance of re-election.
If bank CEOs think that risk is significant, then their nascent plans to take advantage of a multi-year cycle of credit growth might be mothballed and the economy will miss a golden chance to evolve from a transactional to a functional economy and banking system.