Argentina might be the only large country in the world that doesn’t face an existential challenge to its banking system caused by the Covid-19 virus – but that is only because the country’s banks were facing their own crisis already.
Since president Alberto Fernández became president in December 2019, the country has adopted a series of economic and financial policies that are threatening the mainstay of the banks’ business model: income from public-sector securities.
The current administration has attempted to kick-start growth by lowering interest rates and ditching monetary policy as the driver of the fight against inflation in favour of price controls, financial repression and collective wage agreements.
This is pushing interest rates for those public-sector securities into negative territory. Without other obvious sources of income, the banks face a bleak future. And that is before the coronavirus horribly complicates the macroeconomic and financial environment.
Since Argentina’s 2001 financial crisis, the country’s banks have, to a lesser or greater extent, survived by taking the spread between the rates they pay to depositors and the return they make from investing in government and central bank securities.
The relative importance of this margin on total net income has waxed and waned, but it has always – apart from in 2017 – been material to the banks’ balance sheets.
For example, in the immediate aftermath of the 2001 crisis, banks generated income through commissions and fees, but under the administrations of both Néstor and Cristina Kirchner (starting in mid 2003) these fell as the government introduced strict regulations on fees and commission rates (as well as interest-rate caps and floors and mandated lending to certain sectors of the economy).
As these revenues dwindled, securities income kept the banks afloat.
Then came the political revolution that swept Mauricio Macri to power in December 2015. Macri promised a new economic model, immediately doing away with currency controls and reaching a settlement with the holdout bondholders (from the default of 2001). That enabled his administration to raise debt to finance the country’s fiscal adjustment. As the domestic markets offered no liquidity, the international markets financed the period of adjustment.
“The strategy created massive capital inflows – hot money to take advantage of the real interest differentials and the real appreciation of the currency,” says Claudio Irigoyen, Argentina economist at Bank of America. “The central bank’s strategy was to sterilize those inflows by issuing central bank paper and that – with high real rates – was the real source of profitability of the banking system [under Macri].
“There’s a perception that the banking systems normalized and started earning NIM [net interest margin] from lending to corporates, but it was much easier to lend to the central bank.”
However, the Argentine banks also began to complement their business model with loan portfolio growth – a normalization of the banking system. Credit demand from both individual and corporate segments turned positive in real terms, despite lingering high inflation, and the banks began to embrace a flourishing credit impulse.
Private-sector banks such as Banco Supervielle and Banco Galicia led the way, issuing debt and equity into the international markets to drive credit growth and to prepare (in the case of Galicia and Banco BBVA Argentina) for acquisition opportunities.
It was boom time as there was growing confidence that the Macri experiment would endure and the financial system – the smallest in Latin America as a proportion of GDP at about 15%, compared with 65% in Brazil and 120% in Chile – would grow quickly to match those peers.
I expect to see the central bank pivoting once again to cut remunerated reserves and force banks to increase non-remunerated reserve requirements. And that’s the death knell for the banks’ current business model- Juan Manuel Pazos, TPCG Valores
Juan Manuel Pazos, chief economist at TPCG Valores in Buenos Aires, says: “By the end of 2017 and the beginning of 2018, the valuation of Argentine banks was extremely rich as investors weren’t paying for where the banks were but where they expected them to be – or rather they were assigning multiples based on those much larger future revenues.
“Now we are back to a situation where there isn’t going to be that growth – Argentine banks will be one of a kind in terms of the size and growth of the financial system. Banks will have to return to a purely transactional business model, seeking revenues from fees and credit growth that will be lower than inflation. They will also probably be having to pursue subsidized lending, so the banks are going to find it very hard to maintain real returns going forward.”
So far, at least, the situation was comfortably similar to the pre-Macri days. In the first months the banks earned positive returns from public-sector securities and the banks results were solid. The four largest banks – Banco Macro, Galicia, BBVA and Santander Rio – recorded a net income of $576.1 million for the fourth quarter of 2019, up 36.9% compared with the same quarter in 2018, according to data from S&P Global.
Total operating income reached $1.98 billion in the quarter, up from $1.39 billion a year earlier. These results were achieved despite the large depreciation of the peso during that time. Macro’s fourth-quarter results were up a mighty 153.2% in local currency terms year on year, while Galicia’s grew by 111.3%.
The driver of these results was the spike in the interest paid on those public-sector securities. For example, the Leliq – a seven-day instrument issued by the central bank – reached 85% in the fourth quarter of last year.
But these results are backward looking, of course.
Since Fernández was elected – and he appointed new governor Miguel Angel Pesce – the central bank has been slashing interest rates even in the face of stubbornly high inflation. Pesce has cut rates to 38% – well below 2019’s annual rate of 53.8% and possibly below current inflation rates (it is hard to be sure given high monthly volatility and doubts about the accuracy of government data).
Unsurprisingly, banks are responding to this changing environment. For example, Supervielle cut its investment in the Leliq in the fourth quarter, ending the reporting period with a little under 5% of assets invested in this security, down from 19% at the end of the third quarter – and that was while the Leliq still yielded a positive real return.
Cynthia Cohen Freue, senior director and sector lead, financial institutions ratings at S&P Global, says the fact that banks’ liabilities adjust more quickly than assets to a change in underlying interest rates will provide a small bump to profitability in the near term, but that “this positive impact will only last a few months.”
Banks can adjust to the dynamic of a decline in rates, but direct lending is difficult to cope with – and it is [good news] that this is not happening at this point- Cynthia Cohen Freue, S&P Global
Pazos says that he believes the Leliq is still positive in real terms, but the margin is shrinking and appears to be headed into negative territory.
“Inflation is expected to be about 2% for the next four to five months,” he explains, “and Leliqs pay a 38% nominal annual rate, which translates to an effective rate of about 45% [including the compounding of the capitalization], so banks get about half a percentage point – about 7% annually at an ex-ante real rate [deflated by expected inflation not effective inflation] – and there is no duration risk whatsoever.
“But the central bank is not going to allow that to continue for an extended period of time,” he points out. “Eventually I expect to see the central bank pivoting once again to cut remunerated reserves and force banks to increase non-remunerated reserve requirements. And that’s the death knell for the banks’ current business model.”
The fall into negative territory of these securities will be bad, but Pazos also expects that the government will add to the banks’ profitability challenge.
At some point the economy will need credit and, given the government’s fiscal challenges, the public banks’ large books of non-performing loans and the fact that public banks such as Banco Nacion have been reducing lending capacity by increasing dividend payments to the cash-strapped state, the well-capitalized private sector will be in the firing line.
“The private banks’ balance sheets are going to be used by the central bank to provide direct lending where the central bank can no longer do so – and that will be a problem,” says Pazos. “Tax intake is going to be dismal. We estimate a fiscal deficit of up to 2% of GDP, made worse by the coronavirus – we were estimating a deficit of 0.5% previously.”
Pazos and others expect the government will also move to supplement the increase in non-remunerating reserve requirements with the return of the types of prescriptive regulations on the banks that was seen under president Kirchner – now vice-president to Fernandez.
“Back in 2015 we had rates around 40% and the government was forcing banks to lend 10% [of their deposit base] to small and medium-sized enterprises at discounted rates of between 15% and 20%, and that’s a lot,” says Pazos.
Back-of-the-envelope projections suggest that if a similar requirement returns and the central bank increases non-remunerating reserve requirements to around 25%, then already around 35% of a bank’s deposit funding (and most Argentine banks are funded by deposits, not market funding) will be trading below inflation.
“Add to that the exposures to central bank liabilities, which will require a risk premium, and suddenly you are not really comfortable with where about 50% to 60% of your lending is going,” says Pazos.
However, the absence of any such regulations on direct lending requirements is a positive for S&P’s Freue – for now.
“Banks can adjust to the dynamic of a decline in rates, but direct lending is difficult to cope with – and it is [good news] that this is not happening at this point,” she says.
She also adds that the banks learned from 2001 and have reduced their exposure to government bonds – as such the direct fallout of the government’s debt issues and the subsequent collapse in the price of their outstanding bonds has been limited on the banks.
The Government may not have increased direct lending, but it is already beginning to intervene with more prescriptive lending.
In February, the central bank placed a 55% cap on the annual nominal interest rate that banks can charge on credit-card debt, while all bank fees were also frozen for 180 days – with a prohibition on new ones.
S&P has already noted the additional margin pressure caused by the average personal loan rate dropping to 58.4% on March 4 from 66.1% on February 3, while the overdraft rate for business accounts fell to 38.4% from 44.8% in the same period.
“The spreads today in relation to the cost of running a bank are looking very challenging,” says an equity analyst of Latin American banks. “Return on equity across the board is below inflation – which is the key metric I look at because that means that banks are operating in a system that is destroying the economic value of the banks. In the medium term, you are shrinking the size of the country’s financial system.”
The analyst adds that this pressure on banks’ margins will soon become apparent: “Banks mark-to-market pretty quick, and so, with the discount rate already down to 38% by January this year, I think we will start to see the margin pressures showing up in first-quarter results. By the second and third quarters, the true impact of the negative spreads will be clearly visible in the banks’ results.”
The analyst also points out that 2020 results will be further weakened by the introduction of the IFRS 9 accounting standard, which, given the last three years’ high inflation rate, will require the banks to adjust their financial results for that inflation while taxation will be levied on nominal results.
He also expects Banco Macro – of the publicly listed banks – will be most directly impacted by falling interest rates for government securities as it remains most exposed to this ‘business model’, whereas Supervielle and Galicia moved more quickly to build up their lending businesses.
Even so, lending is no hedge for profitability, partly because of those regulations on rates and fees, and partly because loan portfolios are growing below inflation and asset quality is deteriorating in the country’s deepening recession.
That brings us to the other possible driver for banks: growth of both the economy and, from that, credit. But the outlook for Argentina is not good and it seems unlikely growth will return soon.
The country is already into its second year of recession. The government is in talks to try to stave off default and the central bank’s balance sheet is perilously close to insolvency, while strict controls on the official exchange rate are preventing the currency from acting as a shock-absorber.
Industry is highly taxed and highly regulated. Even with a benign global growth outlook and a business-friendly administration, investment decisions are hard to justify (as demonstrated by the low levels of foreign direct investment that fatally weakened Macri’s economic model).
The current administration isn’t planning to lower either the tax or regulatory burden, and the global situation could hardly be worse.
The most bullish outlooks are based on the ability of the government to agree a debt restructuring deal with bondholders and the IMF that gives debt relief and allows the government the fiscal space to avoid austerity.
Covid-19 is only complicating this already tricky balancing act. The government has unilaterally announced a fiscal package worth 3% of GDP, which has blown out the models being discussed with the IMF and the bondholders. It is also introducing strict rules on a civilian lockdown that will paralyze the economy.
Due to the spread of coronavirus and its impact on global activity and international trading, projections on exports are forced to be modified, and the activity growth scenario reduced even more- Hernan Garcia, Banco Galicia
Irigoyen at Bank of America says: “The problem you still have in Argentina is that you need a plan that is consistent with growing at a level that allows you do deal with the fiscal deficit and the big size of the public sector.
“If you don’t solve that problem, you need to issue more debt – which is practically impossible – or you continue to finance with inflation and financial repression. That was before the coronavirus – now it’s way more complicated.”
Banco Galicia’s chief economist, Hernan Garcia, tells Euromoney that he had expected a recovery in the second half of the 2020, driven by a revival of exports that would feed into a recovery in real wages – although he was still projecting a negative result for the year as a whole.
Now he says: “However, due to the spread of coronavirus and its impact on global activity and international trading, projections on exports are forced to be modified, and the activity growth scenario reduced even more; effects that imply an even greater fall in activity than we had originally projected. In our case, this could be derived mainly from the fall in the prices of commodities (mainly soybeans) and from the reduction of activity in Brazil as our main trading partner.
“In addition to this, for the time being, we don’t observe other big growth drivers because when regarding investment, volatility and uncertainty slow down the growth.”
Nor are there drivers of consumption, he says.
“In this scenario, inflation may drop from last year’s levels, mainly as a result of a disindexation of the economy and the regulation of exchange rates.”
While there is no doubt coronavirus is a challenge, there is suspicion among some that the government will be able to use the crisis to mask the failure of its economic strategy.
“We were wondering how the government would explain the lack of growth – and now we know,” says one.
There will also be a coronavirus effect on the debt negotiations. The first and most obvious is that it will delay the timing of talks. There will also be an effect on the nature of these negotiations, although how is less clear.
Some believe it will be positive: the fiscal requirements of the crisis and the ‘bigger picture’ demands for recovery will encourage all parties to find a consensus – though that is a minority view.
Goldman Sachs senior economist Alberto Ramos points out the government’s stance of fiscal spending has long been at odds with the bondholders.
“In his address to Congress on February 12,” Ramos says, “[finance minister Martín Guzmán] stressed that Argentina faced a ‘deep debt restructuring’ whose resolution would likely ‘frustrate’ private bondholders… noting that the government would likely reach a primary fiscal balance only by 2023 and that it would aim for a modest medium-term primary surplus of 0.6% to 0.8% of GDP. These underwhelming targets implicitly suggest that the government is not inclined to make an additional effort even in the medium term.”
Most who spoke to Euromoney also believe that, while debt holders’ expectations on the net present value of the deal have shifted downward, so too have the government’s; and the distance between the parties remains as wide and as entrenched as ever.
There is also a disconnect between Guzman and the IMF even though the IMF raised eyebrows among investors when it seemed to side with the Argentine government by saying that a “definitive debt operation – yielding a meaningful contribution from private sector creditors – is required to help restore debt sustainability with high profitability.”
This was read by some as a shift in IMF policy and one that might have unintended consequences for emerging market sovereign credit markets.
Guzman has outlined his desire to see the most relief on coupon reduction, whereas the IMF focuses on haircuts on principal as its main metric for measuring debt sustainability.
Worse, as the price of government debt have fallen further (now in the low 30 cents on the dollar), the prospect of the distressed debt hedge funds entering the equation becomes increasingly likely.
There have been unconfirmed rumours that these funds – which were referred to as vulture funds by the Kirchner administration – have begun to buy up the debt. If true, that would complicate the negotiations and make a swift agreement even more unlikely.
Yet there are bright spots for the banks among the gloom. For example, Freue believes that the low base of the financial system and recent lending trends mean that there is still an opportunity for banks to increase the size of their commercial lending portfolios.
“Demand for credit is there,” she says. “It’s not huge demand, but given the low base, the private banks will have room to grow credit while maintaining high underwriting standards – the banks will still be able to cherry-pick in segments where they see lower room for deterioration in asset quality.
“Though I expect the banks will be very cautious, especially given the risks from the coronavirus.”
Freue also says the banks should be somewhat protected by their anticipation of this year’s harsher operating environment.
“Given the very good results last year, many banks took the chance to book provisions for this year’s cost-cutting measures in last year’s accounts,” she notes.
All banks have been implementing cost-reduction programmes, although staff accounts for more than half of total costs at most banks, while the strength of the unions makes is difficult to cut quickly in this area.
Meanwhile, Pazos offers his own version of good news.
“Valuations are signalling that Argentine banks are going to have problems,” he says. “From a funding point of view, it’s hard to make sense of the coming business model for the banks, but the market has more than priced in this challenge.”
He points out that Grupo Galicia’s share price has fallen by 68% from its Macri-era peak, while Banco Supervielle’s is down by 77%.
The challenge – although large – will be overcome by the larger banks, he says.
“If you have a private-equity approach to opportunity – in the sense you can buy into these banks and then not look at the valuations for three to five years – then you are probably going to make a decent return.”
Consolidation still on the cards?
During the administration of president Mauricio Macri, when bank valuations rose as if filled with helium, there was much discussion of consolidation of the financial system, which is very fragmented for its small size.
The large banks capitalized to take advantage: Supervielle, Galicia and BBVA all issued equity. Today there is still an expectation that the number of banks will fall, but it seems attrition will do the job in this new environment.
“Consolidation is driven either by a fast-growing market, where some banks can take advantage by conducting M&A, or by shrinkage,” says a financial institutions equity analyst. “We may see some rationalization of the numbers of Argentine banks, because some will have to exit after becoming economically unviable – that might happen.”
However, there are always M&A opportunities, in good times and bad.
“We think Macro is well positioned to conduct acquisitions in this environment,” says Cynthia Cohen Freue, senior director and sector lead, financial institutions ratings at S&P Global. “Banco Macro has grown strongly through M&A in past crises and I think it would be able, and probably willing, to buy some of the banks this time too.”
Market rumours tend to be strongest about some of the few international banks still active in the country, mainly HSBC and the likely sale of Banco do Brasil’s stake in Banco Patagonia.