CITIBANK-ARGENTINA PRESIDENT HIGHLIGHTS IMPACT OF

C O N F I D E N T I A L SECTION 01 OF 03 BUENOS AIRES 001397 SIPDIS E.O. 12958: DECL: 10/08/2028 TAGS: EFIN ECON ETRD PREL AR SUBJECT: CITIBANK-ARGENTINA PRESIDENT HIGHLIGHTS IMPACT OF FINANCIAL CRISIS ON ARGENTINE BANKS AND GOA DEBT DEALS Classified By: Ambassador E.A. Wayne for Reasons 1.4 (b,d) -------------- Summary -------------- ¶1. (C) Citi-Argentina President Juan Jose Bruchou (protect) told Ambassador October 7 that the Argentine banking sector is starting to feel the pinch of the global financial crisis and accompanying flight to quality. While providing assurances that the Argentine financial sector is reasonably stable, Bruchou said the foreign bank association is so concerned about coming difficulties that it plans to approach senior GoA and Central Bank (BCRA) officials to recommend immediate policy adjustments to respond to financial uncertainty, falling commodity prices, pressure on GoA finances, and increased competition from Brazil stemming from the huge depreciation of the real. Bruchou recommends the GoA and BCRA pursue an integrated approach, including increasing interest rates, depreciating the peso to the 3.5/USD range, and slowing spending growth. He thought the benefits of rapid currency depreciation would outweigh the resulting higher inflation pressures. Bruchou also explained the background of the GoA's recent announcement to consider opening up the 2005 debt exchange to Holdout bondholders, and noted that, at current Argentine bond yields, any debt swap with private creditors is off the table. End Summary. -------------- The Return of dollarization -------------- ¶2. (C) Dr. Bruchou (PROTECT throughout) informed the Ambassador that he met October 6 with the other members of the Argentine Bank Association (ABA),which represents foreign banks operating in Argentina. In comparing notes on recent movements in the financial sector, the ABA members agreed that the Argentine financial sector was beginning to feel the bite of the external financial crisis. While the crisis has had a severe impact so far on Argentine debt yields and stock markets, Bruchou claimed that it was only in the last few days that financial institutions started seeing an impact on their balance sheets. ¶3. (C) Since the end of last week, banks are starting to see a return to the dollarization process that was so debilitating to the banks earlier in the year during the March-July farm crisis. While nowhere near as bad as the situation was in April and May, depositors are beginning to change peso deposits into dollars and also starting to take dollars out of the system. Small, local banks were bearing the brunt of this, he claimed, but the big foreign banks were also experiencing an outflow of deposits. As an example, he said that Spanish Bank Santander Rio's CEO commented that their daily dollar sales recently spiked from $3 million to over $12 million. (Comment: Post checked with Argentine bank, Banco Galicia, which is one of the largest traders in currency, and they have seen a similar increase from daily dollar sales of about US$ 3-4 million to $12-15 million, although that volume is still well below the worst levels of five months ago.) ¶4. (C) Bruchou argued that the immediate problem is that Argentines are expecting a strong devaluation of the peso, in response to the over-40% devaluation of the Brazilian Real in recent months (including an almost 22% drop against the dollar and 17% drop against the peso just from Sept 1 - October 7). This is especially true at the retail level, with individual Argentines trained by earlier crises to change savings into dollars at the first sign of weakness in the peso. Just since early September, he noted, the peso had depreciated from 3.01/USD to its current level of about 3.21, roughly a 5% drop from its 2008 peak. While this in part reflects a BCRA decision to let it happen, Bruchou also thought it indicated increasing demand. (He noted the irony that even with the financial crisis emanating from the United States, the reflex in Argentina is to flee to the safety of the dollar.) ¶5. (C) Bruchou claimed that the BCRA had intervened in currency markets on October 6, selling US$ 100 million to prevent a further decline in the exchange rate and keep the peso at about 3.2/USD. Again, he added, this is well below the most difficult days in April and May, when the BCRA was intervening daily with sales often exceeding US$300 million. However, concerns about Argentina's economic stability are clearly increasing, he thought, and were the result of the combination of negative factors particular to Argentina (in BUENOS AIR 00001397 002 OF 003 addition to the global credit crunch): slowing growth, declining commodity prices, particularly soy prices (which are down almost 45% from their July high to about $340/ton), and declining competitiveness vis-a-vis Brazil. (Argentine Press reports that BCRA dollar sales have accelerated since October 6, with estimates in the range of US$250 - 500 million on October 8.) -------------- De-leveraged Society Protects Argentine Banks -------------- ¶6. (C) The silver lining, according to Bruchou, is that the Argentine economy de-leveraged following the 2001/02 crisis to the point where the financial system is not a conduit to transmit financial instability to the real economy. The ratio of credit to GDP in Argentina is only 14%, he said, compared to about 80% in Brazil and 130% in the U.S. Therefore, Argentine companies will not go bankrupt if credit dries up. They mostly finance operations and investment through retained earnings, with short-term credit covering only 10% of operating expenses, compared to roughly 70% among U.S. companies. Bruchou also noted that banks are highly liquid, have low non-performing loan ratios, low exposure to the government, mostly finance themselves with deposits, not debt, and their loans and deposits are both in pesos, so the currency mismatch that existed before the 2001 crisis is no longer a factor. That said, in the Argentine context the banks are always exposed to runs on deposits, and are responding by jacking up lending rates and reducing consumer loans, both of which are leading to lower domestic consumption and reducing aggregate demand. -------------- Call for Integrated GoA/BCRA Approach -------------- ¶7. (C) Given increasing levels of uncertainty, Bruchou said ABA representatives were planning to approach Chief of Cabinet Sergio Massa and other senior GoA and BCRA policy makers to encourage them to develop an "integrated" series of reforms. First, the GoA needs to send a signal to markets on the fiscal side, cutting subsidies and other discretional spending and making it clear that it is prepared to defend the primary fiscal surplus in the face of slowing growth and lower revenues (particularly from export taxes, reduced due to declining commodity prices). Second, Bruchou argued that the BCRA should sharply increase interest rates on BCRA short-term instruments and then begin a clear policy to devalue the peso to the range of 3.5/USD. He vacillated between support for a one-time devaluation or a graduated, staggered devaluation, but either way saw it as an essential response to the Real depreciation. ¶8. (C) The Ambassador noted that the GoA had recently started to take many of the actions that critics of GoA policies have long called for, including slowing spending growth, allowing limited price increases for utilities, and beginning to address Paris Club and private bondholder debts. He noted the great frustration of many that the GoA had not undertaken such reforms 18 months ago. Bruchou agreed, saying that he had told Cabinet Chief Massa in the past that Argentina was waiting too long to make adjustments. ¶9. (C) The Ambassador also questioned whether a sharp depreciation might boost inflation and cause a run on the peso, and noted that BCRA President Redrado had cited these concerns during his October 7 speech at the 90th anniversary of the American Chamber of Commerce (septel). In that speech, Redrado had defended the BCRA's policy of intervening in currency markets to maintain a relatively stable exchange rate. The Ambassador added that Redrado had made clear his preference for relative currency stability vis the US Dollar rather than following Brazil's example, asking rhetorically whether Argentines really wanted to be subject to up to 40% exchange rate fluctuations over short periods, as was occurring in "neighboring countries." Bruchou did not give a clear response to any of these concerns, but appeared to believe that the benefits of a coordinated GoA/BCRA approach outweighed probable negative repercussion of higher inflation. -------------- -------------- History Lesson on Proposal to Re-Open Debt Exchange -------------- -------------- ¶10. (C) Bruchou said he had also warned Sergio Massa months ago that the GoA was running out of time in organizing a debt swap of obligations coming due 2009-2011. He said that Citi BUENOS AIR 00001397 003 OF 003 and Deutsche Bank (DB) had been pushing a plan since late 2007 to help the GoA smooth out its amortization schedule during this period. This would significantly lower its financing needs, he said, and would likely reduce concerns that the GoA may be unable to meet debt payments in coming years. The idea is to refinance the bulge of Guaranteed Loans and Dollar-Denominated "BODENS" coming due over the next three years. He noted that private sector interest in such a swap has always been high, because the participants would be able to exchange illiquid bonds (the Guaranteed Loans) linked to an inflation index to more liquid 5-year bonds tied to a local reference rate (BADLAR). 60% of the Guaranteed Loans are held locally by pension and insurance companies and banks, with the remaining 40% held by foreign investors. ¶11. (C) The problem now, he noted, is that the recent spike in Argentine sovereign bond yields make any debt swap with private creditors infeasible. This includes not only the swap of Guaranteed Loans, but also the broader proposal to re-open the 2005 debt exchange to the holders of approximately US$ 19.5 billion in untendered debt (the so-called "Holdout" bondholders, who declined to participate in the 2005 debt swap). Bruchou said that part of the problem is that both swaps require participants to pony up new cash (in addition to swapping debt instruments),for which they would get additional GoA-issued debt instruments. However, with market yields on 10-year sovereign bonds currently over 20%, the re-financing rates the GoA would have to pay to holdouts and Guaranteed Loan holders is simply too expensive. Therefore, he predicted that the parties would have to wait until financial markets calm to open the exchanges. ¶12. (C) Bruchou explained that the GoA had originally been working with Citi and DB on the mini-debt swap, and with Barclays and a local investment fund, Arcadia Advisors, on re-opening the 2005 debt exchange. He claimed to have convinced Massa to combine the two. Since Arcadia (likely in agreement with U.S. hedge fund Gramercy) had signed commitments from holders of $6 billion face value of untendered bonds, the deal is that Barclays and Arcadia will get fees from the first US$6 billion participating in a future debt swap, Citi and DB will get a small percentage of fees for the next four billion participating, and then each bank will get an even cut of the fees above US$ 10 billion. In return, Barclays and Arcadia will get a cut of the mini-swap. (Bruchou acknowledged that UBS, Credit Suisse, and Italy's UniBanco had approached former President Nestor Kirchner directly in order to be included in the arrangements, but did not clarify their role.) All the banks involved will work to sell the deals, a difficult sale in the current international context. -------------- Comment -------------- ¶13. (C) As President of both AmCham and Citi-Argentina, Juan Bruchou has access to the highest levels of the Argentine government and private sector, and is a valuable source for what is happening in the banking sector and within the GoA and BCRA on policy matters. In this case, the fact that the banks are mobilizing is a significant development. In the current market environment, there are certainly risks associated with the bank association proposal that the GoA implement a relatively rapid 10% depreciation of the currency, even if offset by higher domestic interest rates and constrained government spending. Annual inflation is already at around 20%, and given high capacity utilization, it appears likely that a devaluation will contribute to higher inflationary pressures while rapid domestic adjustment of relative prices will quickly erode any competitive advantage a weaker peso will provide. Nevertheless, most private sector analysts project the exchange rate in 2009 at over 3.35/USD, and if the dollarization phenomenon accelerates and strains the current reserve cushion, the BCRA may have no choice but to allow further weakening. WAYNE