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)

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Summary
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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.

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The Return of dollarization
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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

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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.)

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De-leveraged Society Protects Argentine Banks
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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.

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Call for Integrated GoA/BCRA Approach
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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.

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History Lesson on Proposal to Re-Open Debt Exchange
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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

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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.

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Comment
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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