Unintended Negative Credit Implications of Argentina s New FX Measures

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1 NOVEMBER 8, 2011 SOVEREIGN & SUPRANATIONAL SPECIAL COMMENT Unintended Negative Credit Implications of Argentina s New FX Measures Table of Contents: NEW FX POLICIES SUPPORT FOREIGN RESERVES: CREDIT NEGATIVE IN THE LONG TERM 2 CURB ON DOLLAR PURCHASES IS CREDIT NEGATIVE FOR BANKING SYSTEM 2 MOVE TO REPATRIATE FX PROCEEDS PRESSURES ENERGY COMPANIES 4 NEW LAW REQUIRING REPATRIATION OF FOREIGN INVESTMENTS IS CREDIT NEGATIVE FOR INSURERS 5 Analyst Contacts: NEW YORK Gabriel Torres Vice President-Senior Credit Officer gabriel.torres@moodys.com Gretchen French Vice President-Senior Analyst gretchen.french@moodys.com Beginning last week, Argentina s government (B3 stable) announced several new regulations aimed at simultaneously increasing the supply and reducing the demand for dollars within the country. While the measures will likely result in several billion dollars of new dollar inflows the regulations do not address the underlying factors that led to a nearly $5 billion drop in official reserves so far this year. Improved confidence in government policies will be key to reverse the downward pressure on foreign reserves and the currency in the longer term. The new policies include:» forcing oil, gas, and mining companies to repatriate 100% of their foreign currency earnings» insurance companies must sell all their foreign assets and repatriate the proceeds» official approval is now required to buy dollars in Argentina, and approval is contingent on previous tax declarations proving the necessary income This article addresses the negative credit implications of these measures from the perspective of the sovereign, the banking system, affected energy sector corporate entities and insurance companies, respectively. BUENOS AIRES Maria Andrea Manavella Vice President-Senior Credit Officer andrea.manavella@moodys.com Maria Valeria Azconegui Analyst valeria.azconegui@moodys.com» contacts continued on the last page

2 New FX Policies Support Foreign Reserves: Credit Negative in the Long Term The new regulations will likely result in increased foreign reserves of several billion dollars in the short term, an important factor supporting sovereign creditworthiness. However, the regulations do not address the underlying factors -- mainly a lack of confidence in government policies -- that led to a nearly $5 billion drop in reserves so far this year (see exhibit below). Because the new foreign exchange policies raise concerns about the emergence of dual exchange rates that affect productivity and raise the possibility of a forced devaluation that leads to even higher inflation, they compound the longer-term risks confronting Argentina s creditworthiness. EXHIBIT 1 Argentina s Official Reserves US$ Millions Dec-10 Jan-11 Feb-11 Source: Central Bank of Argentina While we expect the measures to result in an increase in available dollars, we do not expect the increased supply will be sufficient to undo the drop in reserves. In 2010, total oil, gas, and mining exports were $10.4 billion, providing an upper bound to the potential dollar increase. But the actual increase in dollar supply will be lower since much of that $10.4 billion was already repatriated. The potential amounts from the insurance sector are even lower, likely less than $2 billion. The combination of all these policies will result in further pressure for a downward adjustment of the official exchange rate. It will also lead to increased use of informal markets and potentially the formal creation of dual exchange rates. Argentina s high inflation, which has been less than offset by the managed nominal exchange rate depreciation, has resulted in the exchange rate appreciating in real terms. These measures will likely lead to further real appreciation, negatively affecting competitiveness. We don t consider this a sustainable framework and expect it will ultimately result in a larger nominal devaluation in the official exchange rate. Curb on Dollar Purchases Is Credit Negative for Banking System On 31 October, the Argentinean government introduced measures that require individuals and corporations to obtain official approval for purchases of dollars. Introduced under the auspices of preventing money laundering, the new policies require proof of income, tax payments and purpose for exchanged funds prior to approval of the national tax agency before any foreign exchange transaction can proceed. However, the measures appear more directed at making it difficult and time consuming 2 NOVEMBER 8, 2011 SPECIAL COMMENT: UNINTENDED NEGATIVE CREDIT IMPLICATIONS OF ARGENTINA S NEW FX MEASURES

3 to exchange pesos for dollars to curb demand for dollars and reduce capital flight, which have been increasing with concerns about elevated inflation and imminent currency devaluation as confidence in government policies decline. The move threatens to undermine depositor confidence, a credit negative for the banking system. The measure increases uncertainty about the exchange rate, and the rules governing foreign currency access spark deposit volatility and risks deposit withdrawals that will diminish Argentine banks liquidity cushions. The measure risks diminishing depositor confidence, which has been at a historical low, as reflected in the predominantly transactional and short-term nature of banks deposits. More importantly, Argentineans willingness to deposit funds in local banks has depended on a stable exchange rate. The recent peso devaluation and expectations of further depreciation, therefore, challenge the stability of banks funding. Preliminary market estimates show that since the new measure was implemented 31 October, banks have lost about 2% of the total stock of dollar deposits in the system, estimated at $15 billion as of 21 October. Although the financial system reports a low 61% loan-to-deposit ratio, accelerating withdrawals can be expected if confidence weakens. The new regulation also increases banks cost of funding, which has been an important profitability driver for the system over the past quarters, in turn decreasing margins and business volumes. The threat to funding costs and volatility can be seen in Exhibit 2 below, which shows the rapid rise in the average interest rate paid on wholesale bank deposits, or BADLAR. The rate was largely flat during the first half of 2011 at 11%, but started increasing in September and spiked in October when it reached 20%, a trend primarily driven by exchange-rate volatility. EXHIBIT 2 Private Bank BADLAR - Average Interest Rates on Wholesale Bank Deposits 25% 20% 15% 10% 5% 0% Nov-11 Source: Central Bank The rising cost of funding and the potential squeeze in banks liquidity cushions could alter banks loan growth strategy. As of October, the banking system had 52% year-over-year loan book growth, driven mainly by favorable conditions coupled with low deposit rates and peso appreciation in real terms. 3 NOVEMBER 8, 2011 SPECIAL COMMENT: UNINTENDED NEGATIVE CREDIT IMPLICATIONS OF ARGENTINA S NEW FX MEASURES

4 EXHIBIT 3 Loan and Deposit Evolution (ARS billions) Ar$ Billions Deposits (LHS) Loans to the private sector (LHS) Loans to the private sector / Deposits (RHS) 64% 62% 60% 58% 56% 54% 52% 50% 48% Source: Central Bank The system has ample liquidity, both in local and foreign currency, evidenced in the 61% loan todeposits ratio, coupled with limited currency mismatches. Nonetheless, as the cost of funding grows, and deposit withdrawals accelerate, banks will adjust their business plans and loan expansion strategies, to return to a moderate level of loan growth. Move to Repatriate FX Proceeds Pressures Energy Companies On 26 October, Argentina s government announced a new presidential decree requiring that all oil, natural gas, and mining companies repatriate 100% of their foreign currency proceeds. The decree is a significant change from the prior regulation, which allowed the oil and natural gas companies to keep up to 70% of their export proceeds offshore. The government s move is credit negative for Argentine oil and natural gas companies, increasing their transfer and convertibility risk and overall country risk. The move prompted us to downgrade five firms ratings last Monday and to keep them on review for downgrade. The government s move negatively affects Pan American Energy LLC (Ba2 local currency, Ba3 foreign currency, review for downgrade), the largest oil exporter in Argentina, as well as YPF S.A. (Ba2 local currency, review for downgrade) and Petrobras Argentina S.A. (Ba2 local currency, Ba3 foreign currency, review for downgrade). Argentina s government has a history of interfering in the oil and natural gas sector. Over the past decade, the government has subjected energy companies to price controls at the wellhead, onerous export taxes, and restrictions on their export volumes. The result is that Argentina s hydrocarbon exports have declined since the economic crisis of , and by 2010 accounted for less than 10% of the country s total exports. Exports of Argentine energy companies have become less meaningful over the past decade. Pan American Energy remains the largest oil exporter in Argentina, with exports accounting for roughly 63% of its gross sales, while export proceeds are less than 15% of net sales for both YPF and Petrobras Argentina. 4 NOVEMBER 8, 2011 SPECIAL COMMENT: UNINTENDED NEGATIVE CREDIT IMPLICATIONS OF ARGENTINA S NEW FX MEASURES

5 The government s move will come as an even bigger shock to Argentina s mining companies, which until now could keep up to 100% of their export proceeds offshore. Even so, the oil and gas companies previous ability to keep up to 70% of their export proceeds offshore gave them a degree of cushion from the risk of currency controls, particularly since most of their debt obligations are in foreign currencies. In fact, it was one factor that supported rating these companies several notches above the Argentine government s B3 bond rating. Forcing the energy companies to repatriate all of their export proceeds will expose them to greater risk in the event that Argentina sets up tougher barriers to converting or moving foreign exchange. Such new barriers would make it harder for these companies to meet their foreign-currency debt-service obligations. We do not expect the new decree to cause any meaningful changes in Pan American Energy s, YPF s and Petrobras Argentina s day-to-day operations, debt service payments or dividend flows. But the new rule increases their country risk since it demonstrates the Argentine government s unpredictability, and by extension, the risk of increased capital controls and regulatory changes that companies operating in Argentina face. New Law Requiring Repatriation of Foreign Investments Is Credit Negative for Insurers On 26 October, the Argentine insurance regulator issued Resolution No , which requires Argentine primary insurers to repatriate their foreign investment holdings within 50 days. Although some market participants may interpret the new law as simply requiring a change in the domicile of the custody or depositary agent of those assets, instead, we believe that the regulator s objective is to require local insurers to dispose of foreign assets and reinvest the proceeds in local assets issued by Argentine-domiciled entities, 1 a credit negative for many Argentine insurers. Insurers will no longer be able to allocate a portion of their investments to high-quality foreign instruments, which, to varying degrees, will degrade the average credit quality of many insurers investments as they become more concentrated in Argentine assets. The absence of a deep local capital market in Argentina for some security types will constrain the diversification of insurers investment portfolios and will likely result in increased speculative grade instruments in the local market, highly concentrated in sovereign and provincial bonds (B3 stable) and local bank deposits (ceiling of Ba1). The risk profile of insurance products with foreign currency denominated liabilities (i.e., property coverage for large industrial risks and transportation) will worsen given heightened asset-liability management challenges owing to the limited availability of foreign currency denominated local Argentine assets (e.g., foreign currency debt issued by Argentine sovereign, sub-sovereign, corporates, and banks) relative to assets issued by foreign entities in the currency of their country of domicile. Insurers deteriorating investment credit quality will also negatively affect their earnings quality and stability, as well as their risk-adjusted capital adequacy given the greater concentration in deeply speculative-grade local Argentine assets. 1 In some cases, local insurers may be able to hold foreign assets to support the reserves of particular insurance products. The new regulation allows companies to temporarily hold foreign instruments, subject to the regulator s approval, in cases where suitable instruments are not available on the local market. 5 NOVEMBER 8, 2011 SPECIAL COMMENT: UNINTENDED NEGATIVE CREDIT IMPLICATIONS OF ARGENTINA S NEW FX MEASURES

6 About 15% of Argentine insurers investments are currently held outside the country, with foreign investments diversified across asset types such as public and private bonds, stocks, mutual funds and term deposits. 6 NOVEMBER 8, 2011 SPECIAL COMMENT: UNINTENDED NEGATIVE CREDIT IMPLICATIONS OF ARGENTINA S NEW FX MEASURES

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