Dollar Pegging Drags Argentina to Default: 2 Banks Look Safe - Analyst Blog

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Last month, Argentina defaulted for the second time in 13 years on failure of debt payments to the "vulture fund" bondholders. This resulted due to the decade-long legal battle between Elliot Management and the Argentine government. The dollar pegging policy taken by the Argentine government in 1991, holds the key to this default.

Dollar Pegging: Root Cause of the Default

Dollar pegging is a measure of valuing country's own currency at a fixed exchange rate against dollar. The movement of pegged currency is controlled by the movement of dollar. Dollar pegging is used as an effective instrument to control some economic factors including inflation and export-import pricing, and increase foreign investments.


Argentina faced certain acute economic problems between 1975 and 1990. These include hyperinflation, discouraging GDP growth, lack of adequate capital investment and low level of confidence on the government and the central bank. The country also experienced about eight crises related to its currency. The government chose to peg Argentine Peso against the U.S. dollar to address these issues.

The Pegging Effect

Initially the pegging policy was proven to be fruitful for the economy. As a result of this policy, inflation came down to almost 3.4% in 1994 from about 3000% in 1989. The GDP grew at almost 8% per year from 1991 to 1995. Moreover, the volume of foreign investment increased during this period and the export jumped.

However, the pegging's positives didn't last long. In 1998, the sudden drop in the European and Brazilian currencies took the price of Argentine exports to a very high level. But the rigid nature of "pegged exchange rate" didn't allow the government to reduce the interest rate in order to control the situation.

The government was forced to curtail the wages in order to reduce cost. This however led to higher unemployment rate and a decline in tax receipts. As a result, the deficit increased at an alarming rate and the government opted for raising public debt by issuing bonds. Reportedly, the volume of public debt escalated from 29.5% of GDP in 1993 to almost 50.3% in 1999.

Scenario Before the First Sovereign Default

By late 2001, unemployment rate soared to almost 20%. Moreover, the peso witnessed increasing outflow on higher demand for dollar. In order to handle the situation, the government imposed limitations on withdrawals from banks to not more than 1000 pesos/dollar. This policy faced an extreme round of protests which forced the President Fernando de la Rúa to resign.

Default in 2001

Extreme pressure of public debt forced the economy to suffer default and devaluation of its currency. The third-largest Latin American economy announced sovereign default of around $100 billion, the biggest default at the time. The situation was resolved only through large-scale debt restructuring.

In an effort to restructure, the Argentine government offered the bond holders to exchange older bonds for newer issues, which were valued at a fraction of those issued earlier. About 93% of the bond holders accepted the terms. This helped the economy to recover from its crisis in the following years.

Recent Default

The remaining 'holdout' investors or 'vulture funds' - led by NML Capital, a subsidiary of Paul Singer-led Elliot Management Corp. - refused to accept the terms and took Argentina to court to obtain the full value of the securities. The U.S. Supreme Court ruled that the country cannot not make payments to its restructured bondholders unless it pays off the holdout bondholders.

As a result, Argentina faced its second default after it has been forced to terminate the interest payment of $539 million to the bondholders. In June, the country deposited the money with The Bank of New York Mellon Corp. ( BK ), Argentina's trustee bank for its disputed bonds.

Default & Foreign Banks

Meanwhile, the subsidiaries of foreign banks are looking well prepared against the volatility that may occur due to the default. A lion's share of their portfolios consists of peso dominated central bank securities that are not included in the disputed sovereign debt category.

Moreover, most of the private banks have strong equity-to-asset ratios of about 10% with impressive loan loss reserves. Due to the strong financial position, these banks may get local currency liquidity from the central bank if funding volatility elevates.   

Reportedly, these banks - including Citigroup Inc. ( C ) and HSBC Holdings plc ( HSBC ) - are trying to arrange a group of investors who can rescue the country from the default by buying disputed bonds held by Elliott Management Corp.

2 Banking Stocks Look Safe and Attractive

Here are two foreign banking stocks that should perform well despite Argentina's default concerns.

Itau Unibanco Holding SA ( ITUB )

This Zacks Rank #1 (Strong Buy) Brazilian bank operates through Commercial Banking, Itau BBA, Consumer Credit, and Market and Corporation Activity in countries like Brazil, Argentina and the U.S.

The bank has current year EPS growth estimate of 24.2%, compared to industry growth estimate of 10.5%. It also has a strong PE ratio of 10.61. The Zacks Consensus Estimate for the current year has been revised 3.5% up over the last two months.

Banco Santander, S.A. ( SAN )

This Zacks Rank #2 (Buy) Spanish bank that operates in Spain, the UK, Portugal, Latin America and the U.S. Its services include retail banking, wholesale banking, asset management and insurance.

The bank has current year EPS growth estimate of 14.8%, higher than the industry growth estimate. It also has an impressive PE ratio of 15.61.

Bottom Line

Argentina is not a safe investment destination at the moment give the bleak economic outlook. However, certain sectors still has the ability to withstand the ongoing crisis. This is because these are insulated against the shockwaves going through the economy. The stocks mentioned from the banking industry are thus good additions to your portfolio.


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BANK OF NY MELL (BK): Free Stock Analysis Report

CITIGROUP INC (C): Free Stock Analysis Report

BANCO ITAU -ADR (ITUB): Free Stock Analysis Report

BANCO SANTAN SA (SAN): Free Stock Analysis Report

HSBC HOLDINGS (HSBC): Free Stock Analysis Report

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Business , Stocks

Referenced Stocks: BK , C , ITUB , SAN , HSBC

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