Argentina Commercial Banking Report Q3 2007

Economic Analysis - GDP Growth Inches Lower Real GDP growth came in at 8.0% y-o-y in Q107, as expected, given previous monthly estimates of economic activity. We see this as playing in to our view of a deceleration in growth over the coming years, though a higher-than-expected out-turn in Q2 could prompt an upward revision of our 7.0% target for 2007.

Although monthly estimates had already provided a preliminary growth indicator, statistics agency INDEC has confirmed that real GDP expanded 8.0% y-o-y in Q107. This remains a healthy figure, though suggests a gradual deceleration in economic activity, in line with our view, as capacity constraints begin to bite following four years of booming growth. Momentum in the domestic economy remains strong, however, and we currently forecast a robust 7.0% expansion in 2007. Going forward, our core view envisages a relatively soft landing for the economy, with GDP growth easing to 5.1% in 2008, and resorting to trend levels between 3.5-4.0% by the end of the decade (see chart). That said, this forecast is based on our assumption of certain changes to government economic policy following October's presidential election (see 'A Policy Wish List' on June 12), and thus remains vulnerable to political factors.

The Commercial Banking Sector Although weaknesses remain, in line with recent trends the Argentine banking system has continued to reduce its exposure to potential shocks that could endanger its stability. Banking activity has continued to expand throughout the last 3-year period, mostly in terms of deposits and private sector credit growth.

Deposits grew by 25% in 2006, in local currency terms. The expansion of private-sector credit, which has characterised the banking system for the previous three years and been at the root of improving profitability, has continued with private loans growing from around 30% of total assets at the end of 2005, to around 37% at the end of 2006.

However, the combined balance sheets of the banks highlight some of the weaknesses of the system, which have continued throughout the recent period. The banks have continued to increase their dependency on deposits for funding. Deposits, consistent with trend from previous years, rose from 60.7% of total liabilities/capital at the end of 2005 to 66.7% at the end of 2006. Argentina's banking sector retains its vulnerability to anything that could result in a run on deposits. The central bank has recently reported that banks' capital at the end of 2006 amounted to ARS32.1bn, or ARS6bn more than one year previously. Overall, while the increased resilience of the system to negative shocks has been sustained, the need for a progression in structural reform remains.

Press Reports As discussed throughout this report, Argentina's economy is finally growing at a reasonably strong pace, with a real GDP growth of around 7% expected for 2007, a modest current account as a percentage of GDP (rising to 3.8%), and a small budget surplus. Indeed, Argentina's economy is now one of the fastestgrowing in the region. Second, and as a consequence, Argentina's banking system is also growing, with rising trends in loan/asset growth and loan/deposit growth. Over the last year (to December 31 2006), total assets have risen 13% while loans have surged by 39%.

Although such growth is impressive, it masks the struggle the Argentine economy has had to face since the economic slump of the late-1990s/early 2000s period. While the economy is one of the largest in the region in total terms, GDP per capita is still small at US$5,377. Banking deposits per capita are just US$1,402. Trend levels for loans/GDP are rising, but this figure is still only 14.6% compared with say Chile at 67%.

Recent press reports have commented that Argentine banks have assets of just US$83.9bn and deposits of US$55.9bn. The fall in volumes resulted in bloated cost structures and cuts in head count and infrastructure. While cost-to-income ratios are now falling, generally low confidence in banks has meant that there has been a move away from credit to cash. Indeed, in 2006, 85% of home purchases were paid for with cash. Mortgages are worth 1% of GDP compared with Chile's 15% and Mexico's 11%. And deposits are very short on average, making it difficult to fund mortgage books.

On balance, however, prospects are sound. Argentina's economy has been growing since 2003 and there was 8.5% GDP growth in 2006. Unemployment and inflation are falling and the current account is in surplus.