A potential default of sovereign bonds could trigger further U.S. dollar withdrawals while jeopardizing the quality of banks' premium dollar loan book to exporting companies.

With the May 8 deadline for debt talks just hours away, both Argentina's government and bondholders still appear far from a deal. Banks in Latin America's third largest economy are bracing for a no deal scenario. The resulting sovereign default would further complicate an already fragile operating environment, which has seen reduced lending and dwindling dollar deposits, aggravated by a contraction brought about by the global pandemic.

This perfect storm has resulted in a dramatic reduction of dollars in the country's financial system. Dollar deposits have been falling since the 2019 presidential primaries, which signaled a political change and a return to Peronist rule. Savers rushed to withdraw their dollar deposits from bank accounts, which dropped to $17.9 billion in April 2020 from $32.5 billion in August 2019.

To meet dollar demand from customers, banks moved to roll back lending in kind. Banks have pushed to collect loans and offered discounts on peso loans for borrowers willing to cancel their dollar loans early.

Due to regulations, banks in Argentina can only lend dollars to companies with a proven capacity to generate hard currency revenue. That underlying safeguard, however, is now being put to the test as the coronavirus pandemic undermines exporters' ability to ship their products abroad.

Although banks have been conservative in how much they lend in dollars and to whom, the recurrent weakening of the peso has increased the weight of dollar loans on the total loan book. Foreign currency loans accounted for 24% of total loans as of April 2020, up from 18% in early 2018, data from Banco Central de la República Argentina shows. That share grows to above 32% if calculated with the financial market exchange rate, which factors in an even weaker peso.

Government restrictions on access to foreign currency have spawned parallel exchange rates in the country. While the official peso weakened 11% against the dollar year to date, unofficial rates at which companies can access U.S. dollars have seen the currency lose half of its value. Argentina teetering on the edge of default only exacerbates the issue.

"A default darkens everything," Marcelo Elizondo, an Argentine trade specialist, said. "It would generate much more volatility on the exchange rate that would prompt greater interventionism to contain it. A vicious cycle."

With significant slack in foreign sales from the automotive and agricultural sectors, two large export clusters in Argentina, analysts forecast exporters will face greater difficulties to repay their dollar loans.

"The main risk is for agents not being able to access dollars at some point to pay back debt in that currency," Cynthia Cohen Freue, a bank director with S&P Global Ratings, said. "When dollar scarcity is so acute, that risk begins to grow."

In that sense, analysts believe banks could see their premium short-term dollar books wear, as a combination of lower business activity and a potential sovereign default further hampers exporters’ overall ability to repay.

Within Argentine select banking institutions, S&P Global Market Intelligence data shows Grupo Financiero Galicia SA holds as much as 26.1% of its portfolio in dollar loans, while Banco Macro SA and Banco BBVA Argentina SA have a 17.7% and 17.2% exposure, respectively.

Exporters in trouble could trigger defaults

In early 2020, agricultural exporter Vicentin set off alarms when it announced it would default on its estimated $1.35 billion debt, leaving a footprint on banks that had granted the company loans. In March, Banco Macro requested another large food company, Molino Cañuelas, to file for bankruptcy due to its $1.4 billion debt.

Analysts warn a worsening scenario resulting from both the pandemic and the potential default could mean others could follow.

"Those were very specific cases of companies that deteriorated banks' portfolios," S&P Global Ratings’ Freue said. "But with the current situation, it is likely that there will be more cases, including SMEs."

Central bank data shows that out of $8.62 billion lent to companies in foreign currency, 67.70% has non-financial corporates as borrowers, while 24% has been granted to small and medium-sized companies in the exporting chain.

Private banks in the country carry dollar exposure to sectors like oil and gas, food processors and car manufacturers. While the global commodity shock and sanitation controls have slowed soybean business down — producers are refraining from selling to agro exporters at current prices — trade specialists say there is a greater risk on heavy industrial goods.

The auto industry has produced 34.4% fewer vehicles in March, a figure which should drop further in April as manufacturers work at minimum capacity.

"Those sectors are the most affected," Elizondo said. "Half of the Argentine industrial goods are sold to Brazil." Argentina's recent withdrawal from negotiations at the regional trade bloc Mercosur darkens the outlook, he added.

All things considered, Elizondo expects foreign trade to recover in the second half of the year as China reinvigorates its demand for products. "The world will keep on buying food."

Analysts see banks further shrinking their footprint in the dollar loan market as uncertainty lingers.

According to Pablo Firvida, a manager with Grupo Galicia, the impact on profitability will be limited. Banks don't have as much of an incentive given that the margin they earn on the loan is lower than in a local currency product. "It's a public burden to have them," he said, arguing against the reputational damage that banks face every time a crisis takes place in Argentina.

"We are hyper liquid," he said. Just in case, banks have prepared for the worse. "We literally imported planes full of dollar notes last year."

As of May 6, US$ 1 was equivalent to 67.10 Argentine pesos.