Chile's banks stockpile additional provisions as political uncertainty mounts

The Chilean economy is on track for double-digit growth this year, a remarkable recovery when compared to Latin American peers. Despite the impact of COVID-19, Chile's GDP will likely be larger by the end of 2021 than it was before the pandemic.

But with the Nov. 21 presidential elections looming and candidates from opposite ends of the political spectrum expected to go through to a second round, financial markets are far from calm. The latest polls suggest that leftist candidate Gabriel Boric has an edge over right-wing candidate José Kast, although the latter has gained momentum recently.

The political uncertainty that has plagued Chile since violent protests broke out in late 2019 over transportation fare hikes — and escalated into a constitutional crisis — has permeated Chilean assets, with credit-default swaps nearly doubling since the beginning of the year.

A lack of visibility has prompted banks to bulk up provisions as they brace for a transition period that is likely to stretch well into 2022, when Chileans vote on a new constitution. Banks have also boosted liquidity ratios and, in some cases, booked higher loan loss provisions than in the previous quarter.

Banco de Chile, one of the country's leading lenders, raised allowances for loan losses by 59.1% in the third quarter, including some 50 billion Chilean pesos in additional provisions. On Nov. 5, the bank's chief economist, Rodrigo Avarena, told investors that the bank was facing "an increased level of uncertainty and volatility."

This was a recurring theme in third-quarter earnings calls. Banco de Crédito e Inversiones Chief Economist Sergio Lehmann said political uncertainty is "still high and will remain significant." Claudio Soto, his peer at Banco Santander Chile, said the political environment was "challenging" for banks.

All three major banks took additional provisions in the third quarter of 2021, not only due to uncertainty around economic policy but also as they wait to see how portfolios respond to the withdrawal of COVID-19-related government aid.

Chile at a crossroads

This weekend's presidential elections are the first since massive crowds took to the streets in 2019 and 2020 to demand greater equality and income distribution. Following those protests, a constitutional assembly was elected to redraft the existing constitution, a legacy of General Augusto Pinochet's dictatorship.

"This election will prove important in the redrawing of the political map and determining what 'left' and 'right' mean in contemporary Chile," Jennifer Pribble, a political science professor at the University of Richmond, told S&P Global Market Intelligence.

"Chile's political party system is at stake in this election," Pribble said. "The [social unrest] and the resulting call to rewrite the constitution decimated the country's traditional political parties and opened up an extremely fluid political area."

Economic proposals differ substantially between the leading candidates. While Boric advocates greater state intervention in the economy and an overhaul of the private pension funds system, Kast is in favor of corporate tax cuts and is willing to discuss the privatization of national industry.

But regardless of who wins, Pribble argues that the new president will face an unstable environment in which rules are still being rewritten.

"The reform process is the big elephant in the room," said Nikhil Sanghani, a Latin American economist with Capital Economics. "It is clear that political risks in Chile aren't going to go away anytime soon."

Meanwhile, the economic recovery continues. "It is the fastest recovery in Latin America," Sanghani said. "And yet, financial markets have been under pressure pretty much since the start of the year."

Limited visibility ahead

Chile's COVID-19-related assistance to businesses and households was significant, both by way of direct subsidies and loan relief. In addition, the three series of pension fund withdrawals approved by Congress ensured that individuals had access to cash, even if critics claim that the move eroded Chile's long-term financial profile.

Much of that extraordinary liquidity was used to pay off bank debt, according to Ivana Recalde, a bank analyst with S&P Global Ratings. This has kept nonperforming loan ratios at low levels.

Banco de Chile reported an NPL ratio of 0.92% in the third quarter of 2021, milder than the 1.17% reported in the year-ago period, before the pandemic.

"There has been a really high level of liquidity in companies … and households have gotten a lot of money from pension funds and direct government subsidies," said Emiliano Muratore, Santander Chile's chief financial officer.

But despite regular provisions decreasing as a result of repayments, banks have continued to book voluntary reserves. Banco de Crédito e Inversiones recorded nearly $48.8 million of additional provisions in the third quarter, up 58.9% from those booked in the linked period.

Bankers are expecting credit quality to deteriorate next year as welfare aid subsides. Excess liquidity due to recurring pension fund withdrawals has made it difficult for banks to gauge the real impact of NPLs as asset quality indicators continue to be skewed due to the temporary relief measures.

Impact of rising rates

Long-term yields in the Chilean economy have been affected by both inflation and political uncertainty. Credit default swaps and bond yields have gone up, adding to a complex scenario for credit next year.

Banco Central de Chile SA has hiked its benchmark interest rate to 2.75%, the highest level in more than two years, in an attempt to tame 6% annual inflation, the highest level in more than a decade.

But the regulator has also warned that the recent uptick in mortgage rates could pose a threat to housing credit demand. Housing loans have been a major engine for loan growth during the COVID-19 pandemic, but some worry that momentum could lose steam given rising borrowing costs.

High inflation and interest rates bode well for profitability, executives from Banco de Chile said on the bank's earnings call, yet the prospect of lower economic growth could affect both loans and asset quality.

In a report, the central bank warned that "the main risk" for financial stability would be "new forced liquidations of assets that continue to weaken the local capital market." A fourth round of pension fund withdrawals would "increase uncertainty" in the market and further discourage financing in bond markets.

Regardless of the elections, experts point out that fiscal policy will likely tend toward accommodation. "It seems likely that the state will play a bigger role in the economy, and public spending remain fairly high over the next few years," Sanghani said.