Moody's Investor Service further downgraded its rating on Argentina's government bonds to junk on Monday. According to the agency, the downgrade to "Caa1" from "B3" owes to the drop in official reserves and growing concerns over the country's ability to service its foreign debt. What's going on?

Argentina is going through a period of high uncertainty over its inflation rates, which grew to about 30% for last year -- one of the highest in the world. Since 2011, the country has established currency exchange restrictions as its citizens turned massively to the dollar to avoid the erosion of their savings. As a consequence, the country's reserves fell to $27.5 billion from a high of $52.7 billion in 2011.

The issue here is that Argentina does not currently have external funding options, so it has to rely on its official reserves to pay debt. Considering that the government faces dollar debt payments of more than $20 billion between 2014 and 2015, with the current level of reserves it will be tough to make those payments and maintain currency stability.

Will this affect Argentine Banks?
To address this question, let's take a look at three Argentine banks that trade on U.S. exchanges: Grupo Financiero Galicia (NASDAQ:GGAL), Banco Macro (NYSE:BMA), and BBVA Banco Frances (NYSE:BFR). These three banks are highly correlated and have recently posted their fourth-quarter results. Performance-wise, the strong devaluation in late January pushed their stock prices down, but since the beginning of February, prices have recovered.

Grupo Financiero Galicia is up 5.7% year to date. This is the No.1 private bank in Argentina, and it has shown a good performance in 2013. In fact, net income in pesos grew 67% in the fourth quarter year over year. Grupo Financiero Galicia's net income for the quarter represented an annualized return of 3.4% on average assets and 39.5% on average shareholders' equity. Not bad.

Banco Macro isn't in bad shape, either, continuing to show a strong solvency ratio with a 25.3% capitalization ratio in excess capital in the fourth quarter. This means that the bank's core equity capital compared to the total of all assets held by the bank weighted by credit risk is high, and thus the bank holds excess capital, making it solvent. In addition, the Bank's liquid assets remained at an adequate level, growing to 33.3% of total deposits -- the highest quarterly figure for the whole year. The bank's stock is up 4.2% year to date.

BBVA Banco Frances is showing the best performance of the three in year-to-date terms, up 8.6%. The bank's net financial income grew 36.6%, and its private-sector loan portfolio increased 28.1% in 2013. The institution has maintained excellent asset-quality ratios despite the increase in its non-performing loan ratio to 0.76% in the year and the deterioration of the economic environment that prevailed in the second half of the year.  

Looking forward
As you can see, last year was not bad for Argentine banks, but the situation in the country remains complex, and it will certainly affect banks looking forward. Why? There are basically three government measures that give us a hint of what could happen. First, there's the increase in local interest rates, which is meant to capture excess liquidity in pesos and cool down the pressure on the exchange rate. Although this has worked and brought tranquility to the money markets, it makes loans more expensive and less attractive. Second, in early February the central bank limited foreign exchange holdings to banks, forcing them to sell their hard-currency-denominated assets and become a lot more exposed to the peso, elevating risks. Third, new restrictions on bank financing of foreign trade transactions will considerably reduce this business, which was big among grain producers and exporters.

Bottom line
It is true that the Argentine official reserves are free-falling and that there is an increased risk of not meeting foreign-currency debt-service obligations. But the country is also looking at ways to avoid a default by stabilizing the exchange rate and reenter the international debt market. In fact, some clear steps have been made toward this objective. This week the country won France's support in its debt disputes against the "Paris Club," an informal group of official creditors that could unlock future credit for the country. In addition, the country has changed its statistics methodology in order to better reflect its inflation rate. This step will prevent sanctions and improve Argentina's relationship with the IMF, which could also unlock fresh cash.

So far, these steps have worked, and the past two months -- after a 17% overnight devaluation of the peso -- have been relatively calm in terms of expectations. However, almost nothing has been done to ease the rising inflation pressure, and this could lead to another devaluation in mid-2014, starting a new vicious cycle of higher inflation and uncertainty for the peso.

Regarding the outlook for local banks, you have to understand that banking is a heavily regulated business, and in a country like Argentina, where problems are manifested mainly through its monetary variables, it will not be easy for local banks to maneuver the turbulent waters coming ahead.

Louie Grint has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.