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Bad Loans Could Spark an Emerging-Markets Crisis

Bad Loans Could Spark an Emerging-Markets Crisis

Illustration by 731

The world’s largest emerging markets recovered quickly from the 2008 financial crisis because consumers and companies went on a borrowing binge. Now, as those economies cool, bad loans are haunting banks from Turkey to South Africa. India is injecting money into state-run lenders facing a huge rise in soured debt, and Chinese banks have been told to increase provisions against lending losses. “Credit growth in emerging markets has been phenomenal since 2008,” says Satyajit Das, author of a half-dozen books on financial risk. He blames near-zero-percent interest rates in the U.S. and other developed nations, which have kept borrowing costs artificially low. “Many borrowers will struggle to repay the debt,” he says. “We’re ripe for a new emerging-market crisis.”

Credit growth has outpaced economic growth in most emerging markets. In China, borrowing by companies surged to 132 percent of gross domestic product last year, from 104 percent in 2008, according to the World Bank. In Turkey it jumped to 54 percent from 33 percent, and in Brazil to 68 percent from 53 percent. Consumer debt is growing as fast in some countries. Like their rich-country counterparts, emerging-market governments probably will rescue failing banks, Das says. That would push public debt levels higher, trapping some countries in a vicious cycle of rising debt burdens and falling currencies.

Defaults on consumer loans at Brazilian banks rose to a record 8.2 percent in May 2012 before easing to 7 percent in September this year. President Dilma Rousseff has vowed to limit lending by the three state-owned banks—Caixa Econômica Federal, Banco do Brasil (BBAS3:BZ), and development bank BNDES—and Finance Minister Guido Mantega says Brazil plans to reduce the development bank’s loans by 20 percent next year.

Some analysts are dubious. “Will the public banks actually be pulling back? It’s hard to see that yet,” says Robert Stoll, an analyst at Fitch Ratings. “Private-sector banks have slowed down credit expansion a great deal, and the public sector has picked up the slack.” Spokesmen for Caixa and BNDES declined to comment. Paulo Rogério Caffarelli, Banco do Brasil’s vice president for wholesale banking, said in October that the government’s appeal to cut lending didn’t apply to his bank.

India’s Finance Ministry has said it will inject $2 billion into state banks to help them raise more capital to cope with rising delinquencies as the economy cools. Bad loans at Indian banks climbed to 3.9 percent of total lending as of June 30, from 2.4 percent in March 2011, according to the central bank. The figures understate the problem because of rules that allow Indian banks to restructure nonperforming debt, says Michael Shaoul, chairman and chief executive officer of Marketfield Asset Management. “In Brazil, at least you see what the troubles are,” Shaoul says. “In India, you just don’t know how bad things are.”

South Africa faces rising loan losses after a recent credit explosion. Loans to lower-income households with no collateral have more than doubled since 2011 and now make up about 10 percent of all credit in the country, according to the government’s National Credit Regulator.

China’s biggest lenders, led by Industrial & Commercial Bank of China (601398:CH), tripled the amount of bad loans written off in the first half of 2013. The country’s banking regulator has called on banks to purge such loans from their books to prepare for even more defaults. Nonperforming loans at the top four Chinese institutions rose 4 percent in the third quarter, the biggest jump since 2010. The situation is worse at smaller regional lenders, which expanded their balance sheets by about 30 percent last year, three times the rate of the biggest Chinese banks, according to Standard & Poor’s (MHFI). “Small banks will probably fail,” says Ritesh Maheshwari, head of financial-services ratings for the Asia-Pacific region at S&P in Singapore. “Provincial governments will come to aid those banks and then turn to the central government for assistance.”

China is better equipped than other emerging markets to deal with a bank crisis. It has almost $4 trillion of foreign-currency reserves and doesn’t rely on capital inflows from other countries to finance its banks, companies, or consumers. While countries don’t use such reserves to recapitalize banks directly, a big buffer can reassure foreign investors when a government spends money to rescue lenders.

Developing countries with fewer resources would have a harder time plugging holes without losing the confidence of foreign investors. If Turkey’s bad loans reached 25 percent of the total, which happened during the country’s 2001 banking crisis, that would almost equal the value of the country’s foreign-currency reserves, data compiled by Bloomberg show. If nonperforming loans hit that level in South Africa, the total would exceed its reserves.

Banking crises typically follow bubbles in stocks, bonds, or real estate; large inflows of money from abroad; and credit booms, according to a study by Harvard professors Carmen Reinhart and Kenneth Rogoff in the November issue of the Journal of Banking & Finance.

Earlier this year, speculation that the Federal Reserve would soon begin tapering its easy-credit policy sparked an outflow of funds from emerging markets, forcing up interest rates and pushing down currencies. From April through July, about $40 billion flowed out of the 10 largest emerging markets excluding China, according to data compiled by Nikolaos Panigirtzoglou, an analyst at JPMorgan Chase (JPM).

While the flight of capital halted after the Fed decided in September to continue its bond buying program, the episode gave a glimpse of what could happen to countries that rely on money from abroad when the Fed finally slows its stimulus. “Countries running big current-account deficits are extremely vulnerable, as we saw,” says Benn Steil, director of international economics at the Council on Foreign Relations in New York. “Reversing those deficits is a long-term project requiring structural changes and many years. A few months’ delay to the Fed’s tapering isn’t going to be enough time to do all that.”

The bottom line: After five years of relying on cheap bank loans for growth, the top emerging markets may be headed for a hard landing.

Onaran is a reporter for Bloomberg News in New York.

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