Emerging-Market Banks Threatened by End of Credit BoomYalman Onaran
The world’s largest emerging markets recovered quickly from the 2008 financial crisis because consumers and companies went on a borrowing binge. Now that credit spree is coming back to haunt banks in those countries.
As economies cool, delinquent loans are rising from Turkey to South Africa. India is injecting money into state-run lenders facing a surge in soured debt, while Chinese banks have been told to increase provisions for the same reason.
An outflow of funds from emerging markets earlier this year, sparked by speculation that the Federal Reserve would soon begin tapering its easy-credit policy, forced up interest rates in those countries and pushed down currencies. While the flight of capital halted after the Fed decided in September to continue its asset purchases, a reversal could threaten economies and banks in developing nations.
“Credit growth in emerging markets has been phenomenal since 2008 because risk has been underpriced once again, thanks to zero percent interest rates in the developed world,” said Satyajit Das, author of a half dozen books on financial risk who is based in Sydney. “Many borrowers will struggle to repay the debt, and the money flows out of these markets will make the problems worse. We’re ripe for a new emerging-market crisis.”
Even China, which doesn’t rely on inward cash flows to finance its economic expansion, faces a choice of restructuring its indebted and inefficient state-owned industries or allowing inflation to take hold, according to Das and other analysts. Like their Western counterparts, emerging-market governments probably will rescue failing banks if credit deteriorates, adding to those countries’ economic woes, Das said.
The MSCI Emerging Markets Banks Index has dropped 6.5 percent this year, compared with a 17 percent gain for the MSCI World Banks Index, which tracks lenders in developed markets.
While it’s natural for lending to expand along with an economy, credit 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. Credit in South Africa exceeded 150 percent of GDP in 2012. Consumer debt is growing just as fast in some countries.
Those increases have taken place against a backdrop of slowing economies. China, which expanded at an average rate of 10.6 percent in the decade ending 2011, grew only 7.7 percent last year, according to data compiled by Bloomberg. India’s 5 percent growth last year was down from a 7.8 percent average.
Banking crises typically are preceded by asset-price bubbles, large capital inflows and credit booms, according to a study by Harvard University professors Carmen Reinhart and Kenneth Rogoff. Their analysis of 66 countries over two centuries, published in the November issue of the Journal of Banking and Finance, found that the causes for the crises are the same in developed and emerging economies.
Since Brazil’s largest banks curtailed lending last year, the government has used state-owned firms to continue expanding credit. State lenders’ share of loans jumped to more than 50 percent of the total from about 35 percent in 2007, according to central bank data.
While President Dilma Rousseff has vowed to rein in lending by the state firms -- Caixa Economica Federal, Banco do Brasil SA and development bank BNDES -- annual credit expansion by the banks hasn’t slowed much. It increased 27 percent in the 12 months ended in September, compared with 28 percent for the period ended in August. Finance Minister Guido Mantega said in a Nov. 1 interview that Brazil plans to reduce BNDES loans by 20 percent next year as it seeks to curtail government spending.
“Will the public banks actually be pulling back? It’s hard to see that yet,” said Robert Stoll, a New York-based analyst at Fitch Ratings who covers Latin American banks. “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 Rogerio Caffarelli, Banco do Brasil’s vice president for wholesale banking, said last month that the government’s appeal to cut lending didn’t apply to his bank. The lender’s delinquency ratios have remained below the industry average and are expected to remain “stable,” Chief Financial Officer Ivan Monteiro said today in a conference call with analysts.
Moody’s Investors Service lowered its outlook on Brazil’s debt last month, citing government support of those lenders as one of the reasons. Defaults on consumer loans at Brazilian banks rose to a record of 8.2 percent in May 2012, before easing to 7 percent in September this year.
In India, state-controlled lenders have been a major force in the economy much longer. Their share of total banking assets has been about 75 percent for more than a decade. State Bank of India, the nation’s biggest lender by assets, and No. 3 Bank of Baroda, are both government-controlled.
The Finance Ministry said last month it would inject $2 billion into state banks to help them raise more capital to cope with rising delinquencies as the economy cools. Goldman Sachs Group Inc. said it expects growth to slow to 4 percent for the year ending March 31, the weakest pace in more than a decade.
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. Fitch estimates that stressed assets, which include soured debt and restructured loans, will reach a 17-year high of 15 percent of total loans by 2015.
The severity of loans going bad is hidden by rules that allow Indian banks to restructure nonperforming debt, according to Michael Shaoul, chairman and chief executive officer of Marketfield Asset Management LLC. Inflation of 10 percent also makes it hard to distinguish between successful businesses and those failing until a crash, he said.
“In Brazil, at least you see what the troubles are,” said Shaoul, whose New York-based firm manages $17 billion of assets. “In India, you just don’t know how bad things are. It’s all hidden under high inflation and low bank transparency.”
Stressed loans at Indian banks exceed 10 percent of the total when restructured debt is taken into account, according to Standard & Poor’s, which estimates a $41 billion capital shortfall. Plugging the holes at state lenders will strain India’s government, which is grappling with a budget deficit, S&P said in a report last month.
China’s banking system is mostly state-owned. The biggest lenders, led by Industrial & Commercial Bank of China Ltd., tripled the amount of bad loans written off in the first half of 2013. The country’s banking regulator has called on financial firms to purge such loans from their books to prepare for more defaults. Nonperforming loans at the top four banks rose 4 percent in the third quarter, the biggest jump since 2010.
Smaller regional lenders have grown faster than larger and better-known competitors, expanding their balance sheets by about 30 percent last year, three times the rate of the biggest Chinese banks, according to S&P. The fastest-growing one, Xiamen International Bank, doubled its assets last year.
Those institutions fund small and medium-size companies overlooked by what S&P calls megabanks, such as ICBC, the world’s largest lender by assets. Their speedy expansion is partly the result of pressure from regional governments to extend credit, according to S&P.
Off-balance-sheet lending in China can mask bank weaknesses, as do India’s restructured loans. Nonperforming-loan ratios at Chinese firms are about 1 percent. In the late 1990s, before the country embarked on a cleanup of its financial system, Bank of China Ltd. reported a rate of 6 percent. It turned out to have been 15 percent, according to Ritesh Maheshwari, head of financial services ratings for the Asia-Pacific region at S&P in Singapore. Other companies, which didn’t report ratios before 2000, had bad-loan levels as high as 40 percent.
“The same problems can be hiding this time around, too,” Maheshwari said. “Small banks will probably fail. Provincial governments will come to aid those banks and then turn to the central government for assistance.”
A cash crunch in China’s interbank lending market in June may be a harbinger, according to Jonathan Cornish, head of North Asia financial institutions at Fitch. Banks often rely on interbank borrowing to fund off-balance-sheet lending. Bad loans, even when rolled over so they don’t impair earnings, require constant funding, he said. When the biggest banks balked at financing smaller ones, interbank lending rates jumped to record levels until the central bank intervened.
“Despite being such a centrally controlled system, there’s market-type discrimination on interbank lending because the government might not stand behind every bank,” said Cornish, who’s based in Hong Kong.
Chinese bank assets are more than twice the country’s GDP, the highest ratio among emerging markets. Lenders in China also have the highest leverage, with total assets 20 times equity, compared with 13 in Brazil and South Africa and 8 in Turkey.
Even so, China is better equipped than other emerging markets to deal with a collapsing banking system because it has almost $4 trillion of foreign-currency reserves and doesn’t rely on inflows to finance its banks, companies or consumers. While countries don’t use such reserves to recapitalize banks directly, the size of the buffer helps nations defend their currencies against fluctuations when spending government money to rescue lenders.
Developing countries with fewer reserves would have a harder time plugging holes at their banks and defending declining currencies when Western money flows out. Turkey’s reserves would almost be exhausted if bad loans reached 25 percent of the total, which happened during that country’s last banking crisis in 2001, data compiled by Bloomberg show. South Africa’s reserves wouldn’t be sufficient to bail out its banks if nonperforming loans hit that level.
Under a similar stress scenario, injecting capital to cover losses would make Brazil’s government debt jump to 81 percent of economic output from 59 percent and India’s to 71 percent from 50 percent, the data show. Such ratios could spook foreign investors, increase sovereign borrowing costs and further weaken those economies.
“Countries running big current account deficits are extremely vulnerable, as we saw this past summer,” said 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.”
Turkish banks doubled short-term borrowing in other currencies to about 10 percent of total liabilities. While they aren’t exposed to foreign-exchange moves because they lend those funds to domestic companies in dollars or euros, currency shocks can harm borrowers’ ability to repay, said Nergis Kasabali, an analyst at Burgan Yatirim Menkul Degerler AS in Istanbul.
The debts include borrowing by domestic firms to complete construction and infrastructure projects initiated by the government. Some of the loans are from state-owned banks, which hold one-third of the country’s banking assets.
“Those loans will be paid back as long as the economy keeps chugging along,” Kasabali said. “If there’s a big economic shock, perhaps due to tapering and outflow of foreign funds, then they’ll be in trouble.”
Corporate-loan defaults jumped 7 percent in the second quarter, according to the nation’s bank regulator.
Turkish lenders also used short-term funding to invest in government debt, whose value declined after Fed Chairman Ben S. Bernanke said in May that the U.S. central bank could consider reducing the $85 billion in monthly Treasury and mortgage-debt purchases in the next few months. When the Fed does begin tapering, there could be further losses.
Signs of investor concern can be seen in price-to-book values. When that figure dips below 1, it signals distrust in the value of a firm’s assets. Eleven banks among the 50 worldwide with the worst price-to-book ratios are Indian institutions, data compiled by Bloomberg show. The average for the six largest state banks in India was 0.56 at the end of last week. Eighty emerging-market lenders, including eight Chinese, five Brazilian and three Turkish, had values less than 1.
Investor distrust also is reflected in the prices of bonds sold by state-controlled emerging-market banks. Dollar-denominated debt of Turkey’s Turkiye Vakiflar Bankasi TAO due in 2022 has lost 2.7 percent since October 2012, data compiled by Bloomberg show. Yields rose to a record 8.5 percent on Sept. 6 before falling to 7.4 percent on Nov. 8.
Yields of BNDES’s bonds maturing in 2018 reached a two-year high of 4.77 percent on June 24, before dropping to 4.25 percent on Nov. 8. Banco do Brasil 2022 bonds jumped to 5.64 percentage points above similar-maturity U.S. Treasuries on Sept. 4, the highest spread since the bonds were sold in 2011.
South Africa also faces rising loan losses after a recent debt explosion, including a version of subprime lending. Loans to lower-income households, labeled unsecured because there’s no collateral backing the debt, 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.
Lenders, including African Bank Investments Ltd., had to write off more of this type of debt as defaults surged. Almost 10 million borrowers, or half of the total, are late making payments, the credit regulator said in September. Labor unions and farmers’ groups organized protests against the crushing weight of unsecured loans.
South Africa, like other emerging markets, is under pressure to raise interest rates to help curb inflation. India, Indonesia and Brazil already have done so, after foreign investors pulled out, weakening their currencies and driving up prices of imported goods.
About $40 billion flowed out of the 10 largest emerging markets, excluding China, from April through July, according to data compiled by Nikolaos Panigirtzoglou, a London-based analyst at JPMorgan Chase & Co. That reversed in August and September as tapering fears abated, he wrote in an Oct. 21 report.
“Central banks are increasing interest rates due to inflationary pressures that arise from currency losses,” said Steil of the Council on Foreign Relations. “But that limits growth. It’s a double-edged sword.”
Steil said he expects emerging markets with the largest current account deficits to end up turning to the International Monetary Fund. Das, the author and former trader, said he’s concerned that the IMF doesn’t have the resources to help this time around.
“During the last emerging-market crisis, the rest of the world was doing really well,” Das said. “Now the developed world is still licking its own wounds. Even the IMF is financially constrained. It will be tougher to find help.”