FINANCIAL INSTITUTIONS RESEARCH

Which Emerging Market Banking Systems Could Suffer Most From Fed Tapering?
Primary Credit Analyst: Mohamed Damak, Paris 33144207320; mohamed.damak@standardandpoors.com Secondary Contacts: Louise Lundberg, Stockholm (46) 8-440-5938; louise.lundberg@standardandpoors.com Jose M Perez-Gorozpe, Mexico City (52) 55-5081-4442; jose.perez-gorozpe@standardandpoors.com Emmanuel F Volland, Paris (33) 1-4420-6696; emmanuel.volland@standardandpoors.com Goeksenin Karagoez, FRM, Paris (33) 1-4420-6724; goeksenin.karagoez@standardandpoors.com Geeta Chugh, Mumbai (91) 22-3342-1910; geeta.chugh@standardandpoors.com Cheul Soo Cho, CFA, Hong Kong (852) 2533 3559; cheulsoo.cho@standardandpoors.com Matthew D Pirnie, Johannesburg (27) 011-214-1993; matthew.pirnie@standardandpoors.com Angelica G Bala, Mexico City (52) 55-5081-4405; angelica.bala@standardandpoors.com Ivan Tan, Singapore (65) 6239-6335; ivan.tan@standardandpoors.com Amalia Bulacios, Buenos Aires (54) 11-4891-2156; amalia.bulacios@standardandpoors.com

Table Of Contents
The Turkish Banking System Depends The Most On External Debt Economies Are Slowing Down After Years Of Strong Growth Countries With Large Economic Imbalances Are The Most Vulnerable Asset Quality Is Likely To Deteriorate Lower Profitability Is A Likely Outcome Related Criteria And Research

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Which Emerging Market Banking Systems Could Suffer Most From Fed Tapering?
In December 2013, the U.S. Federal Reserve (Fed) announced that it would start progressively tapering its $85 billion monthly bond-buying program, known as quantitative easing (QE), judging the U.S. economic recovery to be on track. The Fed implemented the first three waves of tapering over the past four months, reducing the monthly bond buying by a total of $30 billion. Standard & Poor's Rating Services believes the Fed will continue tapering its program throughout 2014, possibly ending it by October. At that point, the Fed is likely to start normalizing U.S. monetary policy through interest rate increases by the second quarter of 2015. While our base-case scenario assumes that the Fed's gradual removal of unconventional monetary support won't derail the economic recovery in developed countries, we expect emerging markets to experience episodes of instability (see "Credit Conditions: Europe Is On A More Stable Path, Amid Turbulence In Emerging Markets," published on RatingsDirect on March 21, 2014). In particular, countries whose economies display significant external vulnerability, such as a large current account deficit or net external debt, will have a more difficult time coping. To get a better understanding of how the Fed's tapering could affect banking systems in emerging markets, we looked at seven countries: Brazil, Chile, India, Indonesia, Peru, South Africa, and Turkey. We selected these countries because of the external vulnerabilities of some of them, and recent trends in market indicators such as foreign exchange rates and the cost of refinancing of banks' external debt. Overview We expect QE tapering to hit some emerging markets' banking systems either directly due to reduced global liquidity or indirectly through lower economic growth. Of the seven banking systems we examined, Turkey's and to a lesser extent South Africa's appear most vulnerable. The Brazilian banking system will likely feel the indirect impact of the country's economic slowdown. We expect banking systems in Chile, India, Indonesia, and Peru to show relatively higher resilience to tapering's impacts.

Banking systems can feel the impact of tapering directly through more limited access to external funding or through increasing costs to refinance external debt. They can also feel it indirectly through possible central bank interest rate increases, due to currency depreciation and lower capital inflows through the financial account of their balance of payments, which may weigh on economic growth. That, in turn, could hurt asset quality and profitability. We found that banking systems in Turkey and South Africa are the most vulnerable. The Brazilian banking system is likely to continue feeling the indirect impact through a worsening of the country's economic slowdown. We expect the banking systems in Chile, India, Indonesia, and Peru to remain relatively resilient.

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Table 1

BICRA Economic Risk And Industry Risk Scores And Components For Selected Countries
Economic risk factors Credit risk Economic in the Imbalances economy High Industry risk factors Industry Industry risk risk score trend 5 3 5 7 4 Stable Stable Stable Positive Stable

Economic BICRA resilience Brazil Chile India 5 3 5 High

Economic Economic Institutional Competitive Systemwide risk score risk trend framework dynamics funding Stable Stable Negative Stable Stable Intermediate Low High Very high Low High Intermediate High High Intermediate Intermediate Low Low Intermediate High

Intermediate 6

Intermediate Intermediate Intermediate 4 High Very high Low High 5 7 5

Indonesia 7 Peru 4

Intermediate Very high Very high

Intermediate Low

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Table 1

BICRA Economic Risk And Industry Risk Scores And Components For Selected Countries (cont.)
South Africa Turkey 4 6 High High Intermediate Intermediate 5 High Intermediate 6 Negative Negative Low Intermediate Intermediate Intermediate Intermediate Very high 3 6 Negative Stable

BICRA--Banking Industry Country Risk Assessment. Data on April 4, 2014. Source: Standard & Poor's.

The Turkish Banking System Depends The Most On External Debt

Most of the banking systems in the seven countries that we looked at rely on customer deposits as a primary source of funding, but the Turkish and Peruvian systems have pulled away from the pack in terms of external debt (see chart 2). Over the past few years, the Turkish system has increased its recourse to the international capital market. Therefore, we believe that tapering is likely to push up its cost of funding. However, we acknowledge that a portion of external funding is for trade finance transactions, which lowers lenders' risk assessment. In addition, the Turkish banking system has to date shown resilience and managed to roll over its external debt maturing in the first quarter of 2014. We also think the system has a sufficient liquidity buffer to withstand a material decline of its rollover ratio. Refinancing risk appears limited in Peru because most bank debt there is long-term and the system remains highly dollarized. Since September 2012, U.S. dollar-denominated deposits increased, while foreign currency loans declined. In addition, we believe government support will be forthcoming in case of a major market disruption. Peruvian government capacity to bolster its banking system is strong, as its large international reserves show: 33% of GDP at year-end 2013, compared with private sector credit at 28% of GDP on the same date.

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Which Emerging Market Banking Systems Could Suffer Most From Fed Tapering?

Chart 2

The dependence of the Chilean, Indian, Indonesian, and Brazilian banking systems on external funding is low. They remain primarily deposit-funded, and we do not foresee any significant change in domestic depositors' behavior. The South African system appears to have the least vulnerable external funding position due to its low amount of foreign borrowing. Banks there primarily get their funding through core customer deposits and funds from large asset management companies in the country. The latter, however, are more sensitive to pricing and could push South African banks' cost of funding upward if the Fed speeds its tapering and the South African Reserve Bank reacts more aggressively to raise rates.

Economies Are Slowing Down After Years Of Strong Growth

One effect of the Fed's tapering announcement was to trigger a reduction in private capital inflows to some of these countries (see chart 3), resulting in currency depreciation (see chart 4), particularly in Turkey, South Africa, Chile, Indonesia, and to a lesser extent Peru, India, and Brazil.

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Chart 3

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Chart 4

That depreciation led their central banks to hike benchmark rates, except in Chile and Peru. The reactions ranged from significant hikes in Turkey and Brazil since May 2013 to modest revisions in South Africa and India (see chart 5). In contrast, Chile and Peru have reduced their interest rates.

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Which Emerging Market Banking Systems Could Suffer Most From Fed Tapering?

Chart 5

We expect monetary policy tightening and lower private capital inflows to reduce economic growth. In Brazil, growth will likely remain subdued due to low investment rates, significant interest rates hikes, and public spending cuts. We foresee a GDP growth rate of 1.8% for Brazil in 2014 compared with 7.5% in 2010 (see chart 6). Similarly, we expect the rate hike in Turkey to further depress already weak economic performance and job market prospects. Our base-case scenario projects Turkish GDP growth of around 2% in 2014 and 2015, compared with 9.2% in 2010. In South Africa, slowing household consumption, low corporate investment, and labor tensions are likely to result in a low economic growth rate in 2014. Further downside pressure may come from renewed labor tensions and weaker power supply. We expect India and Indonesia to continue displaying strong growth rates, albeit at a lower pace compared with the past three years. After depreciating in the second half of 2013, India's rupee and Indonesia's rupiah exchange rates against the U.S. dollar have partially recovered. We also forecast good growth for Chile and Peru, although lower than historical rates. Interest rate cuts in these two countries aimed to boost growth.

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Which Emerging Market Banking Systems Could Suffer Most From Fed Tapering?

Chart 6

Countries With Large Economic Imbalances Are The Most Vulnerable

Turkey and South Africa display the largest current account deficits and external financing needs among the countries we looked at (see chart 7). We expect gross external financing needs as a percentage of the sum of current account receipts plus usable foreign exchange reserves to reach 128% for Turkey and 110% for South Africa in 2014. However, lower economic growth and local currency depreciation should reduce current account deficits in 2014. Turkey has relied on, among other sources, external debt issuance to finance its current account deficit over the past three years, which increases its vulnerability to debt rollover risk. Similarly, South Africa partly relied on volatile portfolio investment flows to finance its current account deficit. A broad-based, persistent capital flow reversal, or even a sudden stop, could lead to disorderly adjustment in South Africa. Since May 2013, that reversal has been orderly and has remained so into 2014's first quarter. However, conditions could worsen if the Fed accelerates its tapering. Brazil, Peru, and Chile are less exposed to such risks because of their lower current account deficits and foreign currency reserve cushions (see "Policy Risks, Not Tapering, Are Key To Emerging Market Sovereign Ratings," published on RatingsDirect on March 5, 2014).

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Which Emerging Market Banking Systems Could Suffer Most From Fed Tapering?

Chart 7

Where capital inflows wind up is an important consideration as well. Over the past four years, external capital neither found its way into the local real estate market nor fueled asset bubbles (see chart 8). The annual increase in inflation-adjusted residential real estate prices was below 4% for six out of these seven countries. Brazil is the exception, and the increase there is partially due to its specific characteristics (high housing demand, increases in overall wealth, public-sector policies, and the rapid increase in mortgage lending over the past five years, thanks primarily to public-sector bank lending). Underpinning the sharp increase in domestic credit as a percentage of GDP in Turkey is strong domestic consumption financed by bank loans, which supported economic growth in the past but increased external imbalances.

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Chart 8

Asset Quality Is Likely To Deteriorate

How might all this add up for loan performance in these countries? We foresee an increase in credit losses for the majority of these banking sectors because of economic slowdowns, rising interest rates, and the possible negative impact of local currency depreciation on companies with foreign currency debt and local revenues. We don't think any of these countries will experience losses beyond our normalized loss estimates (long-term average annualized credit-related losses based on the average through-the-cycle annual loss rate for each asset class) but believe their earnings buffer will remain sufficient to absorb them. Nevertheless, if the Fed speeds its tapering and central banks react more aggressively to counter the decline in capital inflows or the slide in their local currencies, we may see a higher impact. The Turkish banking system appears the most vulnerable to a deterioration of credit losses because of the proportion of loans in foreign currency to corporates (around one-third of total loans at year-end 2013). We expect credit losses to increase to around 1.5% to 2% in 2014 and 2015 for the large banks we rate, with average nonperforming loans rising to around 4% to 5%, compared with 2.8% on March 31, 2014.

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For the banking system in South Africa, we expect higher credit losses for unsecured loans (10% of total loans) as low economic growth and high household inflation restrain retail clients' repayment capacity in 2014. In our opinion, the retail mortgage book is also exposed to a potential interest rate shock that could emanate from tapering. Households may start to experience debt service ability pressures, in a scenario where interest rates rise 250-300 basis points. The impact of this could be worsened if the real estate market starts to slip once again after stabilizing in 2013. We expect credit losses in the Brazilian banking system also to increase, to 3.7% in 2014 from 3.3% in 2013. Public banks will account for the bulk of that because they have been growing very rapidly over the past few years. The Peruvian system could see a significant increase in its credit losses--from 1.8% in 2014 to 3.5%--if Peru's nuevo sol depreciates by an additional 20%, which is not our base case scenario. Foreign currency consumer loans are the main culprit here. We expect credit losses in the other countries to show moderate increases.

Lower Profitability Is A Likely Outcome

We expect profitability of the banking systems in most of these countries to drop in 2014 (see chart 9) as a result of: Lower business growth; Higher credit losses due to lower economic activity; Higher cost of funds due to higher local interest rates and refinancing rates for debts in foreign currency and the lag in passing the additional costs to clients. That could in turn increase credit losses; and For India and Indonesia specifically, their significant holding of government securities with fixed interest rates.

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Chart 9

Related Criteria And Research

Related criteria
Banks: Banking Industry Country Risk Assessment Methodology And Assumptions, Nov. 9, 2011

Related research
Policy Risks, Not Tapering, Are Key To Emerging Market Sovereign Ratings, March 5, 2014 Credit Conditions: Europe Is On A More Stable Path, Amid Turbulence In Emerging Markets, March 21, 2014 Turkish Banks' Asset Quality Is Vulnerable To An Economic Downturn, Despite Credit Strengths, Feb. 17, 2014 South African Banks: Economic Risks Weigh On 2014 Credit Prospects, Jan. 27, 2014 Ratings On Six Turkish Banks Affirmed Despite Higher Industry Risks; Outlooks Remain Negative, March 5, 2014
Under Standard & Poor's policies, only a Rating Committee can determine a Credit Rating Action (including a Credit Rating change, affirmation or withdrawal, Rating Outlook change, or CreditWatch action). This commentary and its subject matter have not been the subject of Rating Committee action and should not be interpreted as a change to, or affirmation of, a Credit Rating or Rating Outlook.

Additional Contact:

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Financial Institutions Ratings Europe; FIG_Europe@standardandpoors.com

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