The COVID-19 pandemic and its aftermath will continue to dominate credit conditions in 2021. As vaccine rollouts in several countries continue, we believe a high degree of uncertainty remains about the coronavirus pandemic’s evolution and its economic effects. Widespread immunization, which certain countries may achieve by midyear, will help pave the way for a return to more normal levels of social and economic activity. We use this assumption about vaccine timing in assessing the economic and credit implications associated with the pandemic.
Central banks in developed markets are likely to keep exceptionally accommodative monetary policy. For emerging markets (with some key exceptions), this should translate into stronger economic recovery and favorable financing conditions. That said, risks related to vaccine distribution and spikes in COVID-19 cases remain acute for emerging markets, and this may delay economic rebounds and increase risks for their banking systems.
Within this context, we analyzed 15 banking systems among the largest emerging market (EM) economies: Argentina, Brazil, Chile, China, Colombia, India, Indonesia, Malaysia, Mexico, the Philippines, Russia, Saudi Arabia, South Africa, Thailand and Turkey. We identified three main common risks that their banking systems will face in 2021:
- The expected deterioration in asset-quality indicators as regulatory-forbearance measures are lifted;
- The volatile geopolitical environments and, in some cases, domestic-policy uncertainty; and
- For a few banks in EMs, the vulnerability to abrupt movements in capital flows.
Picking up after a major recession
Recovery prospects differ for our selected EMs, and for many of these economies, there is still a long path to pre-pandemic gross domestic product (GDP) levels. China’s state-led recovery, fueled by infrastructure and property, is benefiting EM commodity exporters such as Brazil, Chile, South Africa and Indonesia, which have strong trade ties with China. At the same time, household spending across EMs has been sluggish, with the notable exceptions of Brazil and Turkey. This contrasts with the United States and Europe, where consumers are spearheading the recovery.
We expect weighted-average GDP growth in key EMs (excluding China) to rebound in 2021 to 5.9 percent from a contraction of 6.1 percent in 2020. Threats to EMs’ recovery remain, particularly over the next few months, due to the resurgence of COVID-19 cases and new mutations. Governments are responding with partial lockdowns and other social-distancing measures, preventing the return to normal activities. In addition, slower recovery in Europe and the US could affect those EMs exposed to trade with these countries. Furthermore, the pandemic and related restrictions might postpone the rebound in tourism. Although full lockdowns in EMs are unlikely, the aforementioned factors combined could delay economic recovery, increasing risks for corporations and households.
Three common risks for EM banking systems
In our view, the banking systems in our sample EM countries are exposed to three major sources of risk:
Likely deterioration in asset quality
Nonperforming loans should continue to increase and the costs of risk stabilize at high levels, as central banks gradually remove forbearance measures in markets in which such measures were implemented and as banks start recognizing the full extent of asset-quality deterioration. Like their peers in developed markets, EM central banks acted swiftly through a combination of lifting some regulatory requirements (particularly for problem-loans recognition) and injecting liquidity to help banks cope with severe economic contractions. Overall, we expect the COVID-19-related economic shock to be a profitability event, with many EM banking systems still showing positive net results in 2020-21. But a few banks will report losses because of their higher exposures to the hardest-hit sectors. Moreover, we think that EM banks’ profitability is likely to remain below historical levels due to longer periods of low global interest rates and slower growth.
We expect that exposures to small and medium-sized enterprises (SMEs) will drive asset-quality deterioration, particularly for countries such as Turkey, South Africa, India, China, Indonesia and Thailand. The real-estate sector (including commercial real estate) is another source of risk for EM banks. Immediate risks appear manageable. But the uncertainty and potential long-term impacts from the pandemic might bring structural changes to the commercial real-estate segment via shifts in consumer preferences towards online shopping, more flexible work arrangements and cost-cutting measures from consumer-driven businesses. Pre-COVID-19 oversupply in China, Thailand and Malaysia have exacerbated the risks, while significant exposures in the Philippines and South Africa and growing exposure in Turkey have similarly worsened the situation. Finally, high household leverage in some countries, alongside still-healing job markets, will also contribute to the asset-quality deterioration of EM banks. We see household leverage as high in Malaysia, Thailand, China and South Africa. In a few EMs, the high household indebtedness is mitigated by the substantial contribution of lower-risk mortgages.
Geopolitical and domestic policy uncertainty
We do not expect the US-China relationship to worsen any further in the short term, as newly elected US President Joe Biden’s administration seems to have broadly similar views to the previous one on this topic. Escalated tensions would hamper cross-border investment, supply chains and access to intellectual property and markets, thereby increasing the risk of business disruption and loss of investor confidence. Also, with the new US administration, the potential reinstatement of the Iran nuclear deal could upset Saudi Arabia, some other Gulf Cooperation Council (GCC) countries and Israel. It’s unclear how these governments will tackle the related challenges. In the GCC, 2021 started positively with the resolution of the boycott of Qatar by four Arab countries. In our view, this will improve political and economic cooperation across the GCC. That said, we believe the damage done by the three-year boycott of Qatar to the GCC’s political cohesiveness, both real and perceived, is likely to remain.
If geopolitical risks are heightened, investors could shift their attention to more stable regions. This would prompt an increase in funding costs, lower appetite for regional instruments or major foreign funding outflows. The transmission channels to other EMs include commodity prices (mainly oil)—which are likely to increase in the event of conflict, depending on its severity—or through shifts in investor sentiment.
In our view, Turkey continues to face incrementing geopolitical risks, including through its recent involvement in several regional conflicts. It is also at odds with the European Union (EU) over gas-exploration activities in the Eastern Mediterranean region. Although the immediate prospect of EU or US sanctions has recently subsided, risks remain. We expect the relationship between Turkey and the US to remain complex. The new US administration appears inclined to take a less unilateral approach toward policy issues. However, key differences in geopolitical hotspots will persist.
The elevation of geopolitical tensions between Russia and the US continues to spur uncertainty and risk for Russian banks. Our base-case scenario remains that the Russian economy and financial system could absorb shocks associated with some moderate tightening of sanctions, if any. Alternatively, however, tougher sanctions could have more severe repercussions.
Domestic-policy uncertainty and social-stability risks are also factors to watch, particularly for Malaysia, Thailand, South Africa and some Latin American countries.
Vulnerability to abrupt changes in investor sentiment
Because of COVID-19 impacts and episodes of lower investor-risk appetite, many EMs experienced capital outflows (approximated by net nonresident purchases of EM stocks and bonds) in 2020 or much lower inflows than in 2019. China was the exception, with capital inflows increasing markedly.
However, financing conditions for EMs have continued to improve over the past few months, particularly thanks to the abundance of global liquidity and positive news on COVID-19 vaccines. This means that capital markets will remain accessible for EMs with good credit fundamentals, especially as investors continue to hunt for yield. Easier access to capital markets also means greater vulnerability to abrupt changes in investor sentiment.
This risk is particularly relevant for Turkey, which has the highest, albeit declining, dependence on external funding of the countries in our sample. Turkish banks’ external debt has continued to decline. It remains to be seen if the recent change in the policy direction will reassure investors. We expect that more supportive global liquidity conditions will support Turkish banks’ access to foreign funding. In our view, vulnerability to a sudden change in investor sentiment remains high. Other countries in our sample either have limited external debt or are in a net-external-asset position.