S&P Global Ratings believes that the COVID-19 pandemic and its aftermath will continue to dominate credit conditions in 2021. 

As vaccine rollouts in several countries continue, S&P Global Ratings believes there remains a high degree of uncertainty about the evolution of the coronavirus pandemic and its economic effects. Widespread immunization, which certain countries might 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 (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

Central banks in developed markets are likely to keep exceptionally accommodative monetary policy.   For emerging markets (with some key exceptions), this should translate into a stronger economic recovery and favorable financing conditions. That said, risks related to vaccine distribution and a spike in COVID-19 cases remain acute for emerging markets, and this may delay the economic rebound and increase risks for their banking systems. Within this context, we have analyzed 15 banking systems among the largest emerging market 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 environment 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

While the global economy is getting back on track, countries and regions are moving at different speeds. China was the first in the crisis and the first one out, providing an interesting template of a robust manufacturing recovery, tempered by consumer caution. The U.S. and Europe are mired in challenging new waves of COVID-19 that are weighing on recovery momentum. Nevertheless, in developed markets, prospects for a turnaround in the second quarter are supported by extensive vaccine purchases lined up by their governments and the ability to handle the more onerous cold chain requirements of mRNA medicines.

Recovery prospects differ for our selected EMs, and for many economies there is still a long path to pre-pandemic GDP levels. China's state-led recovery, fueled by infrastructure and property, is benefiting EM commodity exporters like 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 notable exceptions of Brazil and Turkey. This contrasts with the U.S. 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% from a contraction of 6.1% in 2020. Most EMs in Asia and Europe should return to their pre-pandemic (fourth-quarter 2019) GDP levels next year. Major economies in Latin America were some of the worst EMs hit by the COVID-19 downturn, and we expect they will also be among the slowest to recover. We believe that most major Latin American economies will return to their pre-pandemic GDP level in the second half of 2022, then Mexico doing so toward the end of 2023, and Argentina trailing much further behind.

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. Mobility dropped in many EMs because of government-mandated measures and a higher degree of risk aversion among consumers. In addition, a slower recovery in Europe and the U.S. could affect EMs that are exposed to trade with these countries. Furthermore, the pandemic and related restrictions might postpone the rebound in tourism. Although we don't expect full lockdowns in EMs, combined, the aforementioned factors could delay the economic recovery, increasing risks for corporations and households.

Chart 1

Three Common Risks For Banking Systems

In our view, bank systems in our sample EMs are exposed to three major sources of risk.

Likely deterioration in asset quality

We expect nonperforming loans to continue increasing and cost of risk to stabilize at high levels as central banks start to remove regulatory forbearance measures in some of the markets where such measures were implemented and banks start recognizing the full extent of asset quality deterioration (see 'Related Research'). Like peers in developed markets, EM central banks acted swiftly through a combination of lifting some regulatory requirements (particularly for problem loans recognition) and liquidity injection to help banks cope with the severe economic contractions. Overall, we expect the COVID-19-related economic shock to be profitability event with those EM banking systems still showing positive net results in 2020-2021. But a few banks will report losses due to their higher exposure to the hardest hit sectors. Moreover, we think that EM banks profitability is likely to remain below historical levels due to lower for longer global interest rates and slower growth.

We expect exposures to small and medium enterprises (SMEs) will drive asset-quality deterioration, particularly for countries like Turkey, South Africa, India, China, Indonesia, and Thailand. Tourism and export-oriented SMEs are more vulnerable in this challenging environment. In Turkey, SME exposures form nearly a quarter of total loans, as of end-November 2020, but 27% of these exposures benefit from government guarantees. In India, SME exposure accounts for around 20% of total exposures at mid-2020. Stress in Indian SMEs is somewhat tempered by the government's guarantee of new loans taken by SMEs, up to 20% of their aggregate loans, thereby easing liquidity pressure for SMEs. In China, total exposure to SMEs is small but has risen rapidly in the past few years as the government encouraged lending to this segment. We consider that Russian banks have manageable exposure to SME-related risk since large and mid-size businesses dominate the economy, which is reflected in the banks' lending books; we consider that these borrowers are likely to be more financially resilient to COVID-19 fallout than small businesses.

The real estate sector (including commercial real estate) is another source of risk for EM banks. Although immediate risk appears manageable, the uncertainty and potential long-term impact 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. Russian banks have learnt from the previous crises and keep their exposure to real estate and construction rather low, at about 8% of total loans at mid-2020. Pre-COVID-19 oversupply in China, Thailand, and Malaysia exacerbate the risks, while significant exposures in Philippines and South Africa and growing exposure in Turkey, as retail clients turn to durable goods in the context of a depreciating Lira, similarly worsen the situation. In Turkey, real estate exposures rose 37% year on year until end-November 2020, driven by mortgage lending, but we expect a slowdown in 2021 as lending rates increase. In India, many real estate companies are suffering from a combination of low sales velocity and weak prices, which may mean that a few companies will resort to restructuring their debt. That said, Indian banks' exposure to this sector is relatively lower than their EM counterparts'.

Finally, high household leverage in some countries, alongside still-healing job markets, will also contribute to asset-quality deterioration of EM banks. We see household leverage as high in Malaysia, Thailand, China, and South Africa. We consider that the risks of retail lending is manageable for Russian banks, since household leverage is limited, and the high risks of unsecured retail lending that account for less than 17% of total lending book are balanced by a well-performing exposure to residential mortgages, of about 15% of total lending. In a few EMs, the high household indebtedness is somewhat mitigated by the substantial contribution of mortgages (see chart 2).

Table 1

Chart 2

Geopolitical and domestic policy uncertainty

We do not expect the U.S.-China relationship to worsen any further in the short term as the incoming and outgoing U.S. administrations seem to have broadly similar views 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. In addition, with the incoming U.S. 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 heightened, investors could shift their attention to more stable regions. This would prompt an increase in funding costs, a lower appetite for regional instruments, or major foreign funding outflows. The transmission channels to other EMs include through commodity prices (mainly oil), which are likely to increase in case of conflict and depending on its severity, or through a shift 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 EU over gas exploration activities in the Eastern Mediterranean region. Although the immediate prospect of EU or U.S. sanctions has recently subsided, risks remain. We expect the relationship between Turkey and the U.S. to remain complex. The incoming U.S. administration appears inclined to take a less unilateral approach toward policy issues with key NATO allies, including Turkey, and will want to engage with Ankara on a variety of issues. However, key differences in geopolitical hotspots will persist. We understand that the criminal case against state-owned Halkbank for money laundering and fraud will go to trial in the U.S. in March 2021.

The elevation of geopolitical tensions between Russia and the U.S. continues spur uncertainty and risk for the Russian banking sector. The shape and timing of potential additional sanctions are uncertain because they stem from Russia's foreign policy actions and developments in the U.S. political landscape after the 2020 presidential election. Our base-case scenario remains that the Russian economy and financial system could absorb shocks associated with some moderate tightening of sanctions, if any, for example those on selected corporates or non-systemic financial institutions. 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. In Malaysia, marginal parliamentary support for the current government and the recent declaration of an extended state of emergency have raised questions regarding policymaking in the near to medium term. That said, Malaysia's institutions have thus far implemented effective support measures for the economy. In Thailand, a severe economic fallout and incidents of large-scale protests could increase uncertainty and the risk of abrupt changes to political institutions, although this is not our base case. Finally, in South Africa, social protests are recurrent.

Political and social stability risks from within countries and across borders, could interrupt EM banking sectors in a variety of ways, including a delay in the expected economic recovery or more localized pockets of risks through movements in commodity prices, or changes in liquidity conditions.

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 (see chart 3). China was the exception with capital inflows increasing markedly in 2019.

Chart 3

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 the COVID-19 vaccine. 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. An unexpected materialization of geopolitical risks or shift in the country's policy direction could push some investors to look for other more stable markets. Other countries in our sample either have limited external debt or are in a net external asset position (see chart 4).

Chart 4

Related Research

• Global Credit Outlook 2021: Back On Track?, Dec. 3, 2020
• EMEA Financial Institutions Monitor 4Q2020: Banks Prepare As Winter Is Coming, Oct. 23, 2020
• How COVID-19 Is Affecting Bank Ratings: October 2020 Update, Oct. 22, 2020
• POLICY RESPONSES TO COVID-19, International Monetary Fund, https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19