Inflation and rising interest rates will dominate the credit stories of banks in emerging markets in 2022.   Persistent inflationary pressure has prompted some central banks to accelerate the normalization of their interest rates, particularly in EMEA and Latin America. In addition, the Federal Reserve is now likely to raise interest rates faster than initially expected. Rising interest rates might result in higher credit costs, although we expect these to continue to normalize from the pandemic-related highs in most emerging market countries. However, lower and more expensive global liquidity may squeeze banks that rely heavily on external funding. We also expect banks to benefit from higher interest rates as their margins improve.

Political and geopolitical uncertainty will also be a key feature.   Several events since the start of the year have highlighted that political and geopolitical risks remain firmly embedded in the emerging market landscape. As evidenced by the mass protests and civil unrest in Kazakhstan, the tensions between Russia and Ukraine, and the attacks on the United Arab Emirates (UAE) by Iran-backed Houthi rebels, the risks for banking systems can be multifaceted. With several EMs needing to remove both fiscal and monetary stimulus this year, we believe that periodic episodes of unrest are plausible. The impact on banks could materialize through lower business volumes due to changes in investors' perception of risk, increasing delinquencies and a higher cost of risk, or higher instability of local and external funding sources.

Against this backdrop, 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 see the three main risks for 2022 as:

• The volatile geopolitical environment and, in some cases, domestic policy uncertainty;
• Heightened pressure on banks' asset quality from higher interest rates; and
• Some banks' vulnerability to abrupt movements in local or external funding sources.

The Post-Lockdown Recovery Is Slowing

We expect weighted-average GDP growth in key EMs (excluding China) to slow down to 4.3% in 2022 from the rebound in 2021 to 6.1% (see chart 1). Most EMs have returned to pre-pandemic GDP levels (U.S. dollar-denominated), except for Brazil, Turkey, Colombia, and Thailand (see chart 2). High inflation and depreciating local currencies have also hampered the pace of recovery for EMs in 2021 (see chart 3).

Chart 1

Chart 2

Chart 3

Note: Heavy intervention in the official foreign exchange rate market and capital controls limit the pace of depreciation of the official exchange rate, while active parallel exchange rates in Argentina reflect greater depreciation associated with macro-imbalances. Our sovereign database and this chart use the year-end official exchange rate for 2021 of 105 per USD, while the parallel rate for 2021 averaged above 200 pesos per dollar.

Further downside risks remain, particularly in relation to the recent rapid spread of the omicron variant. The latter highlights the inherent uncertainties of the pandemic as well as the importance and benefits of vaccines. While the risk of new, more severe variants displacing omicron and evading existing immunity cannot be ruled out, our current base case assumes that existing vaccines can continue to provide significant protection against severe illness. Furthermore, many governments, businesses, and households around the world are tailoring policies to limit the adverse economic impact of recurring COVID-19 waves. Consequently, we do not expect a repeat of the sharp global economic contraction of the second quarter 2020. Meanwhile, we continue to assess how well each issuer adapts to new waves in its geography or industry.

Political And Geopolitical Uncertainty Is Still The Unwelcome Guest

Rising energy costs, food prices, and unemployment could trigger bouts of social instability in several EMs, ultimately reducing policy predictability. We saw this clearly in Kazakhstan in early 2022 and in Latin America, where several countries have already experienced periods of widespread protests in 2021, in some cases causing a watering down of proposed fiscal consolidation bills. A busy electoral cycle in Latin America this year implies a greater likelihood of less predictable policies. In Turkey, rising social discontent amid very high inflation and strong lira depreciation might result in policy missteps ahead of the 2023 general elections. We cannot rule out additional policy stimulus measures in 2022, even though Turkey still faces lingering imbalances.

In other EMs, geopolitical risks have triggered bouts of instability. We note, for example, the drone or missile strikes orchestrated by Iran-backed Houthi rebels on the UAE. While the UAE's sophisticated air defense system has helped shield the country against these attacks, the Houthis have threatened further attacks, which could contribute to further oil price upside. Similarly, the escalation of tensions between Russia and the West over Ukraine and potentially retaliatory sanctions could have a destabilizing effect on Russia's economy. However, in our base-case scenario, we expect those to be initially manageable given Russia's conservative policy framework and its strong fiscal and external balance sheets.

In addition, given Russia's position as the second-largest oil-producing country in the world, Iran-type sanctions on Russia's oil exports would likely cause a global energy crisis with prices going well above $100 per barrel and disruption to global supply chains. (Note that our current baseline oil price assumption for 2022 is $75 per barrel). In addition, owing to Russia's crucial role as a supplier of natural gas to the EU, a complete shutdown of gas supply could well result in a systemic energy crisis in Europe with significant spillover to global markets. A systemic energy crisis in Europe is not part of our base-case rating scenario. A sharp increase in oil or gas prices could have negative consequences for large hydrocarbon importers like South Africa, Turkey, and all of Eastern Europe.

These developments could affect EM banking systems in a few ways, most notably:

• Decreased business volumes owing to customers' perception of higher risks;
• Higher asset quality pressure on companies affected by the instability or weaker macroeconomic environment, as well as lower-than-expected economic growth.
• An increase in the volatility of funding sources and more constrained access to funding (both local and foreign).

Inflation And Central Banks' Reactions Will Pressure Asset Quality, But Could Boost Profitability

The post-lockdown recovery came with a sharp increase in inflation for most EMs. While initially considered to be transitory, inflation proved to be persistent and linked to higher commodity and food prices, as well as labor and component shortages.

In Turkey, the depreciating lira as a result of the nonconventional monetary policy also pushed up inflation. In Argentina, failure to establish a consistent monetary and exchange-rate policy framework with an independent central bank has undermined the value of the peso. In many EMs, inflation is running above Central Bank targets. We therefore expect some countries to accelerate the normalization of their interest rates. As such, we anticipate heightened pressure on households' disposable income and profit margins for corporations that are unable to fully transfer their costs to customers. At the same time, banks in most EMs could benefit from higher interest rates given the prevalence of variable-rate instruments on the asset side of their balance sheets and, for some banks, non-interest-bearing deposits on the liabilities side. Other banks might also benefit from the ability to promptly re-price their assets and liabilities.

Chart 4

We expect banks' exposures to small and midsize enterprises (SMEs) will continue to drive asset-quality deterioration, particularly in Turkey, South Africa, India, China, Indonesia, Thailand, and Latin America. We note that tourism and export-oriented SMEs are more vulnerable in this environment.

• In Turkey, SME exposures form nearly a quarter of total loans, as of Dec. 31, 2021, with a portion of that still benefitting from government guarantees.
• In India, SME exposures account for around 15% of total exposures at March 31, 2021, but government guarantees somewhat temper that risk.
• In China, lending to micro and small enterprises has risen very rapidly in the past few years--based on the government's encouragement to lend to that segment--and now accounts for about 12% of bank loans at the end of 2021.
• Russian banks' exposure to SME-related risk remains manageable, with banks' lending books already reflecting the dominance of large and midsize businesses in the economy. We consider that banks' exposure to larger borrowers that have shown stronger financial resilience to pandemic-related stress will continue to support banking sector recovery, in the absence of new external shocks that might influence the economy.
• In Brazil and Colombia, SME exposure is about 15% and 12% respectively. We expect that the soft economic environment this year will strain this sector the most, though the government guarantees offered during the pandemic will somewhat mitigate the impact.
• Mexican banks have a manageable exposure to this segment of about 7%.
• Argentine banks' exposure to SME is very low.

We believe that exposure to the real estate sector (including commercial) presents another source of risk for banks in EMs. While the immediate risk appears manageable, the uncertainty and potential long-term impact from the pandemic might bring structural changes to the commercial real estate segment. This could occur, for example, via shifts in consumer preferences toward online shopping, more flexible work arrangements, and cost-cutting measures from consumer-driven businesses.

Russian banks have learned from previous crises and keep their exposure to real estate and construction rather low, at less than 10% of total loans at year-end 2021. Oversupply of real estate in China, Thailand, and Malaysia prior to the pandemic exacerbate these risks. In addition, significant exposures in the Philippines, weak economic prospects in South Africa, and growing exposure in Turkey--as retail clients turn to durable goods in the context of a depreciating lira--could exacerbate this situation. We also see risks in Turkey from the indebtedness of some construction and energy companies in foreign currency compared with revenues in lira. In addition, the depreciation of the lira doesn't help as it often means an increase in production costs (producer prices increased by 10.5% in January 2022, or 93.5% on an annual basis).

In India, the surge in real estate prices and increased sales velocity have reduced pressure on real estate companies. In any case, Indian banks' exposure to this sector is lower than that of their EM counterparts. In China, we estimate that one third of property developers are in financial trouble. In our view, new exposures to property development risks will likely make up 17% of our estimated nonperforming assets (NPAs) for Chinese banks at end-2021, adding one percentage point to our 5.8% NPA forecast. While we believe that the banking sector can absorb this stress overall, smaller and weaker banks are likely to experience greater strain. On the other hand, Latin American banks' exposure to commercial real estate is relatively low and not a major source of risk.

Finally, high household leverage in some countries, alongside higher interest rates, will also contribute to asset quality deterioration. We see household leverage as high in Malaysia, Thailand, China, and South Africa (although authorities are unlikely to hike rates in China and Thailand given the relatively stable inflation outlook). Thailand's household leverage, at 90% of GDP, is one of the highest among emerging markets and has reached unsustainable levels. In our view, banks will need to restructure some of their loans due to the fragile state of household debt. We consider that the risks of retail lending are manageable for Russian banks since household indebtedness is limited. Consumer lending accounts for about 18% of the total lending book, but the risks are balanced by an almost equivalent exposure to residential mortgages. In a few other EMs, the substantial contribution of mortgages somewhat mitigates the high level of household indebtedness.

Chart 5

Banks Remain Vulnerable To Abrupt Movements In Funding Sources

Geopolitical and political risks could spur large movements in local or external funding sources. And, with the Fed now expected to raise interest rates faster than initially expected, global and local liquidity is likely to be scarcer. Among our 15 EMs, Turkey is the most vulnerable due to its high, although declining, banking system external debt. We do not expect significant disruption to Turkish banks' access to external funding sources in 2022 if the government is able to contain lira depreciation. We expect external debt to continue to reduce at the same pace over the next couple of years. In addition, we view the significant amount of foreign currency-denominated assets on Turkish banks' balance sheets as a mitigating factor as they can use them if access to external funding is restricted. However, as most of these assets are either with the government or the central bank, we are uncertain about the banks' ability to access them in times of stress.

Indonesia also displays high external debt in the corporate sector. We note, however, that Indonesian banks still benefit from regulatory forbearance measures that prevent the recognition of the full extent of asset quality deterioration until the end of March 2023. Finally, external debt in the Qatari banking system has also been rising fast. However, we see mitigating factors in the form of either expected stability of a portion of these funding sources due to long-term interest in the country or expected government support in case of problems--as demonstrated in 2017 when some of its neighbors boycotted the country.

Chart 6

We see an increased risk of negative government intervention in the Malaysian banking industry, for example in the repeated and direct relief measures provided by domestic banks. Given the political instability, we believe that such interventions could recur, impeding the banking sector's ability to operate commercially.

Anecdotal evidence suggests a differentiated reaction of local depositors to shocks. In Turkey, we have observed an increase in dollarization of deposits over the past few years, prompted by the clouded political environment and local currency depreciation. The government introduced a new deposit scheme that provides protection to Turkish lira deposit holders against exchange rate movements. However, the intake has been limited to around $13.8 billion or 5% of total foreign currency deposits. The latter reached $247.4 billion as of Feb. 3, 2022.

In other countries, such as those in Latin America, we have not observed major outflows of local funding. However, in countries where the local depositors are allowed to hold foreign currency (FX)-denominated accounts, we might observe some movement toward FX conversion.

Table 1

Related Research

• Emerging Markets Monthly Highlights: Another Difficult Year Is Ending, Challenges Remain, Dec. 16, 2021
• Credit Conditions Emerging Markets: Inflation, The Unwelcome Guest, Dec. 1, 2021
• Turkey Macroeconomic Update: Higher Inflation, Uncertain Growth Path, Feb. 3, 2022
• China's Banks Face A Doubling In Real Estate NPLs, Dec. 15, 2021
• When Rates Rise: UAE Banks Will Benefit From Higher Interest Rates, Feb. 15, 2022
• GCC Banking Sector Outlook: On The Recovery Path In 2022, Jan. 11, 2022.