As major central banks start to tighten monetary policy, liquidity will become scarcer and more expensive worldwide but more so for riskier emerging markets--potentially reducing investor appetite for financial institution debt in these countries. Within that context, S&P Global Ratings has looked at banking systems in five emerging markets that we consider as potentially vulnerable to the changes in global liquidity conditions: Egypt, Indonesia, Qatar, Tunisia, and Turkey. We selected these markets based on a number of qualitative and quantitative factors. In our view, the change in global liquidity conditions can flow through these banking systems through two main channels:

A direct channel.  

• This involves banking systems with significant external debt. Turkey and, to a lesser extent, Qatar are the two main banking systems exposed to this risk, in our view. The impact could come from lower rollover rates of external debt and a depletion of liquidity buffers.

An indirect channel. 

• This includes banking systems exposed to other economic agents with significant external debt, such as the corporate sector (Indonesia) or the sovereign (Tunisia (unrated), and, to a lesser extent, Egypt). The impact could come from lower rollover rates for international capital market debt for the corporates or difficulty in refinancing debt for sovereigns that either would push them to increase their leverage with the local banking system or depreciate their currencies, resulting in economic pressure in those countries.

Our findings show that Turkey and Tunisia are the countries most vulnerable to changing global liquidity conditions. In Turkey, the impact could be direct and through lower rollover rates for banking system external debt. Although the banking system appears to have sufficient foreign currency-denominated assets, a large portion is placed with the central bank or the government, which could reduce their usability in a worst-case scenario. In the case of Tunisia, the risk is tied more to the political transition of the country and its potential impact on discussions with the International Monetary Fund (IMF). In the absence of a smooth transition and financial support from multilaterals, we are of the view that the government could come under severe strain, which could have negative ramifications for the overall economy and banking system.

The Direct Channel: Turkey Is The Most Vulnerable

Turkish banks remain highly vulnerable to negative market sentiment and risk aversion due to their declining but still high external debt, amounting about $143 billion as of March 31, 2021 (see chart 1). As a result of monetary policy normalization by major central banks, global liquidity will decline, increasing refinancing risk for Turkish banks. These risks are compounded by very high local inflation, unpredictable monetary policy, and the potential negative impact of the Russia-Ukraine conflict on commodities imports, the tourism sector, and investor sentiment. Under our base-case scenario, we do not expect a major disruption to Turkish banks' access to syndicated or other major bilateral funding lines in 2022--representing about 51% of their total short-term external debt on March 31, 2022, assuming that local authorities can stabilize the Turkish lira to some extent. Indeed, banks were able to roll over most of their syndicated loans with foreign counterparties in April-June 2022, with rollover rates fluctuating between 88% and 101%--admittedly at a higher price. Nevertheless, we expect lower appetite for senior and subordinated bank bonds.

The other risk we foresee for Turkish banks is the increase in deposit dollarization and ultimately deposit withdrawal if residents start to lose confidence in the system. On May 27, 2022, 58% of deposits were denominated in foreign currencies, up from 44% in 2017. Since the severe currency devaluation in December 2021, local authorities have implemented several measures to push banks and depositors to convert their foreign exchange deposits into Turkish lira, including a foreign exchange-protected deposit scheme with an objective of converting 20% of deposits by Sept. 2, 2022. Banks that will not comply with this limit will be subject to penalties. Although those measures have helped to reduce dollarization from a peak of 69% in mid-December 2021, the deposits benefitting from this scheme covered about 13.7% of deposits on May 31, 2022, so the benefit might turn out to be only temporary.

Turkish banks have still some cards up their sleeves but playing them might be more complicated than what the numbers suggest. We estimate broad liquid assets in foreign currency at around $154.8 billion on March 31, 2022 (including mandatory reserves of about $49.9 billion). This should suffice to cover upcoming funding maturities over the next 12 months, which amounted about $85.7 billion on March 31, 2022. Therefore, on paper, the position appears well matched. However, $75.9 billion of Turkish banks' foreign assets were placed with the Central Bank of the Republic of Turkey (CBRT) on March 31, 2022. As such, under a hypothetical extreme scenario, the CBRT could restrict access to these assets given its already weak foreign exchange reserves, and push banks to default. Clearly, a significant increase in foreign exchange demands by depositors would add pressure on the local currency and, in turn, on already low CBRT's foreign exchange reserves, increasing the risk of capital controls. In 2022, the CBRT enacted a new law requiring exporters and companies operating in the service sectors to convert 40% of their foreign exchange revenues into local currency to contain reserve erosion.

Chart 1

Qatar is another country where we have some concerns about the speed and extent of the buildup of banking system external debt (see chart 2). However, a significant portion of nonresident deposits and amounts due to banks abroad in our view is relatively stable and has proven to be so through various episodes of stress. A significant portion of these funds is linked to longer-term investment interests in Qatar. Reportedly, they also include some deposits from Qatari companies abroad and also possibly from companies that the Qatar Investment Authority partly owns.

Chart 2

We expect the growth in external debt to moderate over the next couple of years as several large infrastructure projects and preparations for World Cup 2022 are finalized and delivered. Plus, new central bank rules have increased reserve requirements for short-term nonresident deposits and the weight of nonresident deposits in the calculation of the liquidity coverage ratio and the net stable funding ratio. This step change is clearly designed to deter banks from using external sources to grow their balance sheets further. External debt grew an average 18% from 2019 to 2021, but we expect it to slow to around 5% over the next couple of years. Finally, higher oil prices should result in stronger domestic deposit growth than we have seen over the past few years.

We also expect funding support to be available from the government and central bank if needed. During the boycott of Qatar by a group of Arab and African states in 2017, the banking system experienced outflows of about $20 billion, which were more than compensated by a more than $40 billion deposit injection from the government and its related entities. Also, given substantial liquid assets held by banks, we estimate that support would be sufficient to cater for a similar stress (see "Qatar Ratings Affirmed At ‘AA-/A-1+’; Outlook Stable," published on May 6, 2022).

To assess Qatari banks' vulnerability to external funding outflows, we first assessed their overall capacity to cover their external liabilities (including interbank deposits, customer deposits, and capital market instruments) using their stock of external assets. To account for the potential illiquidity of some of these assets, we used haircuts ranging from 0% for cash to 100% for other assets, as the nature of these were not disclosed. We used a 15% haircut for the interbank deposits as Qatari banks tend to generally place their money with creditworthy foreign banks. We also used a 50% haircut on banks' lending portfolios, assuming that under stressed conditions, banks will have to fire sell some of these loans to generate liquidity. The results show that banks could withstand a substantial level of stress. If we factor in the support of the government at a similar size as during the boycott, the banking system appears to be fairly protected from expected volatility in market conditions, particularly given the recent increase in oil and gas prices.

The indirect channel: If the political transition doesn't succeed in Tunisia, banks will come under extreme pressure

What Indonesia, Tunisia, and Egypt have in common is relatively low banking system external debt (see chart 3). Tunisia has the highest, though dominated by offshore companies and expatriates, along with multilateral financing lines.

Chart 3

There are some differences among the countries' banking system external debt. In Indonesia, notably, the corporate sector has significant external debt. In Tunisia, the sovereign is highly vulnerable to the refinancing of external debt. In both Egypt and Tunisia, external financing is growing because of the Russia-Ukraine conflict.

We estimate the proportion of foreign currency (mostly U.S. dollar-denominated) corporate debt in Indonesia at about 57% of total corporate debt as of end-December 2021. The proportion has typically fluctuated around 55% depending on foreign exchange movements and lending growth. While regulations (minimum ratings and hedging of short-term external debt) helped corporates increase the share of hedged foreign exchange loans, their still elevated levels of corporate foreign currency debt leave them exposed to Indonesian rupiah volatility and capital outflows. The IMF reported that more than 90% of corporates have complied with the hedging requirements. Indonesia banks do not have material net open foreign exchange positions and currency fluctuations will unlikely affect them. However, they could experience second-order impacts via their loans to exposed corporates.

In our view, sustained devaluation of the rupiah to 15,000 to the dollar could hurt the weakest corporates. This rate has triggered some outflows of capital in the past. However, until now, each time the foreign exchange rate depreciates beyond this level, it typically bounces back within two to three months and hasn't resulted in an increase in delinquencies or banking sector nonperforming loans. The rupiah has been fairly resilient since the beginning of the year, and we expect the Indonesia government will raise interest rates should the need arise to defend its currency and mitigate capital outflows. We expect a rate increase of 50 basis points (bps) in 2022.

Egypt's vulnerability comes from its status as the largest importer of wheat in the world, with more than 80% of imports historically coming from Ukraine and Russia. The provision of the commodity at subsidized affordable prices is important for maintaining economic stability. Domestic wheat production and strategic reserves should last until end-2022. We expect Egypt to continue to diversify wheat imports and replenish strategic reserves. However, this will come at a cost and would likely affect the country's fiscal deficit.

Inflation increased to 13% year on year in April after settling in low single digits, thereby prompting the Central Bank of Egypt (CBE) to raise interest rates by 200 bps (on a discount rate of 11.75%) after the 100 bps increase in March 2022. (The previous monetary policy action was a 300 bps cut in March 2020). The country experienced capital outflows in early March, prompting the CBE to devalue its currency by 15% to preserve reserves. We expect inflation to average 8.0% in 2023. At the same time, we anticipate GDP to grow 5.7% in 2022 before stabilizing at 4.0% thereafter (see "Egypt ‘B/B’ Ratings Affirmed; Outlook Stable," April 22, 2022). We also expect an Egyptian government policy reaction, coupled with external support (from the Gulf countries and IMF), that should prevent a material worsening of the country's external and fiscal position. Risks associated with the depreciation of the currency are likely to remain limited. Foreign exchange lending represented less than 20% at fiscal year-end (June) 2021 and is typically granted for exporters. Also, banks' net foreign exchange position is minimal, as foreign currency deposits are about 15% of the total deposits at the same date.

The story is not the same in Tunisia. Although the country has held several technical discussions with the IMF, a lack of consensus about reforms and the uncertain agenda for a political transition are clouding the outlook, particularly taking into consideration the country's mediocre macroeconomic performance (see chart 4). In our view, a return to some form of constitutional order appears to be a prerequisite for a new program with the IMF, which could be a lengthy process. Depending on the outcome of the referendum scheduled for July 25, 2022, to approve or reject the new constitution, the situation could stabilize or drift in the third quarter of 2022.

Tunisia imported about 42% of its wheat from Ukraine and another 5% from Russia at year-end 2019. The increase in food and oil prices is likely to add further strain on the government's budget and current account deficit. Increasing inflation prompted the central bank to increase its rate by 75 bps in May 2022. On a positive note, foreign exchange reserves have held relatively well, at 129 days of imports as of June 1, 2022, and have been stable over the last three months, thanks primarily to remittances. However, we foresee a decline in the next few months from elevated oil prices, but a good performance by the tourism sector could help. Tunisian banks are not dependent on external funding and most of their external liabilities--11.8% of total assets on Nov. 30, 2021--are either from multilaterals or from entities with economic interests in Tunisia (offshore or nonresidents nationals). Therefore, the risk of an outflow of foreign exchange liabilities appears to be in check. The confidence of residents in their banking system is a factor that we are looking at closely, particularly considering the upcoming referendum and the potentially unstable political environment. That said, in our base case, we expect domestic deposit holders' trust and confidence in the banking system to remain broadly intact.

Chart 4

Related Research

• Banking Industry Country Risk Assessment: Qatar, May 16, 2022
• Middle East And African Banks: Varied Exposure To Russia-Ukraine Conflict, April 4, 2022
• How The Russia-Ukraine Conflict Could Affect Middle East And African Banks, March 4, 2022
• Banks In Emerging Markets: 15 Countries, Three Main Risks (February 2022 Update), Feb. 17, 2022