Banks in emerging markets face a difficult year, owing to tight and potentially volatile financing conditions globally and weaker economic prospects in Europe. Yet S&P Global Ratings believes operating conditions for banks in Armenia, Azerbaijan, Georgia, Kazakhstan, and Uzbekistan will remain supportive in 2023. We anticipate banks can increase new business generation, along with stable profitability and gradually improving asset quality.

Since the Russia-Ukraine conflict began, people, capital, and trade have been streaming into the five countries due to sanctions imposed on Russia and the exit of many international businesses from Russia. We expect this will help fuel economic growth for these countries, apart from Azerbaijan, albeit weaker than observed in 2022. At the same time, a large increase in the number of migrants could result in widening economic imbalances through a rise in house prices and rents.

Nevertheless, we see stable economic and industry risk trends for these markets, even though our Banking Industry and Country Risk Assessments (BICRAs) indicate that, overall, the five banking systems face high risks in the global context (see table 1).

Table 1

GDP Growth To Foster New Business And Asset Quality Improvement

We estimate real GDP growth in Armenia, Azerbaijan, Georgia, Kazakhstan, and Uzbekistan will soften in 2023, after a strong 2022, but will continue to support the banking sectors (see table 2). Political risk remains elevated across the region although it appears contained for now. Potential further sanctions on Russia, one of the region's main trading partners, and possibly deeper recession in Russia, could weaken trade and remittances for the five countries. Also, the relationship between Armenia and Azerbaijan remains fragile, bringing with it the possibility of escalation.

Table 2

For banks in Georgia and Armenia, benefits from migrant flows will subside in 2023.  Last year, Georgia and Armenia benefited from the post-pandemic recovery of tourism, increasing exports, and the contribution of migrants from Russia, Ukraine, and Belarus after the Russia-Ukraine conflict started. We believe the positive impact from immigration and inflow of non-resident deposits on GDP growth could reduce in 2023 because many migrants have already moved on to other countries, returned home, or will do so eventually. We will continue monitoring developments closely.

We expect oil producers Kazakhstan and Azerbaijan will continue benefitting from favorable hydrocarbon prices and rising gas exports.   However, we forecast growth in Azerbaijan will likely be subdued over the next two years because its oilfields are ageing and oil production is in decline. At the same time, Azerbaijan's land borders remained closed in 2022 as part of its anti-pandemic measures; thus immigration is unlikely to enhance economic growth. In the meantime, Kazakhstan remains vulnerable to potential disruptions to the CPC (Caspian Pipeline Consortium) pipeline, which the country relies on for about 80% of its oil exports. A key growth driver for Kazakhstan will be the expansion of the Tengiz oil field, which should significantly increase oil production.

Despite Uzbekistan's uncertain economic prospects, we forecast GDP growth at around 5% in 2023 on the back of restored consumer demand and investments.   Financial and human capital flight from Russia has been fueling consumption and investment, as well as new business growth in various sectors, including banking and IT sectors. We think that good economic growth prospects will support further business growth and profitability of the banking sector. However, we expect foreign direct investment will fall this year due to lower participation from Russian companies, to some extent balanced by revived interest in privatization projects from other foreign investors.

Economic Imbalances Will Likely Remain Contained 

We expect the banking sectors in Armenia and Uzbekistan to be in a growth phase, characterized by higher economic and lending growth than regional peers' and improving asset quality. Georgia and Azerbaijan are recovering from past downturns, with credit losses normalizing toward cycle averages. Kazakhstan remains in a prolonged correction cycle marked by higher problem loans than peers. We expect sound macroeconomic growth prospects are likely to translate into average annual nominal lending growth of 10%-15% in 2023 in the region, thanks to a rise in corporate and consumer lending, as well as mortgage loans under government support programs. In view of high inflation, the real credit growth rate is likely to be in the low single digits, and banks should be able to manage the respective risks.

We consider that the housing sector is not a material source of imbalances in the region. The ratio of mortgage lending to GDP remains significantly below that of more developed markets in Europe, the Middle East, and Africa. However, gradual growth of mortgage lending is positive for banks' profitability and asset quality because mortgage products are simple and straightforward, denominated in local currency, and generally have a good performance track record. Lending to the construction and real estate sector averages 6%-8% of total loans, which is materially lower than before the financial crisis of 2008. Although nominal rents and house prices have risen considerably in Armenia, Georgia, and Uzbekistan since the start of the conflict, especially in capital cities, due to the influx of migrants, we believe the impact will likely be temporary. Consequently, we forecast growth of inflation-adjusted house prices in the region to be in low single digits in 2023.

Credit Quality Should Remain Stable Or Improve  

We expect credit quality indicators, on average, to remain stable or continue improving in 2023 amid the broadly supportive macroeconomic backdrop, even with slightly lower economic growth than in 2022 (see chart 1). Yet several factors could overshadow this base-case forecast, among them weaker macroeconomic growth in the region than expected, for example, due to a gloomier global economic outlook; or a steep rise in geopolitical risks. Higher inflation in the region than the historical average could also erode the creditworthiness of companies and households. Positively, the region is less affected by rising energy costs than European countries due to the availability of energy sources in Azerbaijan, Kazakhstan, and Uzbekistan, and--in the case of Armenia--long-term energy contracts with Russia on favorable terms.

Chart 1

We expect increased currency volatility in the region in 2023. Consequently, high but gradually reducing loan dollarization in Georgia, Armenia, and Uzbekistan heightens potential credit risk in the event of a significant exchange rate shock (see chart 2). In Armenia and Georgia, banks can still issue retail mortgages and consumer loans denominated in foreign currency, although of limited size. We consider this a source of risk for Armenia's and Georgia's banking sectors since we view retail borrowers as among the most sensitive to currency volatility shocks. In 2022, the Armenian dram and Georgian lari both strengthened against the U.S. dollar, which has been favorable for borrowers servicing loans in foreign currency.

Chart 2

Stable Profitability Hinges On Retail Expansion And Declining Risk Costs

High interest rates, increased lending with a focus on retail products, normalizing cost of risk, and control over operating expenses will be the key pillars for stable profitability in the region's banking sectors in 2023. In our base case, we forecast profitability will remain broadly on par with that in 2022. Nevertheless, increased uncertainties in the operating environment, stemming for example from inflationary pressures and rising interest rates, create potential downside (see chart 3).

Chart 3

Residential mortgage and unsecured consumer loans will fuel lending growth due to higher margins and fee income, despite higher credit losses than in other segments.   Following rapid growth in 2021-2022, we expect retail lending will account for 20%-40% of the region's systemwide loans. We think that in Kazakhstan, Azerbaijan, and Georgia, the retail lending credit cycle will moderate, while in Armenia and Uzbekistan growth in that segment will likely remain substantial. We therefore expect competition in the consumer finance segment to intensify, which might lead to more aggressive pricing and risk-taking, putting additional pressure on net interest margins and raising marketing and client-acquisition costs. We believe mortgage lending will remain the most resilient retail banking segment over the next few years, not only because of attractive risk-return ratios for banks but also government support programs that subsidize interest rates for certain population groups. A sustainable increase in the share of mortgage loans in retail lending portfolios in the longer term could reduce yields on interest-bearing assets. 

Commission income is on the rise.   In 2022, we observed abnormally strong growth of non-interest income at some banks in the region. The increase was mainly due to a spike in the volume of currency conversion transactions and money transfers, predominantly from Russia. Although we expect banks will continue such operations, further growth of this business will to a large extent depend on geopolitical developments.

We expect higher interest rates and strong non-interest income will support stable margins.  This is because banks should be able to adjust loan interest rates in line with the growth of funding costs in 2023. The inflow of deposits including current accounts and ample liquidity will balance the increasing cost of external borrowing due to tightening monetary policies (see chart 4). For the first nine months of 2022, compared with the same period in 2021, banks' operating revenue increased substantially, ranging from about +35% in Azerbaijan to fourfold in Armenia, boosted by commission income from money transfers and strong growth in net interest income.

Chart 4

The cost of risk is set to decline gradually.   Except for banks in Georgia and Azerbaijan, which reported much lower cost of risk than regional peers in 2021-2022, credit costs should reduce in 2023. However, we expect they will still be elevated due to low real disposable income of households and small and midsize enterprises, higher inflation, and a rising share of consumer loans (see chart 5). 

Chart 5

Inflation will push up operating expenditure.   We forecast an increase in operating expenditure by at least 10% in 2023 on the back of persistently high inflation, ongoing significant investments in digital transformation, intense competition necessitating marketing expenses, and commoditization of banking products. IT-related costs will likely average 15%-17% of banks' total operating expenses and continue to outpace the related cost savings this year, reflecting the hiring of information technology (IT) specialists, investments in software and hardware, payments to IT vendors and consultants, data protection, and cybersecurity.  

We expect banks' cost-to-income ratios will remain broadly stable this year.   A few large privately owned regional banks will maintain the best cost-to-income ratios, benefitting from economies of scale, market power, price setting, and first-mover advantage into digitalization. Kazakh banks have one of the lowest cost-to-income ratios globally--about 25% for the first half of 2022--thanks to a historically favorable interest rate environment and higher net interest margins than in developed markets. Armenian banks showed a strong improvement in efficiency in 2022, due to high commission income and early investments in digital transformation.

Earnings Support Steady Capital Bases

We expect banks' capitalization to remain broadly stable in 2023 on the back of retained earnings (see chart 6). As is typical for the region, domestic capital markets are shallow and underdeveloped. Therefore, with only a few exceptions, most banks rely on capital injections from shareholders to expand faster than their internal capital generation allows. Positively, we expect that, to maintain the stability of their capital bases, most banks will demonstrate moderate asset growth this year, compared with before the pandemic.

Also, we do not expect material changes to banks' current dividend policies, which range from regular dividend distributions for large Azerbaijan banks to full earnings retention for smaller banks in the region displaying above-market growth. For more than a half of the banks we rate, we assess the capital positions as positive for the ratings, based on our assessment of their current and expected capitalization as measured by our risk-adjusted capital ratio.

Chart 6

A Largely Benign Market Landscape

Overall, we expect well-established banks will maintain their market positions, while mergers and acquisitions will be limited. We do not see potential for foreign entrants or fintech companies as a threat to domestic banks in the region. Following sanctions on Russian banks due to the Russia-Ukraine conflict, business previously carried out by subsidiaries of Russian state-owned banks went to domestic banks. Before the conflict, Kazakhstan's banking sector had the largest amount of Russian capital in the region, accounting for about 14% of total assets. This compared with about 2% in Azerbaijan and Georgia, about 5% in Armenia, and no direct presence in Uzbekistan.

In our view, the Kazakh banking system largely resolved the interruption of Russian banking activities in 2022, through market-based solutions and with regulatory support.   Baiterek NMH JSC acquired the second largest bank in the country--Sberbank--while Bank CenterCredit acquired Alfa Bank, and the redistribution of clients to other banks was smooth. As a result of the downscaling of Russian banks, the banking sector has become more concentrated and local banks' market positions improved (see "Financial Stability Risks Stemming From Sanctioned Russian Bank Subsidiaries In Kazakhstan Have Been Limited," published July 7, 2022, on RatingsDirect).

We expect the government of Uzbekistan will proceed with plans to gradually privatize the banking sector, which has been traditionally dominated by state-owned banks.   This process was delayed due to the pandemic, the Russia-Ukraine conflict, and increased uncertainty related to global economic recovery. However, in December 2022, Hungary-based OTP Bank announced that it will acquire about 97% of mortgage lender Ipoteka Bank's equity from the Uzbek government, with the first part of the transaction to be finalized this year. This is the first large privatization deal that could set the example for others if successfully implemented (see "Ipoteka Bank's Acquisition By Hungarian OTP Bank Likely To Boost Expertise And Improve Governance," published Dec. 13, 2022). We understand work on divesting other large state-owned banks has started but it will take time for new transactions to materialize. Due to uncertainties related to the conflict we expect Russian investors are unlikely to participate. The recent revocation of Turkiston Bank and Hi-Tech Bank's licenses suggests reduced tolerance for violations of banking regulation and a more proactive regulatory stance toward cleaning up weaker institutions; however, it also underpins our view of a less predictable and transparent approach to regulatory actions (see "Uzbekistan-Based Turkiston Bank Downgraded To 'D/D' And Ratings Withdrawn After Central Bank Revokes License," Oct. 11, 2022).

Non-Resident Deposit Inflows Create A Windfall For Banks

We believe the inflow of deposits (largely from Russia) to the region, which spiked in 2022 (see chart 7), will continue on the back of relaxed currency controls in Russia but at a slower pace (see chart 8). We do not expect an immediate outflow of non-resident deposits back to Russia or other countries in 2023 if sanctions on Russia stay in place while compliance scrutiny in Western jurisdictions prevails.

Chart 7

Chart 8

In our view, four main factors point to a continued increase of non-resident deposits this year:

• Banks in the region offer cost-efficient alternative settlement routes after sanctions against Russian banks and citizens and Russia's countermeasures disrupted financial transaction flows for Russian citizens.
• In Russia, banks' efforts to dedollarize resulted in negative interest on foreign-currency denominated current accounts and deposits at many large banks, prompting households to transfer money abroad.
• A large amount of people are moving to Armenia, Georgia, Kazakhstan, and Uzbekistan from Russia, Ukraine, and Belarus amid the exit of international and local companies and the military draft in Russia since September 2022.
• The diaspora in Russia and high-net-worth individuals with dual or multiple citizenships that can be treated as residents in other countries have rerouted some of their money from Russia to countries in the region.

Largely Positive Trends Should Continue This Year

While the impact may vary between countries and individual banks two immediate trends should benefit the region's banking sectors in 2023:

• Higher macroeconomic growth prospects in the region than in developed markets will foster business growth and support stable asset quality; and
• Strong commission income from currency conversion, after robust settlement reported by some banks in 2022, and a normalizing cost of risk should support profitability.

The outlook bias remains largely stable.   The median rating remains rather low in a global comparison at 'B+' (see chart 9). Most outlooks are stable, reflecting our expectation that banks in the region will continue showing resilient performance over the next year on the back of stable economic and industry trends for the respective banking systems.

Chart 9

Table 3

Related Research

• Banking Industry Country Risk Assessment: Uzbekistan, Feb. 3, 2023
• Ipoteka Bank's Acquisition By Hungarian OTP Bank Likely To Boost Expertise And Improve Governance, Dec. 13, 2022
• Azerbaijan, Dec. 12, 2022
• Uzbekistan 'BB-/B' Ratings Affirmed; Outlook Stable, Dec. 2, 2022
• Banking Industry Country Risk Assessment: Azerbaijan, Nov. 9, 2022
• Banking Industry Country Risk Assessment: Georgia, Nov. 1, 2022
• Strong Economic Growth Supports Armenian Banks' Performance; Economic Risk Now Stable; BICRA Group Remains '8', Oct. 24, 2022
• Uzbekistan-Based Turkiston Bank Downgraded To 'D/D' And Ratings Withdrawn After Central Bank Revokes License, Oct. 11, 2022
• Banking Industry Country Risk Assessment: Kazakhstan, Oct. 10, 2022
• Armenia 'B+/B' Ratings Affirmed; Outlook Stable, Oct. 7, 2022
• Kazakhstan Outlook Revised To Negative On Higher External And Financing Risks; 'BBB-/A-3' Ratings Affirmed, Sept. 2, 2022
• Georgia 'BB/B' Ratings Affirmed; Outlook Stable, Aug. 26, 2022
• Financial Stability Risks Stemming From Sanctioned Russian Bank Subsidiaries In Kazakhstan Have Been Limited, July 7, 2022