As major central banks continue to tighten monetary policy, financing conditions are becoming increasingly restrictive, with rising costs and weaker liquidity especially affecting emerging markets. Given that context, S&P Global Ratings assessed the banking systems of five emerging economies, Egypt, Indonesia, Qatar, Tunisia, and Turkiye, each of which we consider to be potentially vulnerable to the changes in global liquidity.

Tighter global financing conditions can affect banking systems directly or indirect, with exposure to those different channels dictated by the particularities of bank funding and economies' wider exposure to external debt.

Direct channel impacts tend to weigh on banking systems with significant net external debts.  In this case, stresses caused by tighter external debt markets manifest directly in lower rollover rates on external debts, which could translate into depleted liquidity buffers. We consider Turkiye's banks to be the most exposed to this risk due to the potential for a sudden and significant decline in their ability to roll over maturing external debt. We also consider Qatar's banking sector to be exposed to direct channel risks, though to a lesser extent.

Indirect effects of tighter international financing conditions tend to be transmitted to banking systems via important non-bank entities with significant exposure to external debt.   That can include corporations (as is the case for Indonesia) or the sovereign (for Tunisia and Egypt). Indirect issues linked to corporations tend to be caused by difficulties rolling over debt on international capital markets, or due to currency depreciation. Sovereign issues are typically linked to refinancing difficulties that prompt increased borrowing from local banks and currency depreciation, which results in wider economic pressures.

Our research suggests that Tunisia is the most vulnerable to indirect channel risk, notably due to ongoing political instability and questions over the government's capacity to secure support from the International Monetary Fund (IMF). We think that failure to secure a deal with the IMF would put the Tunisian government under severe pressure and could have negative ramifications for the economy and the banking system.

Direct Channel:

Turkiye is vulnerable

Our base-case scenario incorporates an expectation that Turkish banks will retain access to external funding, albeit with a moderate decline in rollover rates, so long as the government can contain balance-of-payment risks. At the same time, Turkish banks' external debt should continue reducing gradually over the next two to three years.

We consider that Turkish banks are particularly vulnerable to negative market sentiment, increased risk aversion, reductions in global liquidity, and higher financing costs. This is due to their high external debts, which we estimate at about $144.2 billion at the end of 2022 (see chart 1)--based on the assumption that all the sector's foreign currency repurchase transactions are with external counterparties.

Turkish banks' foreign currency liquidity should be sufficient to offset lower roll-over rates. Yet most of those assets are held at the central bank, or invested in government securities, which could result in reduced availability in a highly-stressed scenario. In addition, we consider the potential loss of depositor confidence as a risk to the banking system. Deposit dollarization dropped to 42.5% as of February 2023, from 64.6% at the end of 2021, due to the protected local currency deposit scheme and after authorities began forcing banks to convert some dollar deposits into local currency.

Turkish banks also remain significantly exposed to risks from the unwinding of economic imbalances that emerged in recent years, including due to a surge in real estate prices and highly accommodative monetary policy amid hyperinflation. That risk has been exacerbated by extremely strong credit growth in the past few years, which was fueled by state incentives that encouraged lending.

The increase in house prices has helped banks' asset quality key ratios, by increasing the value of real estate assets held as collateral. Yet we consider that the possibility of a sharp correction in valuations is increasing and could eventually result in substantial credit losses for the banking system. We also expect the Turkish lira to weaken under pressure from higher interest rates in developed markets, and due to elevated balance-of-payments and exchange-rate vulnerabilities. The Turkish lira's weakness is also weighing on the creditworthiness of Turkiye's corporates, which still have significant aggregate foreign currency debts, equating to about 30% of total loans as of February 2023, down from about 37% as of February 2020.

We expect banks' credit losses to increase to about 3.2% in 2023, up from 2.8% in 2022, and nonperforming loans (NPLs) to remain at 4%-5% in 2023, up from a low 2.2% at the end of 2022. We acknowledge that NPL ratios in Turkiye do not include a large number of restructured loans, which are not recognized as delinquent, and have been affected by the rapid rate of credit expansion, which has inflated the ratios' denominator. We see significant risks to our projections, particularly in the event of a monetary policy reset, significant lira depreciation, and due to impacts from the recent natural disasters that have affected Turkiye

Chart 1

Qatar's risks remain, but are reducing

A build-up of external debt, mostly in the form of non-resident deposits, has been one of our main sources of concern for the Qatari banking system over the past few years (see chart 2). However, in early 2022, Qatar Central Bank changed regulations, with the aim of at reducing the use of external debt to grow domestic balance sheets. That, alongside rising interest rates, led to a significant unwinding of non-resident deposits, and has somewhat changed the overall structure of the country's external debt. Over 2022, non-resident deposits fell by over $20 billion, equal to about one third of their value at the end of 2021, while interbank deposits increased by over 13%, leading to an overall $17 billion decline in net banking system external debt.

Chart 2

We expect the reduction in net external debt to continue in the next 12-24 months, driven by the same factors as in 2022 and supported by a reduced need for external funding. The rationale for Qatar's development of an external debt imbalance was the desire to secure low-cost funding for significant domestic expenditures. With the completion of some major infrastructure developments, and due to increased government revenues, we expect spending (and funding pressures) will ease.

Our concern over Qatar's external funding stability is also mitigated by our understanding that a significant portion of the non-resident deposits are linked to longer-term investments in Qatar. Reportedly, the funds also include deposits from Qatari companies abroad and possibly from companies partly owned by Qatar's sovereign wealth fund. Also, we expect funding support would be available from the government and central bank if needed. For example, during the boycott of Qatar by a group of Arab 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. Indeed, one of Qatar's strengths is its external finances, which are in a strong net asset position, bolstered by the government's substantial wealth fund.

Indirect Channel

Unlike in Turkiye and Qatar, none of the banking systems of Indonesia, Tunisia, or Egypt appear to have external debt that are significant enough to directly cause issues (see chart 3). Yet all three systems are still exposed to external funding pressures through indirect channels.

Indonesia's corporate sector has significant external debt, while Tunisia's sovereign is highly vulnerable to external debt refinancing. Tunisia and Egypt also have growing external financing needs. Of the three countries, Tunisian banks have the highest external funding, underpinned by deposits from offshore companies and expatriates, and the use of multilateral financing lines.

Chart 3

Indonesia's corporate debt structure is a potential weakness

Indonesia's banking system does not have material net open foreign exchange positions and is thus unlikely to be directly affected by currency fluctuation. It could, however, experience second-order effects from currency volatility due to Indonesian corporations' exposure to external debt and thus foreign exchange risk.

Foreign currency (mostly U.S. dollar denominated) corporate debt accounted for an estimated 55% of total Indonesian corporate borrowing as of December 2022, up from 53% as of December 2019. Those high levels of foreign currency external debt weigh on our assessment of credit risk in the country.

Indonesia's introduction, in January 2015, of stringent rules regarding foreign currency borrowing and tighter hedging requirements has helped to increase the share of hedged foreign currency loans. However, the elevated level of foreign-currency debt at corporations means they remain exposed to Indonesian rupiah (IDR) volatility as well as capital outflow risk, particularly in the event of further and more aggressive tightening of monetary policy by the U.S. Federal Reserve.

In our opinion, a currency devaluation to IDR 16,000 to one U.S. dollar, which is sustained for at least six months, could trigger difficulties at weaker Indonesian corporates. In the past five years, that exchange rate was reached once, in May to June 2020, when the COVID-19 pandemic triggered an outflow of capital. The central bank, Bank Indonesia, started a rate-hike cycle in August 2022 and has since increased rates by a cumulative 225 basis points (bps), to 5.75%, to limit capital outflows. We expect robust GDP growth of about 5% in both 2023 and 2024. That growth, combined with the rate hikes, has attracted foreign investors back to the country, and could help support IDR stability.

Egypt is at risk from the effects of currency devaluation

Egypt's exposure to external risks triggered a devaluation of the Egyptian pound (EGP), which has fallen about 50% against the U.S. dollar since early 2022. That has, in turn, led to a spike in inflation and prompted the Central Bank of Egypt to raise rates by a cumulative 1,000 bps since the start of 2022.

The devaluation began with the Russian invasion of Ukraine, when Egypt, like many emerging markets, suffered significant investment outflows--a situation not aided by Egypt's reliance on Russia and Ukraine for about 80% of its wheat imports. Egypt turned for new funding to the International Monetary Fund (IMF), which agreed a new package on condition that the country adopt a flexible exchange rate regime to increase its resilience to external shocks and to rebuild external buffers.

We consider that Egypt remains exposed to external pressures at the sovereign level. That could translate into further inflation that eventually effects economic growth, increases the cost of funding, damages borrowers' credit quality, and contributes to increasing social inequalities.

It is also notable that Egypt's banking system, in the second half of 2022, shifted to a net foreign liability position, from a long-maintained net foreign asset position. The liabilities remain negligible, at about 3% of total loans, and we expect they will gradually decrease over time. This is because Egyptian banks are fundamentally domestically funded, with their only foreign currency needs arising from their lending to importing companies.

Tunisia's reform uncertainty is a threat

Tunisian banks continue to navigate significant macroeconomic pressure, at least some of which is still linked to the country's revolution 12 years ago. Those issues, coupled with the COVID-19 pandemic, have weighed on economic activity, resulting in expected economic growth of 1.3% in 2023, according to the IMF, and fiscal and external deficits likely totaling a cumulative 11.3% of GDP. Tunisia continues to face major hurdles, such as attracting external funding, while internal division between the government and the country's powerful labor unions are reported to have delayed the mobilization of economic resources.

Tunisian authorities and the IMF are in talks aimed at agreeing a program that will entail important economic reforms. In our view, if the country is unable to secure an IMF program, or at least attract bilateral or multilateral support from other parties, it will likely experience major balance-of-payments, fiscal, and currency instability.

Failure to secure support could result in the country defaulting on its financial obligations, which we expect would be accompanied by a significant depreciation of the Tunisian dinar and a major spike in inflation. For Tunisia's banks that would likely mean losses of a magnitude that would require their recapitalization.

That scenario is not part of our base case, which incorporates an expectation that the government will be able to mobilize the necessary resources to avert a crisis. Yet we also consider the risks of a negative outcome to be significant and possible within the next 12 months.

Related Research

Credit Conditions Emerging Markets Q2 2023: Enduring Risks, March 28, 2023

Economic Outlook Emerging Markets Q2 2023: Global Crosscurrents Make For A Bumpy Deceleration, Mar 27, 2023

Scenario Analysis: As Tunisia Seeks Financing, Its Banks Face Uncertain Prospects, Feb 20, 2023