Three reasons why an EM banking crisis may be avoided
Concerns over the health of the global financial system are likely to cause volatility, but we don’t see a crisis brewing following US banks' wobble.
The old saying goes that the Federal Reserve (Fed) raises interest rates until something breaks. There were idiosyncratic factors behind the demise of US regional banks SVB and First Republic, but aggressive interest rate hikes are likely to have played at least some part. And while the sell-off in global banks has since eased, as the dust settles the early indications are that the shock to confidence has resulted in some tightening of US credit conditions. This tightening adds to the list of reasons to expect a US recession later this year.
Fed hiking cycles have in the past exposed EM banking vulnerabilities
Emerging markets (EM) have had their fair share of banking and financial crises down the years as previous interest rate cycles have exposed vulnerabilities. While no two crises are the same, problems in EM have often been preceded by a period of rapid capital inflows that have fuelled a pickup in credit growth. As overheated demand leaks into imports, large current account deficits funded by this “hot money” leave EMs vulnerable to a sudden stop as monetary conditions tighten in developed markets, invariably led by the Fed as the most influential major central bank.
Indeed, we’ve seen sudden stops of capital inflows occur many times in the past after the Fed has raised interest rates. During these periods, we’ve seen how the sudden tightening of domestic financial conditions as a result of these circumstances can very quickly feed back into the real economy. EM banks have then suffered the blowback from subsequent recessions and rising loan defaults.
Some of the conditions that have preceded past EM crises are present today. Certainly, the Fed has raised interest rates very aggressively with the 475 basis points of tightening delivered over the past year, larger than in any other hiking cycle in the past four decades. What’s more, there has been a deterioration in the balance of payments of most EMs such that many now have significant current account deficits that are at least partly funded by short-term capital inflows. These issues cannot be taken lightly given the fraught nature of global sentiment, but there are at least three reasons to think we are not on the verge of a major EM banking crisis.
1 - Large capital buffers offer some protection for EM banks
First, top-down metrics indicate that EM banks are generally in good shape. According to the IMF’s Financial Soundness Indicators, regulatory capital to risk-weighted asset ratios are generally well in excess of the Basel III minimum requirements at 15-20% in major EMs. Banks still face the prospect of rising non-performing loans as economic growth slows in the near term, but large capital buffers should offer at least some protection. In addition, loans are generally funded out of deposits, reducing the vulnerability to a freeze in global funding markets.
2 - Little evidence of excessive bank lending
Second, there is not much evidence of excessive bank lending. One way to identify the early stages of EM crises emanating from the financial system is to monitor credit gaps, such as those published by the Bank of International Settlements (BIS). These measure the deviation of private sector as a share of GDP from long term trends. The idea is that when credit growth exceeds the increase in nominal GDP, the credit gaps rises. Conversely, the credit gap declines when lending expands at a slower rate than the economy. It is always dangerous to generalise about EM, but a quick look at the experiences ahead of the Asian Financial Crisis in the 1990s and problems in Central Eastern European banks in the 2000s show that credit gaps often widen to somewhere in the region of 20-30% of GDP ahead of crises.
However, the latest data suggest there is little cause for concern. These figures need to be treated with care, after all the credit gaps tells us nothing about the absolute size of the debt stock in highly leveraged markets such as China. However, weak credit demand against a backdrop of sluggish economic growth in recent years means that EM credit gaps are generally negative. Indeed, many EMs would probably benefit from a domestic credit cycle that could drive a period of growth. Two markets to keep an eye on are South Korea and Thailand, where leverage has been increasing.
3 - Absence of broader macroeconomic imbalances
Third, just as credit growth does not appear to have been excessive, there is not much evidence of broader macroeconomic imbalances that are about to be exposed by higher global interest rates. Admittedly, there has been some deterioration in balance of payments (BoP) positions such that several major EMs now sit in the vulnerable quadrant of our scatter plot where current account deficits are at least partly funded by short-term capital inflows (defined here as portfolio plus “other” flows). The worst offenders are Chile, Romania, Hungary and Colombia amongst others.
However, much of the deterioration in EM BoP positions has been due to an increase in energy imports. Aside from a handful of cases such as Hungary and Turkey, where non-energy imports have also risen significantly, that reflects the increase in global prices following Russia’s invasion of Ukraine rather than overheated domestic demand. If anything, the need to finance large energy import bills is likely to have crowded out consumption of other goods.
In addition, there does not appear to be any major liquidity strains or currency mis-matches at the macro level. Short term external debts, including those of banks, are easily covered by foreign exchange reserves. Argentina and Turkey, followed by Malaysia and Hungary, appear at most risk on this metric. But these are known problems, and it is worth bearing in mind that short-term external debt has often ballooned well over 250% of foreign exchange reserves ahead of past crises.
EM banks still face a tougher period as higher interest rates hit economic growth and cause non-performing loans to rise. And a deepening of concerns over the health of the global financial system would be likely to cause volatility in EM financial markets. But relatively solid macroeconomic fundamentals mean that a raft of crises emanating from the banking sector is a fairly low probability scenario.