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Inflation and rising interest rates present challenges for Asia-Pacific banks

Standard & Poor's managing director for financial services ratings, Naoko Nemoto, discusses how surging inflation could weaken the credit standing of banks in Asia.

Standard & Poor’s has identified the effects of rising inflation as a key issue for investors to watch in the region’s banking industry. What are the main areas to watch for?
In our view, the rising inflationary pressures we are seeing in many countries around the region could hamper macroeconomic growth and weaken the financial conditions of borrowers. Policymakers in many countries have started to raise policy rates in an effort to cope with inflation. Although the pace of interest rate hikes has been mild, a sharp rise in interest rates could hit borrowers with high debt levels hard and result in a surge of loan delinquencies. The potential risk appears to be more pronounced in countries with a combination of rapid credit growth, rising property prices and high private-sector debt. We recently published an in-depth report, titled Inflation and rising interest rates present challenges for banks in Asia-Pacific, examining the key areas where inflation may have credit implications for the region’s banks, including economic risk, asset quality, earnings, capital and funding liquidity.

You’ve highlighted economic risk as an area where inflation could have credit implications; what is your assessment of that risk?
Inflation could hamper economic growth. Standard & Poor’s associates high and volatile real GDP growth and inflation with higher economic risk. We also take into account our sovereign credit ratings in an assessment of a country’s economic risk, because the creditworthiness of a country’s banking system and government are closely related. In emerging Asia, steps by government to control the prices of fuel and food might mitigate the inflationary pressure to some extent. However, the higher costs of subsidies could worsen fiscal balances and cause distortions in the market. We note that most central banks in the region have begun raising interest rates to control inflation while policymakers have taken various measures to cool down excessive investment and property market bubbles. It will take time for the full impact of these measures to take effect.

Where do you see the biggest threat of inflation for the region’s borrowers and what will that mean for banks’ asset quality?
We believe the largest risk associated with inflation for the banking industry lies in the impact on borrowers. Higher material and energy costs could squeeze manufacturers’ profits, while the prices of goods rising at a faster pace than wage growth could lower consumption. The airline, steel, chemical and retail industries are particularly sensitive to inflation. The degree of impact, however, depends on the pace of inflation, the pricing power of the industry, the competitive environment and demand. More importantly, the rise in interest rates will have a broader impact on financial markets and result in more volatile real estate and stock prices. Sectors that have benefited from low interest rates and ample liquidity may be most affected. The risk of policy overreaction, which would trigger higher volatility, could rise in many countries, including India, China, Singapore, Vietnam and Australia. In China and Hong Kong, the recent high credit growth, rise in property prices and aggressive lending practices in certain market segments heightens credit risk. Despite these concerns, we believe that most banks in Asia-Pacific will be able to maintain their overall sound asset quality.

As you assess the credit implications of rising inflation on the region’s banking sector, what is your view on the risks, both positive and negative, facing earnings?
Higher short-term interest rates improve bank spreads, increasing gross profits. The floating rates on most bank loans change in line with money-market interest rates. But, the cost of funding is not totally linked with market rates. Term deposits, which constitute a large portion of deposits, tend to have longer maturities than loans. Demand deposits are not very sensitive to changes in market interest rates. Therefore, higher money-market rates could lead to improved net interest margins. It should be noted, however, that banks may modify their lending terms according to borrowers’ conditions or the banks’ business strategies. Although the slowdown of the region’s economy could result in slower loan growth, improved net interest margins could offset the negative impact of a deterioration of asset quality.

What is your assessment of the threat of rising inflationary pressure on China’s banking industry?
Concerns about inflation are pushing Chinese policymakers to take measures to tame liquidity and credit growth in China. These, coupled with various regulatory measures introduced to contain credit risks of Chinese banks, are set to take a toll in Chinese banks’ financial performance in the next two years, in our view. We see a high likelihood of credit quality slippage for the whole industry and a rising risk of credit profiles diverging between major players and small lenders. Nonetheless, the government’s measures could help avoid an even more painful hard landing at a later stage, although we caution against policy overreaction. We maintain a stable outlook on the Chinese banking sector, as we have for a long time factored in significant volatility in the credit performance of Chinese banks when we assess the sector. In our view, key credit metrics for the sector, especially for rated major players, are likely to remain supportive of stand-alone credit profiles.

Higher interest rates could result in an overflow of funds from deposits to savings vehicles that offer more lucrative returns. What might this mean for regional banks’ funding liquidity?
We do not expect the current debt structure will change significantly. Most banks in the region enjoy a stable funding base, mainly consisting of core deposits of customers that tend to be less affected by interest rate movements. In some countries, such as China, the deregulation of deposits rates is still underway and current regulations essentially eliminate competition based on deposit rates. In Australia and Korea, reliance on wholesale sources of foreign currency borrowing is relatively high. Although investor confidence is currently high, sustained by the robust performance of banks, funding stability is exposed to changes in market conditions.

What are the implications for banks’ capital as central banks hike interest rates to counter inflationary pressure?
A rise in the medium- and long-term rates in tandem with short-term interest rates would devalue the bond holdings of banks. If securities are held in available-for-sale (AFS) accounts, the devaluation losses could have an impact on the amount of regulatory capital banks set aside to meet minimum reserve requirements. However, revaluation losses on fixed-income securities have a minimum impact on our assessment of capital, as total adjusted capital (TAC), which is our main capital measure, does not incorporate revaluation reserves. We adjust reported capital to remove the impact of revaluation reserves associated with post-tax unrealised gains or losses on AFS securities. Even if the revaluation losses are not reflected in TAC, a significant erosion of regulatory capital could be a risk factor. However, for most banks in the Asia-Pacific region, this risk is remote as they do not generally carry large amounts of bond holdings in their asset portfolios, their net revaluation reserves are positive and the amount of regulatory capital they hold in reserve is high.

Is it possible that Standard & Poor’s will lower any of the region’s bank ratings in the near term on the back of these concerns?
We believe that rated banks in Asia-Pacific will be able to withstand the current inflationary pressure and we do not anticipate conducting any negative rating actions at present. We note that most banks in the Asia-Pacific region maintain sound financial conditions and their net nonperforming loans are at moderate levels. We maintain our stable outlook for the sector. Higher prices and likely higher interest rates would hurt loan growth and could result in higher credit costs, although we expect banks’ robust earnings and capital to absorb the higher costs. We also expect net interest margins to improve. That said, economic conditions in Asia-Pacific are exposed to volatile commodity prices and the still-fragile global economy, due to the region’s net demand for commodities as well as its net exports. We also note that persistent inflation that spreads to non-food items and ineffective policy measures could undermine the asset quality of, and by extension the ratings on, the banks in the region.

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