Banks in emerging G20 markets 'face double-edged sword of inflation and rate increases'

Lenders' margins will benefit but they will be forced to make bigger provisions for loan losses, Moody's says

The King Abdullah Financial District in Riyadh. Moody's says banks in emerging G20 markets including Saudi Arabia will benefit from gradual increases in interest rates. Bloomberg

Banks in emerging markets in the G20 are facing a double-edged sword as higher interest rates are set to improve their margins but a continued rise in the inflation rate could erase gains as it would lead to higher loan loss provisions, Moody's Investors Service said.

Inflation has continued to rise in emerging markets within the G20 — Argentina, Brazil, China, India, Indonesia, Mexico, Russia, Saudi Arabia, South Africa and Turkey — forcing central banks to raise interest rates.

Among the 10 markets, Turkey is grappling with the steepest inflation rate, which hit 73 per cent in May, followed by Argentina, which recorded a 61 per cent rise in consumer prices.

However, inflation in Saudi Arabia, the world’s biggest oil exporter, remains in the low single digits.

A gradual increase in interest rates will improve profits in the banking systems of most emerging markets, with India, Saudi Arabia and South Africa expected to post “comparatively larger increases in margins in 2022-2023”, Moody’s said in a report.

Historically, credit costs for lenders have also increased whenever inflation has risen at a sharp pace in all 10 banking systems.

Moody's expects lenders in Russia and Turkey to record larger increases in credit costs this year and in 2023.

In a scenario where inflation “accelerates materially and leads to significant rate hikes”, credit costs will also increase in Argentina, South Africa and Brazil, the rating agency said.

Asset risks for banks would outweigh margin benefits if inflation increased more sharply. In a scenario where the pace of inflation climbs beyond Moody's expectation, credit costs will exceed the benefits of gains in margins, with the profitability of Brazilian and Turkish banks expected to deteriorate more significantly than in other markets, it said.

“Now that most central banks have tightened monetary policy to curb inflation, we expect inflation to abate in all 10 emerging markets countries in 2023, helping contain asset risks for banks,” said Eugene Tarzimanov, vice president and senior credit officer at Moody's.

“[However], if inflation rates spike steeply and result in sharp increases in debt-servicing costs for borrowers, banks would have to increase their loan-loss provisions to levels that outweigh gains in margins, which would be credit negative.”

Benchmark interest rates around the world are rising as policymakers attempt to keep inflation in check, with consumer prices in the US, the world’s biggest economy, climbing to a 40-year high in May.

The US Federal Reserve, which kept policy rates near zero during the coronavirus pandemic, reacted last month with a larger-than-expected three quarters of a percentage point interest rate increase, its third in three months and the biggest since 1994, as part of efforts to control inflation.

Most central banks around the globe have also increased their benchmark rates to curb consumer prices, driven by the global commodities shortage that has driven up food prices sharply.

Surging oil and gas prices, exacerbated by Russia’s war in Ukraine, are feeding into already rising inflation.

For 2022, inflation globally has been forecast at 5.7 per cent in advanced economies and 8.7 per cent in emerging market and developing economies, according to the International Monetary Fund.

Moody’s said the correlation between changes in inflation, policy rates and net interest margins for banks among the 10 banking systems is strongest in China.

The correlation is the weakest in Turkey and Brazil due to banks in those countries having the smallest share of current and saving account (Casa) deposits, in addition to being heavily reliant on market funding.

Banks in Saudi Arabia and Mexico have the largest share of Casa deposits, which helps them to benefit from policy rate increases, Moody’s said.

The correlation between inflation and credit costs is strongest in Turkey, Argentina, Russia and South Africa due to problem loans.

“Credit costs in these systems typically increase more significantly when inflation rates rise,” the report said.