Emerging market banks face tough challenge as growth slows

A while ago, Temasek, the Singapore state-linked investment fund, grew concerned about the weak balance sheet and problem loans of Standard Chartered Bank. So it briefly considered merging it with DBS, a large local bank. Temasek decided against this plan because of regulatory and tax issues and concerns that the deal created conflicts of interest for the fund itself, because it is the largest shareholder in both lenders. Temasek executives also feared that rather than strengthening StanChart, a merger might cripple DBS.

Although DBS is based in Singapore and StanChart has its headquarters in the UK, it is the latter which is struggling because of its exposure to emerging markets. Once regarded as a proxy for the growth of Asian markets in commodity-rich nations like Indonesia, Standard Chartered has today become a victim of the reversal of fortune suffered by many emerging markets and their heavily indebted corporate borrowers.

The volatile and depressed energy, metals and mining sectors accounted for a combined 29 per cent of StanChart's corporate and commercial loan book in the first half of 2014. Real estate was responsible for another 8 per cent. StanChart has $61bn in commodity related exposures, $38bn in loans outstanding in India and $83bn in loans to Chinese companies at a time when growth is slowing dramatically on the mainland. Moreover, much of the lending uses property as collateral, and property prices in China are under pressure or falling in most places.

Many emerging market banks are expected to face increasing challenges even as their competitors in developed markets slowly heal and ramp up their lending. "In some instances, the decline of local currencies against the dollar has prompted capital outflows, squeezing domestic bank liquidity and pushing up short term rates," the economists of JPMorgan noted in a recent Global Data Watch.

The recent growth of Asian credit has been precipitous. Bank credit as a percentage of gross domestic product rose from 70 per cent in 2008 to 95 per cent now. Add in credit from the capital markets and the figure is considerably bigger. Last year, emerging markets issuance in international debt capital markets hit $359bn, or twice as much as developed markets, according to Bank for International Settlements data.

12%Rate of increase in all emerging markets bank lendingMuch of the lending to Asia outside of China assumed the region would grow on the back of insatiable demand from China. Much of the lending to China itself was based on that same expectation. That faulty thinking was then compounded by assuming that the value of the Chinese property used to back the loans would also continue to rise. But local banks in China, such as Agricultural Bank of China, are beginning to report that their bad loans have doubled - although officially they remain under 3 per cent.

In India, Prime Minister Narendra Modi's efforts to improve the pace of economic growth and get the private sector to invest more are being hampered by high bad debt rates at local banks. Lenders are reluctant to extend credit to corporate borrowers, especially the infrastructure companies that have not been paid by government entities for their earlier work. The chairman of HDFC Bank, Deepak Parekh, cites one company whose accounts receivable are five times its net worth. As a result, many distressed debt investors today are focusing on the region, even on China, which in the past was viewed as too difficult. "We see this opportunity as secular, not cyclical, as credit creation in the emerging markets in recent years has been outsized," KKR said in a recent report.

More importantly, loan growth in the region is finally starting to slow. The rate of increase in all emerging markets bank lending has slowed from 18 per cent annually a few years back to 12 per cent late last year. Hopefully that will lead to better credit allocation.

But banks' hesitation to extend new loans further compounds the slowdown in growth that emerging markets already face. "Banks have become even more cautious," JPMorgan notes. "We think the headwinds from the emerging market credit cycle for economic growth are likely to intensify and be a drag on growth well through this year and next."

The reversal in the fortunes of banks in the emerging markets of Asia today has both benefits and drawbacks. But whether less credit ultimately proves a good or bad thing will surely depend on whether the lending is done more judiciously than in the past.

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