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Banking on inflation: The sectors best-placed for the new economic paradigm

  • Rising inflation will affect emerging market banks’ margins, growth outlooks and asset quality; FX pressure may rise

  • We think banks in Poland, Nigeria, Mexico and Kenya are better-positioned for this new world

  • Banks in Vietnam, Iceland, Hungary and Peru may struggle in the new environment

Banking on inflation: The sectors best-placed for the new economic paradigm
Rahul Shah
Rahul Shah

Head of Financials Equity Research

Tellimer Research
22 November 2021
Published by

After a 40-year bull market in bonds, it looks like the tide may finally be turning. The world’s biggest central banks are scaling down their bond purchases while emerging market central banks have already pulled the trigger on rate hikes. And the recent pick-up in inflation may not be as transitory as initially imagined. If such a paradigm shift is taking place, how should investors in emerging market banks be positioned?

10-year government bond yields

Positioning for the new paradigm

We have already considered one piece of the jigsaw when looking at the impact of interest rate changes on banks’ margins and earnings. We add to this analysis by considering three other factors:

  • Margin sensitivity to interest rates

  • Net foreign currency positioning

  • Real interest rates relative to history

  • Current credit extension versus trend 

Key findings

Banking markets that appear best-positioned for an environment of rising inflation include:

  • Poland. Polish banks are some of the most positively geared to higher interest rates across our sampled markets. Real interest rates are lower than in the past and credit extension is below trend.

  • Ukraine. Real interest rates are much lower than in the past, margins should benefit from higher interest rates and lending volume is not elevated.

  • Nigeria. Nigerian banks are net-long foreign currency, real interest rates are well below historical levels and credit volume is also below trend.

  • Mexico. Mexican banks' credit volumes are below trend, their margins benefit from higher rates and real interest rates are lower than in the past.

  • Kenya. Lending volumes are well below trend. 

 Markets that are less well-placed according to this framework include:

  • Vietnam. Real rates are broadly in line with the past. Interest rate sensitivity of margins compares poorly (due to high volumes of interest rate-bearing deposits) and banks are not typically net long foreign currency.

  • Iceland. This market scores poorly due to the high level of credit extension versus trend, and the low sensitivity of margins to interest rate increases.

  • Hungary. Similarly, Hungary’s lending volume is currently well above trend, while its banks benefit less than EM peers from rising interest rates.

  • Jordan. Real interest rates are not substantially below historical levels, in contrast to most other emerging markets. Credit extension is above trend, foreign currency positioning is neutral and sensitivity to rate hikes also lags most EM peers.

  • Peru. The sampled banks are likely to see a weaker benefit from rate hikes than banks in other markets. Banks are net short foreign currency and current credit volume is above trend.

The banks best-positioned for an inflationary world

Further details regarding our analysis are presented below and in the Appendix

Interest rates

Net interest income generates around two-thirds of emerging market banks’ total revenues. Accordingly, the net interest margin plays a key role in top-line development.

For most emerging markets banks, margins tend to rise when interest rates rise. This is because they tend to have a higher volume of interest rate-sensitive assets (such as variable rate loans) compared with interest rate-sensitive liabilities (such as variable-rate deposits).

A key reason for this is the banks’ ability to attract non-interest-bearing funding (such as demand deposits and shareholders’ equity). Rates have already increased in around one-third of the emerging markets we cover; around two-thirds of markets are expected to hike rates by end-2022. Our detailed study helps to identify the sectors and markets most likely to benefit in such a scenario.

Pre-tax ROE impact of a 100bps rate hike

Currency exchange rates

Emerging markets typically have higher inflation rates than their developed market brethren. Such differentials might increase if global inflation picks up, based on past experience.

Accordingly, we could expect emerging market currency devaluations to increase in frequency and severity over the coming years. We have already seen the US dollar index rise by c5% points year-to-date.

US$ index has been rising in recent months

Many emerging market banks carry a currency mismatch – for example, they might have a high volume of US$ loans to commodity exporters or they might have issued US$ debt instruments to international investors. These mismatches can either hedge or exacerbate the hit to earnings and shareholders’ equity.

Our recent report identifies the impact on emerging market banks of currency fluctuations.

Banks' net foreign currency positioning

Real interest rates

Borrowers should be better able to service their debts in markets with low real interest rates (for example, where nominal interest rates are below the rate of inflation); the volume of credit should have scope to expand.

Accordingly, such markets should be less exposed to a credit crunch, where banks ration credit due to fears over the credit quality outlook.

Real interest rates in EM are well below historical norms

In our analysis, we compare current real interest rates with historical levels to help account for the idiosyncratic features of each market.

Across our broader sample universe, nominal interest rates have typically been 1.3% points above the rate of inflation; today that figure is 1.8% below, with the differential likely to grow further. 

Real interest rates

Credit cycle

Markets go through a natural credit cycle, where easy monetary conditions and high confidence lead to an overextension of credit, which is followed by a deterioration of loan quality and subsequent risk aversion from lenders. Higher interest rates and/or inflation can catalyse or exacerbate this transition; hence this is a key issue bank investors need to consider in the current environment.

To help identify where each market lies in the credit cycle, we compare current levels of credit to the long-term trend. On average, credit volume is 4% above trend across our sampled markets.

Current credit level versus trend

Credit quality cycle

The credit quality cycle is linked to the credit cycle described above but is also subject to other factors. Unfortunately, the sharp slowdown and recovery from pandemic-related lockdowns, combined with related regulatory forbearance, has clouded the credit quality picture. Accordingly, we don’t think disclosed asset quality data is a particularly helpful indicator for cross-country and cross-cycle analysis. Therefore, we are not including this aspect directly in our ranking exercise.

However, we do note that higher inflation could help move legacy non-performing loans transition into performing assets, through a combination of better collateral values and higher nominal cashflows. For banking systems that have experienced a big pick-up in non-performing assets in the past, the new environment may therefore prove helpful.  

Appendix

Inflation-preparedness index sub-scores