FM and EM Banks: The 3-D threat from Coronavirus

The US Federal Reserve yesterday cut interest rates by 100bps, in addition to the 50bps cut announced on 3 March, and also announced a massive asset purchase programme and international co-ordination to protect USD-liquidity in the financial system. These moves highlight the central bank’s concern over the significant negative effect that Covid-19 will have on the US and global economies.

This impact stems not just from the effect of the virus itself (in terms of lost output and consumption by infected workers and their families) but also from the response to this threat from policymakers (border closures, restrictions on gatherings etc) and the private sector (voluntary factory closures, homeworking, reduced consumption and so on). The consequent disruption to supply chains, capital flows and investment activity is likely to be profound. Longer-term political and geopolitical repercussions can also not be discounted.

For EM banks, we see three principal modes of transmission:

Weaker revenues: This will play out through lower margins (the vast majority of banks in our coverage experience a margin squeeze when interest rates fall), reduced investment returns (due to asset price declines) and lower business volumes (less loan demand, potential pressure on deposits (see below), lower transactional activity).

Pressure on liquidity: Fiscal stimulus measures (such as those announced by the UK government last week) may lead governments to tap domestic savers and/or their banking systems. Global capital markets are likely to become increasingly segmented, reflecting border restrictions and heightened uncertainty. Reduced risk appetite (the financial equivalent of stocking up on toilet roll) could also inhibit the availability of liquidity to banks

Asset quality deterioration: While this may take longer to play out than the first two factors, it could ultimately prove to be the most significant impact of Covid-19 for banks. Weaker economic activity and lower collateral prices could see increasing numbers of borrowers defaulting on their loans, leading to banks’ capital erosion.

Which banking systems are most at risk?

Ranking our coverage markets across these three risk factors, and assuming that Covid-19 risks in each market are ultimately broadly equivalent, we see banks in Bangladesh and Argentina as being most at risk, together with Rwanda and Russia. In contrast, banks in Uganda, Nigeria and Egypt seem better equipped to handle the challenging macro environment we are likely to experience over the coming months; they already have significant operational and balance sheet buffers in place.

Note: green shading signifies low risk, red shading denotes high risk.

Valuations are unlikely to provide solace

Unlike the US, many of our covered markets are not facing the challenge of Covid-19 off the back of a prolonged equity bull market. Even before the recent price action, many of the banks we look at were trading at sizeable valuation discounts. Unfortunately, in our view, a combination of ongoing negative newsflow, increased risk aversion and heightened liquidity preference are likely to see bargain hunters washed out by investors looking to exchange FM and EM equities for lower risk and more liquid asset classes.

Figure 2: PE discount to 5-year median (y-axis) versus PB discount to 5-year median (x-axis)

Source: Bloomberg

Top picks: CIEB, GTB, MCBG, VPB

For investors that have the capacity to take the long view, we highlight four high-quality names within our coverage (taken from our 2020 top picks list) that should be strong enough to withstand the coming challenges.

• CIEB EY should continue to generate superior ROE to peers, supporting its high dividend payout. 
• GUARANTY NL should keep delivering industry-leading ROE and, in our view, has the quality to successfully negotiate the uncertain regulatory environment. 
• MCBG MP should continue to see good growth from its international trade and structured finance loans. 
• VPB VN should see continued consumer loan growth at FE Credit. Risk costs could fall given legacy NPLs are now fully provisioned.