Bad Debt in Emerging Markets: Still Early Days
IMF Blog, November 9, 2015
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- Authors: John Caparusso, Yingyuan Chen, Evan Papageorgiou, Shamir Tanna
- Published: November 9, 2015
Emerging market growth and its drivers
- The fifteen largest emerging market economies grew by 48% from 2009 to 2014, a period when the Group of Twenty economies collectively expanded by 6%.
- Growth was driven in part by bank lending that fueled corporate credit expansion, strong earnings, and low defaults.
- The combination of the credit boom, falling commodity prices, and foreign currency borrowing has increased firms' vulnerability and put financial sectors under stress.
Credit booms, credit gaps, and signals of vulnerability
- Credit booms can lead to excess investment, surplus production capacity, deteriorating corporate cash flow, rising default risk, and bank capital losses.
- The credit gap (a country’s increase in borrowing—credit to GDP ratio—relative to its historical average) highlights vulnerable countries.
- By the end of 2014:
- China, Thailand, Turkey, Brazil, and Indonesia had credit gaps above 10%, a level often considered the benchmark for risky credit booms.
- China’s 25% credit gap places the country in the 5% highest credit gaps across emerging markets since the 1970s.
- Other factors beyond credit gaps can cause stress; Russia, Argentina and India currently have low credit gaps but may face other pressures.
- Recent depreciation of corporates’ home currencies against the dollar and falling commodity prices are increasing stress on weaker borrowers; increased borrowing rates could exacerbate the situation.
Emerging market bank buffers and the evolving bad debt cycle
- Emerging market banks are starting to see new non-performing loans at a faster rate, which is now above developed economy levels for the first time since the financial crisis.
- Aggregate Tier 1 capital ratio for emerging market banks is about 11%, well above the regulatory minimum, and has risen slightly since 2009.
- Advanced economy banks have collectively engineered a nearly 4 percentage points increase in Tier 1 capital adequacy ratios over the same period despite lower stated profitability.
- Rather than conserving capital during the boom, emerging market banks channeled essentially all earnings into underwriting further growth.
- As the credit boom ends, the need to build reserves against rising credit losses will strain future earnings and the ability of banks to maintain credit growth.
- Emerging market economies face the risk of rising credit costs, slowing bank earnings, decelerating credit growth, and weak economic performance—with potential global implications given their size.
Policy implications and recommendations
- At this late stage in the credit cycle, policymakers should act to prevent further deterioration in financial sector conditions.
- Use a mix of microprudential and macroprudential tools to keep institutions and the financial system safe and to discourage further accumulation of excess borrowing and foreign indebtedness.
Microprudential measures:
- Consider higher risk weights (capital requirements).
- Consider caps on the most problematic exposures, including property developers, commodity producers, and companies with large foreign currency borrowings.
- Strengthen corporate insolvency regimes.
- Pay special attention to vulnerabilities created by borrowing from overseas and in foreign currencies.
- Monitor banks’ and borrowers’ foreign currency exposures, including derivatives positions.
- Introduce and strengthen stress tests related to foreign currency risks.
Macroprudential and broader market measures:
- Maintain sovereign investment grade-status.
- Accelerate measures to foster money market and corporate bond issuance to improve corporates’ access to funding pools that reduce dependence on capital-constrained banks and potentially flighty offshore creditors.
Source: Bad Debt in Emerging Markets: Still Early Days (IMF blog, November 9, 2015).
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