Rating agency Standard & Poor’s expects that the Federal Reserve will begin exiting its very low interest rate policy in the second quarter of next year, but predicts that the wind-down of its monthly bond purchase program before then will cause developing nations to experience “episodes of instability.”
The Fed’s policymaking Federal Open Market Committee has trimmed the asset purchase program by $10 billion at each of its last three meetings, and S&P said in a report Wednesday that “the Fed will continue tapering its program throughout 2014, possibly ending it by October. At that point, the Fed is likely to start normalizing U.S. monetary policy through interest rate increases by the second quarter of 2015.”
The initial announcement and then implementation of the tapering process last year sparked bouts of volatility in emerging market economies as investors began to withdraw their capital. “While our base-case scenario assumes that the Fed’s gradual removal of unconventional monetary support won’t derail the economic recovery in developed countries, we expect emerging markets to experience episodes of instability,” S&P said.
In particular, “We expect QE tapering to hit some emerging markets’ banking systems either directly due to reduced global liquidity or indirectly through lower economic growth,” the firm’s analysts wrote.
The gauge what the impact of the Fed’s tapering would be on banks in emerging markets, the report examined seven countries – Brazil, India, Indonesia, Peru, South Africa, and Turkey. “We selected these countries because of the external vulnerabilities of some of them, and recent trends in market indicators such as foreign exchange rates and the cost of refinancing of banks’ external debt,” it said.
S&P said banking systems can feel the impact of the Fed’s tapering directly through more limited access to external funding or through increasing costs to refinance external debt.
Central banks in some countries, such as Turkey, have been forced to hike interest rates to counter the fall in their currency, and S&P said this could also impact banks, “due to currency depreciation and lower capital inflows through the financial account of their balance of payments, which may weigh on economic growth. That, in turn, could hurt asset quality and profitability.
The result of the S&P analysts’ study is that the banking systems in Turkey and South Africa are “the most vulnerable.” Tapering is likely to increase the cost of funding for Turkish banks, the report said. For the large Turkish banks rated by S&P, the firm is projecting credit losses to increase to around 1.5% to 2% in 2014 and 2015, with average nonperforming loans up to around 4% to 5%, vs. 2.8% on March 31, 2014.
In South Africa, the pricing-sensitive customer deposits and large asset management companies that its banks rely on for funding could push up their costs “if the Fed speeds its tapering and the South African Reserve Bank reacts more aggressively to raise rates,” the report said.
“A broad-based, persistent capital flow reversal, or even a sudden stop, could lead to disorderly adjustment in South Africa,” S&P warned.
Brazil’s banks will continue to feel the impact indirectly “through a worsening of the country’s economic slowdown,” S&P said, with its economic growth remaining subdued due to low investment rates, significant interest rates hikes, and public spending cuts.
S&P forecasts foresee Brazil’s GDP to grow by just 1.8% in 2014, compared with 7.5% in 2010, and its banks’ credit losses to rise to 3.7% in 2014 from 3.3% in 2013. “Public banks will account for the bulk of that because they have been growing very rapidly over the past few years,” it said.
Meanwhile, “We expect the banking systems in Chile, India, Indonesia, and Peru to remain relatively resilient,” S&P said.