Credit Cycle Analysis: Starting To Look Overextended

BMI View: In this analysis we take a look at credit cycles in Latin America, by comparing the evolution of commercial credit as a percentage of GDP to its long-term trend. We observe that recent credit expansion in the region has started to move above its decade-long trend, suggesting that in some instances, credit growth is starting to look cyclically overextended. This could suggest a period of deleveraging over the coming years, although ongoing structural changes could continue to drive credit as a share of GDP higher in the years ahead.

In an effort to better inform our outlook on major Latin American economies, we have decided to complement our regular analysis of high-frequency data with a more comprehensive assessment of private sector credit cycles in the region. While monthly indicators such as manufacturing surveys, trade data, monthly economic activity indices and inflation offer invaluable insights into short-to-medium-term trends in an economy, this article takes a step back to assess the trajectory of commercial loans as a percentage of GDP across Latin America, and understand where regional credit cycles are in relation to their long-term trends.

Credit Expansion Heading Above Trend

Steep Uptrend An Anomaly?
Brazil - Credit-To-GDP Ratio Versus Underlying Trend

Credit Cycle Analysis: Starting To Look Overextended

BMI View: In this analysis we take a look at credit cycles in Latin America, by comparing the evolution of commercial credit as a percentage of GDP to its long-term trend. We observe that recent credit expansion in the region has started to move above its decade-long trend, suggesting that in some instances, credit growth is starting to look cyclically overextended. This could suggest a period of deleveraging over the coming years, although ongoing structural changes could continue to drive credit as a share of GDP higher in the years ahead.

In an effort to better inform our outlook on major Latin American economies, we have decided to complement our regular analysis of high-frequency data with a more comprehensive assessment of private sector credit cycles in the region. While monthly indicators such as manufacturing surveys, trade data, monthly economic activity indices and inflation offer invaluable insights into short-to-medium-term trends in an economy, this article takes a step back to assess the trajectory of commercial loans as a percentage of GDP across Latin America, and understand where regional credit cycles are in relation to their long-term trends.

Credit Expansion Heading Above Trend

While we caution against inferring overriding regional themes from our analysis, as cases vary based on the deviation from long-term trends and structural considerations, we note that in recent years credit expansion has deviated to the upside from its long-term trend in every major Latin American economy covered in this analysis. Indeed, the 10-year average trends themselves may in fact be anomalies, given that these were generated in historically low interest rate environments and supported by economic recoveries following the global financial crisis. More recently, we attribute the surge in commercial credit as a share of GDP across the region to the unprecedented economic stimulus implemented in China, which has generated high demand for natural resources, bolstering Latin American goods exports and lifting business confidence.

With interest rates having mostly bottomed and set to head higher over the coming months, we believe that a period of cyclical deleveraging could start to take hold over the coming 24 months, as the household debt servicing burden is likely to rise, which could put upside pressure on non-performing loan ratios and increase the cost of borrowing. This will likely place downside pressure on asset prices that have been inflated by rampant credit growth in recent years. Nevertheless, we observe notable structural divergences across Latin American economies, which suggest that credit cycles will begin to deviate from each other, as some economies are still a long way off their long-term peak levels. This is especially the case where commercial credit accounts for only a small share of GDP, compared with more mature economies, such as Brazil and Chile, where the ratio of loans-to-GDP is above 70% in both cases.

Brazil - Rebalancing Pressures Building

The rate of private sector credit expansion in Brazil over the past 10 years has notably deviated from its longer-term averages (going back to the 1990s), as the country started to appear on foreign investors' radar screens as an emerging market bellwether. This unleashed large foreign investments and buoyed business confidence, while increased exchange rate stability and expanding productive capacity have brought inflation under control and pushed interest rates to record lows. Coupled with government efforts to lift an unprecedented number of households out of poverty under the administration of former president Luiz Inácio Lula da Silva and more recently under his successor, President Dilma Rousseff, commercial credit growth has been running rampant.

However, even taking into consideration the structurally steeper trendline in the evolution of credit-to-GDP in Brazil over the past decade, the recent rate of credit expansion, particularly in relation to nominal GDP, has been rising above trend ( see chart below). Although the 'residual' has not been rising to levels suggesting that a period of deleveraging is imminent (it is still less than one standard deviation from its trendline), we believe that ongoing developments in the Brazilian economy could throw the recent rate of credit expansion into question in the not too distant future. Despite the government's best efforts, borrowing costs are heading higher as rising inflation has forced the central bank to hike interest rates by 225 basis points (bps) to 9.50% this year. Moreover, smaller banks' access to financing is becoming increasingly questionable as reliance on state development bank funding is becoming a major concern in light of recent government indications that a pullback could be on the cards ( see 'Credit Risk To Remain Elevated', March 27).

Steep Uptrend An Anomaly?
Brazil - Credit-To-GDP Ratio Versus Underlying Trend

The dominant role of state-owned banks has helped to increase household debt levels by offering interest rates well below those requested by private sector banks. This has been made possible by having the underlying backing of state development bank Bank Nacional de Desenvolvimento Econômico e Social (BNDES), allowing the government to indirectly provide access to cheap credit for lower-income households. More recently, these efforts have helped to push the household debt servicing ratio, which measures the cost of debt payments as a share of disposable income, lower. Accordingly, non-performing loan ratios have started to come down from their 2012 highs.

Debt Servicing Burden Still High By Historical Standards
Brazil - Household Debt Servicing Ratio & Personal Loan Default Rate, %

Nevertheless, we believe that macroeconomic headwinds are building and that demand for new credit will be curtailed by rising interest rates and a higher level of risk attributed to state-run banks. In line with this view, Moody's downgraded BNDES and CEF in March given their close relationship with government policy. Indeed, Brazil still has some of the highest non-performing loans ratio among BRIC economies (Brazil, Russia, India and China), and with the economy stuck in a rut, we expect banking sector asset quality to remain a concern. As we have previously highlighted, we believe that pressure for the Brazilian economy to rebalance is building, as external demand for Brazilian iron ore and steel exports is hit by a slowdown in Chinese economic activity.

We see little scope for consumers to pick up the slack. Instead, high labour costs and a challenging business environment will mean that the path of least resistance will be a steady depreciation of the exchange rate, in order to correct growing external sector imbalances ( see 'Commodity Currencies Likely Peaked As Rebalancing Takes Hold', October 1). This will significantly affect household consumption, in our view, not least due to the ensuing inflationary effects and continued emphasis on raising interest rates by the central bank.

Chile - Cyclically Overextended, Structurally Sustainable

Chile's credit cycle may not have a lot further to go to the upside in the foreseeable future, having moved over one standard deviation above its long-term average in recent quarters. However, because Chile's banking sector is mature and credit as a percentage of GDP already stands at almost 80% of GDP ( see chart), we do not see risks of overheating in Chile and note that disinflationary conditions, which have seen the central bank initiate a monetary easing cycle, should cushion against any sudden reductions in credit expansion in the foreseeable future.

Credit Expansion Starting To Look Overextended
Chile - Credit-To-GDP Ratio Versus Underlying Trend

Colombia - Still A Long Way To Go

Cyclically, Colombia's credit cycle could begin to look overextended to the upside, as the robust rate of expansion has seen credit as a share of GDP start to deviate notably from its long-term trendline. Even if the credit cycle is now beginning to head to new highs ( see right-hand chart below), we believe that at 37% of GDP, commercial credit in Colombia can continue to grow over the coming years. Rising investment in energy and infrastructure will help to solidify Colombia's economic performance, while easy monetary policy should bolster demand for new credit. Although a temporary retracement in credit cannot be ruled out based on the long-term regression analysis in the chart below, we believe that the Colombian banking sector still has major room for growth over the coming years in line with rising consumer segment in the economy ( see 'Unbanked Population Leaves Room For Major Retail Banking Growth', October 22).

Steep Trajectory Has Further To Run
Colombia - Credit-To-GDP Ratio Versus Underlying Trend

Indeed, even at current levels, the debt servicing burden for households is relatively low as a share of aggregate wages, even by historical standards. As such, our favourable outlook on the Colombian economy and recent efforts to lower borrowing costs by the central bank, bode well for a continuation of robust credit growth over the medium term.

A Manageable Burden
Colombia - Household Debt Burden, % Of Aggregate Wages

Mexico - Ready To Steepen Trend?

Recent robust loan growth in Mexico has seen the credit cycle move notably above the long-term trend, which admittedly has been underwhelming over the last 10 years. The trendline is relatively flat and despite heading towards one standard deviation from its long-term trend, commercial credit as a percentage of GDP still only makes up about 18% - about half the share of GDP seen in Colombia. Nevertheless, with some notable weakness in the construction and manufacturing sectors heading into the closing stages of 2013, we acknowledge that a return back down to trend cannot be ruled out, particularly if a recent rate cut by the central bank is followed by a more comprehensive tightening cycle in late 2014, as we currently anticipate ( see 'Fragile Recovery And US Uncertainty To Prompt Another Rate Cut', October 8).

On Trend
Mexico - Credit-To-GDP Ratio Versus Underlying Trend

Looking further ahead, we believe that Mexico's credit cycle has further to go, as recent reforms of the banking sector and our expectations of a rising middle class point towards a structural, rather than cyclical, shift in the credit cycle.

Peru - Vulnerable To A Temporary Deleveraging Process

Based on our assessment of Peru's credit cycle, a temporary deleveraging process cannot be ruled out, suggesting that the recent rate of credit expansion will unlikely be sustained. That said, the central bank unexpectedly cut its key reference rate on November 7 by 25 basis points (bps) to 4.00%, the first adjustment since July 2011. However, we do not anticipate additional interest rate cuts and believe that the move reflects a broader realisation among policymakers that the economy may be heading into a challenging period as mining activity may slow in line with a decline in Chinese economic growth ( see 'Rate Cut Signals Policymakers' Growth Concerns On The Rise', November 8). Therefore, as the economy is set to slow to 5.1% in 2013 and 4.9% in 2014 from 6.3% in 2012, the credit cycle in Peru will also likely begin to cool ( see 'Slowdown To Weigh On Loan Growth', June 19).

Not Ruling Out A Temporary Cooling
Peru - Credit-To-GDP Ratio Versus Underlying Trend

Over the longer term, however, we believe that Peru's credit cycle will adjust structurally higher, as the economy recalibrates towards greater domestic demand. At 28% of GDP, commercial credit is still low by regional standards. Although this highlights the high reliance on mining activity and exports, we believe that one of the highest economic growth rates in the region over the coming years combined with relatively tame inflation, should pave the way for low borrowing costs and steady credit expansion - we forecast average real GDP growth of 5.0% between 2013 and 2017.

Argentina - Steep Structural Uptrend To Remain Following Cyclical Adjustment

The rate of credit expansion in Argentina is likely to have peaked for the time being and we caution that signs of rising non-performing loan rates in the economy and a difficult macroeconomic environment could see Argentina's credit cycle return to trend, and possibly below in the foreseeable future ( see 'Banks Expanding Rapidly, But Risks Rising', September 18). Although still a long way off the pre-2001/2002 sovereign debt default levels, rapid credit expansion as a share of GDP has in large part been driven by stronger economic growth at times of elevated soft commodity prices and negative real interest rates in the economy.

Credit Cycle Overdone
Argentina - Credit-To-GDP Ratio Versus Underlying Trend

Nevertheless, credit as a percentage of GDP remains very low by historical standards and could have significant room to grow. In the near term, expectations of rising prices and a lower nominal value for the exchange rate will likely help to drive demand for credit to purchase tangible assets at a time when we estimate inflation to run closer to 25% year-on-year, rather than the officially reported 10% inflation rate. In the longer term, we believe that years of economic mismanagement by the government of President Cristina Fernández de Kirchner, and prior to that that of her late husband, Néstor Kirchner, may be coming to an end in the run-up to the 2015 presidential election ( see 'Policy Moderation To Fuel Bond Rally, But Risks Remain', November 11). Signs of diminishing political power following October's midterm election defeat for President Fernández's bloc, could be paving the way for more orthodox economic policies going forward, as the government is growing increasingly dependent on scarce foreign capital ( see 'Midterm Vote Signals Policy Moderation Ahead', October 28). Improving economic conditions could begin to drive demand for credit over the coming years, ensuring that the recent steep uptrend in Argentina's credit cycle remains in place following a cyclical adjustment lower.

Venezuela - Interventionism And Inflation Point To Further Upside

Severe inflationary pressures have also been responsible for driving up the rate of credit expansion in the Venezuelan economy, following a sizeable devaluation earlier in 2013 and a sharp expansion of the monetary base. Although still less than one standard deviation from its longer-term trend, Venezuela's credit cycle has started to deviate away from its 10-year old trendline. Runaway inflation and the high likelihood of another one-off devaluation of the bolívar fuerte in early 2014 ( see 'Bolivar Time Bomb Keeps Ticking, Towards 2014 Devaluation', October 1) suggest that the credit cycle may have further to run and that a return to two standard deviations from trend can be expected before a period of meaningful deleveraging sets in.

Responding To High Inflation
Venezuela - Credit-To-GDP Ratio Versus Underlying Trend
see 'Inflation Will Continue To Undermine Banks' Profitability', July 22

Some Methodological Drawbacks

We acknowledge that a simple time-series regression says more about where a credit cycle is in relation to its historical trend, than necessarily providing an indication of how sustainable it is at current levels. However, by supplementing our assessment with more qualitative factors, as well as making judgements based on absolute commercial credit volumes, we believe that the methodology applied helps to inform our general overview of where credit cycles currently are in the region.

Another drawback to this analysis is that the trends identified are time sensitive and therefore subjective in nature, since we choose to compare recent credit expansion with a 10-year trendline, rather than looking at even longer averages. We acknowledge that the past decade may have been somewhat of an anomaly in the rate of credit expansion relative to national output levels, due to the unprecedented flow of foreign investment in Latin American economies and lower trending interest rates. Therefore, we believe that the analysis pursued in this article can be put into a broader context of the direction of monetary policy and the existence of structural imbalances, to help understand whether a period of deleveraging will likely follow recent credit expansion in an economy, or whether credit as a share of GDP can continue to rise.

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