Increasingly Positive Outlook For Emerging Europe's Banks

BMI View: Following a challenging few years, the outlook for banks in Emerging Europe is beginning to look much more promising, as improving external demand bolsters economic activity. However, direct and indirect FX exposure remains a major risk to recovering profitability, particularly in light of the potential for domestic bond market dynamics to create exchange rate pressures.

As signs point towards an ongoing recovery in eurozone demand, the outlook for Emerging Europe has improved considerably, and an export driven recovery across Central (CE) and South-Eastern Europe (SEE) is already underway. While 2012-13 was a challenging period for the banking sector, which struggled against a sharp slowdown in domestic demand, financial market volatility, FX weakness and deteriorating asset quality, the outlook for 2014 is much more promising. In CE and SEE markets, domestic demand should continue its recovery throughout the year, leading a recovery in both retail and corporate credit. Meanwhile, Turkish credit growth will remain at risk of rate hikes, which we believe will have to be implemented in order to stem capital outflows, while Russian credit growth will remain robust, but is liable to decelerate slightly next year.

While the outlook is increasingly positive, we identify several thematic trends across the region that pose risks to recovering profitability, and in some cases, sector stability. In particular, we highlight the risks arising from direct and indirect FX exposure, particularly in light of the potential for exchange rate pressures to arise from the high level of foreign investors present in illiquid domestic bond markets such as Romania and Hungary.

Turkey Remains The Most Vulnerable
Excess Credit Growth & Current Account Balances

Increasingly Positive Outlook For Emerging Europe's Banks

BMI View: Following a challenging few years, the outlook for banks in Emerging Europe is beginning to look much more promising, as improving external demand bolsters economic activity. However, direct and indirect FX exposure remains a major risk to recovering profitability, particularly in light of the potential for domestic bond market dynamics to create exchange rate pressures.

As signs point towards an ongoing recovery in eurozone demand, the outlook for Emerging Europe has improved considerably, and an export driven recovery across Central (CE) and South-Eastern Europe (SEE) is already underway. While 2012-13 was a challenging period for the banking sector, which struggled against a sharp slowdown in domestic demand, financial market volatility, FX weakness and deteriorating asset quality, the outlook for 2014 is much more promising. In CE and SEE markets, domestic demand should continue its recovery throughout the year, leading a recovery in both retail and corporate credit. Meanwhile, Turkish credit growth will remain at risk of rate hikes, which we believe will have to be implemented in order to stem capital outflows, while Russian credit growth will remain robust, but is liable to decelerate slightly next year.

Turkey Remains The Most Vulnerable
Excess Credit Growth & Current Account Balances

While the outlook is increasingly positive, we identify several thematic trends across the region that pose risks to recovering profitability, and in some cases, sector stability. In particular, we highlight the risks arising from direct and indirect FX exposure, particularly in light of the potential for exchange rate pressures to arise from the high level of foreign investors present in illiquid domestic bond markets such as Romania and Hungary.

FX Regulatory Risks Loom Large

Banks in CE and SEE will continue to reduce FX exposure, due partly to regulatory restraints (in Poland, Hungary and Croatia) but also due to the low interest rate and inflation environment which has lowered borrowing costs in local currency terms. This is positive for systemic risk, although banks are liable to suffer in countries such as Hungary and Croatia, where the government has decided to shift the burden of FX risk onto the banking sector, rather than the consumer. While the additional burden of losses generated from adjusting FX loans will generate short-term losses, we think that governments across the region will be wary of imposing terms that are excessively punitive on banks, for fear of pushing any institutions towards a bailout.

Exchange Rate Stability Is A Concern
Bank External Debt Levels, %

To illustrate the point, Croatian banks estimate they will face losses of around EUR46mn a year if the government pushes ahead with a law to restrict variable interest rates on FX-denominated loans. In Poland, the opposition party has seized on FX loans as a political issue ahead of elections, forcing Poland's regulator to warn that an FX to zloty-mortgage conversion could see bank's absorb around USD16bn in losses, forcing three banks into insolvency. However, we think forced FX loan conversions remain unlikely in Poland due to largely absent political willpower over the issue.

Furthermore, indirect FX exposure remains a substantial risk to banks across the region ( see 'EM Selloff: Bad For Growth, Good For Valuations', July 15 2013). While many banks have net neutral FX exposure on their balance sheets, the high level of FX loans in Turkey, Poland, Hungary, Croatia and Romania leaves banks increasingly at risk of deteriorating asset quality in the event of exchange rate weakness, which would cause debt servicing costs to rise.

Rising Local Policy Rates Bring Benefits...

As the chart below shows, central banks across Emerging Europe have been in easing mode since 2012, leading average regional policy rates down to multi-year lows. However, with economy activity picking up pace, we think the rate easing cycle will have bottomed out by end-2013, and expect rates to begin to rise again in 2014. This is a positive development for the banking sector, as steepening local yield curves should improve net interest margins. Indeed, low rates have not been as beneficial for lending conditions as many monetary authorities might have hoped, for several reasons.

Easing Cycle Drawing To An End
Emerging Europe - Simple Average Of Central Bank Policy Rates, %

First, the majority of banks in Emerging Europe have loan-to-deposit ratios around 1.0x, implying a limited requirement for wholesale financing. Lower base and interbank rates are therefore less effective as lowering the cost of funding for banks. Indeed, weak loan demand has made banks disinclined to leverage up on cheaper financing. Furthermore, the deposit structure in Emerging Europe is often skewed towards term-deposits, meaning that deposit funding costs can stay resistant to changes in the base rate, while high competition between banks drives down the cost of loans, adding pressure to net interest margins. Finally, the presence of floating rate loans in countries like Poland has also squeezed margins for banks, which have seen cash flows reduced for these assets.

A Better Year Ahead
Regional Credit Growth, September 2013, % chg y-o-y

...But Tighter Global Liquidity Creates Risks.

However, developed state quantitative easing on global interest rates has created some unusual distortions in the markets. In particular, excess liquidity in the markets created a global hunt for yield, which saw investors pile into increasingly higher risk and less liquid bond markets in order to generate positive return. Domestic debt markets in Emerging Europe as well as most other emerging markets were affected, and we have frequently flagged our concerns surrounding the concentration of non-resident bondholders in relatively illiquid markets, and the potential for a 'vicious circle' to develop.

Concentration Of Foreign Investors In Illiquid Markets Poses FX Risks
Foreign Investor Ownership Of Domestic Debt (% total) and as a share of daily volume (days) - shared axis.

Foreign investor holdings of local debt in Poland, Romania, Hungary and Turkey are on average 60% higher than their seven year average. This creates a particular problem for less liquid markets such as Romania and Hungary, where foreign investor bond holdings are equivalent to around 19x and 25x average daily volume. The major risk is that expectations of rising rates, either in developed markets or domestically, triggers foreign investors to pull out, creating pressure on the local currency. Furthermore, economic activity still relatively subdued, the domestic banks may be unwilling or unable to increase purchases of government bond holdings, increasing the risk of a rapid sell-off.

Banks Still Dominant Holders
Ownership Composition Of Domestic Debt, % total

While bond market losses are clearly negative for foreign investors, domestic banks across the region will inevitably suffer too. Indeed, with a few exceptions, domestic banks remain the largest holders of government bonds across most of Emerging Europe. Government debt securities as a percentage of the banking sector's equity is greater than 100% in the Czech Republic, Slovenia, Slovakia and Hungary. Low loan growth has prompted banks to increase their government debt holdings in order to maintain net interest margins, reinforcing the sovereign feedback loop in the process. Furthermore, fixed income assets will generally lose value in a rising interest rate environment, resulting in spot loss for 'held for trading' and 'available for sale' bond holdings. The risk is particularly severe for countries exposed to 'hot money' flows: Turkish bank capital ratios fell by 180bps to 15.5% in October after sovereign yields soared by an average of 300bps.

Reinforcing The Sovereign Feedback Loop
Banks - Sovereign Bond Holdings As A Percentage Of Equity, %

Despite these risks, we believe the outlook for the banking sector is broadly positive. The economies of Central and South Eastern Europe, in particular, should continue to experience a resumption in external and domestic demand as long as the eurozone recovery remains in play, leading to rising loan demand and improvements in non-performing loans. CEE banks have the highest equity/assets ratio globally, beating LatAm, Emerging Asia and all developed regions, and implying these banks are better insulated from volatility and other external shocks.

CEE Banks Least Leveraged
Global - Large Bank Tangible Leverage Ratios, Q4 2012

The improving economic outlook in CE and SEE also bodes well for non-performing loans, although we stress that stable exchange rates will also be a major determinant of asset quality over the coming quarters. Sizeable direct and indirect FX exposure remains a major risk to the banking sector in Emerging Europe, and weakness in the exchange rate, triggered by the 'vicious cycle' discussed above or other factors, will raise debt servicing costs on FX loans and weaken the overall quality of the loan book. The Turkish lira's 18% slump against the dollar coincided with a 74% increase in corporate non-performing loans in August. These risks are prevalent not only in Turkey, but also in Poland, Hungary, Romania, Croatia, Serbia and Ukraine, primarily due to legacy FX loans to households, in contrast to Turkey where FX exposure is predominant among corporates. Overall, while the sector still faces some near-term challenges, relative to other regions, Emerging Europe banks are starting to look quite attractive again.

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