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Gradual, well-signalled US monetary tightening over the next few years should be manageable for most Asia-Pacific banks, but markets with higher dependence on foreign funding and external debt levels will be more vulnerable due to potentially higher market, credit and liquidity risks, says Fitch Ratings in a special report published on Friday.
Fitch’s base case is for the Fed fund rate to be raised to 3.25% by end-2019, although there could be abrupt changes in market expectations along the way. The feedthrough to Asia-Pacific banks will fall broadly under three transmission channels: US dollar interest rates, foreign-exchange movements and local interest rates. These in turn will have implications for banking sectors’ market, credit and liquidity risks.
Most banking systems have some vulnerability to market risk, although these appear to be limited. Among developed markets, Hong Kong and Singapore have high foreign-currency exposure linked to their roles as financial centres and may also be vulnerable to shifts in investor sentiment that cause market volatility. In emerging market banking sectors, Mongolia and Sri Lanka are vulnerable, with higher levels of foreign-currency liabilities and potential spill-over from macroeconomic weakness.
Higher US rates could also feed through to local interest rate rises, which would most likely affect credit risks in most markets. The degree of pass-through from US dollar to local rates is uncertain, but emerging-market banking systems that stand to be affected by higher local rates and that have thin buffers include China and Vietnam. Indian banks could also be negatively affected by higher local rates in terms of asset quality and from the market risk impact on their security holdings.
Emerging markets will also be more exposed to liquidity risk should rising US rates lead to a capital flight-to-safety scenario, as in previous periods of tightening global liquidity and financial crises. Severe market stresses, including large capital outflows and difficulty in accessing offshore funding markets, is a tail risk that could affect Asia-Pacific banking sectors more harshly than we currently envisage. It is notable that Asia-Pacific banking sectors showed little vulnerability during the last Fed rate hiking cycle from 2004-2006, when the target rate rose to 5.25% from 1.00%. This period mostly correlated with a benign environment, including stable or improved asset quality, profitability and capital adequacy. Since then, most Asia-Pacific banking systems have increased leverage, in some cases, substantially.
That said, the regulatory environment has also become more rigorous, with the adoption of Basel III, increased usage of macro-prudential policy measures and the introduction of “endgame” regulations, such as resolution regimes.
Sri Lankan banks’ vulnerability to Fed tightening has been classified as ‘Medium’ by Fitch along with the other emerging markets of China, India, Indonesia, Mongolia and Vietnam.
Only Malaysia and the Philippines have been classified as ‘Medium/low’ and Thailand as ‘low’.
