Compressed margins and bad debts will curtail profits in the coming year

• The operating environment for the banking and financial service industry in APAC is expected to worsen as trade tension continues to weigh on GDP growth in the region
• Beyond China, the growing level of household and private sector debts in other APAC countries is an emerging source of risk
• Across the region, regulators are introducing new licensing frameworks for digital banks to operate, often with consortia of banks, fintech and big tech companies applying

China continues to cast a long shadow over the Asia Pacific (APAC) region. Deterioration in its ongoing trade dispute with the US has dampened business investment, economic growth and worsened the operating environment for banks in the region. In the short run, some South and Southeast Asian economies may benefit from production reshoring and the shifting of supply chains away from China, but will nevertheless be affected by persistent and sharp slowdown in the country. China’s economy has decelerated faster than expectations, growth slowed to an estimated 6.1% in 2019 versus 6.8% in 2018.

 “Developed Asia will still suffer from weak demand and a decelerating Chinese Compressed margins and bad debts will curtail profits in the coming year economy, while ASEAN with the exception of Singapore will continue to be the bright spot remarked Alicia García Herrero, the chief economist for Asia Pacific at French investment bank Natixis."

She added that 2020 is likely to be more uncertain and fraught with unanticipated event risks than the year before. "Since we started the year, we have already had two major shocks. One was a political shock, the US attack on Iran and Iran’s retaliation. China is a very large investor in Iran and a very large oil importer and I think that increasingly, the US administration is going to come after China in the realm of sanctions rather than tariffs and trade. The second is the Coronavirus. So far, it’s basically a China risk but it could become a global risk," she opined. 

Another key risk for China is the deteriorating health of its corporate sector, especially among private companies. “Credit to the private sector is key for China’s growth but the transmission mechanism is not working well for a number of reasons, including rising fragility in smaller banks which are the most important source of funding of private firms,” commented Garcia Herrero.

The mounting debt in the household sector, particularly in mortgages, also contributes to the growing private sector debt in the country. While this is seen as well under the control of the financial regulators, the primary concern is that measures to rein in the household debts problem will precipitate a drop in household consumption, disrupt the country’s long-term economic growth momentum with spill over impact on the region.

Worsening operating environment

Despite the recently signed phase one trade agreement between the US and China, tariffs and uncertainties remain very much on the table. The operating environment for the banking and financial service industry in APAC is expected to worsen as trade tension continues to weigh on GDP growth in the region. As governments adopt a more accommodative monetary stance to spur growth, interest margins will fall and asset quality risks will rise.

International credit rating agency Moody’s Investor Service (Moody’s), has assigned a negative outlook for the banking industry in Asia Pacific over the next 12 months, citing the US-China trade dispute as the key driver of weaker economic and trade activities in the region, and the erosion of investor confidence.

 “Weaker economic and trade conditions will lead to moderate increases in problem loans for APAC banks,” says Eugene Tarzimanov, a Moody’s vice president and senior credit officer.

He continued: “Meanwhile, banks’ profitability will fall, because they are raising credit provisions while central banks are cutting interest rates to support economic growth.”

“However, APAC banks have generally maintained good capital and liquidity buffers and the probability of government support for these banks will stay high, except for the banks in Hong Kong, because the territory is the only jurisdiction in APAC with an operational resolution regime,” remarked Tarzimanov.

On the positive side, Garcia Herrero cited evidence of an ebbing of key external risks witnessed in 2019 , namely Brexit and the trade-war. However, prospect of a V-shaped recovery remains elusive.

“To add to the positive sides of 2020, central banks will continue to be supportive. Asia is expected to muddle through in 2020 with less friction to growth but saddled by demographic trends and, in some cases, by growing debt,” she added.

High private sector debt

Beyond China, the growing level of household and private sector debts in other APAC countries is an emerging source of risk. However, regulators have been actively reining in excessive credit to the sector and the build-up in leverage is generally moderating.

 According to Moody’s, most APAC banking systems have passed the stress test on capital, except for the banks in India, Sri Lanka and Vietnam, which have lower starting capital ratios and higher starting problem loan ratios.

In particular, elevated property prices will remain a key risk for many banking systems in APAC, due to rapid price appreciation in recent years.

Despite the cooling of price growth in some markets in recent years, lower interest rates in APAC can lead to a renewed surge in property prices, which would be credit negative for banks.

In particular, loans for real estate investment pose a greater risk for banks in Australia, New Zealand and Malaysia, while Indian banks are exposed to the risk of developer financing.

Asset quality will come under pressure Problem loan ratios are expected to increase modestly in many markets. A number of banking systems will post lower non-performing loan ratios, as banks start to address their legacy problem loans.

Coverage against loan loss is generally strong in APAC, with the weighted average for banks rated by Moody’s standing at 150%. Most systems have adopted IFRS 9 accounting standards, with limited impact on banks’ capital and earnings. India, Indonesia, Thailand and Vietnam have yet to implement the new standards.

APAC banks’ capital buffers have been growing for many years since the implementation of Basel II/III risk-based regulatory capital regimes. They have generally kept good core capital buffers that will shield them from rising credit risks.

One mitigating factor about banks’ solvency is the generally held assumption of government support. APAC governments are expected to continue to support banks in cases of need. Reflecting this, the senior unsecured and deposit ratings of most banks in the region include uplifts for government support. Hong Kong so far remains the only market in the region that has an operational resolution regime with statutory bail-in powers.

“In addition, banks in most systems in the region have also maintained strong liquidity positions. They are primarily funded with deposits with limited reliance on market funding,” said Tarzimanov.

Most jurisdictions have successfully implemented reforms to strengthen funding and liquidity, including liquidity coverage ratio and net stable funding ratio requirements. This will help banks maintain robust funding and liquidity.

Other risks that will impact Asia Pacific banks

To mitigate the impact of lower margins banks that are advanced in their digitalisation programmes may experience some relief as they scale down branch networks, automate and replace manual processes, and reduce costs in the long-term.

In fact, across the region, regulators are introducing new licensing frameworks for digital banks to operate, often with consortia of banks, fintech and big tech companies applying.

However, increased digitalisation has also exposed the industry to risks from cyber crimes and frauds.

“Cyberattacks can hurt banks’ credit strength by causing financial losses, eroding brand value and customer trust, and triggering regulatory fines,” said Tarzimanov.

Finally, banks and regulators in the region are also starting to develop and implement sustainable banking and financing policies and guidelines that are aligned with environmental, social and governance principles and best practices.

Compliance to new sustainable banking regulations could open a new area of risks. Banks for example, could be subject to the risks of stranded credit exposures as non-compliant assets may lose value or non-compliant practices may subject them to regulatory sanctions.