Tag: Fitch Ratings

Lower Capital Hurdles Favor U.S. Trust, Custody Banks

The Federal Reserve’s and the Office of the Comptroller of the Currency’s proposed changes to the enhanced supplementary leverage ratio (eSLR) and total loss-absorbing capacity (TLAC) ratio, would provide the most capital relief to trust and custodial banks relative to other U.S. global systemically important banks (GSIBs), Fitch Ratings says.

 

These changes are unlikely to result in near-term rating implications, though this proposal and the impact of other recently proposed rules that reduce capital requirements are credit negative for the sector. The ultimate ratings impact will depend on how individual US GSIBs respond to potentially looser regulatory standards and lower capital requirements.

The proposal would change how the US GSIBs’ eSLR and TLAC ratios are calculated to include half of their respective GSIB capital surcharge as a percentage of risk-based capital, providing the most relief to firms with the lowest relative capital risk. The Fed estimates the proposed changes would reduce the required amount of Tier 1 capital of the US GSIBs by four basis points, or approximately $400 million, and would reduce the amount of Tier 1 capital required across the lead IDI subsidiaries of the GSIBs by approximately $121 billion.

Currently, GSIBs must meet an eSLR of at least 5% at the holding company level, comprised of a minimum 3% base requirement plus a 2% standard buffer, while GSIB insured depository institution (IDI) subsidiaries need a minimum of a 6% SLR to be deemed “well capitalized.” Under the new proposals, eSLR ratios would be adjusted lower to the sum of the 3% required minimum plus 50% of the respective banks’ GSIB surcharge, instead of the prior standard. The same application of the proposed rule would apply for IDIs, replacing the 6% required minimum to be deemed well capitalized.

Amendments to the eSLR calculation, which apply to U.S. GSIBs and their IDIs, would benefit custody and trust banks the most. State Street and Bank of New York Mellon have the lowest GSIB risk-based capital surcharge of 1.5%, which could potentially result in lowering their eSLR by 1.25% at the holding company and up to 2.25% at the IDI level. The proposed amendments don’t incorporate the changes presented in the Senate bill to ease Dodd-Frank Act requirements, which would allow the trust and custody banks to remove certain safe assets such as Fed deposits from their leverage ratios if the bank was predominantly engaged in custodial banking.

Under the proposed legislation, the amount of required eligible debt required for total loss absorbing capital (TLAC) would also fall. The bank holding company TLAC leverage buffer, like the SLR calculation, would be also modified to 50% of the GSIB risk-based capital surcharge buffer, instead of a fixed 2% leverage buffer. The leverage component of the long-term minimum debt requirement would be cut to 2.5% from 4.5% previously.

China RRR Cut Supports Bank Liquidity, Not Stance Change

The cut in China’s required reserve ratio (RRR) is an example of the authorities using its array of policy tools to guard against liquidity shortages, particularly in prioritised sectors, as it continues its efforts to contain financial risks, says Fitch Ratings.

We continue to believe the authorities’ commitment to tackling risks could be tested if economic growth slows, but we do not interpret this RRR cut as a step toward more expansionary policy. The People’s Bank of China (PBoC) emphasised that its “prudent” monetary policy stance remains unchanged.

The one-percentage point cut will apply to banks that faced high RRR ratios (of 17% or 15%), which includes the large banks, mid-tier banks, city banks, non-county rural and foreign banks. The freed-up liquidity will be used to first repay outstanding medium-term lending facility (MLF) loans, which the PBoC estimates at CNY900 billion. This leaves around CNY400 billion of additional liquidity that will be released into the market, with city and non-county rural banks the most likely to benefit. The PBoC expects these banks to use the extra liquidity to support lending and lower interest rates to micro enterprises, and this will form part of these banks’ Macro Prudential Assessment.

The changes will lower funding costs for banks that currently use the MLF. Banks earn interest of 1.6% on their required reserves, while they pay interest of 3.2% to the central bank on MLF loans. The requirement that banks increase lending to micro enterprises will alleviate pressure on borrowing costs for this targeted sector. It reflects efforts to support inclusive finance – an important component of the authorities’ reform agenda – and is in keeping with the more targeted RRR cut in September 2017, which only applied to banks that meet criteria on lending to rural and micro enterprises.

We stated in previous research that ordinary liquidity support would be forthcoming for banks to manage financial system risk and control financing costs for the real economy. Accordingly, this RRR cut aims to alleviate banks’ funding cost pressures, while ensuring targeted sectors receive adequate and lower-cost bank funding. We believe it should be viewed in this way, rather than as a shift in policy stance. Indeed, macro-prudential tightening measures – aimed at curbing shadow banking and excessive reliance on inter-bank funding – have been more concerted and persistent than we had previously expected. The measures contributed to a slowdown in growth of bank claims on non-bank financial institutions to 3% yoy in February 2018, compared with a 40% CAGR from 2013-2017.

That said, overall renminbi loan growth of 12.8% at end-March was still higher than renminbi deposit growth of 8.7%, implying continued deposit pressures at banks. Recent comments from the PBoC governor also emphasised the ongoing shift toward more market-driven interest rates, while local media reported that the PBoC may relax its informal guidance over bank deposit rates, which may lift deposit costs further.

We still expect efforts to contain financial risks to remain the policy focus through most of 2018, bolstered by the authorities’ confidence in the strong growth momentum sustained over the past year. Nevertheless, the government still clearly places much store in achieving high growth rates – and in particular its target of doubling real GDP per capita between 2010 and 2020. The 2018 growth target is set at around 6.5%, virtually unchanged from 2017’s target. This suggests that near-term growth would not be allowed to fall too far without a policy response. Macro-prudential tightening has so far been made in the context of growth exceeding targeted levels.

US’s China Tariffs May Create Risks for Some APAC Corps

The US government’s plan to impose 25% tariffs on imports from China across 1,333 product lines creates risks and complications for affected companies, and could be disruptive for regional and global supply chains, but the direct financial impact on Fitch-rated corporates in APAC is likely to be limited, says Fitch Ratings.

The announced tariffs cover around USD50 billion of Chinese exports, which we estimate would not have a significant effect on the Chinese or global economy. Subsequent and escalating tariff proposals by the Chinese and US governments have increased the risk of a full-blown trade war, and in that event the impact on APAC corporates would be more significant. However, we still believe a negotiated solution is most likely.

Televisions, printers, electronic components and motor vehicles are notable products covered by the US’s initial tariffs – in terms of the value of Chinese exports to the US. The importance of the US as an export market varies across these products. Almost one-third of China’s television exports and 28% of its motor vehicles exports are sent to the US. At the other end of the scale, only 8% of semiconductor shipments and 14% of electrical circuit apparatus go to the US, which should soften the impact on technology companies. Component manufacturers could be affected indirectly by a decline in exports of final products, although the list tended to avoid those products to limit the impact on US consumers.

Companies reliant on products included in the chart – particularly those toward the top – could be the most at risk, at least as far their exports are concerned. That said, the domestic market is more important than exports for many companies with operations in China, particularly Chinese firms. The domestic sales of Chinese automakers dwarf their exports, for example. The US is an important growth market for Hikvision – the only publicly Fitch-rated Chinese technology company likely to be affected by the tariffs directly – but around 70% of its external sales go to domestic customers.

Most Fitch-rated Chinese industrial companies do not export much to the US. Exports account for around half of Midea’s sales, but most go to emerging markets. The impact on Chinese clean-energy companies is likely to be minor. Wind-powered electric generating sets were included on the tariff list, but US imports from China were worth just USD36 million in 2017. Technology barriers have made it difficult for Chinese wind-turbine companies to enter the US market.

Foreign-owned Chinese exporters might be among the most affected by the tariffs. They accounted for 31% of exports last year, and joint ventures another 12%. These figures reflect China’s central role in regional and global supply chains, which could be disrupted by the tariffs.

Companies with the capacity to increase production outside of China might benefit from a shift in US demand, as the tariffs will boost their competitiveness relative to firms that rely on Chinese operations. This could be the case for Asian television manufacturers, such as Korea’s Samsung and LGE, which make most of their televisions in Mexico, Vietnam and Korea. However, a drop in component sales to China is likely to offset any potential upside for these firms. Among Japanese firms, Panasonic is no longer a significant manufacturer of televisions, while Sony focuses on the premium segment where it does not compete directly with Chinese companies.

Tariffs on imports of Chinese components could create complications for manufacturers in the US, highlighting the global nature of supply chains. The credit impact would vary – sectors with global footprints might be less affected, given the ability to shift sourcing and production.

China Can Cope With US Tariffs, But Trade Risks Rising

The US government’s proposal to impose tariffs on USD50 billion-USD60 billion worth of imports from China is unlikely to have a significant impact on the Chinese or global economy, says Fitch Ratings.

The risk that piecemeal protectionist measures escalate into a more damaging trade war has risen in recent months, but China’s measured response so far and US indications of openness to negotiation suggest this scenario should still be avoided.

The US administration has proposed the tariffs in response to what it considers to be unfair Chinese trade policies that have led to the acquisition of US technologies – invoking the authority provided by Section 301 of the US Trade Act. Aerospace, information and communication technology, and machinery will be targeted, with details due within the next two weeks. The administration will also consider measures to block Chinese acquisition of US technology through M&A and press the World Trade Organization to examine China’s technology licensing practices.

USD60 billion is equivalent to around 2.5% of China’s total merchandise exports, or 0.5% of its GDP, but the impact of the tariffs on the Chinese economy would be much smaller. Some of these goods will still end up going to the US, given the lack of substitutes, while others could be diverted to different markets. Moreover, the domestic value-added content of China’s exports is typically only around two-thirds, or less than one-half in the case of ICT goods, which contain a high proportion of imported inputs. Overall, we would not expect these tariffs to create a drag on Chinese GDP growth of much more than 0.1 percentage point this year.

The bigger risk is that the US eventually imposes across-the-board tariffs on China, either because its bilateral trade deficit with China stays large or in the context of an escalating trade war between the two countries. The US accounts for almost one-fifth of China’s total exports, equivalent to 3.6% of Chinese GDP, so broader tariffs could have a sizeable impact on China’s economy, and would have knock-on effects for the supply chain across the rest of Asia. A China-US trade war would also undermine global investor sentiment.

This more severe scenario cannot be ruled out, but we still expect new policies, either from the US or China in retaliation, to continue to fall under sector-specific measures. China has announced its own tariffs targeting USD3 billion worth of US agricultural goods in response to previous US tariffs on steel and aluminium, but Premier Li Keqiang has stated that “a trade war does no good to either side”. Meanwhile, US President Donald Trump has stated that the US and China are in negotiations. In that respect, the 30-day consultation period following the release of US tariff details should temper the prospect of immediate escalation and could provide time for a compromise to be reached.

A more challenging external environment could add to the risk of Chinese policymakers falling back on credit-fuelled stimulus, which would also be a major setback to the deleveraging agenda. Strong external demand was a key factor behind the outperformance of China’s economy last year, which allowed the authorities to focus on addressing financial risks without jeopardising GDP growth targets.

Global Shadow Banking Sees Heightened Regulatory Scrutiny

Continued increases in shadow-banking regulation should be a net positive for system-wide stability and liquidity if maintained over the medium term, says Fitch Ratings.

Overall shadow-banking asset levels have remained manageable. However, more rapid growth in certain regions and activities is expected to attract additional regulatory scrutiny, given the potential indirect effects of market interconnectedness and/or asset price volatility on the overall financial system.

Shadow-banking assets were $45 trillion, as of YE16, or 13.2% of total global financial assets, according to the Financial Stability Board (FSB). This marked an increase of 7.6% over the previous year. In the US, shadow-banking assets remained relatively stable at $14.1 trillion, as of YE16, or 31.6% of total global shadow-banking assets. Conversely, China’s shadow-banking assets increased to $7 trillion, rising from 1.4% of total global shadow-banking assets in 2010 to 15.5% at YE16, a 40.1% CAGR on an exchange rate-adjusted basis, according the to the FSB. Euroarea shadow-banking assets were $10.1 trillion, as of YE16, falling to 22.4% of total global shadow-banking assets from 27.3% in 2010.

Of the $45 trillion of global shadow-banking assets at YE16, 72% were held by collective investment vehicles, such as open-end fixed income, money market, and credit hedge funds, which largely drove asset growth for the last five years. The inherent redemption risk of these vehicles could pressure asset prices in the event of runs, particularly if material leverage is employed.

Globally, banks continue to have modest direct exposure to Other Financial Intermediaries (OFIs), the FSB’s broad measure of shadow-banking activity, both in lending and borrowing. At YE16, aggregate funding and credit interconnectedness between banks and OFIs approximated pre-crisis (2003-2006) levels after several years of decline. Banks’ claims on OFI assets were $6.3 trillion, or 5.6% of total bank assets, while funding from OFIs was $5.9 trillion, or 5.4% of total funding. That said, given the level of broader interconnectedness between banks and shadow-bank participants, and the potential for regulatory arbitrage to be employed by market participants, global regulatory scrutiny is expected to continue.

China’s regulators have responded to rapid shadow-banking growth with increased oversight, particularly on wealth management and trust products, the origination, of which, have begun to level off after years of growth. The increased regulation is aimed at improved transparency and disclosure in order to reduce contagion risks within the system, rather than reducing the scale of shadow banking, which could disrupt the stability and liquidity of the financial system. We believe the Chinese government will continue to focus on regulation as long as it does not materially hamper GDP and economic growth.

China’s shadow-banking sector is more systemic and complex than other more developed markets, with the extent of interconnectivity and risk, creating significant potential risk for Chinese banks. Unlike the US, where non-banks tend to be the dominant shadow-banking participants, banks are a key component in China’s shadow-banking ecosystem. While the shadow-banking products in China may be less complex than in the US, the evolving implicit/explicit guarantees in China make it more difficult to pinpoint who bears the ultimate investment risk. Smaller Chinese banks, relying on the interbank market and shadow banking for liquidity, may see rising funding costs as a result of increased regulation, while larger banks with stronger deposit franchises may be relatively better insulated than smaller, less capitalized peers.

Global Growth Is Booming, Central Banks Turning Less Cautious

The global economy is experiencing boom-like growth conditions and central banks are becoming less cautious as inflation risks rise, according to Fitch’s latest “Global Economic Outlook” (GEO). As a result, Fitch predicts further interest rate rises over the next couple of years.

The US, eurozone and China are all likely to grow well above trend in 2018 and global economic growth is set to remain above 3% for three consecutive years until 2019, a performance not achieved since the mid 2000s.

“The acceleration in private investment, pro-cyclical US fiscal easing and global monetary policies that are still very loose are all boosting growth in the advanced economies, while high commodity prices and the weakening of the dollar have underpinned the emerging market recovery. China is gently touching the brakes but is still prioritising high growth in the near term,” said Brian Coulton, Chief Economist at Fitch.

Growth in advanced economies is benefitting from a strengthening investment cycle as business sentiment improves, external demand picks up and labour resources become increasingly scarce. Tax reforms in the US could also boost investment. The pick-up in bank lending in the eurozone is particularly helping small and medium-sized firms, which account for half of capex, but reduced economic and policy uncertainty and rising capacity utilisation rates are also supporting the investment outlook. We have revised up investment forecasts for the US and the eurozone.

Consumer spending in advanced economies is benefitting from the ongoing tightening in labour markets. Global monetary policy settings remain highly accommodative and credit conditions very easy despite the recent increases in bond yields. US fiscal policy is being eased aggressively, with the federal deficit likely to rise to over 5% of GDP by 2019 from around 3.5% in 2017.

Strong growth and declining unemployment have increased inflation risks in the advanced economies but a sharp surge in inflation still seems unlikely. The trade-off between inflation and unemployment has flattened in recent years, headline unemployment rates may understate slack and rising investment could boost productivity, holding down unit labour costs. Nevertheless, diminishing spare capacity is cementing the move towards monetary policy normalisation.

“Central banks are becoming less cautious about normalising monetary policy in the face of strong growth and diminishing spare capacity. We expect the Fed to raise rates no less than seven times before the end of next year. And while still sounding tentative, the ECB is clearly laying firm groundwork for phasing out QE completely later this year. We now also expect the BoE to raise rates by 25bp this year,” added Coulton.

We expect China’s economy to slow in 2018 as credit growth decelerates, housing sales flatten off and investment growth eases. Macro-prudential tightening has been a bit more concerted than expected but the authorities have recently reaffirmed their commitment to maintaining high growth rates in the short term. The wider emerging-market recovery has been helped by a weaker dollar and rising commodity prices but these benefits are likely to fade. We expect oil prices to fall back below USD60 per barrel (Brent) and the dollar to be supported by faster Fed rate rises and improving US growth prospects.

We have again upgraded growth forecasts as the eurozone recovery powers ahead, US fiscal policy eases by more than anticipated and investment prospects improve. US growth has been revised up to 2.7% in 2018 and 2.5% in 2019 from 2.5% and 2.2%, respectively, in our December 2017 GEO. Eurozone growth has been revised up to 2.5% in 2018 and 1.8% in 2019 from 2.2% and 1.7%, respectively. China’s 2018 forecast has also been revised up slightly (by 0.1pp) but growth is still expected to slow to 6.5% from 6.9% in 2017. Growth forecasts for Japan and the UK are unchanged for 2018 at 1.3% and 1.4%, respectively.

The key risks to the forecasts are a sharp pick-up in US core inflation – which would necessitate more abrupt, growth-negative adjustments in interest rates – and a major escalation in global trade protectionism. US-China trade tensions seem highly likely to increase in coming months but the situation would have to deteriorate quite dramatically to adversely affect the near-term global growth outlook.

Australia Leads the Way on ‘Basel IV’, Banks Well Placed

The Australian Prudential Regulation Authority (APRA) has continued to burnish its conservative credentials by being the first regulator to publish proposals to implement the Basel III endgame standard, also known as “Basel IV”, says Fitch Ratings.

APRA proposes to implement a stricter variant of the international reforms published last December on an accelerated timeline. We do not expect Australian banks to have any difficulty meeting the proposed capital requirements, but changes in risk weights could lead to modest adjustments to the mix of their loan portfolios over time.

The changes published in two discussion papers on 14 February 2018 amend elements of the “unquestionably strong” requirements that were first outlined in July 2017. APRA proposes to adopt tougher risk-weighted asset (RWA) standards, including the controversial output floor, which will prevent modelled capital requirements from falling below a certain level, by 1 January 2021, without the five-year phase-in period that most countries are likely to allow. The discussion paper details extensive “gold-plating” of capital requirements, with increased requirements for retail exposures, loan and credit card facilities, and investment and interest-only residential mortgages compared to international norms. Similarly, APRA has proposed a minimum 4% leverage ratio, which is above the globally agreed 3% minimum.

Australian banks are already well on the way to meeting APRA’s “unquestionably strong” requirements, and the regulator has indicated that the latest changes should not require additional capital beyond what is needed to meet those requirements. However, the “unquestionably strong” 10.5% common equity Tier 1 ratio target for banks using internal models is likely to be reduced to offset the increase in RWAs that will most likely result from the changes in these discussion papers. This is in line with what Fitch had expected when the target was first announced. APRA said it will conduct a quantitative impact study with the banks before finalising the changes to ensure that they are in line with the benchmarks outlined in July 2017.

APRA’s proposed minimum leverage ratio should have no impact on the banks’ capital holdings – reported leverage ratios are already well above the 4% minimum at banks using the advanced models, and well above 3% at the standardised banks.

The proposed standards are unlikely to result in significant changes to banks’ business models, but they may lead to modest adjustment to loan portfolios. For example, the proposed changes to residential and, possibly, commercial mortgage risk-weights would increase charges for riskier loan types, such as investor and interest-only lending, relative to amortising owner-occupier loans for both advanced and standardised banks. This may result in banks increasing pricing for the riskier loan types or emphasising growth in owner-occupier loans. Similarly, increased capital charges for off-balance sheet facilities and credit cards could result in banks repricing products, or raising fees.

APRA also plans to further narrow the gap between the mortgage risk-weights under the advanced and standardised approaches, which is likely to provide some competitive benefit to the smaller banks that use the standardised approaches. APRA expects to release draft revised prudential standards after it has received feedback on its proposals, which is due by mid-May 2018.

Fitch Affirms Australia’s Four Major Banks

Fitch Ratings has affirmed the ratings of Australia’s four major banking groups: Australia and New Zealand Banking Group Limited (ANZ), Commonwealth Bank of Australia (CBA), National Australia Bank Limited (NAB) and Westpac Banking Corporation (WBC). The Outlook on each bank’s Long-Term Issuer Default Rating (IDR) is Stable.

The rating review focuses on the Australian-domiciled entities within each group and therefore does not encompass their overseas subsidiaries.

KEY RATING DRIVERS

VIABILITY RATINGS, IDRS AND SENIOR UNSECURED DEBT
The Long- and Short-Term IDRs and Stable Outlook on all four banks are driven by their Viability Ratings and reflect their dominant franchises in Australia and New Zealand as well as robust regulatory frameworks. Stable, transparent and traditional business models have proven effective in generating consistently strong profitability, while the banks maintained a conservative risk appetite relative to many international peers. High exposure to a heavily indebted household sector and increased focus on conduct related issues from authorities offset some of these strengths.

Australia’s banking regulator has been critical in helping the banking system manage rising macroeconomic risks – including historically high household debt and house prices, low interest rates and subdued wage inflation – through strengthening underwriting standards and increasing capital requirements. This has contributed to improving the banks’ ability to withstand a severe downturn in the housing market and household sector should it occur.

However, a severe downturn is not Fitch’s base case. We expect Australian house prices to remain high relative to international markets, with modest price rises in 2018. Overall, property prices should be supported by low interest rates and population growth. Offsetting this is high household debt, falling rental yields, increasing supply and rising dwelling completions.

Household debt could increase further, driven by historically low interest rates and high house prices, as residential mortgages make up almost 70% of household debt. Household debt reached 188% of disposable income at end-September 2017. Combined with low wage growth and high underemployment, this leaves households increasingly susceptible to higher interest rates and deteriorating labour market conditions.

The four major banks dominate their home markets. Their combined loans accounted for 80% of Australia’s total loans at end-December 2017 and 87% of New Zealand’s gross loans at end-September 2017. The banks have simplified their businesses and footprints with a strong focus on their core banking operations in Australia and New Zealand, or are in the process of doing so. They have well established and long standing competitive advantages and strong pricing power – manifested in strong earnings, profitability and balance sheets – which is likely to be maintained over the next two to three years.

The increased focus on conduct and competition by authorities has resulted in the establishment of a number of inquiries, the outcomes of which are uncertain. This could limit the banks’ growth potential and pricing power, pressuring the banks’ company profiles and ultimately affecting their ratings, although any significant impact appears unlikely to arise within the next two years.

Conduct related issues may also negatively affect our view of risk appetite and ratings if they indicate widespread failing within a bank’s risk-management framework. All four banks have faced a number of conduct related issues in the previous few years, although we continue to see these as isolated cases and believe risk-management frameworks remain robust. CBA has faced particular scrutiny following the August 2017 announcement of failures related to its anti-money laundering and counter-terrorism financing requirements. This, combined with a number of other infractions, prompted a regulatory inquiry into CBA’s governance, culture and accountability. Findings of systemic failure by this inquiry could pressure CBA’s ratings.

Disruptors, particularly in the digital sphere, are increasing in prominence, although they remain a small part of the system. The disruptors also pose some longer-term risks to the franchises of the major banks, although management appears to be addressing this pro-actively with strong IT investments, which we expect to continue.

Fitch expects the banks’ credit risk appetite to remain tight. We believe the banks have robust risk management frameworks. Regulatory intervention and oversight provide an additional restriction on the banks’ ability to take larger risks by weakening underwriting standards. Fitch expects additional regulatory scrutiny on serviceability testing in 2018, particularly around the assessment of borrowers’ expenses, which should further strengthen underwriting. Limits on growth rates for investor and interest-only loans has seen the pace of growth in these products slow; we see these as riskier types of mortgages relative to amortising owner-occupier mortgages. The growth rates of these products could be further curtailed by proposals by the regulator to have them carry higher risk-weights than amortising owner-occupier loans.

We believe the banks’ asset quality is likely to remain a strength relative to similarly rated international peers, although some weakening is possible through 2018. Large losses are not probable without an economic shock, such as may occur if there was a sharper-than-expected slowdown in China. Industries, such as retail, may come under pressure from soft consumer spending due to low wage growth, high household debt and competition from online retailers. However, given the banks’ limited exposure to the retail sector, our base case means any deterioration should be manageable.

Fitch believes the Australian major banks are well-capitalised and will meet Australian Prudential Regulation Authority requirements for “unquestionably strong” capital ratios well ahead of the proposed deadline. Implementation of the final Basel III framework should not be onerous either. Comparisons of risk-weighted ratios with international peers are difficult due to the Australian regulator’s tougher capital standards relative to many other jurisdictions. These include, among other factors, higher minimum risk-weightings for residential mortgages through Pillar 1 and larger capital deductions.

Funding remains a weakness relative to similarly rated international peers. Fitch expects the banks to continue relying on wholesale markets in the medium-term, although strengthened liquidity positions and swapping borrowings into the functional currency – usually either Australian or New Zealand dollars – help offset some of this risk. The banks’ funding profiles are also supported by access to contingent liquidity through the central bank, if needed, and the likelihood that they would benefit from a flight to quality in a stress environment.

Profitability growth is likely to slow in 2018, reflecting Fitch’s expectations for slower asset growth, competition for assets and deposits, higher funding costs and a rise in loan-impairment charges from cyclical lows. Cost management will remain a focus, but could be affected by continued technology investment and regulatory-related costs.

Reality Bites on Interest Rates for Global Economy

World growth prospects remain very strong for 2018 and are unlikely to be derailed by recent financial market volatility, but the balance of inflation risks is shifting, with implications for monetary policy, says Fitch Ratings in its latest Global Economic Update report.

Data released since Fitch’s December 2017 Global Economic Outlook (GEO) show world growth to have recovered even more rapidly than previously thought in 2017 and confirm that momentum has been maintained in early 2018, supported by rising investment, buoyant world trade, loose financial conditions and pro-cyclical fiscal easing.

“Economic slack is diminishing rapidly, and against a backdrop of an even stronger global recovery last year than we thought, market concerns over inflation and forthcoming monetary policy adjustments have risen. This has sparked a rise in global bond yields and significant equity market volatility. But we see this primarily as a correction to an overly sanguine view on the US interest rate outlook rather than signalling any serious threat of a sharp economic slowdown,” said Brian Coulton, Fitch’s Chief Economist.

The rise in oil prices in the aftermath of the extension of OPEC quota reductions, sharp falls in Venezuela’s oil production and declining global crude inventories also adds risks to headline inflation. While we still expect the strong supply response from US shale producers to continue, there are upside risks to our USD52.5/bbl (Brent) oil price forecast for 2018.

The Fed looks increasingly likely to raise rates four times in 2018 following upgrades to its growth forecasts. Concerns about low core inflation have eased and will be further assuaged by the recent pick-up in US wage inflation to an eight-year high of 2.9%. The ECB is sounding much more confident about economic recovery and has acknowledged the recent acceleration in wages, even though core CPI inflation remains below the bank’s comfort zone at 1%. Net asset purchases at EUR30 billion per month through September 2018 are still the base case, but the chances of any extension or upscaling are diminishing and ECB forward guidance is likely to start reflecting this in March. Better-than-expected UK growth increases the chance of a further Bank of England rate increase this year as low unemployment reduces the bank’s tolerance for above-target inflation.

US GDP grew by 2.5% annualised in 4Q17, broadly in line with our GEO forecast. Private domestic demand growth now exceeds 3% on an annual basis, led by a pick-up in business investment. The capex recovery is boosting US imports, imparting a drag on GDP growth from net trade. Nevertheless, with the final tax package worth 0.7% of GDP in its first year, domestic demand is likely to accelerate this year and there are modest upside risk to the GEO growth forecast of 2.5%.

Eurozone GDP grew by 0.6% in 4Q17, in line with our GEO forecast. However, upward revisions to previous quarters saw the 2017 annual outturn hit 2.5%, the strongest growth rate since 2007. PMI surveys remain at very elevated levels, and the ECB’s January bank lending survey showed increasing loan demand from firms. The latter is consistent with an increasingly buoyant outlook for eurozone capex as conditions for SMEs improve, bank lending picks up, and economic and political uncertainties subside.

The strength of the eurozone economy was an important factor supporting UK growth in 4Q17, when GDP expanded by a faster-than-expected 0.5%, taking 2017 annual GDP growth to 1.8%, 0.2pp faster than anticipated. Japan’s 4Q17 GDP data has yet to be released, but upward revisions to earlier quarters and buoyant monthly data point to 2017 growth having beaten the GEO estimate of 1.5% and to upside risks for 2018.

China’s economy grew by 6.8% yoy and by 1.6% qoq in 4Q17. These rates were in line with our GEO forecasts, but upward revisions to preceding quarters pushed 2017 annual growth up to 6.9%, the first incremental increase since 2010. The slowdown in credit and housing sales in late 2017 was consistent with weakening sequential GDP growth through the year (from 1.9% qoq in 2Q17) and points to some mild further slowing ahead.

Aussie Bank Profitability to Come Back Under Pressure

Australian banks’ profit growth is likely to slow in 2018 as global monetary tightening pushes up funding costs, loan-impairment charges rise, and tighter regulation has an impact on business volumes and compliance costs. Fitch Ratings maintains its negative sector outlook to reflect these pressures.

Australian banks are more reliant on offshore wholesale funding than global peers, as the superannuation scheme has created a lack of domestic customer deposits. Global monetary tightening could therefore push up banks’ funding costs. That said, the impact is likely to be contained by banks’ hedging of foreign-currency borrowing back to Australian dollars, while only a portion of the wholesale funding is refinanced each year. Meanwhile, improved liquidity should mitigate the risks associated with dependence on wholesale funding.

Loan-impairment charges fell close to record lows in 2017, which is one reason why profit growth held up better than we had expected. However, impairment charges are likely to increase this year, with asset quality still being challenged in some sectors and regions. At the same time, write-backs from previously impaired assets are likely to fall. Implementation of the Australian equivalent of IFRS9 might also result in higher provisioning charges.

Despite the headwinds, the major Australian banks are likely to remain more profitable than most international peers, owing largely to dominant domestic market positions that give them strong pricing power.

The main risks to banks’ performance stem from high property prices and household debt. We forecast house prices to rise modestly this year. Moreover, the proactive approach by regulators to address household debt risks – such as a tightening of underwriting standards and restrictions on investment mortgages and interest-only loans – should offer some protection to banks’ asset quality in the event of a housing market downturn.

Nevertheless, Australian banks are more highly exposed to residential mortgages than international peers, while households could be sensitive to an eventual increase in interest rates or a rise in unemployment, given that their debt is nearly 200% of disposable income. A significant deterioration in asset quality in the mortgage sector could undermine bank profitability and weaken capitalisation, although this is not our base case.