Tag: Fitch

Greece: Sliding from Periphery to Exit

According to FitchRating, Greece’s predicament gives new meaning to the phrase “peripheral eurozone”. Eventual exit is now the probable outcome.

Critical deadlines in the Greek crisis have frequently come and gone without progress or consequence, but the referendum was a defining moment in determining the country’s economic position in Europe.

The resounding “no” vote provides a substantial boost to the position of the Syriza-led government in its negotiations with creditors. The Greek authorities clearly consider the referendum result to provide a sufficiently strong public mandate to insist on less austerity and a meaningful reduction of the government’s debt burden. From the Greek perspective, if creditors want to ensure the country’s continued membership of the eurozone to avoid a serious – perhaps irrecoverable – setback to broader European integration, they must recognise there are limits to the terms Greece can accept.

Has Greece Miscalculated?

Greece’s strong argument in favour of greater accommodation on the part of creditors faces several hurdles that are likely to prove collectively insurmountable. Most obviously, debt relief would be politically difficult for a number of eurozone governments. Countries that have gone through their own painful economic adjustments in recent years will be loath to write down credit extended to a country seen – rightly or wrongly – as not willing to do the same. The prospect is equally unappealing in countries that have largely avoided the crisis but have provided big financial contributions to the various Greek support packages.

Even if public opinion could be swayed, creditors may take the view that there is still the need for significant policy change in Greece, and that debt relief would simply address the consequences of previous shortcomings, not the root causes. Greece still needs to undertake major reforms to deliver sustainable public finances and more robust economic growth, and creditors may be reluctant to surrender the ongoing conditionality provided by support programmes that could be discontinued if there were wholesale debt forgiveness. The risk would be that Greek imbalances re-emerge, eventually threatening the viability of the eurozone again.

The state of Greece’s banks seriously undermines the government’s negotiating position. Capital controls, bank closures and the cap on European Central Bank (ECB) liquidity mean the economy is steadily being asphyxiated, the consequences of which will be faced primarily by the government rather than its creditors. This adds considerable urgency to the need for the Greek authorities to reach an agreement that would ease the pressure on withdrawals and allow the ECB to reconsider the cap. In the absence of an agreement, it becomes increasingly likely that the government will need to introduce a secondary means of payment, commonly referred to as scrip. An officially sanctioned parallel currency could only be interpreted as an important step towards exit from the eurozone.

A final point, which may only become clear once the history is written, is that the referendum might have tipped the balance of how other eurozone countries weigh the risks of Greece’s continued membership in the common currency area versus its exit. Greece may come to be viewed as a small and uniquely recalcitrant eurozone member that either can be effectively ring-fenced, or cannot be sufficiently altered to fit the eurozone mould, – or both. It could therefore spend some time on the outer edges of the eurozone periphery before membership becomes untenable.

Greece: Sliding from Periphery to Exit

According to FitchRatings, Greece’s predicament gives new meaning to the phrase “peripheral eurozone”. Eventual exit is now the probable outcome.

Critical deadlines in the Greek crisis have frequently come and gone without progress or consequence, but the referendum was a defining moment in determining the country’s economic position in Europe.

The resounding “no” vote provides a substantial boost to the position of the Syriza-led government in its negotiations with creditors. The Greek authorities clearly consider the referendum result to provide a sufficiently strong public mandate to insist on less austerity and a meaningful reduction of the government’s debt burden. From the Greek perspective, if creditors want to ensure the country’s continued membership of the eurozone to avoid a serious – perhaps irrecoverable – setback to broader European integration, they must recognise there are limits to the terms Greece can accept.

Has Greece Miscalculated?

Greece’s strong argument in favour of greater accommodation on the part of creditors faces several hurdles that are likely to prove collectively insurmountable. Most obviously, debt relief would be politically difficult for a number of eurozone governments. Countries that have gone through their own painful economic adjustments in recent years will be loath to write down credit extended to a country seen – rightly or wrongly – as not willing to do the same. The prospect is equally unappealing in countries that have largely avoided the crisis but have provided big financial contributions to the various Greek support packages.

Even if public opinion could be swayed, creditors may take the view that there is still the need for significant policy change in Greece, and that debt relief would simply address the consequences of previous shortcomings, not the root causes. Greece still needs to undertake major reforms to deliver sustainable public finances and more robust economic growth, and creditors may be reluctant to surrender the ongoing conditionality provided by support programmes that could be discontinued if there were wholesale debt forgiveness. The risk would be that Greek imbalances re-emerge, eventually threatening the viability of the eurozone again.

The state of Greece’s banks seriously undermines the government’s negotiating position. Capital controls, bank closures and the cap on European Central Bank (ECB) liquidity mean the economy is steadily being asphyxiated, the consequences of which will be faced primarily by the government rather than its creditors. This adds considerable urgency to the need for the Greek authorities to reach an agreement that would ease the pressure on withdrawals and allow the ECB to reconsider the cap. In the absence of an agreement, it becomes increasingly likely that the government will need to introduce a secondary means of payment, commonly referred to as scrip. An officially sanctioned parallel currency could only be interpreted as an important step towards exit from the eurozone.

A final point, which may only become clear once the history is written, is that the referendum might have tipped the balance of how other eurozone countries weigh the risks of Greece’s continued membership in the common currency area versus its exit. Greece may come to be viewed as a small and uniquely recalcitrant eurozone member that either can be effectively ring-fenced, or cannot be sufficiently altered to fit the eurozone mould, – or both. It could therefore spend some time on the outer edges of the eurozone periphery before membership becomes untenable.

Many Challenges If Resolution Needed On Greek Banks – Fitch

The four largest Greek banks have failed and would also have defaulted had capital controls not been imposed at the outset of the week, due to deposit withdrawals and the ECB’s decision not to raise the Bank of Greece’s (BG) Emergency Liquidity Assistance (ELA) ceiling, says Fitch Ratings.

The Greek banking system’s liquidity and solvency positions are very weak and some banks may be nearing a point where resolution becomes a real possibility. The ECB is responsible for supervising and authorising the four major Greek banks, and the BG is resolution authority for the others.

Resolution of Greek banks, if required, is unlikely to be straightforward. We believe it would be politically unacceptable to impose losses on Greek creditors and that efforts would be made to find a solution which avoids this but still complies with EU legislation. Existing bank resolution laws in Greece are relatively mature, sharing many similarities with the EU’s Bank Recovery and Resolution Directive, although they exclude explicit bail-in of senior unsecured creditors.

In April, Panellinia Bank was liquidated under this framework, with selected assets and liabilities sold to Piraeus Bank. Panellinia’s small size may have facilitated speedy resolution. Potential resolution of any more systemically important banks would be far more complex.

Recapitalisation of Greek banks using domestic resources would be impossible due to the sovereign’s weak financial condition. The remaining EUR10.9bn European Financial Stability Facility notes available to cover potential bank recapitalisation or resolution in Greece were cancelled by the European Stability Mechanism (ESM) when Greece’s bailout programme expired on 30 June.

The Greek deposit insurance fund, which could be used to recapitalise banks contained only around EUR3bn at end-2013. No pan-EU deposit insurance fund yet exists but under the recast Deposit Guarantee Schemes Directive, EU banks can access other countries’ deposit insurance funds. Other EU member states would be highly unlikely to agree to share due to a lack of confidence in Greece and its banking system.

The ESM could still inject funds directly into the banks, but a precondition would be the bail-in of 8% of liabilities and own funds. This would most likely wipe out much or all equity in a failed bank. The equity/assets ratios of the four largest Greek banks were 8%-10% at end-1Q15, but losses incurred since are likely to have reduced this figure. Greek banks have issued limited debt, so ESM rules would theoretically make uninsured deposits vulnerable to bail-in if a bank were to suffer material erosion of own funds before any resolution action.

But any bail-in of uninsured deposits would be politically unacceptable for a Greek government and would also be unlikely to be palatable for Greece’s international creditors, as they overwhelmingly relate to “real economy” SMEs and retail customers. An alternative, more creative, solution would therefore probably be needed to resolve and/or recapitalise Greek banks. This would depend on political goodwill and the outcome of negotiations with creditors, which are still highly uncertain.

The liquidity position of Greek banks is much deteriorated without access to incremental ELA. The ECB only extends ELA to solvent banks and against acceptable collateral. The credit quality of Greek banks’ domestic loan books is exceptionally weak. We calculate that for the country’s four largest banks an aggregated total regulatory capital erosion equivalent to around 4.8% of risk-weighted assets (5% of domestic gross loans) would probably render them non-compliant with the EU minimum total capital requirement of 8%, assuming static risk-weighted assets.

At end-March, these banks reported 90-days-past-due loans equivalent to around 36% of total domestic loans, and arrears may since have risen significantly.

A swift lifting of capital controls is highly unlikely even if there is successful resumption of negotiations with the ECB, IMF and European Commission. Controls on Cypriot banks, lifted in May, lasted two years.

Fed Rate Hike Would Cause Modest US Corporate Discomfort – Fitch

A gradual hike in interest rates would increase the cost of borrowing for US companies, likely resulting in lower profits and slower growth, according to Fitch Ratings.

But while higher rates would cause some discomfort, Fitch continues to believe a gradual rise would have limited impact for U.S. corporate credits as a whole, given the offsetting backdrop of US economic growth and aggressive refinancing by most corporates over the last few years that has resulted in maturities being pushed out with low-coupon, long dated debt.

In contrast, under our stress case scenario, rapid interest rate increases by the Federal Reserve would put additional pressure on credit metrics and could prompt more rating changes. Our stress case scenario includes more rapid rate increases, a choking off of near-term credit, a flattening of the yield curve and a spike in inflation. Against a backdrop of increased M&A activity, interest rate pressure could also impair the financial flexibility of buyers as acquisitions become more expensive to finance.

The ability to handle interest rate increases varies by corporate sector. U.S. Corporate sectors with cost recovery mechanisms (utilities, master limited partnerships (MLPs)) or strong pricing power (aerospace and defense, engineering and construction) are generally among those best able to counter the challenges in the stress case stemming from faster rising inflation and interest rates, while sectors with limited pricing power(such as homebuilders) may encounter more issues.

The secondary effects of a stress scenario are also important, as rising rates in a stagnant economic environment are likely to dampen equity values. Sectors where ongoing access to capital markets is critical for funding growth (REITs and MLPs) are likely to be especially sensitive to the stress scenario, given their high distributions and limited ability to retain cash.

Restoring Trust in Basel IRB Models Will Take Time – Fitch

Greater comparability in capital requirements across EU banks is likely to take time, Fitch Ratings says. Meanwhile, doubts surrounding internal ratings-based (IRB) models are likely to continue to undermine trust in regulatory capital ratios.

The European Banking Authority’s (EBA) consultation on the future of the IRB approach, which closed last month, included proposals for detailed changes to IRB models. Fostering supervisory convergence lies within the EBA’s remit, but to address some of the consistency and comparability issues, legislative changes, particularly to the EU’s Capital Requirements Regulation, will be required. This is likely to take considerable time.

Greater consistency in the way capital ratios are calculated is especially important because almost all the world’s 30 global systemically important banks use IRB models, as do most of the EU’s systemically important banks. Market participants mistrust capital ratios generated using IRB models to calculate risk-weighted assets (RWA) in part because model input variation and definition inconsistencies make meaningful comparison of ratios across banks and countries very difficult.

The Basel Committee on Banking Supervision’s Regulatory Consistency Assessment Programme (RCAP) initiative is making slow progress in reducing RWA variability and there is limited transparency on which banks’ ratios might be overstated. For example, in April 2015, the Committee announced it had agreed to remove just six of around 30 national discretions from Basel II’s capital framework.

The Committee’s reluctance or inability to name the banks whose capital ratios are overstated undermines confidence in the IRB models generally. The Committee’s EU Assessment of Basel III regulations report, published last December under the RCAP, highlighted that the exclusion of sovereigns and other public-sector exposures from the IRB framework, plus liberal risk weights for SME exposures, as permitted in the EU, positively affected the capital ratios of five EU banks. It did not name any banks. We understand that disclosure may be difficult because banks often participate in initiatives voluntarily and the Committee has no legal means to force disclosure.

Unwillingness to name names is not new. In July 2013 the Committee reported on a hypothetical portfolio benchmarking exercise across 32 major international banking groups and found material differences in IRB-calculated RWAs. The names of the outlier banks were not made public. This was also the case in the EBA’s reports, which analysed the consistency of RWA across banks, published in December 2013. A benchmarking exercise of SME and residential mortgages highlighted substantial variations. Naming the banks would be useful for market participants as it could shed some light on the banks’ estimated default probabilities and loss expectations, allowing analysts to adjust reported capital ratios if required.

The Committee’s November 2014 G20 presentation outlined five policy proposals to reduce excessive variability in the IRB approach. We think the most significant initiative is the proposal to introduce some fixed loss given default (LGD) parameters. LGDs, which measure the losses a bank would incur if a borrower defaulted, taking into account mitigating factors such as collateral, are a key input into the IRB models.

The EBA’s discussions on the IRB approach appear to be gaining momentum but its proposed timeline for defining technical standards is set at end-2016. Harmonisation of the definitions of default, LGD, conversion factors, probability of default estimates and the treatment of defaulted assets is essential as a first step towards achieving capital ratio comparability. We think delays to the EBA’s proposed timetable are likely.

China Policy Shift Prioritises Growth Over Debt Problem – Fitch

Fitch Ratings says the Chinese government directives last week concerning local government debt signal a potentially significant policy shift to prioritise growth over managing the country’s debt problem. Uncertainty over the scale and strategy to resolve high local government debt remains a key issue for China’s sovereign credit profile, and the latest directives could reflect a continuation of an “extend and pretend” approach to the issue. The directives should be credit positive for local governments, while broadly neutral for banks.

A joint directive from the Chinese finance ministry, central bank and financial regulator on 15 May, instructed the banks to continue extending loans to local government financing vehicles (LGFV)s for existing projects that had commenced prior to end-2014, and to renegotiate debt where necessary to ensure project completion. This is an explicit form of regulatory forbearance, and serves to delay plans to wind down the role of LGFVs. More broadly, it also suggests that propping up growth in the short term has temporarily taken priority over efforts to resolve solvency problems at the local government level.

Fitch estimates local government debt to have reached 32% of GDP at end-2014, up from 18% at end-2008. The CNY14.9trn increase accounts for 18% of the rise in total debt.

The authorities’ efforts to rein in indebtedness have led to a squeeze on monetary conditions and credit that has dampened growth. GDP expanded 1.3% qoq in 1Q15, and April activity data indicated the slowdown has persisted into the second quarter with weak demand across the board. Fixed-asset investment growth slowed to 12% yoy for the first four months of 2015, a 14-year low. Property investment growth fell to 6% from 8.5% in March as China’s 2009-2014 real estate boom continues to unwind.. This poses downside risk to Fitch’s projection of 6.8% growth for 2015.

Earlier, on 13 May, the central government also announced a USD160bn debt swap plan by which local governments would be allowed to convert LGFV debt for municipal bonds and where the bond yields would be capped.

For local governments, the swap will ease the interest burden at a time when a slowing economy and a significant reduction in land sales are weighing on revenue growth. Local government debt often carries interest rates in excess of 7%, whereas the local bonds that will be converted from debt under this programme will be restricted to yields not in excess of 30% above central government bonds with similar tenors.

Fitch views the development of a local bond market as credit positive in itself for local governments. They will benefit from an extended maturity profile on the bonds compared with LGFV instruments. This will significantly reduce liquidity risks, and ensure a better asset/liability match. It also widens local governments’ funding channels and builds a more transparent fiscal reporting system.

More broadly, Fitch expects the resolution of China’s debt problem will ultimately involve sovereign resources, and that debt will migrate on to the sovereign balance sheet. The agency views the debt-swap plan as part of this process, even though the new local government debt is not expected to carry an explicit sovereign guarantee – as the debt is likely to be perceived as having a strong implicit guarantee. Nonetheless, the expectation of substantial contingent liabilities is factored into China’s ‘A+’/Stable sovereign IDR, affirmed in April 2015.

For Chinese banks, the shift from debt to bonds will affect profitability, especially as the rates on the swapped bonds are being capped. Banks will receive lower yields on the same exposure at a time when net interest margins are coming under pressure owing to the macroeconomic slowdown. Furthermore, the government directive to continue extending loans to LGFVs on certain projects will have a negative effect on banks’ liquidity and leverage. More broadly, the directive highlights that banks remain subject to direct influence from the authorities, which could have an impact on management governance and standards.

However, it also reinforces the role that state banks play in economic stability, and therefore the high likelihood that they will benefit from state support. Furthermore, the impact on liquidity will be offset somewhat by the fact that banks will be able to use municipal and provincial bonds as collateral to access key lending facilities. This will enable them to boost lending to higher-margin business. Notably, too, the conversions should have some positive impact on banks’ reported capital ratios as municipal bonds have lower risk weights than local government loans.

Australia Fiscal Plan Weakens, But Core Strengths Intact – Fitch

According to Fitch Ratings, Australia’s Commonwealth budget, released on 12 May 2015, highlights the continued weakening of the country’s long-term fiscal consolidation plans, but does not fundamentally alter the core factors supporting Australia’s ‘AAA’ rating. These include low debt-to-GDP versus ratings peers, a stable banking system and a credible fiscal policy framework.

Deterioration in the fiscal outlook since the last budget was widely expected alongside the continued weakening of labour market conditions and a tepid recovery in commodity prices that has not brought prices back to levels seen before the downturn.

The fiscal cash deficit widened and government debt projections increased in the fiscal year ending 30 June 2016 (FY16) budget, reflecting in part the deterioration in economic growth dynamics linked to the fall in commodity prices and slowdown in China. Falling terms of trade have impacted long-term revenue growth projections, which have been revised down to 6.3% annually to 2018 from 6.6% at the last economic and fiscal update. Wage growth and corporate income will continue to be challenged by lower commodity prices, resulting in AUD20bn less in tax revenues over the coming four years compared with the outlook in the 2014 budget.

The deteriorating cash balance also reflects higher spending forecasts compared to the government’s Mid-year Economic and Fiscal Outlook in December.

The government still aims to return to a balanced budget by FY20 – even though fiscal consolidation plans have weakened. It is notable though that with a three-year federal election cycle – the next election is due by January 2017 – there remains significant uncertainty as to whether the political commitment to achieve this target will be sustained. Nonetheless, Australia does benefit from a credible policy framework and Fitch expects Australia to continue to have a significantly lower debt burden than its ‘AAA’-rated peers – general government debt was 31.8% of GDP in 2014 versus the ‘AAA’ median of 41.3%. Notably too, the government forecasts debt-to-GDP to begin falling by FY18 after rising for the next two fiscal years. As such, the budget should not have a significant effect on Australia’s existing strong credit profile.

Fitch believes that the iron ore forecast price in the budget of USD48/tonne seems a reasonable base case, but the budget will remain sensitive to further price falls. Australia’s dependence on commodity exports, especially to China, indicates that the sovereign may need a slightly larger buffer in its public finances than some of its peers at the ‘AAA’ level.

Over the longer term, reducing Australia’s dependence on commodities would mitigate a key vulnerability of the economy and sovereign. The FY16 budget includes some policy measures, including infrastructure investments and targeted SME tax cuts, to raise potential growth and spur service sector exports. As yet, it is uncertain to what extent these sorts of policies will be successful in transitioning growth away from mining.

RBA Rate Cut Increases Need for Greater Macro-Prudential Response – Fitch

Fitch Ratings says the Reserve Bank of Australia’s (RBA) recent interest rate cut is likely to lead to a strengthened macro-prudential response from the Australian Prudential Regulatory Authority (APRA) for the Australian banking system, although implementation will probably remain targeted and occur on a bank-by-bank basis.

Today’s rate cut is likely to further fuel the Australian property market, particularly in Sydney, at a time when the authorities are trying to take the steam out of the market. Macro-prudential tools allow the regulator to influence banks’ risk appetite, preserving asset quality and limiting potential losses in the event of an economic shock. The Australian banking system benefits from strong loss absorption capacity given the banks’ sound profit generation and provision levels, as well as adequate capitalisation. These strengths could be undermined by further increases in property prices and household debt, given mortgages form the largest asset class for Australian banks.

APRA has targeted certain higher risk areas such as investor mortgages, indicating growth in excess of 10% per annum would trigger closer regulatory monitoring and may lead to tougher capital requirements. In addition, APRA could use a set of other macro-prudential tools which may include a combination of debt-servicing requirements, additional capital requirements and/or loan-to-value ratio (LVR) restrictions, depending on each lender. Given the existence of lenders’ mortgage insurance (LMI), which mitigates the banks’ risk of higher LVR mortgages, debt-servicing requirements and higher capital requirements on a bank-by-bank basis are likely to be the preferred options.

Growing risks in the housing market and the banks’ mortgage portfolios could be exacerbated if further macro-prudential scrutiny is not forthcoming. The recent interest rate cut may lead to further house price appreciation, especially in cities such as Sydney and Melbourne, where there has been greater investor activity over the past 12 to 18 months. The first rate cut in February 2015 was followed by increased activity in these housing markets. The growth in house prices exceeded lending growth up to the end of 2014, but this trend could reverse as interest rates are at historical lows. At the same time, it makes borrowers vulnerable to a potential increase in interest rates in the medium term. Australia has one of the highest household debt levels globally, and if low interest rates contribute to higher credit growth, it could drive up household indebtedness from already historically high levels.

Falling interest rates may also result in further growth in potentially higher-risk loan types, such as interest-only and investor loans. These loan types already represent a high proportion of new approvals for Australian banks, as shown in Fitch’s “APAC Banks: Chart of the Month, February 2015”. The proportion of new interest-only mortgages is higher than new investor mortgages, suggesting that owner-occupiers are increasing the use of these types of loans at a time when historically-low interest rates should encourage borrowers to pay off debt. Serviceability testing at Fitch-rated Australian banks may provide some offset to this risk, with loans assessed on a principle and interest basis and at interest rates well above the prevailing market rate.

 

Can Indebtedness and Interest Rates Both Increase?

In FitchRating’s latest Global Perspective, James McCormack, Fitch’s Global Head of Sovereign Ratings highlights the dilemma facing the US where rates are low and debt is high. What happens when interest rates rise? Given that both household and corporate debt levels are much higher now, the potential exists for a much more negative impact in terms of debt sustainability and economic performance.

Private sector deleveraging has been a critical feature of the post-crisis US economic recovery, and will remain an important consideration for growth and stability as interest rates move higher. Borrowers have benefited from a more-than 30-year trend of falling rates, but the eventual reversal will test the degree to which private sector balance sheets have been strengthened in the post crisis period. With debt levels still high by historical standards, higher interest rates may have a pronounced impact on growth in the period ahead.

A Cycle Ends: Meaningful Deleveraging

The increase in household debt by 30 percentage points of GDP between 2000 and 2008 was unprecedented, as has been the subsequent deleveraging (see chart 1).

Fitch-01-May2015The previous 30 percentage point increase took more than 40 years, and there had never been a meaningful deleveraging prior to 2009. At end-2014, household debt was back to its 2002 level as a share of GDP, and below its 2008 peak in nominal terms. A similar, though less marked, pattern is evident in the corporate sector, unlike in previous credit cycles when corporate debt levels were more volatile than those of households. Corporate debt is now lower than in 2009 as a share of GDP, but 12% higher than the pre-crisis peak in nominal terms.

The Long View: Lower Rates Allowed for Higher Debt

Taking a much longer view, even accounting for post-crisis reductions, household and corporate debt levels have trended higher since the early 1950s (when data became available). Moreover, it is widely accepted – if not explicitly acknowledged – that a continuation of this trend is a sign the US economy is getting back to “normal”. The resumption of private sector credit growth on the back of improved balance sheets is a big part of the narrative of the US recovery, and a meaningful difference with conditions in the Eurozone. Historical interest rate developments provide insight to the steady run-up in US debt, and are a basis of concern looking forward. Both nominal and real medium-term interest rates (approximated by 10-year US Treasury yields) have been falling since the early 1980s. Over the same period, there have been matching declines in effective interest rates faced by the household and corporate sectors (see chart 2).

Fitch-02-May2015Effective rates are calculated using BEA data on Interest Paid and Received by Sector, and Flow of Funds data on outstanding debt stocks. Critically, for the last 30 years, falling interest rates have offset the effects of higher debt levels to keep interest service ratios manageable (see chart 3).

Fitch-03-May2015There is a strong historical relationship between US economic growth and interest rates in both real and nominal terms. Over the last 50 years real GDP growth and 10-year US Treasury yields (using the GDP deflator) averaged 3.1% and 3.0%, respectively. In nominal terms they averaged 6.7% and 6.6%. On this basis, with 10-year Treasuries yielding less than 2%, they appear low by historical standards. Current conditions are certainly not unique. There have been periods when 10-year Treasury yields were consistently lower than economic growth. The last episode was the mid-2000s, when a global savings glut led to what Alan Greenspan described as a “conundrum”, whereby increases in the Fed Fund rate from 2004 were not matched by 10-year yields. With reasonably strong US growth at the time, households and corporates responded as might be expected – they borrowed more. Private credit growth subsequently outpaced nominal GDP growth and was one of the contributing factors of the global financial crisis.

The critical question is what will happen to 10-year Treasury yields and the effective interest rates faced by the corporate and household sectors as monetary policy is tightened in the current cycle? With smaller current account surpluses in Asia and among Middle East oil exporters, it seems less probable that a global savings glut will continue to hold US rates down. Despite the deleveraging that began in 2009, neither the household nor corporate sector is particularly well placed for a higher interest rate environment. Household interest payments as a share of GDP are now at the same level as the mid-1970s, when debt was lower by 35 percentage points of GDP. Corporate sector debt has increased by less, but interest payments are also at mid-1970s levels. It appears that for the first time since the early 1980s, the outlook for the US economy may be characterised by simultaneous increases in debt levels and effective interest rates. The difference now, however, is household and corporate debt levels are much higher, suggesting the potential for a much more negative impact in terms of debt sustainability and economic performance.

Chinese Banks’ Earnings Unlikely to Improve in 2015 – Fitch

Fitch Ratings says Chinese banks’ 2014 results indicate their earnings remain under pressure and the agency does not expect meaningful improvement in the current year. The banks’ earnings will be challenged by deteriorating asset quality and net interest margins (NIM) that in 2015 will further feel the effects of stiff competition for deposits and on-going deregulation of deposit rates – the latter being especially true for mid-tier banks.

For Fitch-rated Chinese banks that have reported results for 2014, their revenue grew by 13.1%, but net profit only rose by 7.2% due to higher loan provisioning. State banks reported stable, if not slightly higher, NIMs, reflecting efforts to shift towards loans with higher yield, such as micro and small-business loans, and lower-cost funding sources like core deposits. In contrast, the mid-tier banks’ NIMs were under pressure, which they tried to offset by expanding non-interest income.

Fitch estimates the rated banks’ new NPL formation rate accelerated to 0.85% in 2014 from 0.42% a year earlier, as they continued to expand loans and assets. In 2014, loans increased 11.4% and assets expanded 10.6% on average across Fitch’s rated portfolio, with mid-tier banks speeding ahead with asset growth of 16.6%, compared with the state banks’ 9.0%. Fitch views the system’s pace of credit growth as unsustainable, with the banks already being highly leveraged by emerging market standards.

With slower economic growth, all Chinese banks reported further increases in NPLs, special mention loans and overdue loans in 2014, even as more bad loans were written off and/or disposed. The reported system NPL ratio was 1.25% at end-2014 (up from 1.0% at end-2013) while the provision coverage ratio was 232%. However, most mid-tier banks reported NPL ratios of 1.02%-1.3% and provision coverage ratios around 180%-200%. The Viability Ratings on Chinese banks range between ‘bb’ and ‘b’, reflecting, among other things, Fitch’s expectation that slower economic growth could weaken borrowers’ repayment ability and drive further deterioration in asset quality, the pressure on banks from high leverage, and their potential exposure to liquidity events.

Fitch believes the health of credit quality remains overstated across the banking system. Banks with lower provision coverage will face greater pressure to dispose their NPLs in 2015 in order to meet the requirement to maintain a minimum 150% provision coverage ratio.

Although banks have been shoring up capital, their capital positions are unlikely to improve meaningfully as long as their loans and assets keep expanding at the current pace. Banks that adopted revised capital calculations raised their core tier 1 capital ratios by 92-154bps, except Agricultural Bank of China, whose core tier 1 capital ratio fell by 16bp. The mid-tier banks’ core tier 1 remained largely unchanged. The banks’ tier 1 and total capital ratios were also lifted by the issuance of Basel III-compliant securities during 2014, while the state banks reduced their dividend payout ratios and China CITIC Bank suspended the distribution of final dividends to replenish capital.

For the banks that disclosed information on wealth management products (WMPs), outstanding WMPs at the end-2014 increased by 41% on average, with the amount of WMPs issued during 2014 up 35%. The majority of the WMPs have tenors shorter than one year. While most WMPs are non-principal guaranteed by the banks, Fitch believes banks may assume some losses in the event a WMP defaults or provide funding to the entities that bail out the WMPs that are in danger of default.