Tatsat Chronicle Magazine

Rate Hike to Help Indian Banks Post Increase in Margins

The report is focused on banks in the 10 G-20 emerging markets, namely Argentina, Brazil, China, India, Indonesia, Mexico, Russia, Saudi Arabia, South Africa and Turkey.
June 27, 2022
indian banks

Credit rating agency Moody’s Investors Service has said that as a result of rate hikes by central banks, it expects banks in India, Saudi Arabia and Indonesia will see increases in their return on assets as net interest margins widen, while credit costs will hold steady or decline in 2022-23 after significant increases during the pandemic.

“We expect that Indian, Saudi Arabian and South African banks will post larger increases in margins in 2022-23, because of higher policy rates and favourable funding structures,” Moody’s said.

In the case of India, the historic relationship between credit costs and inflation is distorted because of significantly delayed recognition of NPLs and bank restructurings that took place in 2016-18 when inflation was slowing.

“We expect Indian banks’ asset quality will improve in 2022-23 because of recoveries and write-offs of legacy NPLs,” it said. Moody’s said the hike in policy rates in many G-20 emerging markets to curb inflation will improve the margins of the banks. It also said that rapid inflation-driven rate hikes will be a double-edged sword for banks.

The report is focused on banks in the 10 G-20 emerging markets, Argentina, Brazil, China, India, Indonesia, Mexico, Russia, Saudi Arabia, South Africa and Turkey. In line with global trend, inflation has accelerated in many G-20 emerging markets, and central banks in most of the economies have raised rates in response. Interest rate increases generally lead to a widening of banks’ interest margins, providing a boost to their profitability.

However, asset risks for banks also increase when interest rates rise. If inflation rates rise steeply, leading to sharp increases in borrowing costs and economic slowdown, resulting increases in credit costs would outweigh gains in margins, a credit negative. Inflation has accelerated in most G-20 emerging markets, prompting interest rate hikes. Central banks in the majority of the 10 economies have hiked policy rates in response to rising prices.

The impact of rise in inflation and monetary tightening on banks is not clear cut. While the impact of rise in interest rates to contain inflation is complex for banks, there are two key opposing effects.

Higher rates normally result in wider net interest margins (NIMs), boosting banks’ top-line profitability. At the same time, higher rates lead to slower economic growth and heavier debt repayment burdens for borrowers, leading to a weakening of loan quality and increases in credit costs, it said.

“Now that most central banks have tightened monetary policy to curb inflation, we expect inflation to abate in all 10 emerging markets countries in 2023, helping contain asset risks for banks,” said Eugene Tarzimanov, Vice President, Senior Credit Officer at Moody’s.

A rise in inflation typically leads to a widening of banks’ NIMs. In nine out of the 10 emerging markets, banks’ margins have historically widened in tandem with rises in inflation.

“We expect that banks in India, Saudi Arabia and South Africa will see larger increases in margins in 2022-23. If inflation accelerates above our expectations, banks in Brazil and Turkey will post the smallest increases in margins,” says the report. Adding that banks in Russia and Turkey expected to post larger increases in credit costs. If inflation accelerates further, credit costs will also rise in Argentina, South Africa and Brazil.

Asset risks for banks would outweigh margin benefits if inflation rates rose sharply. While inflationary pressure is expected to abate in all 10 markets in 2023, an acceleration of inflation beyond expectations would lead to higher credit costs that outweigh benefits of gains in NIMs. Historically, the profitability of Brazilian and Turkish banks has shown the highest negative correlation with high inflation rates, the report said.