The failure to resolve the issues relating to non-performing assets-NPAs goes directly back to the central banks' largesse. They provided the time to allow these issues to be ignored. Now, it is both worse and too late

Last week, I read a rather disturbing story in the financial news. According to the article, Moody’s, the rating agency, downgraded Singapore’s banking sector to ‘negative’ from ‘stable’. Singapore? Last September, I wrote about problems with banks in several emerging markets, but Singapore was not on the list. It has not received a downgrade since the financial crisis. Its four banks are rated ‘Aa1’, some of the highest rated banks in the world. My first thought was how did this happen and what does it indicate for other emerging markets?

Singapore banks, like every other private bank, want to increase their profits. Like many other international banks this meant increasing loans to higher risk emerging markets. Singapore’s banks lent mostly to borrowers in Southeast Asia. They were successful in doubling their profits, but also their exposure. The region now represents the source of about 40% of those profits. But the region also represents a disproportionate amount of the risk. Last year borrowers outside Singapore were the source of 77% of Singapore banks’ nonperforming loans. What is more disconcerting is that the banking systems in other Southeast Asian countries, like Thailand or Indonesia, seem healthy. It might be time to change that assessment.

What may not be so healthy is the South Korean economy. Korea is caught in a very bad place. It is very difficult for an economy heavily based on exports to grow if its main market, China, is slowing, while its main competitor, Japan, has depreciated its currency. The result is predictable. Whole swaths of its economy including shipping, ship building, construction and real estate are having major issues. The bond market has already experienced a number of bankruptcies and its nonperforming loans have been rising. 

Like China the rate of growth for the Indian economy has been declining since 2010. The predictable effect is a rise in nonperforming loans, up to 3.5% at the end of 2012. India is also like many other countries in another way. The published nonperforming loan number masks the real problem. Rather than push a borrower into default, it looks much better on a bank’s balance sheet if the loan is restructured. Theoretically, a restructured loan is supposed to be good for the overall economy by providing a bit of patience for companies going through a rough patch. Many don’t make it through.

The Reserve Bank of India (RBI) estimates that 15% of restructured loans eventually fail. In the US in certain categories the failure rate of modified loans is as high as 57%. Presently, the number of restructured loans held by Indian banks is roughly 6%. According Fitch, the rating agency the combination of restructured loans and bad loans will reach just under 12% in about 8 months, a level that has doubled in two years.

Brazil is not that different from its other BRIC colleagues. Its state owned banks are the worst offenders for making bad loans. The giant state development bank BNDES, the world’s largest, and the Caixa Economica Federal, the state run mortgage company, have both been downgraded by Moody’s two notches from A3 to Baa3, the lowest level of investment grade. The reason for BNDES is that it has targeted lending to a few favoured customers. It has lent more than four times the value of its tier one capital to its top ten customers. A particularly egregious example is loan to the mining conglomerate EBX. Alone, it amounts to 5.8% of BNDES’s regulatory capital. Grupo EBX is the energy and mining conglomerate owned by Eike Batista. Mr. Batista was once estimated to be the second wealthiest man in the world with assets worth $39 billon. Allegedly, he has lost 99.5% of his wealth and is now down to a mere $200 million.

The problems of the peripheral countries of the Eurozone are well known. What is not widely publicized is the issue of the countries of Central and Eastern Europe. Bad loans among all of these countries stood at 8.2% at the end of 2012. Some are far worse than others. The three worst offenders are Ukraine, where the NPLs level is more than 30%; Albania with more than 20%, and Romania, a member of the EU, whose banks are burdened with NPLs of close to 20%. The bad loans in Southeastern Europe have risen from 14.5% in 2011 to 17% in 2012.

Perhaps, the poster child for problem banks is Vietnam. Vietnam’s 50 banks made excessive loans to inefficient state owned companies and speculative property investments. A story repeated time and time across the world’s emerging markets. The banks’ nonperforming loans account for approximately 6% of outstanding loans, with a strong emphasis on the word approximately. While this has supposedly declined from last year, a recapitalization of the banking system will cost anywhere from 7% to 20% of GDP.

But the size of emerging market bad loans is not the real problem. The real problem is simple: bankruptcy. Countries have to take the crucial step of recognizing that these loans are not going to be paid back. They must do what is necessary to restructure their financial systems. They must take the losses and reallocate capital to more efficient businesses. They must privatize state owned banks whose loan portfolios reflect more political patronage than risk assessment. They must create efficient regulations that are strictly and fairly enforced. But the odds of this occurring are small. Recognition of the size of the problem could result in both a political and financial meltdown. So there are few incentives for doing so. It has simply been easier to accept the free money from central banks.

Without meaningful reform, the emerging market growth story is now past. With these burdens it is unlikely that it will revive anytime soon. Growth rates have been dropping for the past three years and will continue to do so until the inevitable collapse will occur. Time is not on their side. Ignoring these issues will simply make them worse. Reform is the only option, but don’t depend on it.

(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)