JAKARTA (TheInsiderStories) – Currency depreciation and higher domestic interest rates are likely to halt the recent improvement in Indonesian banks’ asset quality and put downward pressure on profitability, says Fitch Ratings. However, their margins are likely to remain strong which, together with high core capital ratios, will act as a buffer against the impact of market turbulence.
Banks’ foreign-currency assets and liabilities are generally well-matched, or hedged, which limits risks from currency weakness. Further declines in the rupiah could, however, create debt-servicing pressures for borrowers with substantial foreign-currency debt and weaker hedging practices, posing asset-quality risks to banks.
System-wide foreign-currency lending accounted for around 15% of total loans at end-1H18, which was down from 17% in 2014 and more than 30% in the 1990s, but is still high compared with regional emerging market peers.
Pressure on the rupiah has drawn a strong response from Bank Indonesia (BI), which has hiked its policy rate by a cumulative 125bp since May 2018 and intervened aggressively in the foreign-exchange market. Fitch expects BI to raise its policy rate by a further 25bp in 2H18 and 50bp in 2019.
Higher interest rates will put upward pressure on banks’ funding costs, and may weigh on GDP growth and asset quality. The major bank’s ‘special-mention’ loans, which were equivalent to 5.2% of total loans at end-1H18 – up from 4.4% at end-2017 – would be at higher risk of becoming NPLs should economic conditions worsen.
Profitability is likely to decline in the near term due to higher credit and funding costs, as well as slower loan growth, but we expect the large banks’ average ROA (2.1% in 1H18) to remain strong compared with regional peers. Major banks’ tighter underwriting and risk controls since the 2015-2016 commodity-sector downturn are likely to contain the deterioration in asset quality.
“We expect their average non-performing ratio to rise only gradually, having fallen to 2.5% at end-1H18 from 2.6% at end 2017 and 3.0% at end 2016. Smaller banks could face more significant risks due to their typically weaker underwriting standards,” Fitch said on Wednesday (26/09).
The profitability and capitalisation of the major banks provides a cushion in the event that market volatility has a more significant impact on Indonesian banks than we expect. Common equity comprises their entire Tier 1 capital, and their average Tier 1 ratio was a healthy 18.8% at end-1H18.
Unhedged foreign-currency exposure averages only around 2% of the banks’ capital. The major banks’ NPL coverage also remains satisfactory at an average of 145%.
Finance companies could be more affected than banks by market volatility, largely through pressure on net interest margins from higher funding costs. Foreign-currency borrowing accounts for around 18% of finance companies’ total debt, but is required by regulation to be hedged.
However, they rely heavily on bank loans and bonds for funding, and these are more sensitive to domestic policy rate changes than bank deposits – which finance companies are not allowed to accept.
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