Featuring: LEBANON | Brazil | Sri Lanka | Hong Kong | the Paradigm of Non-Payment (Banks Edition)

This week we give our perspective on the deepening political and economic crisis in Lebanon and highlight our concerns regarding Brazil’s fiscal outlook. We also comment on Sri Lanka’s political landscape amid lingering sovereign credit vulnerabilities and discuss the latest dynamics in Hong Kong and their likely impact on U.S.-China tensions in the run-up to November. Lastly, we share our thoughts on widespread payment deferral programs due to the pandemic and their likely impact on EM banks.

Market Overview

Rates, inflation, global growth and collapsing precious metals ensured the week was busy with various macro developments as the Nasdaq went onto new highs and the DJIA almost broke-even. This comes as Biden’s VP selection was considered neutral. The U.S. reported higher core and headline beats within the CPI release. We continue to see two trends with inflation: (1) higher core within DM, which is mainly driven by energy and transportation; and (2) lower core in EM, but higher food inflation contributing to overall higher prints. Therefore, both figures are moving in the same direction, albeit for different reasons. Elsewhere the story in U.S. rates was largely technical, although wider inflation break-evens reversed the move in 10yr real yields and auctions were notably weak. The $26bn 30yr auction only garnered a bid-to-cover ratio of 2.14x, which is the lowest in 13 months and weighed significantly on secondary, which ultimately led to a 6bp move from Wednesday to Friday. The volatility in rates kept returns on the low side, with the EMBI unchanged and CEMBI up 0.1% on the week, with spreads 9-14bp tighter. Performance was lifted by Lebanon and Turkey snapping back with Honduras also outperforming, although Suriname, Belarus and Ecuador all lagged. Increasingly, the bifurcation between IG and HY is emerging as rates backed-up, leading to duration selling which had previously been in vogue. We note that the IG/HY spread differential stands at 577bp with the spread ratio at all-time wides of 4.4x. Indeed, this week was about inflation, but next week is about growth and central bank rate decisions. In between we have U.S.-Sino talks as the Phase 1 review gets underway as Congress enters recess, which stalls stimulus talks further and keeps the dollar weak. Thereafter, we’re over to Israeli GDP on Sunday, followed by Japanese and Thai GDP on Monday. This will be followed by Colombia’s GDP on Tuesday, with rate decisions from Indonesia, Zambia and Namibia on Wednesday before the PBoC, Philippines and Turkey on Thursday.

Lebanon’s government resigned, prompting a likely prolonged power vacuum 

Event: Lebanon’s Prime Minister, Hassan Diab, tendered the resignation of his cabinet this week amid escalating social turmoil in the country following the catastrophic explosion at Beirut’s port on August 4th that killed close to 200 people, injured thousands, and displaced hundreds of thousands from their destroyed homes.

Relevance: As we wrote in our commentary on Lebanon last week, the tragedy could not have come at a worse time for Lebanon, which is in the midst of its most acute political and financial crisis since the 15-year civil war which ended in 1990. The government’s resignation is likely to create a prolonged power vacuum within an already combustible social and political environment battered by an economic crisis that is spiraling out of control, widespread mistrust of political elites and public institutions, and the COVID-19 pandemic. What makes the situation even more complicated in Lebanon’s case is the constitutionally mandated sect-based power sharing system among its main religious groups, a remnant of the civil war. Given that context, we are not optimistic about the political establishment’s ability to form a new government and the process is likely to be complex and protracted. A scenario involving early elections is also possible, but unlikely to expedite the government formation process. After the most recent parliamentary elections took place in May 2018, Lebanon’s parties needed eight months to reach a consensus on a new government. Due to persistent political deadlocks and lack of desperately needed structural reforms during the last two years, the authorities have not been able to unlock $11 billion (~20% of pre-crisis GDP) pledged by international donors since April 2018. Going forward, the absence of a permanent government in the near-term will undoubtedly further complicate Lebanon’s negotiations with the IMF over a potential additional multi-billion dollar bailout package. The same logic applies to the debt restructuring process with private creditors after the government defaulted back in March on its $30 billion Eurobond stock amid severe FX liquidity shortages and intensifying pressure from the streets. Given the latest developments, existing and prospective investors in Lebanese assets should now take into account a projected GDP contraction by as much as 25% this year and estimated damages from the port explosion ranging between $7 and $15 billion. Promptly appointing a “national unity government” with the political capital to commit to deep structural reforms in order to secure an IMF package and unlock the already pledged external financing would be a game changer for Lebanon, but we remain highly skeptical about the probability of such a scenario, at least in the near future. Hezbollah’s strong influence in Lebanon’s politics and decision-making is another significant complicating factor when it comes to financial assistance by external donors from both GCC and the West, including securing a formal aid package by the IMF. Taking all of this into consideration, we are of the view that the hard decisions required to start stabilizing Lebanon’s political and economic situation will remain elusive in the short-run, limiting multilateral and bilateral financial support to emergency relief for the time being and postponing the resolution of the crisis further in time.

Brazil’s authorities reportedly exploring options to extend the suspension of constitutional fiscal spending limits  

Event: The local media in Brazil has reported that the Bolsonaro Administration and Congress are considering options to prolong the state of emergency that has allowed the temporary removal of legal fiscal spending caps in order to combat the COVID-19 crisis.

Relevance: If these media reports turn out to be correct and the fiscal exceptions are extended beyond 2020, this will reinforce one of our main concerns about Brazil’s fiscal trajectory. We have worried since the start of the COVID-19 emergency that even after the most acute phase passes, the government’s capacity to unwind the sizable fiscal easing will be hindered by the political economy that is likely to emerge from the crisis and the fact that 2022 is an election year. The landmark achievement of the Bolsonaro Administration in 2019, a pretty robust social security reform, has already been completely undone in terms of the multi-year fiscal savings that it generated by the ongoing spending relaxation necessary to cushion some of the pandemic’s economic and social fallout. Brazil is one of the hardest hit countries globally, having one of the highest ratios of COVID-19 cases and deaths per 1 million of population in EM and the economy has been heavily impacted. Markets expect an economic contraction of 6% YoY in 2020, while the IMF is considerably more skeptical and projects (as of June) a 9.1% GDP decline this year. The currently projected recovery in 2021 is 3.4% and 3.6%, respectively. Due to the decline in fiscal revenues and much higher budget spending, Brazil’s government deficit is projected to balloon to 12-15% this year, from an already elevated 7.5% in 2019, which will contribute to Brazil’s growing sovereign debt burden. Debt/GDP will likely surpass 90% this year and continue to edge higher, placing Brazil among the most indebted EM sovereigns globally and raising questions about fiscal/debt sustainability over the medium-term.

The Rajapaksa brothers consolidate power in Sri Lanka, now in control of both Parliament and Presidency 

Event: The Sri Lanka Podujana Peramuna (SLPP) won last week’s parliamentary elections with a clear majority. The SLPP is led by Prime Minister Mahinda Rajapaksa, who is President Gotabaya Rajapaksa’s brother.

Relevance: Sri Lanka has a very large debt burden (projected to approach 100% of GDP in 2020), an extremely high interest burden (55% of government revenues go toward paying interest) and a significant dependency on tourism. Because of such poor metrics (among others), it screens as one of the more vulnerable sovereign credits. Nonetheless, we see the SLPP win as positive for political stability in the country. With the Parliament and Presidency under control of the same party, we anticipate the Sri Lankan government will have a greater opportunity to focus on finalizing its budget, a possible program with the IMF, and helping the economy out of recession (1Q GDP was -1.6% YoY and 2Q is forecast to be around -9%). However, the Sri Lankan economy and sovereign will remain among the most vulnerable in global EM, especially in a scenario of a material second wave of the pandemic that prolongs the disruption of global economic activity into 2021 and reverses the recent improvement in macroeconomic data as economies across the globe try to cautiously re-start activity.

Hong Kong heats up: China sanctions 11 Americans, HK police arrest pro-opposition media tycoon Jimmy Lai

Event: Earlier this week, China announced sanctions on 11 Americans in retaliation to the U.S. sanctions on 11 Chinese officials last week. In addition, Jimmy Lai, a UK citizen, Hong Kong media tycoon, and prominent supporter of the pro-democracy camp, was arrested under the new National Security Law for collusion with foreign powers.

Relevance: Both events add fuel to gradually re-escalating U.S.-China tensions, supporting our view that relations will continue to worsen in the lead-up to the U.S. elections in November. We view the Chinese sanctions as largely symbolic because they target the same number of individuals as the U.S. sanctions, but notably avoid top government officials and White House aides. As for the Hong Kong arrests, Lai is by far the most high-profile victim of Beijing’s recent crackdown on political dissent in the autonomous region. Other pro-democracy figures arrested for national security crimes on the same day include Agnes Chow, Wilson Li, Andy Li, and at least four others. The arrests reinforce fears that Beijing can use the new law to limit citizens’ freedom of speech and undermine the rule of law in Hong Kong. Furthermore, given Jimmy Lai’s prominent position and activism in media, his arrest has also been construed as an open attack on press freedom in Hong Kong. If Beijing continues on this path, it will likely undermine foreign trust in Hong Kong’s judicial system, leading to increased pressure by external powers and fueling the reigniting of tensions between China and the West.

Global Emerging Markets Corporates in Focus: The Paradigm of Non-Payment (Banks Edition)

Lenders in both developed and emerging markets have been encouraged or, in some cases, required to offer payment deferrals to borrowers. Payment deferrals are sometimes automatic with borrowers needing to opt out of such programs, rather than opt in. In select countries, these changes in payment schedules have few conditions attached, if any. This means, for example, that corporate borrowers need not operate in sectors directly impacted by the COVID-19 pandemic and retail clients may not be required to show that the pandemic has resulted in loss of income to qualify for interest and principal payment holidays. Deferral periods can vary in length from one country to the next but three-month payment holidays are most common in our emerging market universe.

It is clear that such deferrals are necessary to address the devastating impact of the pandemic on many individuals and companies. Having said that, these programs may also have unintended consequences. Below, we address a few thoughts on payment deferrals, focusing on the impact on banks.

  • Interest accrued and interest received may diverge: Where lenders continue to accrue interest on loans subject to deferral regimes, the difference between cash interest received and interest accrued may increase. Stated interest income on loans may no longer give a true picture of this key revenue stream. Cash flow disclosures at banks may become increasingly important.
  • Provisions and one-off charges have already increased (and could remain elevated): Lenders such as Georgian banks have booked one-off charges related to payment deferral programs. In Georgia, this contributed to losses at the two largest banks in the quarter  ending March 2020. Although borrowers in that country who take advantage of these schemes will eventually pay more (due to interest on interest) timing differences led to the one-off charges at the banks. Changes in payment schedules may not be net present value (NPV) neutral for banks.
  • Classification conundrums –  what counts as ‘non-performing’? Payment holidays have altered the way banks classify loans. Such loans are unlikely to be classed as non-performing and may not even be classed as impaired or restructured. As a result, in addition to ‘regular’ asset quality disclosures, in recent weeks, as part of quarterly reporting many banks have also disclosed the amount of loans now under such programs. For some lenders, loans subject to payment schedule changes account for less than 5% of total lending. At others, the figure is a lot higher. The impact of these programs on banks’ customers has varied significantly. The burden of non-payment may be too great for some financial institutions if deferral programs are extended.
  • Fine (and unwritten) print remains important – there may be unintended consequences for borrowers: As mentioned earlier, where interest can be levied on deferred payments, borrowers may end up paying more back to banks than initially envisaged. Added to this, while lenders may be required to keep payment deferral information off borrowers’ credit reference agency reports (in markets where these centralized agencies exist), the bank itself is unlikely to erase such deferrals from its records. As such, taking advantage of such programs may have unintended (if unavoidable) effects on some borrowers. Considering future access to credit, rates, tenors and loan sizes may change in ways that are less favorable to borrowers. Some may no longer have access to credit at all. At the sovereign level, we note that Nigeria decided against participating in payment deferral programs, with comments from the Finance Minister suggesting that onerous conditions may have been attached to the deferrals. For companies and individuals, such conditions may be discovered ex-poste rather than ex-ante, relative to the payment deferral. This makes reading the fine print vital – someone, somewhere has to pay, and it may not be the lender.
  • Reputation repercussions for banks in the social media age: We are all too aware of the ability of stories, true and false, to spread across the world, primarily on social media. Borrowers may choose not to resume payments when moratoriums end and may even take to social media if pressure from lenders is viewed as excessive. Banks may need to balance reputational considerations with any need to enforce repayment. The financial cost of seeking repayment, which can make a difference to the net claim, especially if courts are involved, will also need to be considered.
  • A spike in impaired loans is possible: There may be a significant increase in reported non-performing loans as payment deferral periods end, especially if the economic recovery is delayed. Banks in many countries, from Turkey and to Colombia, have attempted to prepare for this by frontloading expected losses/provisions. This has led to some lenders disclosing losses for the second quarter even where non-performing loan metrics have not changed markedly quarter-on-quarter. It remains to be seen if these provisions will prove sufficient.
  • Buffer boosts may be required: Lenders in India and elsewhere have already begun to boost capital buffers via share capital increases. More banks may consider this if asset quality deterioration is more significant than expected at the end of payment deferral periods. Banks may also consider this if payment moratoriums are extended (on this, we note that in the Philippines, there is talk of extending these programs for a year). Share capital increases are usually positive for bond investors. However, if a privately-owned bank is unable to raise the capital it requires unaided and is in danger of breaching regulatory requirements, the state may intervene. Such intervention may not bode well for some deeply subordinated instruments, if the regulator deems the bank non-viable without the state’s help. Regulatory forbearance may mean banks avoid breaching minimum requirements and holders of subordinated instruments avoid write-downs.
  • Asset sales cannot be ruled out: Where banks cannot raise sufficient new capital, selling assets may be an alternative. Some non-core businesses in various markets are already up for sale. Loans may also be sold. The secondary market for these can vary from one country to the next. It may be that we see state-backed ‘bad banks’ used (again) if authorities choose to alleviate the pressure on banks through such vehicles.
  • Even more Eurobond issuance on the way? As mentioned earlier, there may be a divergence between interest accrued and interest received. This may have implications for liquidity at some banks. We have seen central banks across emerging markets ease liquidity requirements and repo requirements, possibly to help prevent this. Should those actions prove insufficient, banks may consider issuing more bonds in local and/or foreign currencies to boost liquidity. Thus, payment deferrals may also have implications for Eurobond issuance.
  • Who decides when to draw the line? Authorities in many countries are discovering that it was easier to go into lockdown than it is to come out of it. The same may apply to payment deferral schemes. Borrowers’ willingness to pay may decline over the deferral period. In addition, banks may be unable to seek repayment even when a borrower’s business is unlikely to recover if these lenders have their hands tied by lengthy, state-imposed payment holidays. Lenders may no longer be masters of their own fate. The scale of deferrals may be significant enough to impact a bank’s own survival. What began as a health crisis could become a financial crisis if payment moratoriums are extended indefinitely.

Please contact our Co-Heads of Sovereign Research with any questions:

Kathryn Exum, Senior Vice President, Sovereign Research Analyst
[email protected]

Petar Atanasov, Senior Vice President, Sovereign Research Analyst
[email protected]

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