Emerging market banks face ‘high dollarisation risk’

The prospect of tighter US monetary policy increases the vulnerability of highly-dollarised emerging market banks to a spike in credit losses and pressures on their profitability, according to Moody’s.

The rating agency said in a report published Monday that the Federal Reserve is expected to hike interest rates three times this year. As US interest rates rise, the dollar will likely strengthen.

“This risks increasing the real value of emerging market debt, as well as pushing up borrowing costs, adding to pressure on emerging market currencies,” the report said.

“As US interest rates rise, capital flowing into emerging economies is likely to slow, weighing on economic growth in those countries and weakening their currencies,” explained Lev Dorf, an AVP-Analyst at Moody’s and author of the report.

“Currency depreciation could result in long-term risks for highly dollarised banks, such as deterioration of asset quality, higher credit losses, capital erosion, and less stable financial conditions,” added Dorf.

High dollarisation is a structural weakness, particularly for banks in many CIS and Latin American countries, the Moody’s report said.

Banks with large volumes of foreign-currency loans and deposits on their balance sheets are vulnerable to a spike in credit losses and pressure on their profitability and liquidity when the local currency drops sharply in value.

It becomes harder for unhedged foreign-currency borrowers to repay their foreign-currency loans, leading to a wave of credit losses for banks. Depositors will switch to dollars, draining banks of local currency liquidity, or could withdraw their savings if they fear capital controls, or that the bank may be in jeopardy.

High dollarisation also threatens to increase financial instability in times of crisis if central banks foreign currency reservers are insufficient to bail out banks with dollar shortfalls.