The debate rages on… Is Brazil is in a credit bubble? And if so, how worried should we be?
There is no doubt that Brazil’s economy is hot, as evidenced by hard data and anecdotal evidence. There is now a 3-month waiting list for imported luxury cars. Meanwhile, spend-happy Brazilians are heading abroad in droves, splashing out $16.4bn on overseas trips in 2010, a more than 50% jump from 2009.
Almost all analysts agree that consumers cannot keep spending at the same breakneck pace indefinitely. Household indebtedness is on the rise, and economic growth is bound to lose some steam. Nevertheless, I see no crisis on the horizon.
Fast credit growth is a common feature in recent banking crises, but not all credit booms end in tears. In fact, most don’t and Brazil falls into this majority. The country’s banking sector has strong capital buffers and should easily withstand the upswing in bad loans typically associated with fast credit growth. Financial stability is not in danger.
Putting Brazil’s Credit Growth in Context
First, let’s take a look at how fast credit is really growing. As seen in Figure 1 below, annual credit growth is brisk, at 20% on a nominal basis and 13% on an inflation-adjusted basis in May, but this is not a particularly new trend. Prior to the global financial crisis, credit was growing at a faster pace.
Figure 1: Real credit growth is now slower than in 2007-08 on an annual basis
Source: BCB, IBGE, my calculations
So what’s the worry? Well, some observers point to the sharp increase in credit-to-GDP, from less than 26% at the beginning of 2005 to almost 47% in June 2011, to illustrate the strong credit expansion. This shows that considerable financial deepening has occurred in recent years, which is not necessarily a bad thing. In fact, financial deepening tends to positively affect growth.
As seen in Figure 2 below, Brazil has relatively limited credit penetration. The country’s low gross loans-to-GDP ratio provides a structural justification for the country’s fast credit growth, as it helps credit penetration in Brazil catch up with levels elsewhere.
Figure 2: Credit-to-GDP ratios in comparison
Source: Fitch Ratings
Even though I am often wary of ratings agencies, I agree with Moody’s recent assessment of Brazil. The agency notes the country’s low credit-to-GDP ratio and says that “even if a bubble-like event were to materialize, its impact on the government’s balance sheet is not likely to be substantial.”
Nevertheless, if financial deepening occurs too quickly, it can result in a sharp increase in bad loans and jeopardise financial stability. The IMF expressed this concern in June: “Brazil is recovering strongly from the crisis. But new financial stability challenges are emerging in this, and other fast-growing regions.”
So let’s take a look at the banking system’s health.
State of the Banking System
Rapid double-digit credit growth cannot continue indefinitely and authorities need to continue to be vigilant about loan quality. Household debt burdens are on the rise, as are non-performing loans. Nevertheless, financial stability is not in danger as I detail below.
Figure 3: Bad loans have not risen significantly so far
*Amount of credit in arrears/total credit (90 days)
Source: SPC Brasil
Loans in default remain below their historical highs, as seen in Figure 3, and reforms to bankruptcy law in recent years has improved banks’ debt recovery prospects.
Moreover, Brazilian banks have strong capital cushions, as seen in Figure 4. Capital adequacy is well above the minimum required, enabling Brazilian banks to absorb even large loan losses. According to the latest financial stability report from April 2011, even in an extreme scenario where bad loans rise to 10% (as a % of total corporate and individual loans), only financial institutions which hold 0.13% of total assets would be insolvent.
Figure 4: Banks have strong capital cushions
Source: Fitch Ratings
Analysts at Barclay give more reasons for comfort. As Roberto Attuch and Fabio Zagatti note (via FT), about 60% of consumer loans in Brazil are collateralised – secured against payrolls, cars or property – and are at fixed rates, making them safer. Moreover, Brazilian banks are not dealing with currency mismatches (eg. borrowers who have taken out foreign currency-denominated loans, but earn in local currency), which threatens financial stability in certain eastern European economies, like Hungary.
The bigger risk to financial stability comes from events abroad, rather than fast domestic credit growth. The eurozone and US are embroiled in debt crises and the knock-on effects to emerging markets remain unclear. Brazil’s high loan-to-deposit ratio of almost 120% is a potential concern.
Brazilian banks are heavily dependent on wholesale funding to finance loans, rather than retail deposits, which tend to be a more stable source of financing. Wholesale funding dried up during the global financial crisis and if it dries up again, that would severely constrain lending in Brazil and curtail economic growth.
Authorities Have Moved Proactively to Ensure a Soft Landing
The central bank is well aware that credit continues to expand at a fast clip and has taken numerous steps to safeguard financial stability and prevent an abrupt economic adjustment.
- The central bank has embarked on a tightening cycle, and Brazil’s interest rate is the highest among major emerging markets. The SELIC rate (the benchmark interest rate) now stands at 12.5%.
- Series of macroprudential measures:
- In the latest attempt to slow credit growth, the central bank required banks to set aside more capital for credit card loans backed by wages and pensions. (See FT’s Beyond Brics)
- In April 2011, the government doubled the tax on consumer credit to 3% a year from 1.5%.
- In December 2010, authorities upped reserve requirements on time deposits held by banks to 20% from 15%.
- In an earlier blog post, I detailed the steps Brazil has taken to limit foreign capital inflows, which can feed credit growth. (See: Brazil’s Capital Controls: How Successful?)
Overall, Brazil’s central bank has actively used a mix of monetary policy, macroprudential measures and capital controls to prevent economic conditions from getting too bubbly. Despite rapid credit growth, there doesn’t seem to be much cause for concern right now.