Why banks in emerging Asia will face a tougher 2014

High interest rates still a headache.

The credit cycle has turned for Asian banking systems with nearly half the countries monitored by Fitch Ratings having Negative Sector Outlooks for 2014 - mostly in emerging Asia. The negative bias in Fitch's new report reflects challenges expected from higher interest rates, moderation in economic growth, and seasoning of loan portfolios after an extended period of rapid growth.

Here's more from Fitch:

The agency views slower credit growth positively as it would help to prevent overheating in some markets.

That said, all countries except Mongolia have Stable Rating Outlooks, reflecting a combination of factors. Many banks are entering this phase with healthy fundamental strengths, but not those in China and India's state bank sector where conditions have already exerted downward pressures on their Viability Ratings (VRs).

Where there are pressures on bank fundamentals as reflected by the VRs, the rating outlooks reflect sovereign support - as is the case with China and India.

Fed tapering and China are the two key risk themes for 2014 that will have the greatest bearing on bank performance.

The move towards interest-rate normalisation has begun to expose economic imbalances leading to currency pressures and higher market rates. This adjustment will test loan quality where credit expansion has been rapid, particularly in some parts of emerging Asia such as Indonesia, Thailand and Malaysia where a rapid build-up of household debt has occurred.

This may become a source of asset quality problems if unemployment and inflation rises. In most cases earnings and capitalisation buffers remain solid to offset higher credit costs, while funding and liquidity profiles are comfortable to absorb any currency pressures.

For China the pace of credit growth is unsustainable, but is expected to continue in the medium term. Financial system asset quality remains a concern, and the rise in overdue loans is likely to accelerate. Financial liberalisation and rebalancing will add to system pressures. The larger the financial system becomes, the greater the potential for surprises.

Growing linkages between China and the region, in particular Hong Kong, also means the region's fortunes will depend on how successful China rebalances from its unsustainable investment-driven growth model.

The Indian banking system will have another challenging year with stressed assets expected to peak towards the end of the 2014 calendar year at the earliest, with the state banks being most exposed. Any improvement is likely to be gradual, with a pick-up in the economy likely to be slow given the uncertainties during an election year.

Capital-raising is expected to be most prevalent in China and India to offset mounting asset-quality and earning pressures as well as the requirement to meet higher minimum Basel III regulatory capital requirements. In particular, Fitch expects to see active issuance of Basel III capital instruments in both markets during 2014.

For developed Asia, most markets have Stable Sector Outlooks. However, markets such as Australia, New Zealand, Singapore and Hong Kong have high mortgage indebtedness, and would be sensitive to sharp property price adjustments and rising unemployment, although this is not Fitch's base case. China's economic fortunes are ultimately the key variable in the performance of these markets.

For South Korea, the Sector Outlook is Negative because an unsupportive regulatory, social and political environment and an ageing population are adding to the challenges faced by the banks.

With respect to Abenomics, the key uncertainty is whether there will be a meaningful and lasting impact for Japan and the region in 2014. A more durable boost to Japanese economic activity would be positive for Japanese banks, and a counter-balance for regional activity against a more material slowdown in China.