Analysts say higher interest rates to offset banks' gains from rising inflation

Tuesday, April 5, 2011

The Chilean central bank's Monday (Apr 4) announcement that it was hiking its inflation forecast for 2011 to 4.3% from 3.3% will mainly benefit large banks' earnings, although this effect will be offset by higher interest rates, analysts told BNamericas.

Chilean banks have more assets denominated in the country's inflation-linked unit (the UF) than liabilities, and they gain from increasing inflation by managing their balance sheet mismatch between the local currency and the UF.

"It's very hard to quantify the impact [on earnings] since it depends on the gap between assets and liabilities denominated in UFs that each bank operates with, but in general terms it will be positive since all banks are exposed to inflation," local investment bank IM Trust studies department analyst Juan Pablo Correa said.

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When inflation goes up, the main winners are big commercial banks that have a larger portion of their loans indexed to inflation (mainly mortgage loans) and that fund themselves mostly in pesos through checking accounts, said Abraham Martínez, financial institutions director at Fitch.

But the market had already factored in the higher inflation expectations, as UF forwards were up only 5 pesos on Monday to 4.36%, said Rubén Catalán, analyst at the studies department of BCI's stock brokerage.

Besides, further diminishing the effect of interest rate changes on banks' earnings is the fact that they hedge their mismatches through derivatives such as forwards or swaps, analyst at local ratings agency Humphreys Gonzalo Neculmán told BNamericas.


Chilean banks' net profits were down 4.63% year-on-year to 260bn pesos (US$548mn) in January-February compared with the same period in 2010, as a positive inflation adjustment was offset by losses on mark-to-market financial investments and a contraction in net interest margin (NIM) given lower levels of demand deposits, or interest-free funding.

In March, the adjustment of inflation-indexed loans will be 0.24%, similar to the rate seen in February, although well below the 0.37% adjustment seen in March 2010, according to a report by financial services firm Celfin.

"However, rising money market rates are likely to continue attracting funds to time deposits, away from demand deposits. Thus, due to lower year-on-year inflation levels in 1Q11 compared with 1Q10 and higher interest-bearing funding levels, net earnings for the Chilean financial sector are likely to decline in the area of 7% year-on-year in 1Q11," the report reads.

Only from April onward are rising inflation levels likely to filter through to banks' results, Celfin said.

"Spreads had improved in January compared with the low levels seen in 4Q10. However, higher interest rates and large banks' intention to delay transferring those to loan interest rates has put spreads under pressure again," BCI's Catalán wrote in a report with analyst Pamela Auszenker.


While higher inflation boosts banks' profits through the adjustment of their balance sheets, the expected additional increases in the country's TPM benchmark interest rate over the next few months will increase funding costs for banks and also reduce loan demand, Raúl Barros, senior analyst at stock brokerage BBVA Chile's research department, told BNamericas.

Analysts and bankers are projecting a 15% annual increase in lending this year, slightly more than two times the country's expected GDP expansion.

"While higher inflation will have positive effects on banks' short-term earnings, its long-term outcomes - such as more sluggish consumption, higher risk and interest rates - will be more relevant," he said.

Still, an increased TPM will boost big banks' NIMs over the coming months given their higher levels of interest-free funding deposits, Fitch's Martínez said.

"When inflation spirals out of control as it did in 2008, credit risk increases in the lower-income segments of the population as it cuts their disposable income, but we don't see that happening this year," he said.

In mid-March, the central bank announced a higher-than-expected 50 basis point increase in the TPM to 4% to fight rising inflationary pressures. The market is expecting successive interest rate hikes over the course of the year, to end 2011 at around 6%.

The monetary entity said it expected inflation to return to its target band of 2-4% in the second quarter of next year.

To read the central bank's full report in Spanish, go to this link