Still working from home? US banks are getting worried 

Rising FX risk could become a challenge for Turkish banks. In Türkiye, 57% of deposits are dominated in foreign currency. In this context, banks could come under increasing pressure if the domestic lira deteriorates further, especially as the Turkish government is unlikely to be able to support even state-owned banks. Furthermore, there is the potential, albeit unlikely under Erdogan's government, risk of an increase in key interest rates, which in turn could lead to significant write-downs in the securities portfolio.

In both Egypt and Pakistan, sovereign risk has now become more acute. Given the large holdings of government bonds by domestic banks, sovereign defaults would have a catastrophic impact. Both Egypt and Pakistan have some of the highest government-debt ratios (Egypt: 98.4%; Pakistan: 89.6%). Credit-rating agencies recently lowered Egypt's sovereign rating, citing the country's reduced external buffers and shock-absorption capacity. In the case of Pakistan, the latest external rating was CCC- by Fitch, which is just one notch above default grade. In the absence of a sovereign default, even a further rise in interest rate risks could lead to massive write-downs in securities portfolios, which in addition to liquidity could also put a strain on the capitalization of banks. 

China’s post-Covid recovery: stronger-than-expected so far, but mostly domestic and hiding some uneven developments. China’s real GDP exceeded expectations in Q1 2023, growing by +2.2% q/q and +4.5% y/y, after +0.6% q/q and +2.9% y/y in Q4 2022. The sectoral breakdown suggests that higher growth was mainly driven by the services sector, while activity in agriculture, manufacturing and construction moderated in Q1 2023. Other monthly indicators also suggest a stronger-than-expected trade balance (i.e. resilient exports but still weak imports). There now seems even clearer room for an upside revision to our +5.0% real GDP growth forecast for 2023. The recovery story remains focused on consumption, though it is likely to be mostly domestic (i.e. firms operating in China benefiting more than those exporting to China) and the largest impulse from pent-up demand is likely to be felt in the first half of the year. We continue to think that structural issues (e.g. concerning the real estate sector and youth unemployment) mean that consumer spending will take longer to approach its pre-pandemic trend than in 2021 (Figure 5).

President Macron’s roadmap for new reforms falls well short of tackling France’s long-standing structural issues. In a televised speech broadcast on Monday, Macron committed to tackling long-standing structural gaps, such as the deterioration of educational attainment, but also to address growing social discontent over the cost-of-living crisis. He called for renewed social negotiation between trade unions and corporates over wages, careers, better sharing of wealth and senior employment. Prime Minister Elisabeth Borne is expected to reveal a precise reform roadmap as early as next week. However, we doubt it will seriously address France’s structural economic bottlenecks, including the high level of taxation, the elevated yet deteriorating quality of public spending, the low employment rate and low and deteriorating education and skills attainment. Tackling these issues has become even more politically difficult since the passing of the pension reform, which has heightened political and social tensions. In particular, the usage of Article 49.3 of the Constitution – which allows the Government to pass (mostly finance) bills without the backing of Parliament – has become highly sensitive, crystallizing tensions during the passing of the pension reform. 

The benefits of the post-pandemic rebound and higher inflation to public finances are fading fast. The French public deficit narrowed relatively rapidly in the aftermath of the pandemic from -9% of GDP in 2020 to -4.7% in 2022. However, the bulk of the improvement was cyclical, owing to the economy’s post-Covid rebound and high inflation, which boosted revenue receipts (Figure 9). Elevated inflation instantly bolsters revenue intakes such as VAT collections, which are collected on a nominal base. The very robust pace of job creation also boosted social-contribution collections. On the other hand, expenditures typically take longer to increase since the indexation of transfers (such as pensions) to inflation is implemented with a lag (and often times only partially indexed), owing to legislative and calendar constraints. 

With the corrosive impact of inflation on growth increasing over time, and the government stepping in to mitigate the effect of inflation on household and corporate incomes, high price pressures will inevitably lead to a deterioration of public finances. France’s economy has been losing momentum since the second half of last year, while the government has been stepping up its response to the energy crisis through lower taxes, cost-of-living adjustments and higher fiscal transfers to households and corporates. Expenditures are increasing at a faster pace while revenue collection is flattening (Figure 9, latest data only available through Q3 2022). The more recent monthly data published by the French Budget Office in the Ministry of Finance show that through February the cumulative government finances shortfall hit more than EUR50bn (Figure 10) – a level comparable to 2021 when the public deficit ended at -6.5% of GDP. Corporation tax and VAT receipts are falling rapidly on a year-on-year basis, though income-tax collections are holding up thus far.

We expect the public deficit to widen to -5.3% of GDP in 2023, before narrowing to -4.6% in 2024. The higher deficit from last year is consistent with (i) an economy that is decelerating rapidly (we expect real GDP to nudge up by a meagre +0.4% this year, after +2.6% in 2022) and (ii) stepped-up government intervention to alleviate the effects of the energy crisis on incomes. Discretionary budget cuts and the exceptional levy on utilities’ profits (estimated to bring in EUR5bn-EUR7bn) should limit the widening of the primary deficit to -3.2% (from an estimated -2.8% in 2022). Net interest payments should increase from around 1.9% of GDP in 2022 (EUR50bn) to 2.1% in 2023 (EUR57.5bn) as higher funding costs continue to feed through. However, while increasing from a trough of 1.1% in 2020 to 1.8% at the end of 2022 (and 2.0% expected in 2023), the effective interest rate that the French state pays to its creditors is still very low. This is because only a fraction of the public debt is rolled over every year, with the average duration of French government bonds at 8.5 years.

The office sector in particular, which never fully-recovered from the pandemic shock, has come under market stress. As part of general cost-cutting measures, many companies have not only frozen hiring (or laid off staff in some sectors) but also reduced their office footprint to lower fixed costs. With a higher share of the workforce working remotely, the vacancy rate of available office space has increased from 16.8% at the beginning of 2020 to 18.7% at the beginning of 2023. The net absorption is already negative (Figure 13), and office properties have lost value due to declining rental income; this trend is likely to continue.

Banks are most exposed to the recent valuation changes in CRE (Figure 14). Despite the painful lessons learnt from the fallout of the US subprime mortgage crisis (and the more stringent regulatory requirements associated with the Dodd-Frank Act), real-estate-related credit growth has far outstripped nominal GDP growth in the US. The outstanding stock of mortgage loans increased from USD3,480bn in mid-2011 to USD5,390bn at end-2022 (+55%), of which more than half is for CRE, which also accounts for the  rapid expansion of real estate-related credit.

Going forward, we expect gradually rising pressures on CRE amid tighter financing conditions and still high economic uncertainty. So far, the low liquidity of some CRE assets has delayed – but not prevented – a deeper correction. More CRE loans are likely to become impaired but this process is bound to be gradual due to the longer duration and bank incentives to delay loss recognition by ever-greening loans. While CRE loan impairments stand at pre-pandemic lows, the asset quality is likely to deteriorate if the US economy slips into recession during the second half of the year (based on our recent growth forecast); however, the rise of default rates will depend on the severity of the economic downturn and vary across CRE segments.