Latin American banks look solid moving into 2022 as economies return to pre-pandemic "normality," with rating agencies giving the sector a stable outlook despite a forecast of slower growth and higher interest rates.

Asset quality, while stronger than expected, may weaken on "softer economic performance expected for 2022 and weaker credit growth," S&P Global Ratings analyst Cynthia Cohen Freue said. Higher interest rates, all but assured thanks to strong inflation, will be passed onto clients. "We do not expect serious deterioration in margins."

Slower growth may also bring higher nonperforming loan ratios and more defaults, Cohen Freue said. However, the rise in interest rates will help prop up profitability and offset moderation in loan growth, according to Moody's 2022 outlook for banks published in December 2021. Additionally, inflation will curb banks' risk appetite and lead them to be more cautious and make safer bets on loans for corporates, payroll and mortgages, Moody's said. Retail loans are forecast to grow at a higher rate than corporate loans because of high demand from consumers and weak appetites from companies, according to S&P Global Ratings.

Moody's said it could be prompted to change its outlook to negative on longer-lasting inflation, weak labor markets and an end to government support, which would weigh on confidence and asset quality, as well as increasing credit costs.

'Political uncertainty'

Latin America will start 2022 with headline inflation running twice as high as expected a year ago and with Brazil and Peru at nearly three times the target, according to Oxford Economics. Central banks are expected to raise rates to tackle inflation in most places.

In 2022, S&P Global Ratings expects average GDP growth of 2% for the six biggest countries in Latin America, a slide from a projected 6.1% increase in 2021. Chile and Brazil are among the most at risk for deterioration.

And there is the political drama.

"The defining theme of Latin America's outlook in 2022 is enduring political uncertainty," Oxford Economics said in a report.

Volatility in Colombia and Brazil is expected, with elections in May and October, respectively. Argentina may face unrest amid International Monetary Fund negotiations. Also roiling markets are the Peruvian Congress' attempt to oust President Pedro Castillo after just months in office, and Mexican President Andrés Manuel López Obrador's efforts to nationalize the energy sector against the will of the supreme court, local businesses and the international community, Oxford Economics said.

Still, Moody's identified potential positive catalysts as a stronger economic recovery, improved supply chains and deepening financial inclusion. And even if economic growth is moderate, it should support household credit demand and prompt even more from corporate customers as banks maintain reserve buffers and increase capital retention.

Finally, the banks are well provisioned from 2020 and 2021, and spikes in provisions are not expected in 2022, which should help contribute to profitability, Cohen Freue said.

Brazil

Brazil's economy recovered faster than expected, but growth prospects are moderate, according to S&P Global Ratings. Inflation is expected to remain about 10%, likely driving interest rates to 11% from 7.75%, the highest in real terms since 2015. GDP is expected to grow 0.8% in 2022 from 4.8% in 2021.

In October 2021, Fitch Ratings said that while the financial performance of Brazil's banking system had stabilized, the outlook is negative for long-term credit conditions and business volumes because of debt levels and consumer leverage, on top of inflation and anemic job recovery. Over the past two years, credit to individuals in Brazil grew 27% to 2.4 trillion reais. That household debt, elevated by higher interest rates, may lead to higher provisioning expenses.

Loan moratoriums, government stimulus and regulatory forbearance have masked the pandemic's impact on asset quality deterioration, Fitch said. Banking federation Febraban noted loan defaults in the country fell to a low of 2.2% during the end of 2021, but defaults could return to growth in 2022.

Topping all of that off is an election pitting presidential incumbent Jair Bolsonaro against former President Luiz Inácio Lula da Silva. The former is trailing in polls.

Chile

Chile's economy should grow 2% — if not less — compared to an expected increase of more than 11% in 2021, according to S&P Global Ratings. Demand soared 20% above pre-pandemic levels in 2021, thanks to three rounds of stimulus measures. A fourth stimulus round may come but will not be enough to support growth.

"Public debt may continue on an upward trajectory," said Nikhil Sanghani, an emerging markets economist at Capital Economics.

According to the Oxford Economics report, Chile needs to slash spending by 5% of GDP. "The risk of a fiscal cliff is real, and a disorderly withdrawal of stimulus in Chile could lead to a double-dip recession or to another wave of social unrest — or both."

Mexico

S&P Global Ratings forecast Mexico's GDP growth at 2.8% for 2022 and 5.8% for 2021, citing supply chain bottlenecks that have hurt the manufacturing sector. Investor sentiment in key sectors like energy has also been dampened with a lack of incentive in government policy, the report highlighted. The country's central bank had noted these supply chain problems in a November 2021 meeting, wherein it raised the benchmark to 5%, citing heightened inflation expectations.

The challenge for the sector will be to reverse a significant contraction in credit, which had narrowed since its lowest point in April when loans shrank by 14.6% year on year. Banco de México's most recent data shows that credit in October weakened by 6.1%.

Banks, however, have a healthy average capitalization ratio of 19%, above the required minimum of 10.5%, according to the National Banking and Securities Commission. The problem is a lack of demand for credit because of informality and a dependency on remittances, despite government efforts to make lending easier. In a recent financial stability report, the central bank highlighted that current liquidity and capital levels allow for a prudent expansion of bank credit.