Banks in the biggest emerging markets are losing the confidence of investors as loans turn sour after a two-year credit binge.

Brazil's financial shares have lost more this year than counterparts in crisis-stricken Europe as consumer defaults hit a 12-month high in June and borrowing costs climbed to 46 percent. Bank stocks in China are trading at lower valuations than global emerging-market indexes for the first time since 2006. The country faces a financial crisis with bad debt that may jump to 30 percent of total loans, Fitch Ratings said.

In India, the cost of insuring banks against default has climbed to the highest level in a year. Loan-loss provisions at State Bank of India (SBIN), the nation's largest lender, rose 77 percent in the first three months of 2011, while net income fell 99 percent.

"People are beginning to smell the credit cycle turning," Michael Shaoul, chairman of Marketfield Asset Management and chief executive officer of New York-based brokerage Oscar Gruss & Son, said in an interview. "Credit cycles have tremendous momentum, and whenever they turn you want to pay attention," said Shaoul, who recommends selling high-yield bonds in emerging markets and betting on further losses in bank shares.

Loans to Brazilian shoppers, Chinese infrastructure projects and Indian developers have fueled the global economic recovery and turned emerging-market banks into some of the world's biggest companies by market value. Now increased debt burdens threaten growth as central banks raise interest rates to fight inflation, U.S. hiring stalls and Europe deepens austerity measures. China and Brazil may see expansion cut by at least 50 percent in the next few years, according to economic consulting firms A. Gary Shilling & Co. and Capital Economics Ltd.

Citigroup, HSBC

A slowdown would curb profits at global banks including New York-based Citigroup Inc. (C) and London-based HSBC Holdings Plc (HSBA), which boosted lending in the fastest-expanding economies to fuel growth after the U.S. credit bubble burst in 2008. Prices of commodities such as copper are vulnerable to a drop in demand from China, the world's biggest consumer of the metal, said Gary Shilling, who founded the Springfield, New Jersey-based firm bearing his name and predicted the U.S. recession that began in December 2007.

"China isn't this juggernaut that's going to grow forever without any interruption," Shilling said in a July 14 interview with Bloomberg Television's Betty Liu, adding that the government may be forced to bail out banks as bad debts grow.

China Loan Surge

Chinese lenders expanded credit at a record pace in 2009 and 2010, making more than 17.5 trillion yuan ($2.7 trillion) of new loans as the government moved to offset a collapse in exports during the global recession. The surge in loans exceeded credit expansions in the U.S. before its financial crisis, in Japan before its stock and property bubbles collapsed in 1990 and in South Korea before the Asian financial crisis of the late 1990s, according to Fitch.

Brazil's annual credit-growth rate accelerated to as high as 34 percent in September 2008, the fastest since at least 1995, before moderating. The pace has picked up again, exceeding 19 percent for 11 months through June, central bank data show.

Andreia de Matos Esmeraldo, a babysitter and housecleaner in Rio de Janeiro, is one of the reasons. The 43-year-old resident of Rocinha, Rio's biggest slum, carries her HSBC credit-card statement in her purse as a reminder that using the card to purchase clothes and shoes isn't free. The bill shows an annual interest rate of 456 percent on 3,000 reais ($1,936) of debt she ran up that she has agreed to pay off in installments.

'Love to Shop'

"I love to shop, it gives me this personal satisfaction," Esmeraldo, who also sells products for Natura Cosmeticos SA (NATU3), Brazil's largest cosmetics company, said in an interview. "But two days later I feel sick because I have to pay it back."

Credit is expanding in developing nations after a decade of relative economic stability. Brazil has experienced boom-and- bust cycles of inflation, currency devaluations and interest- rate swings since the end of military government in 1985. Almost half of Chinese bank loans turned sour following the Asian financial crisis, while hundreds of Russian banks were shut when the government defaulted on $40 billion of ruble debt in 1998.

Most governments in the largest emerging markets are now strong enough to prevent an increase in bad debt from hobbling their banking systems, Amer Bisat, a former senior economist at the International Monetary Fund who manages money at hedge fund Traxis Partners LP in New York, said in a phone interview.

'Cushion of Savings'

China has $3.2 trillion of foreign-exchange reserves, the world's largest holdings. Brazil, India and Russia control a combined stash of about $1 trillion. The average debt burden in the four largest emerging economies, known as the BRICs after Goldman Sachs Group Inc. coined the term in 2001, is 40 percent of gross domestic product, compared with 102 percent for developed nations, according to IMF estimates.

"So long as the economy continues to grow at trend, the system can take a significant amount of banking problems," Bisat said. "The cushion of savings through reserves is so big that a lot of problems can be absorbed."

Surging profits during the past two years boosted the capital cushion of developing-nation banks. Lenders in the MSCI BRIC Index have an average Tier 1 capital ratio of 11.1 percent, up from 10.3 percent in 2009, according to data compiled by Bloomberg. That compares with the 11.8 percent average for banks in the MSCI World (MXWO) Index for developed countries. Banco Bradesco SA (BBDC4), Brazil's second-largest lender by market value, has a Tier 1 ratio of 14.7 percent, data compiled by Bloomberg show.

Capital Requirements

"Brazilian banks are well-capitalized," Will Landers, who runs Latin America equity funds for BlackRock Inc., the world's largest money manager, said in a July 5 interview on Bloomberg Television. "We're really not worried about any type of banking crisis."

Policy makers have already taken steps to slow credit growth. Brazil raised reserve and capital requirements on some loans in December, doubled to 3 percent a tax on consumer credit in April and required banks to hold more capital against certain credit-card loans last month. The Reserve Bank of India has asked lenders to set aside more cash for bad loans and double provisions for restructured debt.

China raised banks' reserve requirements 12 times since the beginning of 2010. The China Banking Regulatory Commission told lenders last month that they haven't set aside sufficient funds to cover losses on loans to local governments and ordered them to accelerate debt collection, a person with knowledge of the matter said.

Struggle to Grow

"China as a country has the capacity to be able to absorb" increased defaults, Piyush Gupta, CEO of Singapore- based DBS Group Holdings Ltd., southeast Asia's largest bank, said in a July 19 interview on Bloomberg Television.

China's leaders maintained economic growth of at least 7.6 percent in the late 1990s even after bad debt jumped to more than 40 percent of total loans, according to data compiled by Bloomberg and "Red Capitalism" authors Carl E. Walter and Fraser J.T. Howie.

This time around emerging countries may struggle to grow out of their debt problems because demand from the U.S. and Europe is slowing, said Richard Duncan, a partner at Singapore- based Blackhorse Asset Management who was a consultant to the IMF during the Asian financial crisis and has worked for the World Bank as a financial-industry specialist.

The U.S. jobless rate climbed for a third straight month in June to 9.2 percent. Retail sales in Europe, where policy makers are struggling to solve sovereign debt crises in member countries including Greece and Portugal, sank 1.1 percent in May for the biggest decline since April 2010.

'Excess Capacity'

In the past, emerging countries' export growth "helped them overcome a lot of bad mistakes in the banking sector," Duncan, the author of "The Corruption of Capitalism," said in a phone interview. Now in China, "they have massive excess capacity, which they financed with credit, and no one to sell the capacity to," Duncan said.

China's local governments, which the National Audit Office estimates have 10.7 trillion yuan of debt, are struggling to repay their obligations after the People's Bank of China lifted its main lending rate five times since October 2010. About a third of local government financing vehicles, used to get around laws prohibiting direct borrowing, don't have cash flow to service their debt, according to China's banking regulator.

Yichun City Construction Investment & Development Co., an investment vehicle for the city of about 1.3 million people near China's border with Russia, sold 1.2 billion yuan of bonds in 2009 backed only by a pledge from the local government and possible future land sales.

Warrior Princesses

Money raised from the sale is being used for the destruction of what the prospectus calls "shanty towns." Single-floor traditional wooden homes in the valley are being demolished to make way for thousands of low-income apartments.

The company has also financed a new reservoir, an airport terminal and parklands, one featuring faux Corinthian columns topped by winged warrior princesses and bronze sculptures of chariot-riding gods. The Yichun financing vehicle would have lost money every year from 2006 to 2008 except for direct government subsidies.

Fitch cited financing vehicles and property-related lending as primary areas of concern when it said in April it may cut the country's local-currency debt rating. China has the worst grade in Fitch's three-level scale of potential for systemic stress. Sixty percent of countries that received the score had banking crises within a few years, according to a June 21 presentation by the ratings company.

Cutting Estimates

An increase in Chinese banks' bad-debt ratio to 30 percent is "not inconceivable," Andrew Colquhoun, head of Fitch's Asia-Pacific sovereign debt unit, said on an April 13 conference call. Moody's Investors Service estimates nonperforming loans may climb as high as 18 percent in a "stress" case, according to a July 5 statement. China's total bad loan ratio was 1.1 percent at the end of 2010, according to the central bank.

Investors are cutting their estimates for the value of Chinese bank assets. The MSCI China Financials Index's price-to- book ratio, a measure of share prices relative to net assets, has tumbled to 1.8, the lowest level since February 2009, from 2.8 two years ago, according to monthly data compiled by Bloomberg. The ratio for Chinese lenders slipped below that of the MSCI Emerging Markets Index on June 21 for the first time since January 2006, data compiled by Bloomberg show.

Industrial & Commercial Bank of China (601398) Ltd., the world's largest lender by market value, slumped 8.2 percent since the end of March even after saying bad loans dropped almost 4 percent in the first quarter.

'Increasingly Tangible'

Credit-default swaps on Bank of China Ltd. (3988), the nation's third-largest lender by assets, jumped to 153 basis points from 106 on March 31, according to data compiled by Bloomberg and CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in privately negotiated markets.

"We expect Chinese banks' nonperforming loans to rise noticeably over the next few years," Liao Qiang, a director at Standard & Poor's in Beijing, said in an e-mailed response to questions on July 21. "This could be increasingly tangible as policy tightening continues."

Brazil's biggest lender, Itau Unibanco Holding SA (ITUB4), raised its default-rate forecast for 2011 to between 4.5 percent and 4.6 percent on July 11. The Sao Paulo-based bank had forecast a rate of 4.2 percent to 4.5 percent. Itau's shares have tumbled 21 percent this year, helping to drag down the MSCI Brazil Financials Index by 19 percent in local currency terms. That compares with a 12 percent retreat in Europe's Stoxx 600 Banks Index and a 7.3 percent drop in the S&P 500 Financials Index. (S5FINL)

Brazilians' Burden

Credit Suisse Group AG lowered its rating of Itau on July 26 to "neutral" from "outperform" and cut its earnings forecasts for Brazilian banks by an average of 4 percent this year on concern that higher provisioning costs will crimp industry profits.

Brazilians' debt burdens are rising after the central bank lifted its benchmark interest rate five times this year to the highest level since March 2009. The average interest rate on consumer loans was 46.1 percent in June, up from 40.6 percent in December, according to the central bank. The average rate on company loans increased to 30.8 percent from 27.9 percent.

Loan payments by Brazilian consumers climbed to 26 percent of disposable income in March, up from 24 percent a year earlier. The rising costs of debt signals Brazil's consumers are "overstretched," Neil Shearing, a senior emerging-markets economist at Capital Economics in London, wrote in a July 12 report.

'Lower Echelon'

A retrenchment may drag down Brazil's economic growth rate to 2.5 percent in 2013, from 7.6 percent last year, according to Shearing. That compares with the 4.5 percent median forecast in a Bloomberg News survey.

"The people doing the borrowing are the people in the lower echelon in terms of income, and that's worrisome," Simon Nocera, a co-founder of San Francisco-based hedge fund Lumen Advisors LLC and a former economist at the IMF, said in an interview. Nonperforming loans "will be higher than previous credit cycles."

Borrowing costs for Brazil's mid-sized banks are climbing amid speculation that loan losses will increase. Yields on Banco Bonsucesso SA's dollar bonds due in 2020 rose 85 basis points this year to 10.6 percent after Moody's cut its outlook in December for lenders specializing in payroll-deductible loans, which are deducted directly from workers' salaries.

Banco Panamericano SA (BPNM4), which was bailed out with a 2.5 billion-real loan from its controlling shareholder in November after suspected accounting fraud, increased its assets to $8.1 billion as of September from $4.4 billion two years earlier, data compiled by Bloomberg show. Banco Cruzeiro do Sul SA, which focuses on payroll-deductible loans, has seen its assets rise to $7.2 billion from $2.7 billion during the past three years, the data show.

'New Reality'

"Banks will have to face a new reality," Brigitte Posch, emerging-markets portfolio manager at Pacific Investment Management Co., which oversees about $1.3 trillion worldwide, said at the Bloomberg Brazil conference in New York on July 14. "That will affect the relative value of those bonds, and we don't think it's the right moment to invest in the mid-sized banks sector in Brazil."

In India, debt ratings for companies are deteriorating at the fastest pace since 2009 as slower economic growth and 11 interest-rate increases by the central bank since March 2010 heighten the risk of defaults. ICRA Ltd., the local unit of Moody's, lowered rankings for 34 borrowers last quarter, according to data compiled by Bloomberg.

Stress Tests

Indian lenders' nonperforming assets may rise 25 percent in the year ending March 31, 2012, to 2.92 percent, the central bank said on June 14 after conducting stress tests. The Indian banking system is under pressure and higher provisioning is "imminent" if regulators want to control asset quality, Diwakar Gupta, Mumbai-based managing director and chief financial officer of State Bank of India, said on July 2.

Bad loans "are going to rise because we will have to pass on the rate increase," the bank's chairman, Pratip Chaudhuri, told reporters in Mumbai after the central bank increased borrowing costs on July 26. "Interest-rate sensitive sectors like real estate and education loans will most definitely be affected," Chaudhuri said.

Ghanshyam Kulwal, 46, an exporter of towels and sheets in Mumbai, is feeling the squeeze. He bought a two-bedroom apartment in the suburb of Kandivali in 2003 for his wife and two children, taking a loan from what was then ABN Amro Bank NV at a floating rate of 6 percent. Today he's paying 12.5 percent.

"The government's one-point agenda to check inflation by raising rates has led to common people like me suffering a lot," Kulwal said.

ICICI Swaps

The cost of insuring State Bank of India's bonds against non-payment with five-year credit-default swaps increased as much as 48 basis points this year to 208 on July 18, the highest since July 2010, according to CMA. Swaps for ICICI Bank Ltd., the second-biggest Indian lender, jumped by as much as 54 basis points to a 12-month high of 253 on July 19.

"Whenever you have a period of high growth and the macroeconomic picture changes, there will always be an issue" with credit quality, said Sampath Kumar, an analyst at brokerage India Infoline Ltd. in Mumbai.

Lenders in other emerging economies are also showing signs of stress. Bank of Moscow needed the biggest bailout in Russian history last month after racking up at least 150 billion rubles ($5.4 billion) of unsecured bad loans. The $14 billion rescue of the country's fifth-largest bank signaled Russian lenders' health may be "substantially worse" than most investors judge, Carroll Colley, a director at New York-based research firm Eurasia Group, wrote in a July 8 report.

Turkish Boom

Russian lenders accounting for 51 percent of the banking system's assets failed central bank stress tests this year. Losses in the stress scenario may amount to 5.2 percent of gross domestic product, Bank Rossii said in an April report.

In Turkey, annual credit growth of more than 30 percent has fueled a boom in domestic demand that widened the country's 12- month current-account deficit to a record $68.2 billion in May. The combination of loose credit and a growing trade gap makes Turkey's financial system vulnerable to a drop in risk appetite, according to Shaoul, whose $741 million Marketfield Fund has climbed 7.3 percent during the past year, beating 66 percent of peers, according to data compiled by Bloomberg.

Banco Santander

Souring loans in emerging markets could affect global banks. Banco Santander SA (SAN) shares sank 3.2 percent on July 27 after Spain's biggest lender reported a 32 percent surge in loan-loss provisions in Brazil, an increase that surprised investors, according to Daragh Quinn, an analyst at Nomura International in Madrid.

Citigroup, the third-largest U.S. bank, gets more than half of its profit from emerging markets, CEO Vikram Pandit, 54, said in March. Consumer lending in Asia jumped 41 percent in the two years through June to $66.7 billion, as deposits rose 27.7 percent. In India, Pandit's native country, the bank boosted lending to corporate clients by 33 percent in the year ended March 31. Loans to small and medium enterprises jumped 35 percent, according to a company statement.

While second-quarter revenue from its consumer bank's Latin American and Asian units rose a combined 13 percent to $4.46 billion, profit fell 14 percent.

"They will have to rein in what has obviously been a real surge in consumer lending," said Richard Staite, a London-based analyst with Atlantic Equities, who has an "overweight" rating on Citigroup shares. "Investors will want reassurance going forward about the level of credit quality."

'Well-Balanced'

Citigroup has a "well-balanced, focused growth strategy in the emerging markets," Jon Diat, a New York-based spokesman, said in an e-mailed statement. "In India and Brazil, Citi has a very focused consumer strategy that targets the most creditworthy clients, and our corporate business works closely with top-tier local corporate and multinational entities."

Second-quarter earnings reports may provide more clues on the outlook for nonperforming loans and bank earnings in emerging markets. At least 126 companies in the MSCI Emerging Markets Financials Index are scheduled to report results in the next 30 days, according to data compiled by Bloomberg. Last quarter, profits missed analysts' estimates by 3 percent on average, the data show.

"We are only at the beginning," said Mohamed Abdel-Hadi, whose HC GEM Sector Rotation Fund has climbed 7.4 percent this year, beating 86 percent of peers, in part because of bets that financial stocks would underperform. "Over the next few quarters, we expect to see NPLs rising across emerging-market banks."