OREANDA-NEWS. Nigerian banks are experiencing a sharp rise in non-performing loans (NPL) but in isolation asset-quality deterioration is not yet a negative driver for the 11 rated commercial banks in the country, says Fitch Ratings.

Worsening NPL trends in the sector have accelerated since end-2015 and we expect this to continue because operating conditions remain difficult. The Nigerian Central Bank's latest financial stability report says sector NPLs rose to 11.7% of gross loans at end-June 2016 from 5.3% at end-2015. This exceeds our start-of-year expectations for a 10% NPL ratio by end-2016. But NPLs are not evenly spread among banks and sector NPL ratios are distorted by some exceptionally high concentrations. For example, First Bank of Nigeria, the country's largest bank, reported a 23% NPL ratio at end-June 2016. Some tolerance remains on NPL ratios for the banks' Viability Ratings, which are all in the 'b' range.

Other key concerns are tightening foreign currency (FC) liquidity, weakening capital adequacy ratios and the sovereign's ability to support banks, given its weaker financial flexibility. If current challenges do not ease, the banks could face further downgrades.

Our discussions with banks indicate that most impairments are concentrated in the private sector, which is affected by FC shortages and the depreciation of the naira. Borrowers are struggling to access scarce FC and those dependent on naira income are finding it hard to meet escalating repayment costs triggered by the depreciation.

Sector NPLs would have been higher if banks had not undertaken widespread restructuring of loans to the oil and gas sector, which accounts for 30% of total sector loans. Asset-quality indicators in these portfolios are therefore holding up as borrowers are able to comply with generous loan maturity extensions. But the central bank warns that it is expecting continued deterioration across banks' oil and gas portfolios during 2H16 as the sector faces sustained low oil prices and production disruptions.

Nigeria's central bank sets an informal maximum 5% NPL ratio for all banks. Once this is breached, the regulator can impose measures to boost capital, such as restrictions on dividend payments. In a one-off policy change, the central bank allowed banks to write off fully reserved NPLs by end-2016. Writing off loans is normally protracted, but even this measure is unlikely to significantly bring down the level of sector NPLs.

The central bank says that unreserved NPLs represented a high 31% of regulatory capital in the sector at end-June 2016, far higher than the 6% reported at end-2015. This puts further pressure on capital ratios, which have been affected by currency devaluation, causing some banks to report limited buffers over regulatory minimums.

Nigeria's economy remains in recession and we think it will be difficult for banks to contain the escalation of NPLs. Data published by the National Bureau of Statistics shows that domestic output in 2Q16 contracted by 2%, following a 0.4% contraction in 1Q16. Low global oil prices, a reduction in oil production levels, energy and FC shortages, price rises, with inflation reaching 17.6% in August, and weak consumer demand are all contributing to the downturn.

We expect real GDP to contract by 1% in 2016, against our previous forecast of a 1.5% expansion. We do expect a limited bounce-back and our 2017 forecast foresees a recovery to 2.6%. But the medium-term growth outlook remains significantly lower than the 5.6% growth of 2010-2014.