Inside investment: The fog of debt

'The miasma that cloaks Beijing in darkness'

I had already been thinking about changing my newspaper print subscription from the Financial Times to the Wall Street Journal when I walked into the restaurant at the Boston Marriott in late January to attend a breakfast meeting. The FT is a fine paper, but it has not been delivered at all this year due to the collapse of distribution after the Boston Globe, its distribution partner, tried to save money by squeezing the paper carriers, a plan that backfired.

I picked up a complimentary WSJ at the maître d’hôtel’s desk. An erstwhile emerging markets bond fund manager, I shuddered like the old fire horse hearing the station bell in the distance when I espied the headline ‘Debt haunts emerging markets’.

The article began: ‘Underlying this month’s market turmoil runs a deeper worry that mounting debt burdens in developing nations, particularly in Asia and Latin America, threaten to become a drag on global growth.’

Intrigued and concerned, I consulted two reports. The first was: ‘Capital flows to emerging markets,’ published by the Institute of International Finance in January. The second was the IMF’s paper from last October: ‘Corporate leverage in emerging markets – a concern?’

The IMF reports that corporate debt, mostly local currency bank loans, in emerging market countries quadrupled between 2004 and 2014, from $4 trillion to $18 trillion; further, the biggest debt growth has been in construction, followed by oil and gas, both cyclical sectors. 

It is interesting to note that EM corporate debt had remained fairly flat in the five years preceding zero interest-rate policy (Zirp) and quantitative easing. Now we know who got the easy money. Corporate debt is now 88% of GDP for emerging countries in aggregate; it had been under 50% previously. China alone now stands at 130%, compared with the US at 70%. 

Latin America had a similar quadrupling of debt in the 10 years before August 1982, when Mexico suspended debt payments, so the present situation may be viewed as disturbing.

Much as the miasma that cloaks the streets of Beijing in darkness lifted when factories were closed for the Olympics, looking deeper into the data provides clarification. While EM corporate debt-to-GDP ratios have been steadily rising, public debt has remained unchanged (38% of GDP pre-crisis to 39% today.) And while overall corporate debt has risen sharply since the crisis, there has been little change outside of China since commodity prices stopped rising in 2010. (A few countries now have lower corporate debt ratios than in 2007, including Russia, Poland, South Africa and Hungary.)

There has been a negative net flow of funds from emerging market countries for two years, with net flows of minus $111 billion in 2014 and minus $735 billion in 2015. Two points should be borne in mind. First, the annual flows turned negative, not from an increase in outflows, which have remained fairly constant for several years, but mainly from a precipitous drop in inflows. 

Second, in 2015, almost all outflows were from China, and outflows accelerated in the fourth quarter, peaking in December when the People’s Bank of China announced that it would no longer link the yuan wholly to the dollar but to a trade-weighted basket of which 26.4% is dollars.

The IIF opines that the December flows were primarily by Chinese companies repaying or hedging dollar indebtedness in light of the future devaluations of the yuan indicated by the new basket. China has spent a considerable amount of reserves to devalue gradually; one may surmise that this is to allow local companies time to hedge their dollar exposure, which implies further revaluation once the requisite time has elapsed.

Below the disturbing global statistics are two points. Firstly, the surge in EM corporate debt has overwhelmingly resulted from borrowing by Chinese state-owned enterprises in local currency. Secondly, outside of China, the debt increase has been in companies in construction and resources, and mainly in Latin America. It seems a relatively safe bet that the Chinese state will look after the well-being of the SOEs, for reasons of national pride if nothing else. The rest of the problem is then theoretically manageable, despite the likelihood of defaults in the commodity/energy sector. But this does not mean that defaults will not become more widespread. There is considerable risk in the flow numbers.

There is an investing disorder that I shall call the ‘Nat Rothschild syndrome,’ in honour of the yclept gentleman’s ill-fated investment in Bumi of Indonesia.

The syndrome is ‘the erroneous belief that the emerging market counterparty is the source of repayment of money invested’. This is almost never true. One must, however, admire the fight Rothschild put up once he realised he had been conned. 

When flows become negative, borrowers are under intense pressure not to repay, partly for fear of becoming the laughing stock of their national peers. (One can imagine the awkward silence when a local ‘repayer’ walks into the bar of the Rio Yacht Club.) The ultimate counterparty for a foreign lender to an EM company is not the borrower, but another foreigner who will lend that company additional money to repay the first foreign lender or buy the stake directly. 

Here, then, is the key to EM credit monitoring: when a foreign bond holder perceives a reluctance among his fellows in London, New York, or elsewhere to advance additional money to EM borrowers, he should discreetly exit his positions.