Why Emerging-Market Debt Issuers Are Vulnerable

$2 trillion debt boom leaves emerging-market companies, and banks, at risk at the first sign of trouble.

Emerging-market companies that took on more than $2 trillion of foreign borrowing since 2008 are vulnerable to an evaporation of funding at the first sign of trouble, according to the Bank for International Settlements (BIS).

Bond investors willing to lend generously when conditions are good can pull out in a crisis or when central banks tighten monetary policy, analysts led by Claudio Borio, head of the monetary and economic department, wrote in the BIS annual report. Emerging-market companies that lose access to external debt markets may then be forced to withdraw bank deposits, depriving domestic lenders of funding as well, they said.

Low interest rates and central bank stimulus in developed nations, combined with a retreat in global bank lending, have encouraged emerging-market borrowers to raise debt abroad, according to the Basel, Switzerland-based BIS, which hosts the Basel Committee on Banking Supervision that sets global capital standards. Demand for higher-yielding securities also helped suppress borrowing costs for riskier issuers.

“Like an elephant in a paddling pool, the huge size disparity between global investor portfolios and recipient markets can amplify distortions,” the analysts wrote. “It is far from reassuring that these flows have swelled on the back of an aggressive search for yield: strongly pro-cyclical, they surge and reverse as conditions and sentiment change.”

Average nominal yields on long-term bonds of emerging nations fell to about 5 percent as of May 2013, from 8 percent at the beginning of 2005, according to the BIS. Adjusted for inflation, this amounted to real long-term rates of just 1 percent last year, it said.

Loose financing conditions “feed into the real economy, leading to excessive leverage in some sectors and overinvestment in the industries particularly in vogue, such as real estate,” according to the report. “If a shock hits the economy, overextended households or firms often find themselves unable to service their debt.”

Emerging-market companies sell bonds mainly through foreign units, exposing them to currency risk, the BIS said. The true size of their borrowing could also be masked as foreign direct investment, making it a “hidden vulnerability,” according to the report.


Market Selloff

With emerging markets becoming more important to the global economy and financial system, any stress affecting them will probably hurt developed nations, too, it said.

“The ramifications would be particularly serious if China, home to an outsize financial boom, were to falter,” the analysts wrote. That would hurt commodity exporters that have seen strong credit and asset price increases drive up debt and property prices, as well as other nations still recovering from the financial crisis, the BIS said.

Emerging markets were roiled in May 2013 after former Federal Reserve Chairman Ben S. Bernanke signaled the U.S. central bank may consider withdrawing stimulus. While a contraction in Chinese manufacturing helped spark another selloff in January, bond prices soon recovered, evidence of “a puzzling disconnect between the markets’ buoyancy and underlying economic conditions globally,” the BIS said.

Emerging nations now look more resilient than they did a year ago, according to Barclays Plc analysts Christian Keller and Koon Chow writing in the London-based bank’s Emerging Markets Quarterly.

Weaker currencies and higher interest rates help make policy adjustment easier and support investor appetite for emerging-market assets, they wrote. A revival of global growth should help backstop emerging economies, according to Barclays.

Countries have also reduced their vulnerability by cutting current-account deficits, a process that’s expected to continue, the Barclays analysts said.

Although emerging markets have sought to make themselves more resilient by running current account surpluses, boosting foreign exchange reserves, making exchange rates more flexible and strengthening financial systems, those measures may be less effective than hoped, according to the BIS.

“Historically, some of the most damaging financial booms have occurred in countries with strong external positions,” the report said, citing the U.S. ahead of the Great Depression and Japan in the 1980s. “Time and again, in both advanced and emerging-market economies, seemingly strong bank balance sheets have turned out to mask unsuspected vulnerabilities that surface only after the financial boom has given way to bust.”

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