Corporate Debt in Emerging Economies: A Threat to Financial Stability?
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by MSRM Professor Viral Acharya, lead author and member of Committee on International Economic Policy and Reform
During 1999-2007, the international balance sheets of emerging economies grew stronger through a combination of current account surpluses, a shift from debt funding to equity funding, and the stockpiling of liquid foreign reserves. This risk-mitigating strategy improved the international financial standing of many emerging economies and helped these economies withstand the 2008- 2009 global financial crisis.
However, a combination of domestic and external factors has led to a partial reversal of this strategy, with some emerging economies accumulating significant external debt since 2010. Previewed by the May 2013 “taper tantrum,” there has been considerable speculation that a tightening of dollar-funding conditions and a macroeconomic slowdown in emerging economies may result in financial instability in some emerging economies.
The risk of a global shock to international funding conditions is extensively documented. In view of the central role of the dollar in international funding markets, global financial conditions are significantly influenced by the stance of U.S. monetary policy. In particular, it is now widely accepted that the federal funds rate plays an important role in determining the availability of dollar funding.
In related fashion, and as recent experience with international spillovers suggests, the withdrawal of quantitative easing by the Federal Reserve could be associated with tighter funding conditions for international borrowers globally. If this is the case, the impact could be felt most acutely in those emerging economies with the deepest financial markets and the poorest economic fundamentals. The effect might come both from the quantity and the price sides since there might be a tighter supply of dollars but, at the same time, the cost of borrowing might increase in local currency terms. In addition, in terms of valuation effects, expected dollar appreciation will increase the value of dollar debt, as has been witnessed during the course of the past year, where the real burden of dollar-denominated debt has increased in emerging markets.
In addition to the shift in dollar-funding conditions, macro-financial fundamentals have deteriorated in a number of emerging economies since 2007. Current account balances have declined and foreign debt levels have increased. Credit growth has increased and leverage for some sectors (including the corporate sector) has climbed. Simultaneously, forecasts of potential output growth have been revised downward, and the drop in commodity prices has damaged the income prospects of commodity exporters.
The scale, composition, and volatility of international financial flows are a clear concern for policymakers in emerging economies. Through a variety of channels, a reversal in international financial flows risks destabilizing their domestic financial markets and the real sectors. Countries running high current account deficits are particularly vulnerable to such reversals, facing the risk of a traditional sudden stop. But those with large outstanding stocks of debt liabilities in foreign currency could be vulnerable as well, facing both rollover risk and risks to their financial terms of trade.
Looking at international balance sheets, the traditional focus has been on the cross-border positions of banks and sovereigns. While these can be (and have been) sources of shocks, they are also amplification mechanisms for the difficulties emanating in the real sector. As we have seen on a number of occasions, a systemic financial disruption can have its origin in the strains on balance sheets in the nonfinancial and household sectors.
The (direct and indirect) international financial positions of nonfinancial firms have been drawing increasing attention. Large corporates can directly obtain funding from international banks, the international bond market, and non-bank intermediaries, while small firms borrow from their own banks in foreign currency terms. Indirectly, the corporate sector may induce financial inflows by borrowing from the domestic financial sector that, in turn, obtains external funding. The foreign currency debt obligations of the corporate sector are of particular concern, whether owed to foreign creditors or domestic lenders.
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However, a combination of domestic and external factors has led to a partial reversal of this strategy, with some emerging economies accumulating significant external debt since 2010. Previewed by the May 2013 “taper tantrum,” there has been considerable speculation that a tightening of dollar-funding conditions and a macroeconomic slowdown in emerging economies may result in financial instability in some emerging economies.
The risk of a global shock to international funding conditions is extensively documented. In view of the central role of the dollar in international funding markets, global financial conditions are significantly influenced by the stance of U.S. monetary policy. In particular, it is now widely accepted that the federal funds rate plays an important role in determining the availability of dollar funding.
In related fashion, and as recent experience with international spillovers suggests, the withdrawal of quantitative easing by the Federal Reserve could be associated with tighter funding conditions for international borrowers globally. If this is the case, the impact could be felt most acutely in those emerging economies with the deepest financial markets and the poorest economic fundamentals. The effect might come both from the quantity and the price sides since there might be a tighter supply of dollars but, at the same time, the cost of borrowing might increase in local currency terms. In addition, in terms of valuation effects, expected dollar appreciation will increase the value of dollar debt, as has been witnessed during the course of the past year, where the real burden of dollar-denominated debt has increased in emerging markets.
In addition to the shift in dollar-funding conditions, macro-financial fundamentals have deteriorated in a number of emerging economies since 2007. Current account balances have declined and foreign debt levels have increased. Credit growth has increased and leverage for some sectors (including the corporate sector) has climbed. Simultaneously, forecasts of potential output growth have been revised downward, and the drop in commodity prices has damaged the income prospects of commodity exporters.
The scale, composition, and volatility of international financial flows are a clear concern for policymakers in emerging economies. Through a variety of channels, a reversal in international financial flows risks destabilizing their domestic financial markets and the real sectors. Countries running high current account deficits are particularly vulnerable to such reversals, facing the risk of a traditional sudden stop. But those with large outstanding stocks of debt liabilities in foreign currency could be vulnerable as well, facing both rollover risk and risks to their financial terms of trade.
Looking at international balance sheets, the traditional focus has been on the cross-border positions of banks and sovereigns. While these can be (and have been) sources of shocks, they are also amplification mechanisms for the difficulties emanating in the real sector. As we have seen on a number of occasions, a systemic financial disruption can have its origin in the strains on balance sheets in the nonfinancial and household sectors.
The (direct and indirect) international financial positions of nonfinancial firms have been drawing increasing attention. Large corporates can directly obtain funding from international banks, the international bond market, and non-bank intermediaries, while small firms borrow from their own banks in foreign currency terms. Indirectly, the corporate sector may induce financial inflows by borrowing from the domestic financial sector that, in turn, obtains external funding. The foreign currency debt obligations of the corporate sector are of particular concern, whether owed to foreign creditors or domestic lenders.
Download the full PDF of this paper.