Corporate Leverage In Emerging Markets: Increased liquidity and corporate leverage

Summary

In October 2015, IMF published “Corporate Leverage In Emerging Markets – A Concern?” to analyze risks in financial markets in EM. High EM corporate leverage can potentially lead to credit crunch and financial crisis in 2008. IMF gave five recommendations to prevent the crisis.

Why did the EM Corporate Leverage Increase?

After the Great Recession in 2008, Fed, BOJ and ECB conducted own quantitative easing that provides copious liquidity in financial markets. Fed purchased assets worth of $3.5 trillion while BOJ and ECB have purchased approximately $8.5 billion and $6.3 billion of government securities.

As the liquidity flew into EM, leverage in nonfinancial corporations rose from $4 trillion in 2004 to $18 trillion in 2014 (Figure 1). At the same time, corporate debt to GDP ratio increased by 26% (Figure 2). This copious capital grew the nonfinancial industries, but sudden spike in leverage might cause bubble in financial markets.

Figure 1 EM corporate debt and market capitalization ($ Billion). Source: IMF

Figure 2  EM corporate debt to GDP ratio. Source: IMF

Quantitative Easing Expanded the Corporate Leverage

Although loans are still the largest component of the debt, the proportion of bond is continuously growing. The share of bond rose from 9% in 20014 to 17% in 2014 (Figure). It showed a significant increment in 2008, when U.S. conducted the QE (Quantitative Easing). With strengthen regulations, banks reduced cross-board lending while financial institutions issued more bonds with favorable conditions for EM corporations.

Figure 3  EM corporate debt compositions and their growth rate. Source: IMF

QE effect on EM on three different ways. First, emerging nations lowered interest rates to defend domestic currencies (Figure 4). After the QE the domestic currencies appreciated, which pressured exports and increased capital inflow. By lowering interest rates, emerging nations could stabilize exports and restrict capital inflow.

Figure 4 Interest Rate of Advanced nations (U.S. and Eurozone) and emerging markets (Indonesia and Mexico).

Source: FRED

Second, global liquidity flew into EM fixed income market. As yields in U.S. declined (Figure 5) after the QE, investors increased the portion of bonds in the EM in their portfolio. Because yields in EM have relatively high yields (Figure 5), it gives portfolio gives portfolio effect that allows to maintain certain level of risk and yields in the investors’ portfolio.

Figure 5 Advanced nations (U.S.) and emerging nations (South Korea and New Zealand) 10 year government yields.

Source: FRED

For last, the corporations were more attractive to have foreign currency-denominated bonds. With appreciated domestic currency, the corporations could issue foreign currency-denominated bonds with cheaper price. It led to issuing more foreign bonds especially in Southeast Asia, EMEA and Latin America (Figure 6).

Figure 6 Issuance By Region. Source: IMF

Problem raised when the corporations cannot bear significant increase of debt. Despite the leverage has been increased, their net profit has been declined (Figure 7). I can lead to credit crunch and another financial crisis when interest rate starts to rise.

Figure 7 Ratio of EM corporation leverage to its profit. Source: IMF

Global Economic Conditions and Fixed Income Markets

High corporate leverage came from increased liquidity, which can be weakened by global economic conditions rather than domestic reasons. Like liquidity, corporate leverage in EM is highly concentrated on construction and energy industries. With recent fall in commodity and real estate markets, net profits in those industries have fallen (Figure 9).

Figure 8 Corporations in EM leverage to total asset. Source:  IMF

Liquidity has been improved after the Great Recession, but their profit has been weakened as global economic sentiments fallen down. It means that corporations could raise capital but their profits have not been significantly improved. Fortunately, foreign exchange risk has not been increased due to increased foreign reserves, exports and use of derivatives. Yet fallen profits and increased leverage are still big concerns for the EM.

IMF Recommendation on the Emerging Market

IMF gave five recommendations to prepare for quantitative tightening.

1. Careful monitoring of vulnerable sectors of the economy and systemically important firms as well as their linkages to the financial sector is vital
   
2. The collection of financial data on the corporate sector, including foreign exchange exposures, needs improvement.
   
   
3. Macroprudential policies can be deployed to limit excessive increases in corporate sector leverage intermediated by banks.
   
   
4. Microprudential measures should also be considered. For instance, regulators can conduct bank stress tests related to foreign currency risks, including derivatives positions.
   
   
5. Emerging markets should be prepared for corporate distress and sporadic failures in the wake of monetary policy normalization in advanced economies, and where needed and feasible, should reform insolvency regimes.

Quantitative Easing and Its Side Effect

Global financial markets have enjoyed high liquidity came from the QE. They have been grown prior to the financial crisis level, but it caused by high liquidity not improved economic conditions. Unless the economic conditions will improve, this artificial growth will cause another financial crisis. Emerging nations should acknowledge risk in the markets, and prepare for the potential crisis.