Officials of the International Monetary Fund (IMF) and the Bank for International Settlements (BIS) have been warning that the Fed’s move to normalize U.S. monetary policy may cause lots of problems for emerging market economies (EMEs), which could spill back into the U.S.
However, they disagree on the policy approach. The BIS thinks the Fed should move forward with normalization despite the adverse consequences, while the IMF prefers a more cautious wait-and-see approach. Both agencies agree that EMEs have accumulated too much debt over the past several years, especially among non-financial corporations.
Leverage in EMEs may be already becoming unsustainable as global credit conditions tighten following the Fed’s termination of QE during October 2014 and the rate hike at the end of last year. Firms may be forced to decrease capital spending, and employment may suffer. Factors such as the strong dollar and the decline in oil prices may work to amplify the risk of such an unwinding. This process has already started according to Jaime Caruana, General Manager of the BIS, in an interesting 2/5 lecture he gave titled “Credit, commodities and currencies” at the London School of Economics and Political Science.
Disappointing global growth, large shifts in exchange rates, and the sharp fall in commodity prices all are “part of a longer movie” that his lecture scripts. Caruana explains that “[r]ather than being separate exogenous ‘shocks’, they are manifestations of a major realignment of economic and financial forces associated with the long-anticipated shift of global monetary forces.”
Let’s explore the important lecture’s key points before discussing the policy implications:
(1) Illusion of sustainability.
In his overview, Caruana states: “During boom times, when asset prices are rising and financial markets are tranquil, borrowers may be lulled into a false sense of security. We could dub this the ‘illusion of sustainability’ whereby even large debt levels appear sustainable when credit conditions are easy and asset prices soar. …
“But as the cycle turns, the combination of falling asset prices and more turbulent markets means that what was viewed previously as sustainable levels of debt begins to look much more challenging. … This realisation may elicit deleveraging and outflows that amplify the downward cycle. Policymakers can try to stem the decline in asset prices by loosening monetary policy to turn back the tide, but the already large stock of debt means that monetary policy becomes less effective.”
(2) EME debt-to-GDP ratios excessive.
There’s no question that EMEs have taken on a lot of debt in the past decade or so. EME nonfinancial corporate debt increased to well over $18 trillion in 2014 from about $4 trillion in 2004, according to the IMF’s October 2015 Global Financial Stability Report (GFSR). It also highlighted that the average EME corporate debt-to-GDP ratio has increased to nearly 75% in 2014 from just under 50% in 2003. In 2013, the debt of non-financial companies in EMEs relative to GDP overtook that of advanced economies for the first time, and the gap has continued to widen, noted the BIS lecture.
(3) Capital investment despite declining profit.
The debt-to-GDP ratio of EMEs started growing faster than that of advanced economies just as EMEs’ non-financial corporate profitability dropped below that of advanced economies, the BIS lecture observed. Indicative estimates suggest that while the borrowing has likely been used to fund investments, it’s possible that more favorable lending conditions have allowed for more debt-financed capital spending on less profitable projects, pointed out the IMF’s GFSR.
(4) Credit conditions tightening.
The BIS reports that global liquidity conditions may have started to tighten. Total U.S. dollar debt of all non-bank borrowers outside the United States, a measure of global liquidity, was $9.8 trillion in September 2015, unchanged from June. For the first time since 2009, the dollar debt of non-banks in EMEs is also unchanged at $3.3 trillion in September 2015 compared to June.
(5) Risk amplifiers.
Two market conditions are amplifying the impact of the Fed’s credit tightening on EMEs, specifically weaker oil prices and the stronger dollar. Caruana hypothesizes: “Highly leveraged producers may attempt to maintain, or even increase, output levels even as the oil price falls in order to remain liquid and to meet interest payments and tighter credit conditions.”
He also notes that EME state-owned oil companies contributed to the heavy borrowing over the past decade. So the decline in oil also has impacted the “fiscal position of governments” that had grown “increasingly reliant on revenues from oil to finance government expenditure.”
Regarding the dollar, the BIS provides the following rule of thumb: “[A] 1% depreciation of the US dollar is associated with a 0.6 percentage point increase in the quarterly growth rate of US dollar-denominated cross-border lending outside the United States.” Similarly, a stronger dollar results in pressure to reduce dollar debt. Exacerbating the situation, the unwinding of “carry trades” might further “create additional downward pressure in foreign exchange markets” and “contribute to a general tightening of financial conditions at home.”
(6) EME dollar debt is a known unknown.
Last year’s December BIS Quarterly Review estimates the dollar-denominated debt for EME non-financial companies at 10% of their respective total debt including bonds and loans as of Q2-2015. That doesn’t seem like a very big number. However, the key findings of the BIS’s dollar-debt study are listed on page 31 along with lots of caveats. Specifically, the data are very limited.
Data related to loans to offshore national affiliates, loans to foreign entities inside a country, or off-balance sheet positions are largely unavailable. Also, not known is the credit quality of the estimated dollar debt. Acknowledging this challenge, the BIS states: “We find that, underlying the generally rapid growth of dollar credit, the sheer variety of forms and channels for dollar borrowing can make for different vulnerabilities.” Even so, Caruana says not to worry too much about EMEs’ dollar debt, for three reasons: 1) many EME companies have dollar cash flows, which makes debt service more manageable; 2) many of the dollar-debt securities have long maturities; and 3) EMEs hold a lot of foreign exchange reserves.
(7) BIS to Fed: Do not delay.
With all these EME credit, commodity, and currency trends considered, Caruana says “bumpiness should be expected,” but that’s not a reason to “delay normalization.” He concludes: “The temptation may be to try to keep the financial booms going, or to give them a new lease of life, but this will be just a palliative unless the stock of debt is adjusted and vulnerabilities are reduced.”
(8) IMF to Fed: Don’t rush.
Since at least July 2014, the IMF has been warning the Fed to hold off on raising interest rates, or at least to do so very gradually. That’s on the condition that there’s a strong presence of wage or price pressures. Much of the IMF’s concern is related to the expected spillover effects on EMEs from the Fed’s tightening. IMF head Christine Lagarde has strongly advocated for this wait-and-see approach in several recent speeches, including one in mid-January of this year. Lagarde is also lobbying for a host of global policy reforms. Those include a stronger global financial safety net and a framework for safer capital flows.
Indeed, capital outflows are a major issue for EMEs right now. The Institute of International Finance (IIF) estimates that total net capital outflows from emerging markets in 2015 were at $735 billion, up from outflows of $111 billion in 2014. Looking ahead to 2016, the IIF expects that the “impact of the Fed’s shift to a tightening cycle may be limited as long as it is gradual, but flows to EMs will continue to face headwinds from growth and debt concerns.”
Dr. Ed Yardeni
is the President of Yardeni Research, Inc., a provider of independent global investment strategy research. To read more of his blogs, CLICK HERE NOW.
© 2022 Newsmax Finance. All rights reserved.