The deleveraging risk in emerging markets
Although a 25 basis point rate hike by the Federal Reserve in December was in line with market expectations, it’s the tone of the US central bank that has created uncertainty. The Federal Reserve now expects rates to go up thrice in 2017 compared with the earlier estimate of two hikes of 25 basis points each. The revised outlook came at a time when US bond yields were rising in anticipation of an expansionary fiscal policy, likely to be adopted by the incoming Donald Trump administration. Trump is expected to run a higher budget deficit by increasing public spending and reducing taxes. However, as labour market conditions are tightening and the US economy is witnessing one of its longest expansion streaks in the postwar era, a fiscal push at this stage could become inflationary. This might force the Federal Reserve to change course and raise rates at a faster pace.
Sharp rate hikes in the US can increase the risk for emerging markets as corporate leverage has increased significantly in recent years because of easy availability of money. A new International Monetary Fund working paper, Emerging Market Corporate Leverage and Global Financial Conditions, which studied the relationship of leverage growth in emerging markets to US monetary conditions and, broadly, global financial conditions, highlighted the magnitude of the rise in corporate debt. Between 2004 and 2014, corporate debt in non-financial firms went up from about $4 trillion to over $18 trillion. The debt-to-gross domestic product (GDP) ratio in emerging markets during this period went up by 26 percentage points. Specifically, the paper notes that a one percentage point reduction in US policy rates leads to an increase in leverage growth of 9 basis points in emerging economies. This is significant given the average leverage growth of 35 basis points per year. The study covered over 400,000 firms from over 24 emerging market economies.
Corporate debt in emerging market economies has not necessarily increased only because of direct foreign exchange borrowings by firms, but also because of the impact that global financial conditions have on domestic markets. An accommodative condition in global markets increases capital flows in developing countries, which leads to currency appreciation. Reduction in policy rates to discourage capital flows and currency appreciation results in higher borrowing by firms.
Now, a sharp reversal in US policy rates and tightening of the financial condition in global markets can trigger large-scale deleveraging in emerging market economies. Capital outflows could result in currency depreciation and a rise in inflation, resulting in higher policy rates in emerging economies. This will make servicing of both foreign and domestic debt difficult for firms.
As noted above, corporate leverage has gone up significantly in emerging market economies and, according to the Bank for International Settlements, at an aggregate level, corporate debt-to-GDP ratio in emerging markets is higher than in advanced economies. Among developing economies, China remains a major risk with a corporate debt-to-GDP ratio of about 170%. Chinese authorities have been struggling to maintain stability in the currency market amid rising capital outflows. A sharp rise in US interest rates is likely to accelerate outflows which could elevate the risks emanating from China. A recent note by Nomura aptly describes the situation: “There is a strong consensus that state control and fiscal space will allow Beijing to kick the proverbial can down the road in 2017. This is a reasonable base case forecast, but in terms of risk-weighted probability scenarios, we believe that the market is too sanguine over the risk of Beijing losing its grip.”
The financial condition can tighten much more than what is warranted by the Federal Reserve rate hikes. An expansionary fiscal policy by the Trump administration may lead to a higher current account deficit and the US might have to import capital from the rest of the world. However, recent trends show that large investors in the US government bond market, including China, are reducing their holdings. Therefore, it is possible that lower supply of savings from the rest of the world will push up bond yields in the US, resulting in a further tightening of the financial condition, and accelerate the process of deleveraging in emerging market economies.
Where does this leave India? Even though corporate leverage in India is at a much lower level compared to other developing economies, volatility in capital flows—as noted by the latest “Financial Stability Report” of the Reserve Bank of India—can add pressure on the exchange rate. At this stage, the corporate debt problem is largely domestic in nature but a considerable depreciation in the rupee can intensify the difficulty.
The rise in interest rates in the US and its impact on the financial condition will be one of the biggest risks for the global economy in 2017.
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