I do not know if it is possible to have two epiphanies in a short period. Well, why not? I have had two now, on global risks. The US Federal Reserve is raising interest rates. There is political uncertainty in a few parts of the world, including the developed world. There are trade disputes. These are serious threats to the global economy and global financial assets. But which ones, in particular, are threatened the most? The identification of the vulnerable ones constitutes my epiphanies. I think there are two of them. One is debt in emerging markets. The second is US commercial debt. These will set off chain reactions in other assets, including in American and emerging stock markets.
Developing countries have many hotspots now—from Asia to Latin America. Turkey’s inflation rate is around 10% and its president wants the central bank to cut interest rates. He assembled investors in Istanbul and told them he was taking direct control of the country’s economic and monetary policy. The Turkish lira has been one of the weakest currencies in the developing world for quite some time now. As mentioned last week, India faces many headwinds too—rising crude oil prices, external debt repayments of more than $100 billion in the next several quarters, a rising current account deficit and foreign portfolio outflows. Rupee depreciation—orderly or not—is to be expected over the next several quarters. A big China manufacturing group, DunAn Group, sent a letter begging the Chinese government to help it out with its $7 billion (in equivalent domestic currency) of debt. It warned that if it defaulted, this might even cause systemic risk. Private corporate defaults in China were up nearly 30% in the first four months of the year. A former Chinese policymaker and an adviser to the state council (cabinet of ministers), Xia Bin, said systemic risks were rising fast. He added that China’s bad debts in the banking system were beyond the reported 2% and Chinese banks’ exposure to the property market was much higher than official figures suggested. The Chinese currency is more overvalued in real terms than most other currencies of developing economies.
It is against this backdrop, even as the Reserve Bank of India (RBI) was liberalizing conditions for foreign portfolio investors to buy into Indian rupee sovereign and corporate debt securities in April, that the Bank for International Settlements released its global liquidity report for the year ended December 2017, on 27 April. Debt securities issued by non-banks in developing countries in dollars in the year 2017 were 21.6% higher than 2016. For non-financial sector borrowers, the increase was 21.3%. In general, the overall increase in foreign currency indebtedness (loans and debt securities) for developing country non-bank borrowers since the end of 2007 has been to the order of $2.21 trillion—from $1.46 trillion to $3.67 trillion. That is a compounded annual growth rate (CAGR) of 9.7% over the decade from end-2007 to end-2017. That is a sizeable increase in foreign currency liability. Their servicing becomes onerous with each basis point increase in the US interest rate and in the dollar. That is why the currencies of emerging economies have begun to weaken.
There was a feeling that in the global monetary policy accommodation cycle that began in 2008, developing countries were cautious about borrowing in hard currencies. Well, a CAGR of 9.7% is anything but cautious. Even now, some analysts are in denial as they claim that much of the foreign currency borrowing has been done by sovereigns. That does not matter. We can go one step further. Borrowing in domestic currency from foreign investors is akin to borrowing in hard currency. As long as the currency of the lender is different from that of the borrower, there is foreign currency risk.
We will go a step further. Even domestic currency borrowing—if done excessively—carries with it foreign currency risk. If excessive domestic credit growth results in an overvalued currency in real terms through higher inflation, then the risk of a currency depreciation is high. Importantly, whether we like it or not, whether it is correct or not, bond markets view developed and developing country risks differently. Just compare the yields on the 10-year government bonds of Greece, Portugal, Spain and Italy with those of Indonesia, Brazil, India and Malaysia. The yields do not seem either right or fair but they are there. Hence, these caveats are relevant for India. Given its inability to sustain even moderate export growth, opening up either domestic credit markets to foreign lenders or liberalizing external commercial borrowings is fraught with more risks, especially in these times.
Thus, spillover risks are now big for emerging economies. One can and should keep tilting at windmills for some possible moral suasion but as long as developing countries tie their currencies to the dollar in a hard or soft peg, and as long as borrowers from these countries are tempted to engage in their own version of ‘carry trade’ (borrow at low rates in hard currency and invest or lend in domestic markets), spillover risks will remain. They are again in play in 2018 as they were in 2013. There will be a spillback on risk appetite in developed country markets since their markets have been whistling through the rise in yields in US treasuries. We will take up the risk in US commercial debt market next week.
V. Anantha Nageswaran is an independent consultant based in Singapore. He blogs regularly at Thegoldstandardsite.wordpress.com. Read Anantha’s Mint columns at www.livemint.com/baretalk
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