EM corporate debt: lessons for CMU

7 min read

They say timing is everything and so it turned out this week. The EC launched its detailed and extensive blueprint for Capital Markets Union; the IMF came out with a stark warning on the effects of EM corporate debt leverage as the rate environment turns; while right on cue the IIF said investors dumped US$40bn of EM assets in the third quarter, making it the worst quarter since Q4 2008 (which still sends a shiver down the spine).

While each of those elements has received a ton of individual coverage, I was taken as much by what lessons the EC should draw on CMU from IMF concerns about EM corporate debt expansion. It’s almost as if Christine Lagarde were sending a not-so-oblique message to Jonathan Hill to be careful in what he asks for in nailing his colours so firmly to the mast of funding diversification into the capital markets and other non-bank sources.

My question is this: should the EC be concerned that, notwithstanding their benefits, bond markets can and do facilitate easy exit routes for institutional investors in the event of economic distress or global event-risk; exit routes that can and do leave leveraged issuers, in particular, dangerously exposed to unsustainable debt-service costs and market access issues; and investors exposed to brutal mark-to-market losses? Yes.

In its piece on EM corporate leverage in the October GFSR, the IMF didn’t focus on bond financing per se. It’s rightly more concerned about the rise of overall EM corporate indebtedness – US$4trn to over US$18trn in the decade to 2014; debt-to-GDP ratio 26 percentage points higher – in a tightening US monetary environment. The Fund said EM should be prepared for the eventuality of corporate failures; and insolvency regimes should be reformed to enable rapid resolution of both failed and salvageable firms. Yikes!

The fact that bond issuance had nearly doubled over the same period to 17% of that alarming number makes the shift to capital markets a material talking point, though, both in and of itself but also around CMU in Europe.

The IMF estimates that EM bond volumes have nearly doubled since the crisis and totalled more than US$900bn last year. Global factors, it said, allowed an initially limited industry subset in a few economies to broaden out to a much wider set of borrowers. Bearing that in mind, how many times have we seen the following play out over the past 30 years, particularly in an EM context?

Easy money leads to frantic search for yield leads to debt binges and bubbles as issuers lock in cheap money and investors lock in yield pick-up and performance. And then the converse: tight global money leads to local currency depreciation leads to unsustainable foreign currency debt-service costs leads to global risk aversion leads to panicked capital outflows, huge volatility, crisis in susceptible economies, borrower insolvency and huge losses for investors?

There’s no easier transmission channel out there to facilitate those scenarios than the bond market. Since 2010, the IMF noted, firms have used bond issuance less for investment and more to refinance debt. That’s a natural corollary of low bond yields, tight credit spreads and a pull-back in cross-border bank lending so no great revelations.

But while the shifting market structure has offered attractive funding diversification opportunities, it has at the same time increased issuer leverage and FX exposure. Ballooning EM leverage has typically been associated with a subsequent reversal of capital flows, the IMF tells us.

The Fund is clear that bonds have many benefits, but corporate exposure to volatility in funding conditions is a real downside. Plus, the IMF said bond financing tends to be associated with weaker monitoring standards due to a larger pool of bond investors who may “choose” not to monitor the business activities of issuers. “This can create incentives for excessive risk-taking behaviour by firms,” it noted.

One thing did catch my eye in the IMF paper: the financial condition of EM borrowers appears broadly to have deteriorated in recent years. Since the crisis, bonds have on average been issued by more leveraged and less profitable firms; solvency and liquidity have also generally deteriorated among issuing firms. Average maturities for domestic and offshore bonds, though, have lengthened by more than a year relative to the pre-crisis period. This mitigates rollover risk for borrowers but on the flip side it increases duration exposure for investors in a compressed spread environment.

So what solutions do Christine Lagarde and her Washington cohorts offer up?

  • Close monitoring of sectors and systemically important firms most exposed to risks and the sectors and large firms closely connected to them, including across the financial system
  • Prepare for contingencies
  • Higher bank capital requirements for corporate exposures
  • Higher risk weights and caps on the share of foreign currency exposures on banks’ balance sheets
  • LTV and debt-service-coverage ratios to address CRE risks
  • Active provisioning
  • Higher equity capital (love that one…)
  • Greater emphasis on macro-prudential measures to enhance the resilience of banks and other important non-bank classes of intermediaries
  • A macro-prudential orientation in the supervision of asset managers and funds that have significant corporate bond exposures
  • Microprudential and other tools such as stress tests related to FX risks including derivatives positions
  • Active encouragement of FX hedging
  • Exchange rate depreciation
  • Use of monetary policy and reserves
  • Public provision of emergency FX hedging facilities
  • Fiscal policy adjustment
  • Liquidity provision to the financial system

The IMF did forget one crucial tool in that long list: they forgot to throw in the kitchen sink. But my more serious point is that the European Commission needs to focus not just on creating policy tools and regulatory work-arounds to force a shift in European capital markets stratification; it needs to follow closely the lessons of EM capital market-isation and draw the appropriate conclusions.

EM corporate borrowers aren’t too far removed from the unrated European SMEs that have become such a focus in the CMU debate. What goes up must come down; or better put what goes in must come out – eventually, and when you’re least expecting it – is a vital lesson for everyone, not just EM borrowers.

As a final point I’ll say this: European technocrats should in my view be spending a lot more time working on delivering better bank lending outcomes rather than writing off the lending piece and tying the banks up in overly prescriptive rules and hefty capital and other minimum requirements. Stick that in your CMU pipe, Messrs Juncker and Hill.

Keith Mullin