The Fed and EM Debt

 

Federal Reserve Chairman Jay Powell, unruffled by the bullying of President Trump and market commentators, raised interest rates this week and reaffirmed his commitment to unwind the extraordinarily loose monetary policies of the past decade. Suddenly, it is dawning on investors that the infamous Fed “put” – the firm commitment of the Federal Reserve to support the stock market in the name of financial stability and the “wealth effect” – can no longer be taken for granted. The Fed’s return to orthodoxy, if pursued, will not only unsettle the U.S stock market. It will have far-reaching consequences across financial markets, and certainly present a challenge for emerging markets.

The problem for emerging markets comes on two fronts. Tightened liquidity will lead to higher interest rates across global bond markets. As markets reprice the cost of credit, the “yield chase” which occurred in recent years will revert: investors will no longer have to pursue ever-more risky borrowers to achieve a modicum of returns. One of the best indicators of the changing market environment is the spread between the interest which high-yield lenders (“junk’) have to pay over the risk-free U.S. Treasury rate. As shown in the chart below, this spread has been surging. This is bad news for emerging markets because EM debt is a substitute for U.S. high yield debt.

Moreover, the higher cost of credit for emerging markets comes in the wake of a huge credit splurge. EM borrowers enthusiastically took advantage of the appetite of global yield-chasers over the past five years. As the tide now ebbs, borrowers will have to refinance at higher rates. Unfortunately, it appears that most of this lending did not go into productive investments and it did little to boost economic output. The chart below shows the increase in the total credit- to- GDP ratios for major EM countries, as reported in the data of the Bank for International Settlements (BIS).

The following chart shows the average GDP growth for the past five years compared to the past 20 years and also Fixed Capital Formation over the past five and 20 years.

 

These chart show that this debt accumulation has by-and-large not led to more investment or more growth. Quite the opposite, In many countries it appears that the marginal returns from debt are declining.

A few country-specific comments:

China’s debt load increase is unprecedented. Though it has financed increased capital formation it appears that a significant amount of investment has been in very low return infrastructure and real estate developments. Marginal returns from debt and investment are declining fast, and GDP growth is expected to fall below the current 6% annual rate.

Brazil’s debt load has increased at a very high rate and is now at very high levels for a country with high interest rates and prone to financial instability. The increase in debt of the past five years was used to finance current spending and interest expense.

Colombia’s debt increase is very large but absolute levels are moderately high and at least GDP growth has been sustained and capital formation has been boosted.

Chile’s debt ratio has increased sharply and debt levels are very high, but growth has sputtered. Though capital formation has increased, I suspect a significant amount of investment has been  in “glamour” real estate developments.

Turkey has seen a large increase in debt, much of it sourced in foreign currency. Debt levels are approaching high levels. The country has seen high growth in GDP and increasing capital formation, much of this in large infrastructure projects but also in glamour real estate. The crisis this year has thrown Turkey into what is likely to be a multi-year period of austerity and deleveraging.

Mexico’s debt has increased but remains at manageable levels. Growth and capital formation are steady at low levels.

India is the main outlier in EM. Debt is moderately high but it is has been declining. Both GDP growth and capital formation have increased. India appears well positioned for a new credit cycle.

 

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Trade Wars

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India Watch

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China Watch:

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China Technology Watch

Brazil Watch

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EM Investor Watch

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Tech Watch

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