Viral Acharya, Stephen Cecchetti, José De Gregorio, Sebnem Kalemli-Ozcan, Philip R. Lane, Ugo Panizza
Emerging market firms have borrowed in foreign currency to take advantage of low interest rates
October 5, 2015: This column argues that when the Fed inevitably raises rates, such borrowing will be a threat to emerging economy financial systems. Yet so long as authorities use their existing prudential tools wisely, the risks appear manageable.
A major question facing the world’s central bankers is whether a tightening of US monetary policy portends another round of financial stress or even a wave of crises in emerging economies.
During earlier decades, emerging economies borrowed heavily in international markets, while at the same time operating under fixed exchange rate regimes. Since these debts were unhedged, the result was exposure to both sovereign risk and exchange rate risk. In such an environment, any change in the willingness of global investors to bear risk quickly led to a capital flow reversal, occasionally triggering a full-blown crisis. This narrative played out over and over again in Latin America and Asia during the 1980s and 1990s.
Policymakers in emerging economies learned their lesson, improving macroeconomic management and financial regulation, allowing for greater exchange rate flexibility and reducing unhedged debt burdens. During the first decade of this century, through a combination of current account surpluses, rising foreign exchange reserves and a shift from debt to equity financing, both public and private sector balance sheets grew stronger.
More recently this situation has changed. As the 2007-2009 financial crisis ravaged the advanced economies, emerging market countries returned to issuing external debt. But, unlike in earlier episodes, this time it was corporates, rather than governments, that borrowed both through the issuance of bonds and indirectly through their domestic banking systems. Researchers at the Bank for International Settlements and Inter-American Development Bank have documented a rapid increase of external borrowing of non-financial corporates through offshore issuance of debt securities (Avdjiev et al. 2014) and shown that external borrowing by these corporations is mostly in US dollars (Caballero et al. 2014) and may be driven by carry trade activities (Bruno and Shin 2015). There is also evidence that offshore borrowing by non-financial corporations is correlated with credit growth in both Latin America and East Asia (Inter-American Development Bank 2014), possibly amplifying cross-border financial linkages (for a discussion of this phenomenon and the need to obtain more complete and reliable data for evaluating risks arising from these linkages, see Lane 2015). Finally, in parallel work to our report, the IMF (2015) also analyses the rise of corporate leverage in emerging markets.
The concern is that this foreign currency cross-border corporate borrowing will put emerging market economy financial systems at risk when the Fed inevitably begins to raise rates.
Getting to grips with foreign currency cross-border corporate borrowing
The newly issued report of the Committee on International Economic Policy and Reform that we have authored investigates this issue in detail (Acharya et al. 2015), explaining how the primary concern relates to the foreign currency liabilities of non-financial corporates that are not hedged by revenues in foreign currencies. Such risk can be heightened further when there is a maturity mismatch, with borrowers relying on long-term funding revenues to fund short-term loans (regardless of currency). With an increase in uncertainty, the worry is that corporates will struggle to rollover the foreign currency short-term debt, as they did during the Taper Tantrum two years ago.
Should the health of non-financial corporates become impaired, the situation could easily harm both the domestic financial intermediaries and fiscal authorities. As the distressed firms try to meet obligations that would otherwise go unmet, banks could suffer outflows of deposit liabilities. As the riskiness of assets issued by the firms rise, their valuation on banks’ balance sheets could fall. To the extent that they are counterparties to foreign exchange derivatives used as hedges by non-financial corporates, domestic banks will suffer losses.
If globally active non-financial corporations lose access to international and domestic bond markets, they will turn to domestic banks. Favouring what may be seen as too-big-to-fail borrowers, the banks will then reduce funding to small and medium-sized enterprises (SMEs).
Policymakers have a challenging task controlling these risks directly, as it is difficult to intervene to reduce the external foreign-currency borrowing by what are generally unregulated institutions. The concern is less about the direct impact of these firms on the real economy – something that can be managed through traditional stabilisation policy – than the impact that non-financial corporate balance sheet stress has on banks and the financial system.
Fortunately, central banks and regulators have a variety of micro- and macroprudential tools to at their disposal to cope with these risks. These include capital regulatory tools that can be used to contain the concentration of lending and securities holdings in bank assets, and liquidity regulation that can be used to contain the bank impairment from large deposit outflows. As for risks arising from derivatives position, here the solution is to require central clearing. And, on SME lending, while the chronic shortage can be made worse, for countries that want to take action some form of subsidisation is the only realistic path available.
Our conclusion is that the risks arising from non-financial corporate issuance of foreign currency-denominated bonds are very real. And, in the past decade they have grown significantly. But, while the vulnerabilities are surely larger in some emerging market economies than in others, so long as the authorities use their existing prudential tools wisely, they appear manageable.