Walter Molano | Dealing with a new debt crisis
Quantitative easing was sold to the general public as an initiative to expand private-sector spending by electronically creating money to buy financial assets.
However, it was nothing more than giving the banks free money to improve profitability, in the process repairing their capitalisation levels. Reducing the definition to a more simplistic explanation would have been political suicide. Therefore, policymakers cloaked it in an obscure economic and financial jargon that few would question.
In order to make sure that the enhanced profits would not end up in the hands of shareholders and employees, the central bank put strict limitations on dividends and bonuses in order to maximise the recapitalisation process. In other words, the objective was to direct the funds to the most profitable sectors, even if that meant the emerging markets.
That is why emerging market debt soared. Since 2000, emerging market sovereign - external and domestic - debt exploded sixfold, reaching more than US$6 trillion at the end of last year. On the positive side, sovereign external debt doubled, reaching US$1.1 trillion.
Today, this represents about 26 per cent of emerging market GDP. In contrast, it was about 42 per cent of GDP in 2000.
Of course, the large devaluations that occurred this year mean that the ratio will be higher. On the negative side, the real increase in debt came in the form of local currency issues. They total more than US$5 trillion. Government officials will point out that these debentures will be easier to roll over. Still, a lot of them are in the hands of foreigners.
A closer look at the numbers shows a troublesome picture. Most of the local sovereign debt issuance is concentrated in a handful of countries. At the end of 2013, the total stock of China's domestic debt was US$1.3 trillion, with 15 per cent in foreign hands. That translates into US$225 billion. Brazil's domestic debt stock was US$860 billion, with 39 per cent (or US$335 billion) owned
by foreigners. Meanwhile, Mexico's domestic debt load was US$680 billion, with 30 per cent (US$204 billion) owned externally.
This could help explain why these currencies have been under so much strain as the United States moves to tighter monetary policy. It also highlights a channel of contagion between these markets.
Corporate emerging market debt is the other sector that witnessed explosive growth. Since 2005, corporate emerging market debt expanded fourfold - reaching almost US$1 trillion. The top corporate issuers were Brazil, China, Russia and Mexico.
Capital market activities
The problem is that the amortisation schedule for the next three years will be onerous. This year was relatively light, with US$74 billion coming due. A flurry of capital market activity at the start of the year helped CFOs meet their needs. However, the schedule increases 66 per cent in 2016 to US$123 billion in corporate bond amortisations of which US$81 billion will be in investment-grade bonds and US$42 billion in high-yield issues.
Chinese corporates have US$19 billion coming due, Russia US$24 billion and Brazil US$16 billion. The amortisations peak in 2017, expanding another 62 per cent to US$200 billion. Of the total, US$121 billion will be for investment-grade bonds and US$78 billion in high-yield obligations. Chinese corporates again lead the way, with US$41 billion; Russian companies have US$23 billion and Brazilian firms have US$15 billion falling due.
This will put an enormous strain on central bank reserves and corporate balance sheets. It will also be very painful for emerging market households.
The tidal wave of funds that made their way into the emerging world allowed hundreds of millions of households to be pulled out of poverty by allowing them access to cheaper financing. Not only will most of these households find themselves pushed back into poverty, many will be ruined as they are forced into bankruptcy. Hence, one of the unintended outcomes of quantitative easing could be social and political unrest across the emerging world.
The next three years could be very tough for the asset class. We are probably in for a new debt crisis, but it will be different from previous episodes. The problem will be more at the corporate level, as companies struggle to refinance their external obligations.
Some of this corporate debt could become sovereign. A good percentage of the bonds were issued by state-owned entities, or companies that are deemed too strategically important to allow them to fall into foreign hands. Thus, governments may be forced to recapitalise them by assuming foreign obligations or nationalising them.
Likewise, another problematic area may be in local currency obligations. Some governments may be forced to impose capital controls to limit the drawdown of reserves. It will also mean more downward pressure on exchange rates.
Last of all, greater issuance by sovereigns will crowd out corporates. All of this suggests that the IMF and World Bank may be forced to play a greater role in providing guidance and financing for the emerging markets universe as they deal with their debt obligations.
Dr Walter T. Molano is a managing partner and the head of research at BCP Securities LLC.