beyondbrics

Watch out for a possible bust in emerging market corporate debt.

That’s not the language the International Monetary Fund employs but it is one of the warnings contained in its Global Financial Stability Report published on Wednesday. The authors say that while the growth in EM corporate debt is welcome, the rapid pace at which funds have flowed into these assets means there is the potential for “mispricing and a sudden reversal”.  As we said, a possible bust.

The report says bluntly that net capital inflows into EMs have been strong, driven by low interest rates in the developed world. The totals have not been excessive by past standards but they have been dominated to a worrying degree by portfolio and bank-related inflows, which can be volatile.

The volatile nature of portfolio flows means that they could reverse rapidly if investors take fright or valuations are perceived as too stretched.

And the flows into corporate debt have been particularly high:

Over the past year, flows into emerging market corporate external debt have surpassed flows into U.S. high-yield debt on an asset-weighted basis.

Gross issuance accounted for nearly half of all new private credit in some regions (e.g., Latin America)… The issuance of emerging market corporate debt is on track to reach another record high this year, with firms in Latin America and Asia leading the expansion.

This is good if it is kept under control with good credit quality checks. Otherwise there will be trouble ahead:

High issuance can represent a healthy development to the extent that some previously credit-constrained companies gain access to capital markets; but the risk is that large capital flows may be moving too quickly into this asset class, potentially leading to mispricing and a sudden reversal. Reports of accounting scandals and fraudulent practices suggest that due diligence is slackening, and investors have continued to move down the credit spectrum.

In some cases, such as Chinese property companies, borrowers have gone abroad – and exported credit risk – because of tightening credit conditions at home.

Meanwhile, domestic banks in EMs, which have grown rapidly, could see deteriorating credit quality. These questions are already “to the fore” in China. Brazil and Turkey might be next, says the Fund. And in Hong Kong and Singapore, high-end real estate markets are “showing signs of bubble dynamics”. The report says:

Historical experience suggests that bank asset quality in many emerging markets is likely to deteriorate in coming years… Our model predicts that nonperforming loan (NPL) ratios will rise in many emerging markets, even in a baseline scenario in which external and domestic variables normalize gradually as the expansion phase of the credit cycle reaches  its end.

The predicted increase is largest in Asia, where strong credit growth has been supported by accommodative monetary policy, and NPL ratios are at recent lows.

And it could be much worse if there is an external shock:

Sovereign risks in the euro area, or fiscal strains elsewhere, could spill over to global markets, resulting in risk retrenchment, a reversal of capital inflows, and a decline in commodity prices. Our analysis indicates that vulnerabilities to a sudden stop currently are less elevated in EMEA than in Asia and Latin America, which are at more advanced phases of the credit cycle.

In sum, says the IMF:

Emerging markets risks have increased. Rapid domestic credit growth, balance sheet releveraging, and rising asset prices may ultimately lead to deteriorating bank asset quality in emerging markets as the credit cycle matures.

At the same time, emerging markets remain vulnerable to external shocks. The analysis in this report reveals that a sudden stop of capital flows coupled with a rise in funding costs and a fall in global growth could strain capitalization in emerging market banks.

Related reading:
IMF: EMs still vulnerable to domestic pressures and external shocks, beyondbrics