In recent months, the credit markets have seen a plethora of incidents on quality corporate issuers, whether from the advanced (Volkswagen) or emerging (Petrobras) economies. All of these incidents can be linked to idiosyncratic issues. However, their proliferation does raise the question about the potentiality of a comprehensive re-pricing of credit risk which would, definitively, include emerging assets.
Emerging corporate leverage has increased. This risk was pointed out by the IMF in its latest Global Financial Stability Report1 (GFSR). In this issue of the GFSR, the Fund stresses the capacity that emerging businesses have had to continue issuing debt instruments at lower rates on longer and longer maturities. According to the IMF, emerging corporate leverage, measured as the ratio of debt stock to GDP, increased by 15 basis points from 60% to 75% since 2011, rising from $11 trillion to $18 trillion.
Bond issues by emerging businesses are offsetting the downward trend in domestic credit. This increase in emerging corporate leverage is the fruit of both cyclical and structural factors. Cyclical factors are tied to the boom in construction and energy. Structural factors are mostly the result of the post-2008-crisis regulation that reduced cross-border bank credit. As a result, the structure of corporate indebtedness in the emerging economies has changed. The portion of debt financed by bond issues rose from 9% to 17% in the ten years from 2004 to 2014.
The extent of the lift-off is still a challenging subject for emerging credit. The re-composition of debt financing happened with no rise in spreads due to the entry of the G5 central banks, one after the other, into zero-rate policies. In such a context, Fed's lift-off holds the risk of a deterioration in liquidity conditions for the emerging credit markets2.
In absolute terms, the outlook for emerging credit is more nuanced. Overall factors, specifically those resulting from the Fed's strategy, are expected to give way, in the short term, to more idiosyncratic factors. Indeed, the US curve's flattening trend predicts a slowdown the pace of job creation over the next one to two years; a reasonable projection given the point at which the US economic cycle stands. From the standpoint of risk premiums – i.e.that credit yields are formed on the basis of how the forward spread (the slope) of the US curve and credit spread behave – spreads should remain the essential drivers of credit performance. This still bodes well for more selective portfolio strategies. That said, liquidity conditions remain a sticking point.
1 IMF (2015), Global Financial Stability Report, April 2015 Chapter 3: "Corporate leverage in emerging markets – a concern?”.
2 According to the International Monetary Fund, a 100 bp increase in US rates leads, on average, to a drop in capital inflows equivalent to two points of GDP over six quarters following the shock. The net effect remains dependent on the domestic conditions of the emerging countries, specifically their ability to repatriate funds held abroad. See IMF (2014), Regional Economic Outlook Western Hemisphere, World Economic and Financial Surveys, April Issue, Chapter 3 “Taper Tantrum or Tedium: How Will the Normalization of U.S. Monetary Policy Affect Latin America and the Caribbean?”.