Beginning in the early 2000s, corporations in emerging economies began to massively increase their borrowing in international capital markets. The reasons why this occurred are not completely clear though they most likely involve low interest rates globally and the search for higher yields by international investors. In any case, the surge was dramatic: between 2004 and 2014, the corporate debt of non-financial firms in emerging markets more than quadrupled from around $4 trillion to over $18 trillion in 2014, according to research by the International Monetary Fund, with the average corporate debt-to-GDP ratio rising 26 percentage points.
For Latin America, this increase in foreign borrowing was important as additional research by the IDB shows. In a credit constrained environment, fueled in part by the region’s low savings rates, access to these international credit lines allowed the corporations of the region to boost investment. It helped pay for equipment and other inputs needed to propel the commodity boom in the oil and gas, mining, and agricultural sectors and helped finance growing areas of the economy like telecommunications. It also catalyzed consumption and spurred growth.
But the rising level of debt also came with built-in vulnerabilities. Increasingly through bond issuances rather than bank loans, the debt was almost entirely in dollars. This has exposed the region to the risk of higher interest rates and currency appreciation in the United States similar to what we have observed in recent months. Moreover, it makes Latin America vulnerable to other external shocks, including investor panic in response to a political or economic crisis in a major emerging economy. In June 2016, nonfinancial corporations in Latin America and the Caribbean owed $406 billion on bonds issued abroad, including foreign subsidiaries, an almost threefold increase from June 2010, according to the Bank of International Settlements, an international institution which serves central banks. With those kinds of liabilities, corporate debt is both a potentially positive factor in the region’s economies and a potential source of great concern.
Exactly how important is this corporate debt for the macroeconomic performance of emerging economies? And how vulnerable does it make the region? In a recent study, conducted along with Jongho Park of the University of Maryland, we sought to find out. We examined 2500 corporate bonds that were representative of corporate bonds issued in 7 emerging economies, including those issued by corporations from Brazil, Chile, Mexico and Peru. We measured the premiums (or spreads) that these bonds paid over the safe interest rate offered for United States Treasury Bonds, the safest bonds on earth. And for each country we averaged these premiums to determine how much corporate debt from each of these economies was costing. Though there was considerable variety, we found corporations in emerging economies were paying on average 3.7% on top of the U.S. Treasury rate.
More importantly, we found that these premiums exhibit considerable fluctuations over time and that we could use the average premiums for each country as a leading indicator to tell us how much foreign financing is affecting its economy. The results were sobering. It turns out that there is considerable synchronicity, or co-movement, between current fluctuations in the indicator and future investment and consumption in these economies. There is a certain logic to this pattern. If a company finds out that it will be facing a higher premium today, it will likely delay future investment plans because financing has suddenly gotten more expensive. Harsher financial conditions cause companies to reduce hiring and lower wages, affecting family pocketbooks. These individual impacts, when multiplied through the economy, deeply affect activity. And they explain how we can use the premiums’ average to predict economic growth. A normal increase of 1.5% in the indicator (equal to one standard deviation), for example, leads to a fall in real output growth one year down the line of about 0.75%, with the economy returning to its mean long-run growth rates only three years later. Thus the study finds that the considerable borrowing by corporations from emerging economies in international markets can potentially be a channel by which external financial shocks may propagate and cause economic havoc in these economies in the future.
What can be done? Corporate debt on the international bond markets has both advantages and disadvantages: it is both a source of needed financing and the cause of considerable vulnerability for emerging economies. But negative impacts on the overall health of economies can be reduced. At present, the quality of public information on corporations’ exposure to international debt is patchy at best, in part because current accounting practices do not include reporting on overseas subsidiaries. Moreover, firms may hedge their risk with financial derivatives. And that information is not publicly available either, making the extent of corporations’ real vulnerabilities hard to assess. New regulations mandating better reporting on these two fronts and improved monitoring by financial authorities might go a long way towards resolving these problems. Policymakers in emerging markets also should be prepared to assist corporations that face distress as a result of monetary policy tightening in the United States and expected rising interest rates there. With so much at stake, emerging markets cannot afford to be passive when it comes to their corporate debt. Precaution is the best prevention.