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February 4, 2013 1:54 pm
A roaring trade in emerging market bonds has triggered fears an EM debt bubble is inflating.
Never before has the developing world enjoyed such low borrowing costs, at least in US dollars. The risk is that some emerging economies – and their companies – may be borrowing too much in foreign currencies.
The volume of foreign currency bonds sold by emerging market companies and banks smashed records in 2012, reaching more than $300bn, according to Dealogic. The pace of issuance so far in 2013 is almost twice last year’s, indicating that new records are likely to be made.
The International Monetary Fund is keeping a watchful eye on some smaller, poorer states to ensure they do not commit what has been dubbed the “original sin” of emerging markets. But this time it may be companies, rather than governments, that are indulging.
Indeed, some fund managers have voiced fears that EM companies issuing debt denominated in foreign currencies lack foreign currency earnings and have not hedged their exchange rate exposure. So, if their local currencies fall, their debt burden will in effect rise, and could even lead to bankruptcies.
“The ones committing original sin now are companies,” says Sergio Trigo Paz, head of emerging market debt at BlackRock. “If their domestic currencies start to drift some will have big problems . . . [Currency] mismatches can put even good companies in trouble.”
The potential pitfalls were apparent in the global financial crisis. Only a handful of emerging market currencies managed to hold their ground against the US dollar in 2008. The Mexican peso, Brazilian real, Turkish lira and the South Korean won all tumbled at least 20 per cent.
As a result, some companies paid a heavy price for dollar-denominated debts. Several Mexican and Brazilian companies were forced to restructure as a result of an increased foreign debt burden.
The biggest victim was Cemex. The combination of shrinking demand and $15bn of debts incurred in a US acquisition spree forced the Mexican cement and building materials giant into a debt restructuring in 2009.
Although the size of the debt pile was the biggest culprit, the mismatch between its mostly Mexican peso assets and revenues and the dollar debts exacerbated its financial stress. “The dramatic Mexican peso decline caused a lot of problems during the crisis,” says Esther Chan, a fund manager at Aberdeen Asset Management. “Currency mismatches on balance sheets can be a massive issue.”
If their domestic currencies start to drift some will have big problems . . . [Currency] mismatches can put even good companies in trouble
- Sergio Trigo Paz, BlackRock
Yet most fund managers argue that they – and the companies to which they lend – are well aware of the risks and have taken precautions.
Emerging market currencies have continued to be volatile in recent years, encouraging caution. Many companies are big exporters, so they have a “natural hedge” in the form of international sales. Those that do not export large amounts tend to buy protection against currency moves.
“It’s not a big issue at the moment,” says Maxim Vydrine, an emerging market bond fund manager at Amundi. “It’s a well-flagged issue for both investors and borrowers.”
If emerging market companies are sinning, there may be little they can do about it. Local bond markets have grown rapidly in size over the past decade, but for the most part cannot offer companies the same size and duration that the international market does.
Companies with large capital expenditure and investment needs arguably have no choice but to turn to international institutional lenders, Ms Chan says.
More mature local debt markets could encourage more domestic funding. There are signs that this is happening: the volume of local currency corporate bonds doubled between 2007 and late 2011 to the US dollar equivalent of $4.1tn, according to Bank of America Merrill Lynch.
Yet there are persistent concerns that some companies are taking too much risk and “yield-hungry” investors are too sanguine.
Emerging markets: News and comment from more than 40 emerging economies
Some eastern European companies could be wrongfooted by the effects of the strengthening euro, for example, while some South African groups may feel the pain of the weak rand. But Mr Paz forecasts problems will become apparent first in junk-rated emerging market corporate bonds, and could quickly spread – the “popcorn syndrome”.
“When one country or company pops you better put a lid on it quickly or there will be popcorn everywhere quickly,” he says.
“We’re preparing a game plan for when the popcorn starts to pop. The first popcorns are already cooking.”
Although developing countries are largely in robust fiscal and economic shape, defaults in the corporate sector can in extremis spread to the banking sector and on to the sovereign, points out David Riley, head of sovereign ratings at Fitch.
“Corporate credit crises can have big implications for a country, by hurting banks and spilling into the broader economy,” he says.
Few analysts and fund managers expect emerging market companies to become a major trouble spot. But even those that are bullish on this rapidly growing asset class say that any strengthening of the US dollar could pose risks for some companies.
“Even if a company has hedged, a climbing dollar can still cause pain,” Mr Vydrine says. “Some hedges aren’t perfect.”
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