Emerging market debt burdens may be sorely understated

For emerging economies, coronavirus struck first through the financial markets. Long before the numbers of cases and deaths in these countries began to spread alarm, many emerging markets experienced a sudden halt in foreign investment inflows.

Overseas investors have taken $95bn out of EM stocks and bonds since late January, according to the Institute of International Finance, dwarfing the withdrawals that followed the onset of the global financial crisis in September 2008.

As Covid-19 infections rise and fragile health systems struggle to cope, foreign investors may be low on the list of concerns for EM governments. But these outflows will have a big impact on the fiscal measures policymakers can bring to bear on the crisis.

Emerging markets’ overseas liabilities, moreover, may be bigger than previously imagined. A paper published by Matteo Maggiori at Stanford and colleagues at Harvard, Chicago Booth and Columbia Business School suggests the true ownership of EM bonds by overseas investors is much greater than shown in standard data — in some countries, by many multiples.

The paper also suggests that foreign holdings of shares issued by Chinese companies may be many times greater than the $160bn that shows up in US national accounts. Should US-China relations sour in the aftermath of the coronavirus crisis, these giant holdings could become a source of significant risk.

Mr Maggiori and his colleagues question the normal practice of allocating securities in national accounts on the basis of the residency rather than the nationality of their issuer. 

It may make sense, for example, for a bond issued by a Brazilian subsidiary of Banco Santander to be added to the debt statistics of Brazil (the residency of its issuer) rather than Spain (the nationality of the issuer’s ultimate owner), because the bond’s proceeds are likely to be put to use in Brazil.

But it makes much less sense for a bond issued by Petrobras International Finance Company, a Cayman Island subsidiary of the Brazilian oil group, to be added to the debt statistics of the Cayman Islands. Yet that is what happens in standard, residency-based financial statistics such as the US’s Treasury International Capital data (TIC) and the IMF’s Coordinated Portfolio Investment Survey (CPIS).

Mr Maggiori says this results in a vast understatement of the investments by US, European and other international investors in emerging economies. So the academics developed an algorithm to reallocate the securities logged in the TIC and CPIS data according to nationality rather than residency.

The results are startling. TIC data show that US ownership of Brazilian bonds at the end of 2017 amounted to $8bn, based on the residency of issuers. But restated by nationality, the total rises to $68bn. For Chinese bonds, the total rises from $3bn to $55bn. 

Mr Maggiori says the results sound a warning as the coronavirus crisis threatens to tip emerging markets into a debt crisis.

“If we are going to see a wave of corporate defaults, it’s a risk worth thinking about that a lot of issuance has taken place offshore,” he said. “[Our work] shows that exposures are quite large.”

What is also striking is the role played by tax havens such as the Cayman Islands. In the TIC data, of Brazil’s $59bn in reallocated bonds, $42bn were issued in tax havens. Of China’s $52bn, $44bn were issued in tax havens. 

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The results also shine a light on the role of so-called variable interest equity structures in US investments in Chinese companies. VIEs allow US investors to hold shares in these companies, circumventing Chinese restrictions on foreign ownership of some operating businesses. But in these transactions what investors actually buy are shares in listed companies, generally resident in the Cayman Islands, that give them a claim on the profits of Chinese operating businesses.

By reallocating such investments on the basis of nationality rather than residence, the paper shows that US “ownership” of Chinese companies at the end of 2017 was not $160bn, as shown in US national statistics, but $700bn. This puts it closer to the amount of Chinese ownership of US Treasuries, of about $1.1tn. 

This is significant because Chinese regulators are certainly aware of the smoke-and-mirrors act being carried out by VIEs. They could, should they wish, bring the practice to an end.

Mr Maggiori is not suggesting they will. But he thinks the risk is worth noting. “You read a lot about the possibility of China dumping its US Treasuries but very little about the possibility of China imposing its own regulations. If we’re talking about one, we should certainly be talking about the other,” he said.

jonathan.wheatley@ft.com