Two recent papers have changed how market participants are thinking about capital flows and risk in emerging markets. Typically, economists monitor balance of payments (BoP) accounts to determine how dependent countries, especially developing economies, are on external sources of capital to finance their imports and debt service. When countries running large current account deficits see foreign investors begin to pull out their funds or demand higher rates for borrowing, it typically causes problem for the deficit country.
That's all common knowledge, but what these papers reveal is that, in recent years, much of the borrowing in emerging markets hasn't been counted in standard current account surplus/deficit figures. The reason is that external debts are typically recorded based on the residence of the borrowing institution, rather than on the nationality of the borrower. Specifically, emerging market corporations having been issuing debt in foreign countries denominated in foreign currency. Because developed market interest rates - especially in the U.S., during the period of QE - have been so low, it has made sense for these emerging market corporates to borrow, for example, in USD and invest those funds in higher-yielding opportunities whether in their home countries or abroad.
International debt securities outstanding (all borrowers) by residence and nationality of issuer. Source: BIS, Shin 2013
The chart above shows how different those debt obligations look for a country like China when figures are adjusted to include securities issued by Chinese corporate firms through subsidiaries in other countries. The charts look similar for Brazil, India, etc.
As QE ends and borrowing costs rise, these flows will naturally reverse, and the size of the debt load presents serious challenges for EM deficit countries. Two things investors should be thinking through are: 1) how previously low estimates of EM obligations and the revised figures should change foreign investor attitudes about the riskiness of investing funds in countries where current account deficits so large, especially as the U.S. turns gradually toward a tighter, rates-up environment; 2) the linkages and the risk of contagion from EM to developed market financial assets: since low DM rates have been used to fund the chase for yield by EM corporate borrowers and asset managers, even DM countries with strong growth prospects could see asset sales as this "carry trade" unwinds.
This is a topic whose consequences will play out over many months, and we will come back to it with some ideas about portfolio balancing and specific investment ideas. In the mean time, some reading:
Philip Turner, "The global long-term interest rate, financial risks and policy choices in EMEs," http://www.bis.org/publ/work441.pdf Hyun Song Shin et. al., "Global Liquidity through the lens of Monetary Aggregates," http://www.imf.org/external/pubs/ft/wp/2014/wp1409.pdf Jill Malandrino of The Street's Options Profits and I dive more into the subject in this video:
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