New BIS Data Show Over-Indebted Emerging Market Entities Signal Continued Global Economic Slowdown

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by: Martin Lowy


The beginning of the global credit bust came in 2015 Q3.

The global credit bust will slow economic growth even for the U.S.

Central banks may be powerless to stem the rising tide of credit weakness.

Back on October 6, 2015, I wrote about how changes in the perceived risks of emerging market debt and other risky debt was making interest rates for many kinds of borrowers increase, regardless of what the Fed or other central banks wanted to happen. That scenario has played out even more brutally than I expected. And it is continuing to play out as the global economy slows.

On December 21, 2015, I wrote about how debt bubbles grow and pop and concluded that the world was in a dangerous position that could well lead to a U.S. recession despite the apparent strength of the U.S. economy.

And on January 27, 2016, I wrote about how increasing market values mislead lenders and bond investors into lending too much based on the inflated values. I concluded that a recession in 2016 then looked likely to me. Since then, almost every day, we see new evidence of the over-lending phenomenon and its aftermath-bad or depreciated credits. These bits of evidence draw me ever more strongly toward the recession hypothesis.

A speech by BIS (Bank for International Settlements, the central bankers' bank) General Manager Jaime Caruana February 5, 2016 highlighted emerging market debt problems and their possible impact on the global economy. The data from BIS economists that Mr. Caruana used could have been produced only by a great institution like the BIS whose economists have their eye on the ball. Taken as a whole, the data are arresting. Some of that data are reflected in the following three charts:

These three charts (Graph 2 in Caruana's presentation) show that leverage in a substantial number of emerging market companies has increased to well over 100% of nominal equity (and we should be dubious that the equity number is not overstated in many cases) just as the profitability of such companies is declining fairly sharply (rightmost chart). Many of these highly leveraged companies will have great difficulty meeting their obligations, and to the extent that the obligations are not long term, an even larger number of such companies will not be able to roll the debt over. (Total non-financial sector company debt is estimated at $1.1 trillion, so it is not a trivial part of the world's outstanding credit.)

The part of this debt that is denominated in dollars (as opposed to a local currency) is particularly affected by global credit conditions. Here is the BIS take on the growth of dollar-denominated EME debt, which the BIS General Manager describes as having stopped growing in the third quarter of 2015 for the first time since 2009.

The natural suggestion to derive from this Graph 3 data is that the global credit cycle may have turned from positive to negative in the fourth quarter of 2015, after stagnating in the third quarter. And, as Mr. Caruana observed, the credit cycle can turn very abruptly and, for dollar-denominated debt, deteriorating foreign exchange conditions can play an amplifying role.

The following set of charts from shows the one-year changes in the number of local currency of China, Brazil, Russia and Turkey that a U.S. dollar can buy.





All four currencies have depreciated significantly against the dollar over the last year. The amplifying role that such changes can imply is shown in the following BIS charts (Graph 5 of Mr. Caruana's presentation).

In Graph 5, the outstanding dollar credit appears to be going up in 2015, but in fact the transition already was occurring. Looking at stocks of debt can be misleading, if we are looking for a turn in the cycle.

Dollar-denominated EME debt is especially volatile if the borrower does not have natural sources of dollars with which to repay. In such an event, the borrower will have to use local currency to buy dollars, thus driving down the value of the local currency, which has a snowball effect, as each repayment becomes more expensive in local currency terms. This seems to have been happening in a number of EME markets, including China.

Moreover, as exchange rates decline against the dollar, the investing world tends to see increased credit risk in the sovereign's debts, as illustrated by the next set of charts, Graph 7, that describes changes in CDS pricing (CDS prices go up when the market sees credit weaken).

As you can see, the price of CDS protection for a currency rises (bottom right panel) as a domestic currency weakens. That perception naturally will lead to higher costs of credit for the sovereign, as well as for its corporates and SOEs (state-owned enterprises), even if they have the benefit of government guarantees. Again, this is a factor pointing to economic slowdown. Brazil, as you can see, unfortunately, is in deep trouble.

Shipping is Slipping

Shipping is another bellwether of economic activity. And shipping rates are in the tank, with new ships coming onto the seas nevertheless, as cheap, abundant credit for nearly a decade led to increased building. As a consequence of reduced demand and increased supply, dry bulk carriers (see here) and container ships are losing money. (See here for Maersk statements on container ships.) Oil tankers might have tanked, too, except that they are stuffed with oil owned by speculators who hope for the price to rise.

Increasing evidence of credit weakness and threats of default

Thus the evidence is piling up that credit defaults are going to increase in many parts of the world and in many industries. And that will leave exposed the many businesses and SOEs that would not have been able to borrow in less permissive climate, and it will cause losses for their lenders. Just as on the upside, rising apparent asset values lead to more and more credit, on the downside, declining apparent asset values lead to tighter credit. Whether central banks could stem that tide seems problematic. Indeed, perhaps central banks should not even try to do so, because that likely would exacerbate the existing misallocation of resources.

Thus the world economy is going to have to pay for the natural misallocation of resources that occurred in the easy money era. And it may be that among the worst misallocations were those that were caused by low U.S. interest rates that seemed to enable a sensible arbitrage (carry trade) that disappeared when the tide went out, (I am working on a sequel article to this one that will discuss how the misallocation of resources occurred in the 2002-2006 credit boom and will try to give some idea of how it occurred in the easy money period of 2010-2015.) Misallocation of resources is not merely am economists' construct. It has real-world consequences when the credit cycle turns.

For investors, I do not think the bottom in riskier bonds or in the stock markets has come. I think the world has first to recognize the fundamental economic weakness that the credit bust will enforce. Then markets will capitulate and begin to heal.

For those with a long-term investment horizon, this may already be a good time to buy. But that may test one's stomach over the next six months, if I am right that the global economy, including the U.S. economy, is going get weaker. This is not intended as an alarmist prediction. I do not think the U.S. will experience a financial crisis because the large banks are so much better capitalized than they were last time around and so much less exposed to trading markets. But I am less sanguine about banks in other parts of the world that have less real capital and more foreign currency exposure. In Europe and many other places, the banks did not clear out the dead wood left over from the last (2002-2006) credit boom and did not raise sufficient new capital. Basel 3's leniency in postponing capital adequacy requirements and the lack of hardheaded supervision that would have forced losses to be recognized may lead to many new failures. Unsuspecting owners of Coco bonds (quasi-equity without equity's upside) of European banks may be right to be fearful, as it is reported they are.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.