Unconventional monetary policy from the US Federal Reserve has been the driving force behind market movements over the past six years. It’s sent equity, bond and commodity markets sky high, lowered the value of the US Dollar and, up until recently, stymied volatility.
It has also contributed to the massive expansion in USD borrowing outside the US, something that may lead to a wave of market volatility should the Federal Reserve begin to lift interest rates later this year.
That’s the warning from CBA’s senior currency strategist Elias Haddad in a research note in which he suggests potential rate hikes from the Fed “could lead to a wave of defaults and spikes in volatility of greater magnitude than when the Fed first hint that it might taper its asset purchases in May 2013”.
Here’s Haddad on the splurge in offshore USD borrowing in recent years.
“According to the Bank for International Settlements (BIS), non-bank borrowing (which excludes inter-bank transfers) outside the US ballooned from US$5.6 trillion in 2008 to a record high of US$9.2 trillion in late 2014 or more than 15% of non-US GDP. Looking at the breakdown, debt securities and bank loans account for US$4.2 trillion and US$4.9 trillion, respectively, of cross-border USD credit. Geographically, Emerging Markets (EM) account for over a third (US$3.3 trillion) of USD cross-border credit (chart 2) with the bulk of it concentrated in China (US$1.1 trillion, 11% of GDP), Brazil (US$300 billion, 13% of GDP) and India (US$125 billion, 6% of GDP)”.
Here’s how offshore US Dollar debt issuance has grown.
With the Federal Reserve poised to lift interest rates later in the year, it could amplify risks in credit markets.
“The risk is that rolling-over and servicing that debt will become more expensive for borrowers outside the US because the Fed is on track to begin lifting its policy rate this year, US bond yields are rising and the USD is trending higher, the recent correction lower notwithstanding”.
Sighting research from the BIS, he believes that global asset managers, rather than banks, will be more exposed to any potential volatility in credit markets given the majority of the debt issued has been in the form of bonds used to finance carry trades “which tend to be speculative in nature”.
In essence, debt has been issued in US Dollars at lower interest rates to finance investment in foreign denominated assets offering higher returns.
While Haddad believes risks have increased, he offers four reasons why a “full-blown debt crisis should be avoided” on this occasion.
- Most EM have flexible exchange rates which should act as an economic shock absorber should financial tensions occur.
- Excluding China (which has a current account surplus of about 2.8% of GDP), the current account deficits of most EM countries are small and should not be problematic to recycle. Only South Africa and Turkey have current account deficits in excess of 5% of GDP.
- EM foreign exchange reserves total over US$7.7 trillion compared to well under US$1 trillion in the late 1990s. This equates to some 84% of the stock of outstanding USD credit outside of the US.
- Most EM corporate borrowers have little currency mismatch on their balance sheets. For instance non-financial borrowers in Brazil, Mexico, Russia and South Africa tend to be commodity producers so their USD earnings generally line up with their USD debt. The risk is that a further decline in commodity prices lowers USD earnings at a time when debt servicing costs are rising because of higher US interest and a stronger USD.
While these may prevent a full-blown credit crisis in emerging markets from forming, it comes as a timely reminder that risks are continuing to build even as risk assets globally continue to march higher.