Since the global financial crisis in 2007/08, the debt obligations of non-financial corporates in emerging market economies have been on a steep upward trend that threatens to undermine wider debt sustainability.
According to the IMF, the debt of non-financial corporations rose from $4 trillion in 2004 to well over $18 trillion in 2014 across major emerging market economies, and according to the Bank of International Settlement (BIS), this debt increased from around $9 trillion at the end of 2008 to just over $25 trillion by the end of 2015. In relative terms, corporate debt almost doubled as a percentage of GDP from 57 to 104 per cent over the past seven years. This is markedly higher than in many advanced economies prior to the global financial crisis.
The main danger posed by this development to overall debt sustainability in these economies is that these constitute major contingent liabilities: If the experiences of Latin America in the 1980s and East Asia in the 1990s (as well as those of many EMU economies more recently) are anything to go by, unsustainable corporate debt has a habit of ending up on public balance sheets when corporate bankruptcies threaten to undermine macroeconomic stability.
This recent expansion of corporate external balance sheets in many emerging market economies appears to be closely linked to excess liquidity in the international financial markets fuelled, in particular, by the extensive use of asset purchasing programmes - so-called quantitative easing (QE) programmes - by advanced economy Central Banks since 2008. McCauley et al (2015, BIS Working Paper 483) estimate that overseas US dollar credit provided through bank loans and bonds reached $9.8 trillion by 2014. Around $7 trillion are thought to have fuelled the expansion of US dollar credits in emerging market economies (e.g. Wheatley and Kynge, Emerging Markets: Deeper into the red, Financial Times 17 November 2015).
The channels through which original and leveraged QE cash reaches emerging market corporates are various: These asset purchasing programmes drive down returns on safe assets (such as US T-Bills) and send asset managers in search for higher-yield but also higher-risk assets elsewhere, such as corporate bonds in emerging markets. QE cash also finds its way from commercial banks to financial institutions with high-risk investment strategies, such as hedge funds. Finally, foreign direct investment (FDI) plays a role, in particular through intra-company loans that are making up large shares of overall FDI in countries such as China and Brazil.
This very high sensitivity of capital flows into emerging market economies more generally, to policy changes in advanced economies is also evident in the (short-term) fall out from Brexit and the pending Italian banking crisis: While many emerging economies had begun to register a significant increases in capital outflows following the end of in particular the US Federal Bank's asset-purchasing programmes in 2014 and eventually growing fears over corporate bankruptcies and fragile debt sustainability in these economies, Brexit and uncertainty about Italy's problems instantly reversed this trend more recently, and for now.
Moreover, it is fast becoming clear that debt-financed investment by corporates in emerging economies does not favour economic activity supportive of longer-term structural transformation. Rather, albeit with some regional differences, the bulk of debt-financed corporate investment has so far ended up in sectors such as construction and services with a high degree of speculative economic activity.
In most cases corporate debt has primarily been contracted in international financial markets and foreign-denominated currencies, with one exception: China. While Chinese corporate debt has increased very significantly over the past six years to no less than an estimated 170% of GDP in 2015 and its total debt now stands at around 250% of GDP, the lion's share of its corporate debt is held by state-owned enterprises with domestic banks or in domestic-currency bonds.
Keeping such regional differences in mind, and pending further volatility in capital flows to and from emerging markets, the graph included in this note charts the debt servicing ratios (DSR) of non-financial corporations in large developing economies between end-2007 and end-2015. DSRs reflect the share of (sectoral) income used to service debt and are generally considered to be a reliable warning indicator of pending banking crises.