External shocks have been more frequent in the 21st century than earlier. These shocks have been rapidly transmitted to the emerging market economies (EMEs) through trade, finance and confidence channels, raising serious financial stability concerns.
As the impact of external shocks has been pervasive and enduring, a deeper understanding of external vulnerabilities of EMEs at any point of time is crucial for policymakers. They can insulate the economy proactively, or at least reduce the adverse impact through appropriate policy initiatives.New areas of concern
Traditionally, low levels of reserves and currency overvaluation have been treated as major factors behind the pre-2008 financial crises in the EMEs.
On the basis of lessons learnt from the past crises, the EMEs have not only built up sizeable reserves, particularly in the aftermath of the East-Asian crisis, but also allowed their exchange rates to be more flexible, barring a few countries in the Middle East where the exchange rates remain pegged.
Indicators of overheating, such as GDP growing above the potential, and credit growth being well above the long-term trend, are currently not the sources of vulnerabilities for EMEs. Even indicators such as external current account deficit, money supply and inflation are at manageable levels in most EMEs.
Are we in a situation in which the EMEs are vulnerable, despite major lead indicators of vulnerability remaining within safe limits? Yes, this time is different. Relatively less lethal predictors of vulnerability like capital flows, corporate leverage, external debt, debt repaying capacity have emerged as a potential threat to financial stability.
While capital has become more mobile now than ever before because of globalisation, liberalisation and technological progress, the resilience of EMEs has suffered a setback in recent years for multiple reasons — both domestic and global. Capital flows to EMEs have emerged as the key source of uncertainty and market volatility in the post-crisis period.
According to the April 2016 World Economic Outlook of the IMF, net capital flow to EMEs as proportion to GDP has been declining steadily since 2010 and has become negative in 2015. International Institute of Finance (IIF) estimates suggest that in terms of net capital outflows from the EMEs, 2015 was the worst year in last two decades, and in 2016, the outlook for capital inflows remains grim.
The corporate debt of non-financial companies as proportion of GDP, as reported by the Bank for International Settlements (BIS, Working Paper No. 550, March 2016), has increased phenomenally in the EMEs since 2009 and surpassed the same for developed countries since 2014.
In absolute terms, the corporate debt of major EMEs surged from $4 trillion in 2004 to $18 trillion in 2014, and further to $21 trillion by the middle of 2016.
While the bulk of the outstanding corporate debt is bank loans, bonds issued by corporates have risen significantly since 2009. According to the BIS, the share of bond issuance as proportion to total debt by corporates in EMEs has gone up from around 10 per cent in 2009 to 20 per cent in 2014.
Moreover, even as local currency bonds constitute the major chunk, the share of foreign currency bonds in the total bonds issued by EMEs, has increased significantly.External corporate debt
As global banks were risk-averse and global interest rates were perceived to remain low for a longer period, corporates in EMEs, like South Africa, Brazil, Chile, Russia, Indonesia, Philippines, Mexico, Turkey accelerated their borrowing from the global markets through issuance of foreign currency bonds.
Another dimension of the problem is that corporates in the non-tradable sector borrowed more in foreign currency vis-a-vis in home currency, than those in the tradable sector. Corporates in the tradable sector borrowing in foreign currency, are unlikely to face a serious repayment problem as they have natural hedge because of their earnings in foreign currency. However, in the non-tradable sector, corporates borrowing in foreign currency encounter repayment risk as their earnings are in local currency.
Since the taper tantrum, EMEs have generally encountered bouts of depreciation pressure on their exchange rates. Nevertheless, export growth from EMEs continues to remain sluggish. Despite the natural hedge, corporates in the tradables sector also find it difficult to service their external debt due to fall in export in many EMEs.
According to the BIS working paper, return on equity in developed and EMEs was around 12.5 per cent in 2013. By 2015, this has come down significantly to about 8 per cent in EMEs compared to above 10 per cent in developed countries. Moreover, the debt repaying capacity, measured by interest coverage ratio —the ratio of earnings before interest, taxes, depreciation, and amortization (EBITDA) to interest expenses — has dwindled to below 6 in EMEs compared to more than 10 in developed countries in 2015.
Normalisation of monetary policy has already started in the US. As corporate debts are negotiated at flexible interest rates, typically linked to the LIBOR, pick up in the LIBOR would seriously jeopardise further the debt repaying capacity of corporates in EMEs.
Any default by corporates in servicing their external debt would disrupt debt flows to EMEs, going forward. Therefore, external vulnerabilities of EMEs are alarming due to sluggish export, depreciation of the home currency, low return on equity, low interest coverage ratio, high corporate debt and expected turnaround in global interest rates.
Unlike in developed countries, economic fundamentals are generally fragile in EMEs. Even with unchanged fundamentals, financial markets in EMEs suffer setback when there is flight to safety for reasons beyond their control.Pointers for India
Although India is better positioned to withstand external shocks, policymakers must strengthen macro-fundamentals further. The credit market is passing through a critical phase of consolidation. Corporate leverage is a complex issue, which cannot be ignored. Large corporate borrowers in certain sectors like infrastructure, iron and steel, contribute to the problem of non-performing assets of banks in a big way and face repayment problems.
Indian economy is not completely insulated from the destabilising impact of volatile capital flows to EMEs. In an uncertain world, the best policy option is to keep the house in order.
The writer was principal adviser and head of the monetary policy department of RBI