Publish in Perspectives - Monday, September 26, 2016
Brazil’s rate of debt growth has been the highest in the region as a whole, reaching 38 percent of that country’s GDP in 2015, compared with 22 percent a decade earlier, Moody's says. (Photo: Wharton)
Is corporate debt a ticking time bomb in Latin America?
In a report published on July 20, Moody’s Investors Service warned about growing indebtedness in the world’s emerging markets, noting that in Latin America the ratio of external debt to Gross Domestic Product was 48 percent, in line with the 47 percent ratio in the Asia-Pacific region.
Moody’s report notes that companies and governments in emerging markets increased their debt issues in recent years because of the low cost of credit, and their external debt shot up to $8.2 billion in 2015, compared with only $3 billion in 2005. “External vulnerability has increased significantly in about 75 percent of the emerging economies around the world,” the report says. The boom in indebtedness has been produced largely in the private sector, where external debt has increased by 14.3 percent since 2015, compared with 5.9 percent in the public sector. In Latin America as a whole, Moody’s stressed, this pattern of growing debt has been most notable in Brazil and Mexico. Brazil’s rate of debt growth has been the highest in the region as a whole, reaching 38 percent of that country’s GDP in 2015, compared with 22 percent a decade earlier.
For investors, dollar-denominated debt issued by firms in riskier and less-developed countries has been one of the most profitable investments, with returns averaging more than 11 percent, according to the JPMorgan Emerging Markets Corporate Debt Fund, the CEMBI Broad. For their part, American companies with debt rated “investment quality” have provided an average return of only 3.3 percent. Meanwhile, equivalent debt denominated in British pounds sterling has averaged 1.8 percent, and debt denominated in euros has offered even lower returns.
No wonder so many investors have opted to take their money out of fixed income markets in the world’s largest economies and have reinvested it into emerging market debt. Over the past six months alone, some $18 billion has been invested in emerging debt funds, according to Bank of America Merrill Lynch. “In a low-interest rate environment, when rates are generally low around the globe, and there are negative interest rates in many parts of the developed world, the tendency for human beings is go and look for yield in riskier parts of the planet,” notes John Bates, emerging market corporate analyst at PineBridge Investments in London, which manages funds worth about $81 billion. “When you look at pension funds and insurance fund investments – their mantra is generally a very conservative goal or mandate in terms of what they are trying to invest in. But obviously with the lower interest rate environment, the tendency is to step away from the very safest investments and look into areas that are slightly more high-yielding, or relatively high-yielding.”
Bates worries that some investors who have little or no experience in emerging market bonds may be taking on more risk than they should. “These are tourists with very fat pockets,” Bates told Reuters in an earlier interview. “Typically, emerging market debt is a small allocation within a big pension fund or asset allocator, so if you get a big fund dipping into that pool, then removing that money there could [create] some very severe repercussions.”
Emerging market corporate bond markets may be seeing an “investment balloon effect,” he says. “This hunt for yields is driving spreads tighter, and it is pretty indiscriminate, and even heavier the further down the credit spectrum you go.” Over the past few months, Bates adds, “we’ve seen the dynamic where the fundamental picture in emerging markets is relatively stable, but we’ve seen valuations tightening a lot. The emerging market world has become a lot more expensive, and it’s not really because the fundamentals have gotten any better but because of the technical factors of investors chasing high yields.”
According to Bates, it is “really interesting” that in the emerging market corporate world, the investible universe is actually decreasing. In 2016, “we’ve seen a record number of calls and tenders and buybacks from corporate issues. [Thus, companies] are actually using the low interest-rate environment to refinance their debt. Forty percent of the Latin American issuance has been alongside buybacks, so the net effect of that is actually no increase in the investible universe in bonds.”
For example, in Latin America, adds Bates, Pemex, the Mexican state oil firm, “has issued a substantial amount of bonds right across their credit curve, but they also announced that they were repurchasing a lot of bonds as well. Pemex’s new issues, which are at lower rates, and slightly longer duration, are paying for bonds Pemex issued three or four years ago at higher rates and shorter duration. The risk there is that if we move into an environment where we have higher interest rates, it could mean that other asset classes become more attractive again, and then you have lots of people trying to get out of [this] asset class.”
THE RISKS IN LATIN AMERICA
According to Juan Gabriel Fernandez, executive director of the Center for Financial Studies at ESE, the Business School of the Universidad de los Andes in Santiago, Chile, “Whenever you evaluate risk in these situations, there is always the possibility of a bubble.” Nevertheless, considering the data available at the moment, he does not believe that this is the case in Latin America. “You don’t see megaprojects of dubious financial profitability in this flow, nor is there evidence of a great mismatch of currencies in order to take advantage of the conditions of indebtedness — which could possibility lead to an additional risk of reconnecting in the future. Currently, there does not seem to be any situation we could call a bubble,” he says.
Bates notes that there are “two kinds of main external threats that can happen in Latin America.” The first category is exemplified by the recent Brazilian banking crisis, in which the sector was heavily exposed to real estate projects and large-scale megaprojects that were “left in the lurch when banks were left without liquidity to fund them…. That sort of real estate bubble is not as likely now,” he adds. “We’ve just been through the Brazilian ‘car wash’ scandal, and the economy looks to have stabilized a lot. There are quite a few reforms (...) So I think that the market looks to be a lot better placed to deal with lower interest rates at the moment.”
The other threat involves currencies, Bates points out. “Emerging market currency is a key component, particularly in the dollar-denominated debt markets. Traditionally, Latin American companies have only been able to borrow in decent amounts of money short-term and at relatively high interest rates. This is why the U.S. dollar-denominated market really took off, and it suited a lot of large Latin American companies, particularly the Mexicans, because they had significant exports into the U.S., and therefore they had U.S. dollar revenue streams which they could match against their dollar-denominated debt. One of the mismatches in currencies that has happened in the past is for those companies that have borrowed a lot of money long-term in U.S. dollars then have dollar revenue streams, and as their [local] currencies devalue, they end up having to find a lot more of their local currency to pay off each dollar of debt.” For Latin America, “This is less of an issue,” because many commodity companies – in mining, petroleum, and so forth — export significant amounts of their output, and these products tend to be dollar-based products. “So when the local currency devalues, they tend to do quite well; and devaluation can actually help [their] exports of dollar products. But it goes the opposite way for companies that tend to have local revenue streams.”
Diego Fernando Palencia Silva, director of the postgraduate finance program at the Pontifical Xavierian University in Cali, Colombia, says observers have noted Colombians are taking advantage of historically low interest rates to issue large amounts of corporate and governmental debt before there are any additional rate hikes. Such increases are the result of a policy that the Bank of Colombia has been carrying out since September 2015.
Despite all that, Palencia Silva believes that the fixed-income market is not overly risky. “Emerging countries have learned from history; and there is no bubble in the prices of corporate debt because of the strict monitoring carried out by central banks and the messages of confidence that are currently being sent with a contractive monetary policy that is supposed to dampen any rise in inflation.” In any case, these foreign investments in emerging markets are subject to variations in coming months because of, among other factors, “the negative outlook that some countries, such as Colombia and Mexico, have received in their risk ratings as a result of the deterioration in their macroeconomic variables, which will probably bring adjustments in capital and pressures on their currencies.”
EFFECTS AND CONSEQUENCES
Fernandez believes that the latest data about corporate debt do not reveal any frenetic activity — and this situation is good news for South American companies because it enables them to access cheap financing. “If they are careful about mismatches, they shouldn’t wind up creating problems. But that doesn’t mean that this shouldn’t be a matter of concern.”
When it comes to sovereign debt, Fernandez sees no sign of alarm. “This is more a result of the global situation, and the end of the super-cycle in raw materials that enables countries such as Venezuela and Argentina — and Chile, to a lesser degree — to have a public spending policy that is clearly no longer sustainable. If the market finances excesses in fiscal expenditures through public debt without correctly evaluating the risks that are facing countries – as has already happened in the past – then the debt market could wind up being affected,” he notes.
Fernandez adds that the market — and regulators — must be cautious about all of the variables affecting the demand – and supply – of funds. Foreign direct investment differs from a purely financial investment and “in much the same way, it is not the same thing for an international pension fund to invest in Latin American debt that has foreign exchange coverage as it is for a hedge fund to engage in the same activity.” Thus, while there is no evidence that there is excess investment, “there are concerns about that [happening], and it is a good thing that such concerns exist.”
INVEST IN OR LEAVE THE MARKET?
Many investors wonder if it is still worthwhile to invest in Latin American fixed-income vehicles, or if it is time to undo their positions and take their profits. Notes Palencia Silva on corporate debt: “It is essential to have a very short-term horizon for your investments, which means investing in debt products that have a short curve, with daily monitoring and very conservative volatility levels, which can mean making speculative investments. This is where there can be distortions that affect the overall level of risk in this type of market, affecting its exchange rate and generating additional pressures on the rate of inflation in the countries [involved].”
According to Palencia Silva, “The most attractive counties to invest in are the members of the MILA (Latin American Integrated Market) … Colombia, Chile, Peru and Mexico,” because “their central banks engender trust with their monetary policy that adjusts itself to the current volatility in international markets.” Despite that, he warns that emerging markets, especially Colombia, have been affected in recent months by macroeconomic adjustments that imply a possible increase in the discount rate of the U.S. Fed.
Fernandez also notes that in the longer term, macroeconomics and politics play a more significant role. Latin America still has great income inequality and significant poverty, where many people have relatively low purchasing power and fall outside the formal economy. Thus, “almost all industries have a very high potential for growth over the long term if those sorts of people are incorporated into the formal economy.” Also over the long term, “whatever investment option you consider will earn a higher average rate of return in Latin America” than in many other countries, but that depends on progress on productivity and political stability. He adds: “Over the medium term, while one can foresee a positive change toward more liberal positions with regard to economics and fiscal responsibility in almost the entire continent, there are also some signals that are hard to evaluate.”
Fernandez believes that one of the greatest challenges facing Chile is to control public spending. Chile is enduring its third year of sluggish economic growth and suffered its first contraction in six years during the second quarter of 2016, when GDP shrank by 0.4 percent compared with the previous three months. In September, Chile’s central bank cut its growth forecast for 2017 to 1.75 percent to 2.75 percent, down from its June estimate of 2 percent to 3 percent. Fernandez says that the rating agencies are studying the impact of this slowdown on the country’s indebtedness.
Fernandez adds that Argentina “is implementing a series of messages that, if they get results, will allow it to once again play an important role in international markets. However, President Mauricio Macri is facing greater challenges with the reorganization of the economic system, and the process of cutting subsidies [which his government is undertaking] is neither easy nor popular.” As for Peru and Colombia, “everything seems to indicate that the market is punishing both countries excessively, especially Colombia. If that country manages to move ahead in its peace process with the FARC rebels, it would eliminate an important risk factor for a geographical area that is almost one third of the country.”
With respect to Brazil, he says, “it is in a situation of political uncertainty that makes any financial analysis difficult, which is similar to the case in Venezuela.” In the latter troubled country, he concludes, “It seems that the situation is unsustainable, and while that generates opportunities for extreme growth, it does so at an extremely high risk.”
Republished with permission from http://www.knowledge.wharton.upenn.edu -- the online research and business analysis journal of the Wharton School of the University of Pennsylvania.