Markets

Start Worrying About Emerging Markets

Despite reform, no one's prepared for what comes next.

Risk is rising.

Photographer: Mauricio Lima/AFP

For all the hand-wringing over when and how the Federal Reserve would begin tapering its massive bond-buying program, emerging nations appear to be relatively well-prepared for higher U.S. interest rates. Compared with the period before the 1997 financial crisis, many of them have ably shored up their defenses -- freeing exchange rates, amassing foreign-exchange reserves and paring back their dollar-denominated debt.

Such structural reforms were much needed. And they should prevent any immediate crisis, especially given how deliberately the Fed is inching up rates. But none of these countries should be feeling complacent: A confluence of factors appears to be raising rather than lowering the risks to emerging markets.

Start with debt levels. While many companies have sought to pay back their dollar loans, the level of foreign-currency debt in emerging markets -- uncovered by foreign-currency revenue or hedges -- remains worryingly high. U.S. dollar credit to overseas nonbank borrowers has risen by more than 50 percent since 2009, to around $10 trillion. As much as three-quarters of this debt is denominated in dollars, and emerging-market borrowers account for a significant portion of it. Chinese companies alone owe more than $1.1 trillion to overseas creditors. The equivalent figure in Brazil and Mexico is close to $400 billion; in Russia, it's $700 billion.

Rising rates make this debt more difficult to service for borrowers already struggling to meet their commitments. Withdrawal of the Fed's liquidity support makes the dollars needed to repay the debt scarcer and more expensive. Although the European Central Bank, the Bank of Japan and the People's Bank of China are still providing liquidity, none of them can offer badly needed dollars.

Worse, the rebound in commodity prices that buoyed sentiment at the end of last year seems to have faded. This is doubly dangerous. Exporters of raw materials, such as Indonesia and Brazil, will generate less and less dollar revenue to pay back debt. Lower commodity revenue also shrinks liquidity by reducing global capital flows --- most notably in the form of petro-dollar recycling -- with adverse effects for financing, asset prices and interest rates.

Positive steps, such as financing in local currencies, may create new problems. Even in countries where most debt is denominated in local currency -- such as Malaysia, Mexico, Poland, Turkey and South Africa -- investors are oftentimes foreigners. A stronger dollar and deteriorating credit conditions may lead to foreign investors withdrawing, with sales of securities creating a vicious downward spiral in emerging-market debt as well as currencies.

Finally, all these countries will suffer greatly should the U.S. economy stumble as a consequence of the Fed's normalizing its monetary policy. Despite buoyant markets, that possibility is hardly negligible.

Financial risk also remains high. American corporations have increased debt by $7.8 trillion since 2010; median debt across companies listed on the S&P 500 Index is near a historic high of more than 1.5 times earnings. Average interest coverage ratios -- current earnings divided by interest expenses -- have fallen sharply, to less than 6-to-1, the lowest level since the financial crisis.

The International Monetary Fund estimates that U.S. companies accounting for 10 percent of corporate assets can't currently meet their interest expenses out of earnings. If interest rates rise, that figure will more than double. Escalating borrowing costs combined with modest earnings growth could put companies with combined assets of almost $4 trillion at greater risk of default. Energy, real estate and utilities are especially vulnerable.

A stronger dollar could also reduce export competitiveness, further threatening growth. And as rising rates increase the cost of government borrowing, President Donald Trump's administration will have less room to respond -- say, by juicing the economy with billions in infrastructure spending.

This is why financial defenses in emerging markets may prove inadequate. Too many of these economies remain narrowly based, dependent on commodities or a few other exports. Corruption remains high and governance weak. Political risks -- from Turkey to South Africa, Eastern Europe to Latin America -- are rising. Growing opposition to trade and globalization is limiting options for governments.

Investors and policy makers seem to be ignoring these risks. To adapt Robert Louis Stevenson, the world has a grand memory for forgetting.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

    To contact the author of this story:
    Satyajit Das at sdassydney@gmail.com

    To contact the editor responsible for this story:
    Timothy Lavin at tlavin1@bloomberg.net

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