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Global debt canaries struggle, but signs of broader credit stress are limited

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Global debt canaries struggle, but signs of broader credit stress are limited

The first canaries in the coal mine of global debt are struggling, but so far, signs of broader credit contagion are limited.

The end of an era of historically low U.S. interest rates is already claiming emerging-market casualties, with Argentina forced back to its old if little-loved partner the IMF and Turkey pressured into emergency rate hikes. Both countries are exposed to changes in global conditions by their heavy dependence on foreign financing. Yet, while other middle-income nations, notably Brazil, have seen speculative raids on their currencies, strengthened economic fundamentals should head off any repeat of the cascading debt runs seen in previous episodes of panic, analysts said.

The continuing rise of global debt levels since the financial crisis of 2007-2008 has prompted warnings that the adjustment to higher interest rates might be a painful one for weaker debtors. Total borrowing by emerging markets rose to 210% of GDP by 2017, from 145% in 2007, outpacing the increase in mature markets to 382% from 358% in the same period, according to the Institute for International Finance.

Yet while some countries are vulnerable, in the aggregate, economies have lower current account deficits than in 2013, when emerging market bond prices were buffeted by the "taper tantrum" as the Fed prepared to reduce quantitative easing. Most have also kept growth in public debt under control, according to Société Générale. Emerging markets' current-account shortfall was just 0.6% of GDP in 2017, excluding China, while public debt ratios were half those of the U.S.

"An EM-wide systemic crisis is unlikely, but certain countries will face greater challenges than others," SocGen's Jason Daw and Phoenix Kalen wrote, adding the caveat that corporate credit markets warrant close attention.

Corporate debt

Total credit to nonfinancial corporations rose to 93.9% of emerging market GDP in the fourth quarter of 2017, up from 60.1% in 2008, according to the Bank for International Settlements. Much of this increase came in China, where nonfinancial corporate debt jumped to 160.3% of GDP from 96.3%. China's trade surplus and its position as the world's second-largest net creditor after Japan mean it is well placed to deal with the contingent liabilities presented by overstretched state companies. Nonfinancial companies in Turkey, whose debts have almost doubled to the equivalent of 67.5% of GDP from 35.7% in 2008, could be the catalyst for systemic problems, said Paul McNamara, investment director at asset management group GAM. Much of this Turkish corporate debt is also in euros or dollars.

The Turkish lira has come under renewed pressure despite 425 basis points in official rate hikes since late May as investors have been unnerved by President Recep Tayyip Erdogan's open pressure on the central bank to keep interest rates low ahead of June 24 elections. McNamara thinks that the country is in danger of following in the path of Argentina, which was forced to request a $50 billion credit line from the IMF.

Brazil, with a fiscal deficit running at almost 8% of GDP and gross public debt set to approach 90% of output this year, has also faced a testing time on currency markets, with the real depreciating about 17% against the dollar since its 2018 highs in January. But the country's current account is nearly in balance, and inflation is under control.

"It's worth making clear that Brazil is in a very different position," CreditSights analysts wrote in a recent note. "Both Argentina and Turkey have serious questions about balance of payments stress, high inflation and low reserves. At a sovereign level, default risks are low for external sovereign credit in Brazil and much lower than either of those sovereigns."

While October national elections and an ongoing truckers strike add to uncertainty in Brazil, its central bank has also shown itself willing to flood the market with foreign exchange swaps to defend its currency. If that fails, it can fall back on $380 billion in foreign reserves.

Investors moved $1.9 billion out of emerging-market bond funds during the week covering May 31 through June 6, the seventh straight week of selling, Jefferies said in a recent note. The rise in Treasury yields to about 3% has also sucked funds out of high-yield U.S. corporate bonds, which saw $3 billion in outflows, the largest redemption in 13 weeks.

High yield outflows

Even though U.S. companies' ability to pay their debts, as measured by their interest coverage ratios, has deteriorated sharply since 2013, according to the Institute for International Finance, there is little sign of stress even among junk-rated credits. The difference in yield between non-investment-grade corporate bonds and Treasurys remained near 10-year lows June 19, at 340 basis points, down from highs of over 860 basis points in February 2016, when fears that Fed rate hikes would drain liquidity spooked investors, and from more than 2,140 basis points at the height of the financial crisis in December 2008, data from the St. Louis Fed shows.

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"While high-yield bonds are certainly liquidity-oriented assets, they haven't been overly correlated to the U.S. dollar or interest rates early in the raising cycle," Arnim Holzer, portfolio manager at EAB Investment Group, said in an interview. "If the Fed begins to tighten more aggressively or give signals that the current path may not be enough to manage the inflation dynamic, one could see U.S. high yield soften. A more aggressive Fed could slow the economic recovery and increase the historically low default rates to more impactful levels."

Nor have the struggles of some emerging-market borrowers made investors more concerned that weaker U.S. debtors could also struggle as rates rise.

"Short of a major credit event or a significant economic surprise, high yield seems unimpacted by the emerging markets volatility," Holzer said. "Certainly, if a major set of EM bonds and currencies began to default or [sell off] it could impact the appetite for credit in general. But with global growth solid, it looks as if the EM difficulties are more related to adjusting to higher rates and a stronger U.S. dollar rather than a credit contagion."