Emerging Market Corporate Sector Debt: A Stitch in Time Could Save Billions

IMF Blog, June 17, 2014

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Low global interest rates and large foreign investor inflows enabled nonfinancial corporations to raise record levels of debt following the global financial crisis.
Economic expansion initially supported earnings growth, helping to prevent leverage from rising too far and too fast.
Recently, slowing growth prospects have begun to put pressure on firms’ profitability.
Higher debt loads have led to growing interest expense, despite low interest rates, weakening firms’ ability to service their debt.

Debt-servicing pressures increase firm vulnerability to shocks such as large withdrawals of foreign capital, geopolitical uncertainties, or a sharp rise in interest rates.
Analysis of a sample of 15,000 large and small companies in emerging markets suggests:
- A combination of a 25 percent decline in earnings and 25 percent increase in borrowing costs could amplify the proportion of weak firms and their debt service inability.
Historical precedent:
- Earnings have declined 20–30 percent in the weaker firms, while interest expense rose 10–50 percent in the aftermath of U.S. investment bank Lehman Brothers’ bankruptcy.
Within the sample of 15 countries:
- The debts of highly leveraged and weak firms could increase two-fold by $740 billion, rising to 35 percent of total corporate debt from 17 percent currently.

External debt has been rising and now comprises more than one-quarter of total corporate debt in a number of countries.
Since the market turbulence in May 2013:
- Currencies have dipped by up to 30 percent.
- Long term government bond yields have increased nearly 150 bps, on average.
Corporations with high foreign currency debts may face a “triple whammy”: foreign exchange losses from debt principal and interest payments; lower revenues; and higher refinancing costs.
Analysis shows that a 30 percent depreciation in nominal exchange rates could erode 20–30 percent of earnings in some countries, even after accounting for natural hedges from overseas earnings.

For most countries, the banking sector appears healthy with sufficient levels of capital buffers.
However, lax recognition of doubtful assets and loan forbearance may mask the true extent of asset quality risk in a few countries.
There is a danger that high corporate loan losses could overwhelm what were thought to be adequate levels of balance sheet equity capital and loan loss buffers.
Countries with weak bank provisioning and thin loss absorbing buffers are at risk.

Corporate leverage has yet to reach precarious levels in most countries; preemptive policy actions could help alleviate systemic risks.
Recommended policy focus areas:
- Containing the rapid growth of corporate leverage, particularly in foreign currencies.
- Implementing stronger macroprudential policies in countries where large capital inflows have fueled growth.
- Improving data collection while mandating better corporate disclosure of foreign currency liabilities.
- Bolstering banks’ resilience through active provisioning and the buildup of more capital.
In the case of emerging market companies, a stitch in time could save billions.

Authors: Julian Chow, Shamir Tanna — June 17, 2014