Stocks and Shares

Are emerging markets too risky? (Part II of II)

OfWealth is taking a close look at the emerging markets. In part I we reminded ourselves that these are still the places in the world set to have the strongest growth trajectories in future. We also highlighted how emerging market stocks are cheap at the moment. But there are legitimate concerns about debt levels. So should we be investing in these cheap and growing markets? Or are the risks too high?

Getting to the bottom of this isn’t straightforward. For that reason today’s article is a little longer than usual. So please bear with me – sometimes there are no short cuts. The good news is that there are a lot of charts.

Just after my last article I saw a summary of the International Monetary Fund’s (IMF’s) latest projections for world economic growth in 2015 and 2016. Although the IMF has been reducing its expectations, the figures clearly back up our thesis that emerging markets are generally the fastest growing parts of the world.

The IMF projects 3.1% real world GDP growth for 2015 (“real” means on top of inflation). “Advanced economies”, which mainly consist of the USA, Western Europe and Japan, are expected to grow by 2%. “Emerging market and developing economies” have 4% growth pencilled in, which is twice as much. It’s a similar picture for next year as well: 3.6% for the world, 2.2% for advanced economies and 4.5% for emerging markets.

Within the emerging markets, Asia is the place with the highest growth. The IMF expects 6.5% growth in 2015 and 6.4% in 2016. In turn those figures are dominated by China and India. China has been slowing down, but is still set to grow 6.8% this year and 6.3% next year. India has been speeding up, and is expected to grow by 7.3% and then 7.6%.

There are weak spots too, especially in commodity exporting countries. Both Russia and Brazil are in recession this year, and are expected to remain in recession next year, although less severe than now.

There are weak spots too, especially in commodity exporting countries. Both Russia and Brazil are in recession this year, and are expected to remain in recession next year, although less severe than now.

Russia has been hit by the collapse of oil and other commodity prices and Western economic sanctions. Brazil has also been hit by weak commodities in general and the political scandal that has blown up around massive corruption at state controlled oil company Petroleo Brasileiro (NYSE:PBR), known as Petrobras.

If commodity prices rebound then both of these countries are likely to rebound as well. Whatever their short term problems they are likely to still have a strong long term growth trajectory ahead of them. Russia in particular looks oversold, given that it has low levels of government and private debt and large foreign exchange reserves, meaning a financial solvency crisis is unlikely.

But let’s get back to the question that we posed in our previous article. This is whether investors should be concerned about the levels of corporate debt in emerging markets in general.

Let’s start with this chart, from another recent IMF publication. Focus on the blue (ex-China) and red (China) bars, which show total emerging market corporate debt between 2003 and 2014, measured in US dollars.

(The other bars look at stock market capitalisation, which is more or less irrelevant since it’s a function of market valuation multiples. Since emerging market stocks have been in a bear market since 2011 it’s no surprise that “mcap” hasn’t kept pace with debts. It would be much more relevant to track corporate profits or book value instead, which aren’t affected by the vagaries of market pricing.)

Source: IMF

The obvious conclusion is that corporate debt has indeed ballooned in emerging markets over the past decade (and a bit). But examine the chart a bit more closely and you can see that most of that growth has been in China (red bars).

Obviously China is the big one. It’s economy is already the biggest in the world, when measured using GDP adjusted for purchasing power parity (PPP). PPP takes account of price differences between countries, which can be huge. In that sense it’s a measure of the volume of an economy, instead of a dollar value at current market exchange rates.

For this reason GDP at PPP rates is a useful measure when comparing countries, especially when some are high income (high wages and prices) and others low income (lower wages and prices). I’ll come back to China later on.

So corporate debt has risen a lot. But looked at in isolation that doesn’t tell us much. After all, most of these countries have fast growing economies as well. The next chart compares corporate debt to GDP over the same period. We can see that there was a big increase from 2009 onwards.

Source: IMF


Breaking it down further, this next chart shows how corporate debt changed by country between 2007 and 2014, as a percentage of GDP. China, Turkey and Chile stand out as the countries with the biggest corporate credit booms. Brazil, India and Peru follow on behind. But the corporate sector in many countries has actually been reducing debt in relation to the size of the economy, notably in Eastern Europe, Russia and South Africa.

Source: IMF

In other words, emerging market corporate debt levels overall have risen sharply in relation to GDP, but not in every country. It turns out that it’s not in every industry sector either.

The main culprits for increased leverage have been the construction sector and oil & gas. Both these industries have added a lot of debt, both in China and in Latin America. This next chart shows how the relationship between debt and equity (net assets) has changed for listed companies in selected regions and sectors between 2007 and 2013.

Source: IMF

With this information a picture is starting to form. Emerging market corporate debt has shot up relative to GDP, with a concentration in China and Latin America in the construction and oil & gas industries.

I suspect a large part of the Latin American oil & gas debt growth can be explained by Petrobras alone, which has piled on debt in recent years to fund capital investment (and the associated bribes). With the oil price in the doldrums that investment may turn out to be much less profitable than expected.

As for construction in Latin America there has clearly been a lot going on and localised bubbles.

As for construction in Latin America there has clearly been a lot going on and localised bubbles. I was talking recently to a friend who finances real estate development in Colombia, and he gave the impression that things are booming.

And another friend has just returned from Brazil, where real estate prices are high and appear to be out of whack with the weak economy, lack of affordable mortgage financing, and uncertain political situation (the president, Dilma Rousseff, may face impeachment).

I’ll come back to Brazil in future. Today we need to focus on China. But first there’s a bit more big picture stuff to consider.

When looking at the riskiness of corporate debt levels we need to look at solvency issues: specifically the ability of companies to pay interest on their debts.

This next chart compares company liabilities with profits. Two measures of profit are used. I don’t want to get too technical, but to understand this chart you’ll need to know what “EBIT” and “EBITDA” mean.

“EBIT” is earnings before interest and tax – in other words the profit that remains from sales after companies have paid all their expenses except interest payable to lenders and tax to the government.

“EBITDA” is earnings before interest, tax, depreciation and amortisation. Depreciation and amortisation are write downs that companies take on their asset values every year, which are meant to reflect their declining values over time.

For example, machinery loses value over time and eventually has to be replaced, so it’s value is depreciated. But these are non-cash accounting charges in the short term – until the assets are replaced – so adding them back to profit gives a proxy for how much cash a company is making, before paying debt interest and taxes.

Company cash flows indicate a company’s ability to pay interest on its debts in the short term (in the longer term a lot of that cash will need to be invested in new assets).

So when liabilities, and hence interest costs, are low relative to EBITDA then companies are in a strong position to service their debts, and vice versa. So here’s that chart I promised you.


Source: IMF

Looking at this it’s clear that liabilities have risen since 2008 relative to both measures of profits. It’s also worth noting that this is looking at gross liabilities and not net ones. Many companies may have been stockpiling cash assets as well, which would improve the picture because net debts would be smaller.

One thing is clear though. Relative to EBITDA – which remember is similar to cash flow – gross liabilities are much lower than the late 1990s and probably still around the same levels as the early 2000s.

A comparison to the late 1990s is important. The massive Asian crisis was in 1997 and the Russian crisis was in 1998 – both brought about by too much debt, of both the government and corporate kinds.

…on this evidence, corporate debts are not yet out of control relative to profits. A repeat of the Asian crisis looks unlikely.

Government debt levels in those countries are generally lower than back then, relative to GDP. And on this evidence, corporate debts are not yet out of control relative to profits. A repeat of the Asian crisis looks unlikely.

The IMF goes on to look at how companies are doing their borrowing. There’s been a big expansion in emerging market bond issuance and a relative decline of bank lending as a source of finance.

Source: IMF


The following chart shows a similar story, with bonds making up an ever increasing part of the debts, although it’s still small relative to bank loans.

Source: IMF

That in itself isn’t a problem. Except that debt to banks tends to be in local currency, which is less risky, whereas bonds offer easier access to foreign currency borrowing, especially US dollars. If emerging market currencies collapse – as many have done over the past year or so – and foreign debts are high, companies can find their local profits are no longer big enough to pay the bond interest.

This next chart shows that the absolute amount of foreign currency bonds has risen, but as a proportion of total bonds it has fallen over time. In other words a bigger percentage of emerging market corporate bonds are in local currency these days, which is good news as it’s less risky.

Source: IMF

Again a lot of this comes down to China. China’s domestic financial markets have been developing rapidly over the past decade or so.

When I was working for UBS on setting up their China business in the early 2000s the Chinese bond market was tiny. Barely a blip. For that reason we struggled to get the big New York bosses of the global fixed income business excited about the prospects in China. They were some of the shortest term “thinkers” that I ever came across in banking – which is quite an achievement, to say the least – and extremely parochial.

Fortunately they were overruled by the bank’s CEO, so we went ahead and got the necessary licences. As you can see in this next chart, the expansion of emerging market bond issuance has been dominated by spectacular growth in China.

Source: IMF

Like so much these days, understanding the riddle about whether there are dangerous levels of corporate debt in emerging markets comes down to what’s happening in China.

Among the emerging markets China has had the fastest expansion of total corporate debt relative to GDP, especially in the construction and oil & gas sectors, and has had explosive growth in its corporate bond market.

The evidence of whether Chinese corporate debts are at excessive levels is mixed. One piece of good news is that most of those debts are in local currency, the renminbi yuan.

The evidence of whether Chinese corporate debts are at excessive levels is mixed. One piece of good news is that most of those debts are in local currency, the renminbi yuan. This means there is little currency risk.

This next chart shows average bond issuance for China and selected regions for the periods 2003 to 2007 (pre-global financial crisis) and 2010 to 2014.

Source: IMF


Clearly the vast majority of Chinese bonds are in local currency. As well as that, bank lending to companies in China is also dominated by local currency loans. Also, to the extent that there are foreign currency debts we don’t know how much of that currency risk has been hedged by corporate borrowers. Investment banks like to sell currency hedges to bond issuers, so they can collect an extra fee. But not all management teams take them up on it.

Whatever the currency, the overall amounts of Chinese corporate borrowing have been large, which still means there could be insolvency risk. Again the IMF provides some insight into this.

“SOEs” are state-owned enterprises, meaning they are majority owned by  one or other arm of the Chinese government. Our last chart compares the progress of leverage ratios – meaning debt relative to equity (net assets) – of SOEs and private companies in China between 2003 and 2013.

Source: IMF

The blue line shows the median SOE leverage, and has been pretty flat over time. The green line shows the median private company leverage, which has actually fallen to around half its level in 2005 and 2006. Both these lines indicate that there’s little to worry about when it comes to Chinese corporate debt levels. (Note: the median company sits in the middle of the distribution. Half of companies have more leverage, and half have less.)

However, the story is a little different for the most leveraged Chinese companies. A company at the “90th percentile” of the distribution is near the top end of the risk spectrum. 90% of companies have less leverage and only 10% have more leverage.

The red line shows the trend for the 90th percentile of SOEs and the yellow line the same for private Chinese companies. As at the median level, private companies in China have sharply reduced leverage since 2006, which should mean they are less risky now.

However, SOEs at the 90th percentile have sharply increased their leverage since 2003. So this is apparently where the real risk lies in China. A relatively small number of highly leveraged state-owned companies.

What we don’t know is whether they are big or small SOEs. But given the other evidence it’s likely that they include the big oil & gas companies and a lot of smaller construction businesses.

So if there is a debt bust in China this is where it’s likely to happen. In certain highly leveraged government controlled industries. But there’s good news here as well. China still has a massive US$3.6 trillion of foreign exchange reserves. It’s used a portion of these in the past to bail out the big banks. It would almost certainly use them again in future if it needed to bail out other industries to avoid a banking crisis, or to keep strategic sectors functioning (and what could be more strategic than energy and construction?).

There’s clearly been a huge increase in emerging market corporate debt in recent years. But it’s not across the board, and it doesn’t look out of control in relation to profits. That said, there are clearly pockets of high risk out there such as construction and oil & gas in China and Latin America.

…the Chinese government has huge foreign exchange reserves that it can use to bail out companies and banks.

Most of the debt run up in China has been in local currency. China has been cutting interest rates as the economy weakens, but still has plenty of room to cut rates further (unlike the USA, eurozone, Britain, Switzerland, Japan and so on…). The Chinese base rate is still 4.6% – a long way from the US’s 0.25%. And the Chinese government has huge foreign exchange reserves that it can use to bail out companies and banks.

So yes, there are risks in emerging markets. But it looks like the fear of them could be overdone. Especially when emerging market stocks are already pretty cheap, especially in China. Lower prices mean a lot of the risk is already baked in.

We’re still going through “crash season”, so caution remains the watchword for investors. But our conclusion at OfWealth is that emerging markets remain highly attractive investments for the medium to long term – say two years and beyond. Whatever may happen to market prices in the short term, over coming months.

Stay tuned OfWealthers,

Rob Marstrand

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.