I’m not a financial analyst, but I have money in the bank, a mortgage and some investments, so I’m very interested in the financial health of the world economy.
A recent report – “Global dollar credit: links to US monetary policy and leverage” – published by the Bank for International Settlements in January 2015, is boring but very relevant to the world financial economy.
It shows how the Fed’s zero rates and quantitative easing has flooded the emerging world with dollar liquidity in the boom years. As the US Federal reserve cut rates, a tsunami of US investments went around the world looking for better investments than the measly sums the US could offer.
This abundance of funds then enticed Asian and Latin American companies to borrow like never before in US dollars – at real rates near 1% interest. Firms based in emerging markets seemed to fit the bill. Some are big names: state-owned energy giants like Russia’s Gazprom and Brazil’s Petrobras have been issuing dollar bonds via subsidiaries based in Luxembourg and the Cayman Islands. Others are smaller. Recent months have seen Lodha group, an Indian property developer, Eskom, a South African power generator, and Yasar, a Turkish firm that makes TV dinners, sell dollar-denominated bonds. By borrowing dollars at several percentage points below the prevailing interest rate in their domestic currency, CEOs have pepped up profits in the short term.
This would have been great if interest rates stayed at 1%. But all that borrowing will become the possible ignition point of the next financial crisis when the US Federal reserve increases interest rates and all the money goes flooding back to the US looking for less risky investments.
We’ve heard in the news about China wanting to increase the role of the Yuan Renminbi, but contrary to popular belief, the world is today more “dollarized” than ever before. Foreigners have borrowed $9 trillion in US currency. This is up from $2 trillion in 2000.
The emerging market share – mostly Asian – of US dollar loans has doubled to $4.5 trillion since the 2008 Lehman crisis.
Borrowers of US dollar debt outside US
The result is that the world credit system is acutely sensitive to any shift by the Fed. “Changes in the short-term policy rate are promptly reflected in the cost of $5 trillion in US dollar bank loans,” said the BIS.
Total US dollar debt outside US
Markets are already pricing in such a change. The Fed’s so-called “dot plot” – the gauge of future thinking by Fed members – hints at three rate rises this year, kicking off in June.
What happened at the recent Fed meeting was that the views were a little more dovish- meaning there was a belief amongst commentators that the increase in rates could either be delayed AND could be less than first thought, which may stave off the crisis in withdrawing funds from emerging markets and may reduce the burden on companies.
Another support for this view of the US$ changes could initiate the next crisis, is the visible as the dollar rises at a parabolic rate, (smashing the Brazilian real, the Turkish lira, the South African rand and the Malaysian Ringgit on the way through) and driving the euro to a 12-year low of $1.05.
The dollar index (DXY) has soared 24pc since July, and 40pc since mid-2011. This is a bigger and steeper rise than the dollar rally in the mid-1990s – also caused by a US recovery at a time of European weakness, and by Fed tightening – which set off the East Asian crisis and Russia’s default in 1998.
So all these US$ loans taken out need to be paid back in increasingly expensive US$. And while Emerging market governments learned the bitter lesson of that shock. They no longer borrow in dollars. Companies, though, have more than made up for them.
But not only is the value of this money rising, its likley that these loans won’t be extended when they are due for repayment as the US increases interest rates and as investors seek safer returns.
Financial analysts are commenting that Asian and Latin American companies are frantically trying to hedge their dollar debts, which drives the dollar even higher and feeds a vicious circle.
Companies are hanging on by their fingertips across the world. Brazilian airline Gol was a secure investment four years ago when the Real was the strongest currency in the world. Three quarters of Gol’s debt is in dollars. This has now turned bad as the Real goes into free-fall, losing half its value vs the US$. Interest payments on Gol’s debts have doubled, relative to its income stream in Brazil. These loans must be either repaid or rolled over soon, and in a far less positive environment potentially signalling bankruptcy for Gol.
Closer to home we’ve struck trouble with Malaysia’s 1MDB state wealth fund coming close to default earlier this year after borrowing too heavily in USD to buy energy projects and speculate on land. Its bonds are currently trading at junk level.
The BIS data also shows that the US dollar debts of Chinese companies have jumped fivefold to $1.1 trillion since 2008, and are almost certainly higher if disguised sources are included.
Digging further where foreign debts and earnings line up there is little reason to worry. Asian firms’ foreign-currency debts tripled from $700 billion to $2.1 trillion between 2008 and 2014, going from 7.9% of regional GDP to 12.3%, according to economists at Morgan Stanley, a bank. To see whether the surge was bearable, the economists looked at the accounts of 762 firms across Asia. The findings were reassuring: on average 22% of their debt is dollar-denominated, but so are 21% of earnings. Although Asian firms are a big part of the emerging-markets’ borrowing binge, on the whole they seem well placed to cope with a rising dollar.
Where should we look for the next source of economic problems- Russian and South American firms defaulting on UD dollar bonds and Chiese firms doing likewise.
Some analysts believe that the European Central banks increase in liquidity can provide some stimulus to keep the financial world going. The European Central Bank’s will add €60bn in QE each month. This is a double-edged effect for the world as a whole. It pushes the dollar yet higher. That may matter more in the end than keeping investments positive.
It is possible that the Fed will retreat once again and NOT increase rates or delay increasing, judging that the world economy is still too fragile to withstand any tightening. And this is backed by The Atlanta Fed’s forecasting model for real GDP growth in the US which has slowed sharply since mid-February. But this is contradicted by a recent speech by Fed Vice-chairman Stanley Fischer, inevitably the US will increase rates and this could potentially be the trigger for a wave of corporate failures unable to pay back loans and unable to afford increasing interest rates.