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The New Global Financial Crisis: Emerging Market Bonds

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By John Richardson on 11-Dec-2014


By John Richardson

EXACTLY how the new global financial crisis will gather momentum is becoming clearer by the day.

Greatly adding to this clarity was the latest Bank for International Settlements (BIS) quarterly report, which was released earlier this week.

The BIS warned that:

  • Off-shore lending in US dollars had soared to $9 trillion, and, as a result, posed a growing risk to emerging markets and therefore the world’s financial stability.
  • Dollar loans to Chinese companies were rising at an annual rate of 47%. They had jumped to $1.1 trillion from almost nothing five years ago. Cross-border credit had reached $456 billion in Brazil, $381 billion in Mexico and $715 billion in Russia.
  • A significant percentage of Chinese lending involved intra-firm financing. I have been warning about this threat throughout this year. This intra-company lending echoed practices by German industrial companies in the 1920s, which hid the extent of exposure ahead of the Great Depression, argued Ambrose Evans-Pritchard in this excellent summary of the BIS report, which was published in the UK’s Daily Telegraph.
  • 55% of collateralised debt obligations (remember that name?) were now being issued based on leveraged loans, the BIS added. This is an “unprecedented level”, an even worse percentage than ahead of the 2008 crash, said the BIS.

This new leveraging-up in emerging markets is the result of all the cheap money that flowed into the region during the Fed’s quantitative easing (QE). But now, of course, QE is over.

“The appreciation of the dollar [since the end of QE] against the backdrop of divergent monetary policies may, if persistent, have a profound impact on the global economy. A continued depreciation of domestic [emerging market] currencies against the dollar could reduce the creditworthiness of many firms, potentially inducing a tightening of financial conditions,” wrote the BIS.

Because of the unique role that the US dollar played in the global economy, there was no “lender of last resort” standing behind these trillions of dollars in off-share greenback-based transactions, the BIS added.

Ironically, therefore, it was entirely wrong for the US corporate sector and stock markets to cheer last week’s very strong US jobs-growth report.

The surge in job creation has raised the prospect of US interest rates being increased more quickly than financial markets had expected.

Higher rates would further strengthen the dollar against other currencies. This would place more pressure on emerging market bond issuers – as the cost of servicing their US dollar-based debt would increase even further.

Since 2009, no less than $550bn of new corporate bonds had been issued in the developing world, added the BIS report.

The risk is that as emerging market companies confront debt defaults, there will be a repeat of the widespread financial-sector panic that led to the 2008 crisis.

History is set to repeat itself, but as always, history will not repeat itself in exactly the same way.

“The new threat may lie in non-leveraged investments by asset managers and pension funds funnelling vast sums of excess capital around the world, especially into emerging markets [including corporate bonds],” wrote Evans-Pritchard, in the same Daily Telegraph article.

“Many of these are so-called ‘macro-tourists’ chasing yield, in some cases with little grasp of global geopolitics.

“Studies suggest that they have a low tolerance for losses. They engage in clustering and crowd behaviours, and are apt to pull-out en masse, risking a bad feedback-loop. This could prove to be today’s systemic danger.”

The BIS is worried that regulators have been so focused on preventing investment banks from leveraging-up again – which, of course, was the cause of the Lehman Bros Crisis – that they have completely missed this new risk.

Post-2008 capital adequacy requirements were, in fact, likely to contribute to the new global financial crisis, warned Gillian Tett, the award-winning Financial Times journalist, in this important article – which I also discussed last week.

She wrote that new regulations prevented banks from acting as “market makers” in corporate bond markets. This meant that it now took seven times as long to sell a corporate bond as it did in 2008, she said.

If panic ensued amongst those who hold emerging market bonds – and also the buyers of bonds issued by shale oil companies – she warned that there would be a  rush to “crowded exits”. Everyone would be trying to sell their bonds at the same time with very few buyers.

This would force investors, under huge pressure from their banks, to sell other assets in order to compensate for the falling value of their, in effect, temporarily worthless corporate bonds.

You would then have a broad-based collapse in all commodity and equity markets – including even “blue chip” equities – for instance, shares in Apple.

There is no point at all in hiding from this new reality by pretending that “everything will turn out alright in the end”.  That was the same mistake that some petrochemicals companies made in September 2008.

Instead, companies need to go back to their boards, and back to their planning departments, and build solid contingency plans on how to get through this crisis.