The most sobering lesson of the global financial crisis was that developments expected to increase resilience – the “originate and distribute” model of finance – turned out to reduce it.
Does a similar danger now threaten stability? Yes. The next round of global illiquidity might derive from foreign currency bonds of non-financial companies of emerging economies. The centre would be asset managers, not banks.
Last summer's "taper tantrum" was a foretaste. The indication by the US Federal Reserve that it was considering a reduction in the rate at which it would expand its balance sheet had a dramatic effect on emerging economies. As the International Monetary Fund noted in its October world economic outlook: "Expectations for earlier US monetary policy tightening and slowing growth in emerging market economies prompted major capital outflows from emerging markets during June 2013." The results included a widening of risk spreads, equity market falls and big declines in exchange rates against the dollar.
Why did turmoil follow the mere possibility of a tightening in Fed monetary policy? At a conference on Asia at the Federal Reserve Bank of San Francisco, Hyun Song Shin of Princeton University, among the world's foremost financial economists, suggested an answer: the growth of demand for the private sector bonds of emerging economies.
In booms, finance floods the market, driving excesses; in busts, finance dries up, causing slumps. This phenomenon is known by the loose term "global liquidity". Before the global financial crisis, banks were the main providers of liquidity. Since 2010, a locus has been the bond finance of non-financial corporate sectors of emerging economies. Asset managers (BlackRock, Vanguard, Fidelity, Pimco and so forth) drive the flows. This, then, is the "second phase of global liquidity". It is also why portfolio flows to emerging economies reversed last summer.
Widening gap
External finance of emerging economies has changed in two ways: non-banks have become bigger borrowers, relative to banks; and debt securities have largely replaced loans. Much borrowing is done abroad. An indication is the widening gap between borrowing by place of residence and by nationality: Chinese companies, for example, issue foreign currency bonds in Hong Kong, not the mainland.
The purchasers of these bonds search for yield in a low-yield world by lending longer and riskier. Borrowers take advantage of the lower cost of foreign-currency bonds. But in the process, they assume a currency mismatch: foreign currency debt against domestic currency assets. These borrowers are speculating on their domestic currencies. Students of the Asian financial crisis of 1997-98 will find this disturbingly familiar. Non-financial companies have taken on a “carry trade”, by financing local assets with apparently cheap dollars.
When funding conditions turn, such trades can become lethal. As the Fed is expected to tighten, the dollar will rise, prices of dollar bonds will fall and dollar funding will reverse. As the bonds they issued lose value, borrowers will be forced to post more domestic currency as collateral. That will squeeze their cash flows and trigger a downturn in corporate spending. A fall in the exchange rate will exacerbate the squeeze upon them. Highly indebted non-financial corporations may even go bankrupt, imperilling domestic creditors, including the banks.
Such a pattern of currency and risk mismatches partly explains the volatility last summer. That stress eased, but the Fed will tighten at some point. Then the doom loop is set to restart: a brutal unwinding, with attendant corporate distress and even sharp recessions.
Thus, even asset managers may be a source of cyclical instability – provided they, too, behave pro-cyclically, just as leveraged lenders do. The two fundamental problems, in this case, are the lack of long-term holders of the debt and the currency mismatches inside borrowers.
Indeed, non-financial corporations are behaving more like banks, with rising financial assets (in domestic currency) and liabilities (in foreign currency).
The case that the development of this new pattern of financing could be a source of vulnerability and volatility seems strong. The story underlines a point that emerged in previous crises in emerging economies: national balance sheets matter. Currency mismatches emerge whenever borrowers find it attractive to borrow in apparently cheaper foreign currencies. They have repeatedly proved devastating to emerging economies, whether they have occurred in the government sector, the banking sector or the non-financial corporate sector.
Financial housekeeping
Yet it is hard to know how big such risks are without better data. The meticulous monitoring of build-ups of mismatches is an essential part of better financial housekeeping. Focusing on the financial sector's leverage and mismatches is, alas, insufficient. One must track the debt issuance of domestic financial and non-financial corporations – both onshore and offshore – and the build-up of domestic currency deposits of non-financial corporations.
These are, as Prof Shin argues, in part the counterpart of their foreign currency borrowing. The dollar value of the deposits of the non-financial corporations of emerging economies has been volatile, partly because of swings in exchange rates, but has also been rising rapidly.
What, finally, are the policy implications, beyond the well-known fact that the combination of today’s hyper-aggressive central banks with the private sector’s reach for yield is bound to create fragility?
One is that controls on capital inflows count for next to nothing if companies can borrow offshore. Another is that currency adjustments, albeit vital for managing our volatile world, will expose such mismatches. Above all, managing a return to normal monetary conditions without further large-scale instability is going to be quite difficult.
Emerging economies must be aware of such perils. So must the institutions charged with helping them.
– Copyright The Financial Times Limited 2013.
