Raghuram Rajan's tough battle against bubbles

RBI governor Raghuram Rajan tried to tell his colleagues about the dangers from flood of money from developed countries, but no one wants to listen. Eventually interest rates will rise higher than the present levels either because of uncertainty, inflation fears or tapering

You have to feel sorry for India's new central bank governor, Raghuram Rajan. He recently pointed out that the flood of money from developed countries could have a major impact on the policies of developing countries and sows the seeds of another crisis. He complained, "Are we in a world where we continue to blow up bubbles elsewhere?" The response was less than satisfying. Instead of concern or sympathy all he got was a shrug. Central bankers feel that the problems of emerging markets do not concern them. It is up to emerging markets to fend for themselves. Or, in the words of former US Treasury Secretary John Connolly: the US dollar “is our currency, but your problem.”

So far, the flood of cheap money has not had a bad effect in developing or emerging markets. Default rates on corporate bonds in developed markets have been very low. The rate is similar to the levels seen during 2005 to 2007 at 2.4%. But with low cost easy money, more middle market firms have had access to funds. But access to money does not necessarily mean profit growth. In fact, profit growth has been declining in the past few quarters to the low single digits for Standard & Poor’s 500 Index companies. This level of earnings growth is more consistent with a default rate of 6% rather than 2.4%. This implies that there are quite a few “zombie” companies out there: a company that can’t grow, but can survive only because they have access to money at very low interest rates. If interest rates rise, as they have since May, then the number of defaults may increase sharply.

This problem is not limited to developed countries. Emerging market (EM) companies have had access to bond markets as never before. Emerging market corporate bond sales have doubled since 2005. In 2012, they reached a record $200 billion. EM corporations surpassed that record by the end of May of this year. The companies account for 80% of all hard currency debt sold in 2013. Many of these corporations are accessing the market for the first time. A fifth of Asian local currency bonds are in debut deals. The proportion in the US and Europe is usually about 3%. The market is now about $1 trillion in size and surpasses US junk bonds as an asset class.

As the size of the market has grown, so have the defaults. EM corporate bond defaults rose to $22 billion in 2012, a huge leap from 2011 when there was only $182 million worth of defaults. Of the 25 defaults, just under half were in Latin America, mostly Brazil. There were nine defaults in emerging Europe and five in Asia. The market is much safer than in 1997. The main difference is that much of the debt is now denominated in local currency. Still there is substantial exposure to currency fluctuations and any rises in interest rates could be traumatic.

In India defaults reached a 10-year high of 4.5% up from 3.5% a year ago with 32 issuers defaulting. Much of the credit risk is concentrated in ten of the largest companies. According to a report by Credit Suisse, the gross debt of these companies topped $100 billion. The companies are by order of their debt levels: Reliance ADA Group, Vedanta Resources, Essar Group, Adani Group, Jaypee Group, JSW Group, GMR Group, Lanco Group, Videocon Group and GVK Group. The stress of this mountain of credit is showing up also in the banking system where impaired assets have risen from 4% in 2009 to 9% this year and is forecast to rise to at least 12% by 2015. This information is undoubtedly on the low side and much of the bad debt is located in state banks. Worse, much of this debt is not denominates in rupees. India has $225 billion in dollar-denominated debt and more than half is not hedged.

The problem of foreign currency lending is far less of a problem than it was during the Asian crises. With often very strong reserves many countries have been able to borrow in their own currencies. But, local currencies bonds protect only against currency depreciation not capital flight. Much of the debt was sold to foreigners. In Indonesia, foreigners now hold about a third of the local currency bonds. The number is about the same in Malaysia. These bonds were purchased for the yield but when the local currency falls as it has by 18% in Indonesia, they become much less attractive.

Bankruptcies are not so far a problem in Southeast Asia, but they are in South Korea. Investors picture corporate South Korea through the lens of Samsung with its ever growing smart phone profits. There is another South Korea. Second tier chaebols exposed to cyclically weak sectors such as construction, shipbuilding and shipping. One of these, Tongyang with interests from financial services to construction and tourism, is on the verge of bankruptcy and may default on $1.4 billion worth of bonds and commercial paper sold to retail investors this year. The problems of the corporate sector are on top of already severe issues associated with consumer debt.

China came out with better growth last week, but the cause of the growth was the same as it has been for the past five years: infrastructure spending fuelled by more debt. Earlier this year, China’s debt growth rose at a blistering 52% for the first five months of 2013. It has since slowed and is now closer to 20% year-on-year. In the last five years China’s total debt went from 130% of gross domestic product (GDP) in 2008 to about 200% today. Corporate debt made a large part of this. Chinese corporate debt has grown from 71% of equity in 2007 to 104% today. This compares unfavourably with other BRICs. Corporate debt in Brazil rose from 76% to 92% of equity. In contrast, India’s rise from 67% to 77% of equity looks conservative. Chinese companies owe a total of 64 trillion yuan ($10.45 trillion), and amount that has grown 260% in the past five years from 24 trillion ($3.92 trillion).

Brazil’s corporations are in better shape than China’s, but they are still in trouble. Moody’s, Standard & Poor’s or Fitch has negative outlooks on 26 Brazilian corporate borrowers. In total Brazilian corporate debt in doubt is $104 billion triple the amount of negative outlooks for Mexico, which recently had defaults by three large real estate developers in the amount of $2.75 billion. The bonds are now trading at 20 cents on the dollar.

But the large amount of corporate debt in emerging markets is not the real problem. The real problem is the illiquidity. Last year, thanks to low yields in the US, these markets were hot. Now they are in the deep freeze. The liquidity of EM corporate debt markets is poor in most cases and abysmal in a few. In some markets, no one is selling these bonds and no one is buying. A don’t ask, don’t tell situation, so it is difficult to value these bonds. Many of these bonds are held by ETFs, who have to maintain the link to an index. This could mean forced sales.

Raghuram Rajan tried to tell his colleagues about the dangers, but apparently they don’t want to listen. Eventually interest rates will rise higher than the present levels either because of uncertainty, inflation fears or tapering. Then everyone will definitely feel the effects of Mr Rajan’s bubbles. At that point they will start to pay attention but it is probably already too late.

 
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