Dispelling myths about Emerging Market debt growth

Executive Summary

There is a widely held perception that emerging market (EM) debt growth was spread broadly across markets. The truth is that the growth in the past decade has been focused almost entirely in China.

  • EM economies have low levels of
    fragility today, thanks to healthy current accounts, low external borrowings,
    and reasonable fiscal balances.
  • We remain sanguine about
    China’s capacity to manage their leverage for many reasons:

    • China’s
      debt is supported by the country’s high saving rates.
    • There
      is low to no reliance on external borrowings.
    • The
      government has ample fiscal capacity to absorb bad debts, if necessary.
    • The
      government has unparalleled assets (land and stocks) to cover its liabilities.

EM debt growth is mostly about China

Earlier
this year, we published a
blog that discussed our optimism about EM equities
following a
volatile 2018. In that blog, we tackled a few contemporary controversies in
emerging markets, including China’s growth deceleration, the broad-based
strength of the U.S. dollar, and the perceived structural fragilities in EM.
Here, we focus on an oft-cited but, in our view, misguided reason for those
perceived fragilities: the build-up of leverage and indebtedness in EM over the
past decade.

The
popular belief that emerging markets are generally more susceptible to market
volatility due to higher leverage is unjustified. There is only one notable
story of massive “levering up” in the EM landscape, and that is centered in
China. Given China’s significance in the emerging world, it tends to obfuscate
everything when it comes to generalizations related to EM, including
generalizations about EM debt. China saw a massive 120% increase in its debt
level (from 161% to 281%) in the past decade. The rest of EM observed a
moderate debt increase of 29%, smaller than the 31% increase in developed
markets over the same period. Figure 1.

Figure 1: Outside China, EM debt growth has been moderate
Total debt to GDP

Source: EM Advisors, as of 12/18.

From a
historical perspective, overall debt levels in the developed world rose
frenetically between 1990 and 2010, but have gone relatively flat in the
aftermath of the financial crisis. In EM, the opposite is true. EM aggregate
debt levels as a share of GDP were largely stable in the 1990s and the 2000s,
but since the crisis, cumulative debt in EM has surged by roughly 50 percentage
points of GDP, from relatively low levels. 

While
this type of ramp up in leverage makes it easy to draw analogs to historical
debt crises in EM, the vast majority of EM economies remain extraordinarily
resilient, thanks to their modest external borrowings, healthy current accounts
and reasonable fiscal balances. In fact, many of these markets have positive
current accounts, and none of them have current account deficits exceeding 5%
today. One major exception is Turkey, which, with an unusually large current
account deficit, has more non-financial private sector borrowing in a foreign
currency than any other major EM country. Figure
2.
  Furthermore, reliance on foreign
funding remains relatively moderate across major EM economies. Figure 3.

Figure 2: Healthy current account balance across most EM
Current account to GDP

Sources: IMFWEO, World Bank, OECD, Haver, EM Advisors, Bloomberg, as of 12/18. Taiwan* data is as of 9/18.

Figure 3: Reliance on foreign funding is moderate
External debt stock to GNI (2017)

Sources: World Bank International Debt Statistics, as of 12/17. Note: Data is from the largest 15 MSCI EM Countries, excluding Korea, Taiwan, Poland, UAE, and Malaysia due to lack of data.  
The MSCI Emerging Markets Index is designed to measure equity market performance of emerging markets. Indices are unmanaged and cannot be purchased directly by investors. An investment cannot be made into an index.

Fiscal
balances have largely been improving and are contained across EM. Figure 4. The only notable exceptions
are Brazil and India, but even in these countries, large deficits are being
tackled. India saw remarkable improvements in consolidated fiscal balance
between 2010 and 2018, and Brazil swore in a new president in October 2018 who
has vowed to tackle fiscal issues in the country, starting with pension reform.
These countries have been the major beneficiaries of an environment of
unconventional global monetary policy and, not surprisingly, are also the ones
suffering the most as the tide recedes.

Figure 4: Fiscal balances are improving across most EM economies
Fiscal balance to GDP

Sources: IMR, OECD, EMD, World Bank, Haver, EM Advisors, as of 12/18

Other
than these fragile circumstances, most EM economies, in our view, are in good
shape to weather potential debt-related pressures.

Why China leverage does not concern us

China’s
large, sustained run-up in debt as a share of GDP has left many concerned about
the after effects of its leverage boom. From its initial fiscal stimulus
associated with the global financial crisis to today, China’s debt-to-GDP ratio
has surged by more than 100%. Undoubtedly there will be asset impairments, and
slower credit growth should be expected in the long term as the country
deleverages. This has manifested recently in the record-high pace of corporate
debt defaults in 2018, and the sweeping rules introduced to tackle China’s
shadow banking system. While the country faces longer-term, debt-induced credit
risks and a potential slowdown in growth, we believe China is on steady
footing, and remain sanguine about their capacity to manage their leverage for
multiple reasons.

1.  China’s debt is supported by the country’s
extraordinarily high saving rates.

At 46%
of GDP, China’s domestic saving rate in 2017 was nearly two and a half times
the U.S. rate of 19%. Although the rate has been declining since its 2010 peak
of 50%, it is still twice the EM average. Figure
5.
With ample savings, companies and local governments can essentially
mitigate their debt as the economy supports borrowers and creates inflation,
which erodes the debt repayment pressure.

Figure 5: China boasts an exceptionally high savings rate
National savings rates (2017)

Source: IMFWEO, as of 12/17.

2.  China has low to no reliance on external
borrowing.

It is
worth mentioning that China’s foreign exchange (FX) reserve alone can cover all
of its external debt, and more. Figure
6.

Figure 6: China’s FX reserve is nearly twice its external debt
FX reserve to external debt stock (2017)

Source: World Bank International Debt Statistics, as of 12/17. Note: Data is from the largest 15 MSCI EM countries, excluding Korea, Taiwan, Poland, UAE, and Malaysia due to lack of data.
The MSCI Emerging Markets Index is designed to measure equity market performance of emerging markets. Indices are unmanaged and cannot be purchased directly by investors. An investment cannot be made into an index.

3. China’s fiscal capacity is
unlike any other nation on earth.

When it
comes to taking fiscal measures such as bank recapitalization or introducing a
prudential regulatory regime, China has the best public balance sheet in the
world to deal with high-leverage circumstances. Inherently, China’s balance
sheet health is blessed with low levels of fiscal debt. It has been almost
immune to domestic balance sheet recession like Japan in the 1990s and the
United States in 2008, when central banks struggled to stimulate demand as
highly levered firms and households paid down debts.

4. The government has
unparalleled assets (land and stocks) on the balance sheet to cover its
liabilities.

According
to Merrill Lynch’s estimates, the Chinese government’s stake in state-owned
enterprises (SOEs) had a book value of over US$9 trillion as of December 2018.
The government could privatize these assets if necessary to fund stimuli
through measures including implementing lower reserve requirements and
consumption-boosting tax cuts.

Figure 7: The corporate sector is largely responsible for China’s debt growth
China debt growth by category

Source: IMF, as of 12/17.

One of
the misconceptions underlying concerns about China’s debt fragility is that
debt resides at the federal government level. In fact, growth in debt has been
consistently concentrated in China’s corporate sector. Figure 7. Granted, many of these corporates are associated with the
state in some form. However, the government has been curbing loans to bloated
SOEs. Figure 8. Even the biggest
private conglomerates have been restrained from continuing with their
debt-fueled acquisition sprees.

Figure 8: Non-SOEs now account for more than 50% of credit formation
Credit formation distribution by company type

Sources: WIND, Bernstein analysis, as of 12/31/17.

Another
area of growth has been at the local government level. This has been a legacy
issue for China, as local governments enjoy a large degree of autonomy and have
historically accumulated high levels of indebtedness. Consequentially, this has
led local governments to borrow from local SOEs and affiliated private
companies to shore up their accounts. Here too, the federal government has
taken steps to rein in the problem, through surgical measures including cutting
excess capacities in troubled industries such as steel and coal.

The
rapid rise of household debt in the last few years is not particularly
disturbing to us. China’s household credit has been suppressed until recently,
as private households only obtained access to bank loans in 2003. A steep increase
in real estate prices has stimulated demand for mortgages which, along with the
rapid rise of online consumer lending, have jointly contributed to much of the
rise of household debt. In general, however, the value of mortgages in China
remains under control, especially compared with mortgages in the developed
world. Figure 9.

Figure 9: Mortgage loan-to-value ratio in China remains low
Property loan-to-value

Sources: Haver, PBoC, Bernstein Analysis, as of 12/31/2018.

Putting EM leverage into perspective

While
last year’s debt crises in Argentina and Turkey cast doubt on the
sustainability of EM leverage, it would be a mistake to draw the conclusion
that there are widespread structural fragilities in the system. The increase in
the EM debt level in the last decade was almost entirely driven by China as a
result of the country’s sheer size and growth pace. We believe, outside of
China, there are no systemic concerns about debt levels, current accounts,
external borrowing, or fiscal balances.

Inevitably,
China’s growth will slip due to trade-related external challenges, slower
credit growth, the country’s focus on deleveraging, and its more cautious
stance on local government spending. However, the country is well-equipped to
tackle any leverage concerns, thanks to its massive savings and fiscal
capacity. Remember, China is a net creditor with the largest FX reserve in the
world and has the wherewithal to resolve any debt issues internally and
gradually.

We
continue to believe that this environment of heightened market tension
associated with macro uncertainties favors those with an idiosyncratic approach
rather than momentum or passive strategies. It creates opportunities for
skilled active managers to unearth extraordinary companies with structural
growth drivers, durable competitive advantages, and real options that manifest
over time. 

Important Information

Blog header imager: Joseph Choi / Stocksy

The MSCI Emerging Markets Index is designed to measure equity
market performance of emerging markets. Indices are unmanaged and cannot be
purchased directly by investors.

The opinions referenced above are those of the authors. These
comments should not be construed as recommendations, but as an illustration of
broader themes. Forward-looking statements are not guarantees of future
results. They involve risks, uncertainties and assumptions; there can be no
assurance that actual results will not differ materially from expectations.

The mention of specific countries, industries, securities, issuers
or sectors does not constitute a recommendation on behalf of any fund or
Invesco.

Fixed-income investments are subject to credit risk of the issuer
and the effects of changing interest rates.

An investment in emerging market countries carries greater risks
compared to more developed economies.

Leverage created from borrowing or certain types of transactions
or instruments may impair liquidity, cause positions to be liquidated at an
unfavorable time, lose more than the amount invested, or increase volatility.

Fixed-income investments are subject to credit risk of the issuer
and the effects of changing interest rates.

An investment in emerging market countries carries greater risks
compared to more developed economies.

Leverage created from borrowing or certain types of transactions
or instruments may impair liquidity, cause positions to be liquidated at an
unfavorable time, lose more than the amount invested, or increase volatility.

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