Saturday, September 5, 2015

More on bond market distortions

FT points to a BIS paper by Valentina Bruno and Hyun Shin which draws attention to the spectacular growth of the now $1.7 trillion emerging market (EM) dollar bond market, which now outstrips even the more established US high-yield debt market. It claims the motivating factor for a significant share of these issuance as simply "carry trade" (borrow in cheap dollars and invest in higher interest rate securities at home) by EM non-financial firms. The authors examined firm-level balance sheet data for 3500 non-financial companies in 47 developed and emerging countries that issued dollar bonds in 2002-14,
The dataset combines bond issuance data with firm-level financial information. We find that firms with already high cash holdings are more likely to issue US dollar-denominated bonds, and that the proceeds of the bond issue add to cash holdings. The tendency to add cash is more pronounced during periods when the dollar carry trade is more favourable and is prevalent for emerging market firms. 
They find that the issuance is more likely when the local currency is gaining in value against US dollar. They also find that a large portion of this is raised by overseas subsidiaries of the EM firm. In fact, nearly half the international debt issuance by non-bank private corporates of EM countries in the 2009-13 period were by the firm's overseas subsidiary. In other words, these EM firms were pursuing a corporate version of "carry trade", as they seek to profit from financial arbitraging, rather than using the borrowings for investment purposes or for re-balancing their debt portfolio.
Their findings carry great relevance for policy makers in EM economies.

1. The scale and pace of such debt accumulation is staggering - it is estimated that the total outstanding USD-denominated debt of non-banks located outside the US stood at $9.2 trillion in end-September 2014, against $6 trillion at the beginning of 2010. In a matter of 2-3 years, fortunes can be reversed dramatically. It is one more, and increasingly large, channel of capital inflows into EM's when credit is plentiful, with all the attendant risks when sudden-stops ensue. The attendant risks are well documented.

2. A large part of the overseas issuance by subsidiaries come back to the firm headquarters as borrowings from the subsidiary. Such flows apart from increasing firm and country vulnerability to exogenous shocks, also raises a host of regulatory concerns. For a start, discriminating such flows from plain tax avoidance or even money laundering is very difficult. It creates a financial flows channel within each firm which facilitates transfer pricing and other similar policies aimed at avoiding taxes and evading various regulatory requirements.

3. The subsidiary which transfers money to the parent firm acts as a "shadow bank" or a "surrogate intermediary". Given that a significant share of these issuances were done by firms with strong balance sheets and deployed for financial investments, and held as cash, rather than capital investments, its effects on the domestic credit markets can be uncertain. The graphic below shows the increasing share of non-residential EM non-bank issuances.
4. The traditional measures of a firm's external indebtedness may no longer be a reliable estimation of the firm's true external debt exposure. It may be necessary to take into account, off-shore borrowings by subsidiaries, thought accurate information on this may not be very easy to get.

5. This is a powerful example of the distortions engendered by the extraordinary monetary accommodation in developed economies. As the authors show, it has distorted the incentives of yield-hungry fixed income investors in developed economies and non-financial corporates in EM countries, leaving both parties vulnerable when the tide turns. 

6. The carry trade by non-bank corporates in EMs is yet another reiteration of arguably the biggest failure of financial markets, its characteristic disciplining powers break down when credit is plentiful,
The size and maturity of issuance follow the pattern of risk-taking in financial markets, with periods of easy financing conditions being associated with larger issuance as well as longer maturities.
7. There exists wide heterogeneity among countries in issuances. India has among the lowest USD non-bank bond issuance of any large country.
However, this can change dramatically once the regulations are relaxed. Reversing the course or managing such issuances are virtually impossible. 

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