Tuesday, September 1, 2015

Bond market distortions amplify capital flows volatility

One of the defining features of the post-Lehman cross-border capital flows has been the dominant role played by bond market investors. Whereas in the earlier periods, large commercial lenders were the primary overseas lenders, the onset of stricter regulations shifted the onus to shadow banks, asset managers. A BIS study has shown that overseas lending from the US banks and bond mutual funds (BlackRock, Franklin Templeton, Pimco etc) to emerging market non-financial issuers, companies and countries, has doubled since the crisis to $9 trillion. The extraordinary monetary easing in the US, accompanied by rock-bottom yields, left these fund managers with little choice but to search for yields in emerging markets (EM).

The growth in dollar-credit from the US investors to non-banks outside the US till June 2014 is shown below. The declining share of bank loans mirrors the sharp rise in bond market investments, especially to EMs.
The World Bank has estimated that corporates and sovereigns in emerging economies sold $1.5 trillion in debt in the five years to 2014, about three times that in the 2002-07 period. China, Brazil, and India were the largest recipients. India's off-shore issuance (to skirt around the domestic capital flows management regime) has risen significantly since 2009. 
The Times writes about the distortions engendered by these flows,
EPFR Global, a fund-tracking company, calculates that global bond funds have allocated 16 percent of their holdings to emerging-market bonds. Relative to the 2.5 percent recommended benchmark for these securities suggested by the Barclays aggregate bond index, that is a very aggressive bet... Among the many beneficiaries of this largess were commodity-driven borrowers such as the state-owned oil companies Petrobras in Brazil and Pemex in Mexico, the Russian state-owned natural gas exporter Gazprom, and real estate developers in China.
One of the more extreme cases of this bond market frenzy was Mongolia. In 2012, with expectations high that the relatively tiny economy would reap the benefits from China’s ceaseless appetite for raw materials, the government sold $1.5 billion worth of bonds, with demand from investors reaching $10 billion. That meant, in effect, that the country was in a position to borrow an amount twice the size of its $4 billion gross domestic product. Three years later, the International Monetary Fund is warning that Mongolia may not be able to make good on these loans... and the yields have shot up to about 9 percent from 4 percent...
Russian train companies easily sold dollar bonds, despite the fact that their revenues were earned in rubles. Even Ecuador, a country that defaulted in 2008, was able to raise $2 billion last year. Brazil, China, Malaysia, Russia, Turkey and others have sold more than $2 trillion in bonds, mostly to American mutual fund companies, since 2009. As this money flowed into their countries, financing skyscrapers in Istanbul and oil exploration in Brazil, economies and currencies strengthened. Now the reverse is occurring, led by a slowing Chinese economy, and as that money heads for safety, local currencies are plunging.
This highlights an inter-temporal asset-liability mismatch in the books of these asset managers. Their assets (bond mutual funds and exchange traded funds) are often in illiquid or hard-to-sell investments, whereas their investors are free to withdraw anytime. Since bond investors typically rush to redeem their positions when faced with such turmoil, especially in the currency markets, any panic-sale has the potential to trigger a forced-sale of infrequently traded assets, thereby unraveling the bond markets. On the debtor's side, the sharp devaluation of their currency that invariably follows such episodes adds to their debt burden.

This game of massive inflows where private corporations (and governments) leverage-up on plentiful external credit, followed by sudden-stops in response to shocks and panic flight to the exit gates has been replayed too many times to be kept track. A large share of such inflows end up financing hubris-driven projects with limited social value and/or doubtful commercial viability. The capital flights leaves in its wake the ruins of incomplete or failed projects with massive debts, battered corporate balance sheets, vulnerable banks (exposed to these corporations), and economies on the brink.

Countries like India which have been aggressively courting capital from asset managers like pension funds to finance their infrastructure investment requirements would do well to keep these lessons in mind as they go about this. Most infrastructure investments have their revenue streams in local currency. Financing such investments with foreign currency denominated liabilities is fraught with considerable risks. This is all the more so since the volatility engendered by cross-border capital flows, which has become all too frequent, does not discriminate between prudent and reckless borrowers. In any case, given the scale of the country's infrastructure financing requirements, foreign capital can at best be small change.

All this assumes even greater significance given that economic fundamentals are no insurance against the volatility induced by bouts of global financial market turmoil and that markets react excessively when faced with such uncertainty. 


Pratik Datta said...

External commercial borrowing (ECB) in foreign currency without hedging exposes the domestic borrower to currency risk. However, this can be avoided in 2 ways: (a) by allowing the borrower to hedge its risk by creating a liquid currency derivatives market - for borrowers with natural hedge (exchange earning through exports), this may not even be necessary; (b) by allowing the domestic borrower to take ECB in domestic currency. For example, India is now opening up to the idea of INR denominate off-shore bonds. This passes on the currency risk to the investor and therefore, even if the Indian borrower's revenue stream is in INR, its debt burden is immune from currency risk. Even with these two safeguards, some Indian firms may take ECBs and go bankrupt - this is perfectly fine. Bad firms should die off. Besides this, there is no other market failure that Indian regulators need to be worried about.

Gulzar Natarajan said...

Pratik, thanks for the comment. You are spot on with these two market failures.

Unfortunately, if history and global experience is any indicator, these two failures are not going to go away anytime soon. The second one is simply way ahead in time and is covered in voluminous academic literature (original sin etc)... it is for this reason that even countries like China struggle with internationalization of its currency and countries like Brazil have been trying to do this for decades without any success (except in financial market booms, when cross-border capital flows indiscriminately, only to flee abruptly when the tide turns)... the first one is liquid and broad enough only for dollar hedging. again global experience is instructive. further, even if the hedging is available, borrowers (and lenders) become complacent and prefer not to hedge at the slightest signs of exch rate stability (again, vast body of behavioral finance literature on this available)

as to the underlying reasons, I have blogged about both in great detail. the MGI report on 2014 gives an idea of the limited depth and breadth of such markets... a bit of a chicken and egg problem.

so i agree that if we can mitigate these market failures then we can stop worrying about these concerns... but conditional on the world (markets) as we see and its history, my concerns.