The report is a difficult read, most likely a too-many-chefs problem that muddies the flavor of what could have been a promising dish. But there are some good ingredients here; let’s see what can be made of them.
The fact is that emerging market corporate leverage has increased, quite dramatically, in the last few years. That worries the IMF because in the past “mounting emerging market leverage has typically been associated with a subsequent reversal of capital flows…To dampen adverse macroeconomic consequences, the policy response could include, if warranted, exchange rate depreciation and the use of monetary policy and reserves” (p. 105-106). This is standard IMF framing.
But the rise in leverage is anything but standard, and the IMF’s own research shows it.
Most significant is the decline in cross-border bank lending, which is apparently being driven largely by regulatory changes. A key outcome of the financial crisis has been clarification that each country is responsible for its own banks, wherever they may be operating in the world. Regulatory changes have subsequently provided strong incentive for global banks to divest their foreign branches, typically by selling to a local competitor.
To a significant extent, the contraction of global bank lending has been replaced by expansion of capital market lending, through an expansion of bond issuance. Also, ex-China, an increasing fraction of bond issuance is in foreign currency, mainly dollars but also euros. Thus, the location of foreign exchange risk has now shifted out of the banking sector and into the corporate sector, where it is largely invisible. Have the EME corporates hedged that risk, or haven’t they? No one knows.
That’s why the IMF calls for “collection of data on corporate sector finances, including foreign currency exposures, [to] be improved.” They are telling us that no one knows what the exposures are, but they are clearly worried that the exposures have not been hedged. Indeed the BIS study, cited above, presents data that suggests the exposures have deliberately not been hedged, as corporations have used their borrowing capacity to engage in a carry trade, borrowing in cheap dollars and lending (or investing) in higher yielding domestic currency assets. The IMF report emphasizes that most of the borrowed funds have been used for capital investment, but this is not really counter to the BIS study since capital investment is just a different kind of carry trade.
All of this–the shift from bank lending to capital markets, and the shift of foreign exchange risk from bank balance sheets to corporate balance sheets–has only been accelerated by the recent period of extraordinary low interest rates and quantitative easing in the developed world. Just so, the IMF report cites regression evidence linking increased leverage to negative “shadow interest rates” in the US. They are worried, clearly, that the shift to higher interest rates globally will push overleveraged EME corporates into bankruptcy, that consequent defaults on remaining domestic bank loans will undermine EME banking systems causing massive credit crunch, which will require massive policy response with or without the aid of the IMF. They are worried, let it be plainly said, about the last crisis not the next one.
Given the two shifts, it is not at all clear why the IMF is so focused on crisis transmission through a domestic banking credit crunch. The more obvious transmission would seem to be to holders of EME dollar- and euro-denominated bonds, the price of which has already plummeted as everyone knows. And the more obvious pressure for policy intervention concerns EME central bank defense of the exchange rate. EME corporates have been profiting from a very nice carry trade on an interest rate differential, but are now poised to lose more or less everything they gained as EME currencies depreciate against the dollar. The de facto hedge on which the EME corporates have been relying, so it appears, is with the EME central banks. It’s a political thing, not an economic thing, and we’ll have to see how it plays out.
The central problem is with the FX risk associated with the market-based credit issued to EME corporates. But the IMF is stuck in the usual frame of over-leverage. Hence it calls for limiting “corporate sector leverage intermediated by banks” and “bank stress tests related to foreign currency risks”, as if the problem is too much bank lending. They should read their own report.
