Emerging-market companies have been binging on debt for years, borrowing record sums and increasingly tapping international bond markets to take advantage of cheap credit and outsized demand from institutional investors scouring the world for any sort of decent yield.
But the boisterous party may soon be coming to an end, and the cleanup could be messy.
Barring another global economic earthquake, the growing piles of emerging-market (EM) debt are still manageable. But the caution flags are out in the face of stiff headwinds stemming from weaker commodity export prices, volatile currency swings and sputtering economies across large swaths of the developed and emerging worlds.
If the U.S. Federal Reserve Board finally gets off the fence and begins raising interest rates soon, it will only add to the headaches of corporate treasurers already wrestling with the impact of a strong greenback, which is driving up financing costs.
Debt monitors hit emerging-market issuers with more than 130 credit downgrades in the first quarter, while only 25 got an upgrade. For now, default rates remain low, despite such well-publicized exceptions as Chinese property developer Kaisa Group Holdings. And foreign investors have not been rushing for the exits.
"Although there are few individual markets that investors feel comfortable with, the relative value and higher yields of the asset class have – so far – prevented the flight from this asset class," EPFR Global, which tracks international fund flows, noted last week.
But that could change quickly.
"We expect defaults to rise for some of the more leveraged companies that have a currency mismatch or a liquidity need that will lead them to hit the wall if investors lose confidence in their business model," says Cedric Rimaud, director of emerging markets research with Gimme Credit in Bangkok.
By the end of last year, non-financial corporate debt in the emerging world totalled in excess of $2.4-trillion (U.S.), more than triple the level of just five years ago. A hefty chunk of that is in bonds denominated in U.S. dollars and, to a lesser extent, other so-called hard currencies.
Back in the dark post-recession days when central banks were taking interest rates to historic lows and pundits were ruminating about the "new normal" of slow growth in industrial economies, pension funds, insurers and other institutional investors began pouring money into companies operating in still expanding parts of the world such as China, Brazil, Mexico and much of Southeast Asia.
"That debt pool is the most serious threat to the [global] financial system," says Marko Papic, chief geopolitical strategist with BCA Research in Montreal. "That's where the euphoria really moved after 2008."
Mr. Papic hastens to add that we're not in imminent danger of revisiting the Great Meltdown of that year. But the huge exposure to emerging bonds that aren't necessarily priced to reflect their inherent risks is a problem that tends to fly under the radar.
In a harsh assessment, BCA concludes in its latest report that "the weakness in EM assets is broad-based, endogenous and persistent."
As in the developed world, though, some of the biggest credit risks reside in the resource sector. Bonds issued by state-owned and private sector firms involved in energy and other commodities account for more than one-third of the EM non-financial corporate bonds issued in hard currencies since 2007, the International Monetary Fund says.
Debt accumulated by non-financial companies reached a record 83 per cent of the emerging countries' total gross domestic product last year, compared with 67 per cent in 2009.
A 2011 study of developed economies by the Bank for International Settlements concluded that growth is impeded when national corporate debt levels exceed 90 per cent. China's non-financial corporate sector, by far the biggest borrower in the emerging world, has piled on so much debt that the ratio has soared above 150 per cent of GDP. About half of all Chinese debt is linked one way or another to real estate.
"I would be cautious about Chinese companies with high leverage and short-term financing needs, as the lower growth and the huge debt pile in the country means that the pressure is becoming hard to bear for some of the lower-quality bond issuers," Mr. Rimaud warns. "Chinese property issuers are to be treated with great caution."
Add in the risks stemming from such negatives as weak governance, low disclosure standards even at major companies and occasional cases of corruption (hello Petrobras), and it's easy to make a bearish case for the asset class.
"Emerging markets need fundamental economic reforms," BCA notes in its report. "And yet for no good reason, investors believe that EM policy makers are about to deliver on such reforms."