EM dollar bond issuers engage in corporate ‘carry trade’
IS paper suggests companies are raising cash in US currency for financial, not commercial, reasons
What happens when industrial companies act like hedge funds? The companies in question are manufacturers, transport groups, utilities and other large businesses in emerging markets that have sold dollar bonds to international investors.
Work published by the Bank for International Settlements suggests that these groups, as yet unnamed, have used that funding to invest at home, profiting from differences in interest rates for dollar and local-currency borrowers. They have become part of the so-called shadow banking system, funnelling dollars around the world unnoticed by bank regulators.
The trade, enabled in part by the rise of China, is another sign of the way the financial system continues to evolve and, with the world’s second-largest economy having slowed, highlights uncertain links and effects that may be exposed.
Ten years ago the finance director of a Brazilian conglomerate or an Indian tractor maker would have struggled to raise debt denominated in a hard currency such as the dollar. Doing so was called the “original sin” of borrowers, and left them at risk of default if the value of the local currency collapsed.
But then the financial world noticed the burgeoning Bric economies — Brazil, Russia, India and China — and began to fund the commodity boom created by their rapid growth.
Capital became even more plentiful after the 2008 financial crisis. Low returns for debt in mature markets pushed investment tourists abroad. The total for emerging market dollar bonds outstanding is about $1.7tn, larger than the long-established US high-yield debt market.
For holders of such debt the straightforward risk is that much of the lending was indiscriminate. Companies involved in extracting and shipping raw materials to China will be hit by falling prices. Currency weakness will put pressure on businesses that are not paid in dollars. Any return home by the investment tourists will push up borrowing costs, making it harder to refinance.
The BIS paper provides reassurance, however. The authors, Valentina Bruno of the American University and Hyun Song Shin of the BIS, spent a year constructing a database of non-financial firms based outside the US that have issued dollar debt. They matched foreign subsidiaries to ultimate parents, so the financial units of non-financial companies are included. Balance sheet data were analysed for 3,500 companies in 47 countries, advanced and emerging, that issued dollar bonds between 2002 and 2014.
It turns out that emerging market companies tend to borrow dollars when they hold plenty of cash, so net debt relative to profits or equity is low. Indeed most of the emerging market companies borrowing in dollars are judged investment-grade by the rating agencies. So, little need for investors to worry.
The wrinkle is a systemic one. The paper finds that the proceeds of such bond issuance are more likely than other forms of financing to end up as cash, and issuance is more likely when the local currency is gaining in value versus the dollar.
While some companies in mature economies take a precautionary approach to debt, raising cash for a rainy day, the behaviour of emerging market borrowers does not fit the pattern, the data suggest.
In effect it looks like a corporate version of the “carry trade”, a common financial tactic of borrowing cheaply in one currency and investing the proceeds in another where interest rates are higher.
The paper suggests some cash is raised for financial, not commercial, reasons. By doing so companies become shadow banks, financial intermediaries moving dollars into local economies.
Proceeds of such bond issuance are more likely than other forms of financing to end up as cash
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Manufacturers do not have to act explicitly like hedge fund managers. Simply depositing funds with a local bank will help it extend credit to other customers, while buying local commercial paper provides funds to domestic businesses.
The realisation prompts further questions. If it becomes more expensive to borrow in dollars — because, say, China fears prompt less dollar lending — will the corporate carry trade stop? Will it matter if it does?
The size of such trades is hard to disentangle from corporate balance sheets, and the authors say their work is a starting point. But if these new shadow banks go back to behaving like normal businesses, the effects in the financial system look equally hard to disentangle in advance. |
