Rising global interest rates could prompt a new credit crunch in emerging markets, as businesses that have ridden the wave of cheap money to load up on debt are pushed into crisis, the International Monetary Fund has said.

The debts of non-financial firms in emerging market economies quadrupled, from $4tn (£2.6tn) in 2004 to well over $18tn in 2014, according to the IMF’s twice-yearly Global Financial Stability Report.

This borrowing binge has taken business debt as a share of economic output from less than half, in 2004, to almost 75%.

Emerging market debt as a percentage of GDP
Emerging market debt as a percentage of GDP

China’s firms have led the spree, but businesses in other countries, including Turkey, Chile and Brazil, have also ramped up their debts — and could prove vulnerable as interest rates rise.

With the US Federal Reserve expected to raise interest rates in the coming months, the IMF warns that emerging market governments should ready themselves for an increase in corporate failures, as firms struggle to meet sharply higher borrowing costs.

That could create distress among the local banks who have bought much of this new debt, causing them in turn to rein in lending, in a “vicious cycle” reminiscent of the credit crisis of 2008-09.

“Shocks to the corporate sector could quickly spill over to the financial sector and generate a vicious cycle as banks curtail lending. Decreased loan supply would then lower aggregate demand and collateral values, further reducing access to finance and thereby economic activity, and in turn, increasing losses to the financial sector,” the IMF warns.

Its economists find that the sharp increase in borrowing has been driven largely by international factors, including the historically low interest rates and quantitative easing unleashed by central banks in the US, Japan and Europe, as they have sought to rekindle growth in the wake of the sub-prime crisis.

“Monetary policy has been exceptionally accommodative across major advanced economies. Firms in emerging markets have faced greater incentives and opportunities to increase leverage as a result of the ensuing unusually favourable global financial conditions,” the IMF says.

It also warns that borrowing appears to have risen fastest in sectors that would be most vulnerable to an economic downturn, including construction, and oil and gas; and that some of the heaviest borrowers have taken out debts in foreign currencies, which would leave them doubly exposed if rising rates coincide with a depreciation.

“Emerging markets must prepare for the adverse domestic stability implications of global financial tightening,” the IMF says.

The IMF published the warning as the world’s finance ministers and central bankers prepare to gather for its annual meeting in Lima, Peru, next month.

Its analysis underscores the backlash that the Federal Reserve could face if it starts to tighten policy and unleashes chaos in emerging economies.

Janet Yellen, the Fed’s chair, made clear that its recent decision to delay a long-planned increase in rates was a result of the turmoil in emerging markets, in particular China. The IMF has called on the Fed to delay policy “lift-off”, because of the potential impact on other economies.

Andy Haldane, the Bank of England’s chief economist, warned recently that the world could be facing the latest leg in a financial crisis “trilogy”, that began in US mortgage markets, flared up again in the eurozone, and has now shifted to emerging markets.

In a separate chapter of the Global Financial Stability Report, also published on Tuesday, the IMF urged regulators to take action to reduce the risks that liquidity in financial markets could evaporate, creating lurching swings in prices.

“Since market liquidity is prone to suddenly drying up, policymakers should adopt pre-emptive strategies to cope with such shifts in market liquidity,” it says.

Some investors have been warning that changes in regulation, and in the structure of markets since the global credit crisis, have increased the danger that markets could seize up in future.

“In recent years, factors such as investors’ higher risk appetite and low interest rates have been masking growing underlying fragilities in market liquidity,” said Gaston Gelos, chief of the global financial stability analysis division at the IMF.

He called for regulators to continue reforms to boost liquidity, such as enforcing equal access to electronic trading platforms; but he warned that “central banks and financial supervisors need to be prepared for episodes of liquidity breakdowns.”


Heather Stewart

The GuardianTramp

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