Executive Summary
The financial press has given much attention to the rise in corporate debt in emerging countries. The conventional narrative states that abundant liquidity in the aftermath of the Global Financial Crisis (GFC) accompanied an investment boom that led to a significant increase in corporate leverage in the emerging markets. Faced with rising borrowing costs, some of these companies, including quasi-sovereigns, may not generate sufficient earnings to service their debt, which will subsequently lead to rising default rates.
We investigate the impact of these claims on the relevant subset of emerging market (EM) corporates of most interest to GMO emerging debt investors, namely state-owned enterprises (SOEs) or quasi-sovereigns, which make up a little under two-thirds of the EM corporate debt universe.[1] The first part of our research focuses on the direct impact of rising rates on non-financial SOE fundamentals. In the second part, we examine vulnerability of a “sudden stop” possibly precipitated by rising rates or any other myriad uncertainties and how governments may react. Lastly, we make some observations about the government-owned bank fundamentals, because they are one-third of our corporate investment universe and are most likely to serve as government agents to fight against a possible SOE liquidity squeeze.
Using our investment framework, we observe that SOE fundamentals are weak relative to their own history, and this is a concern. Digging deeper, we expect these entities should be able to withstand gradually rising interest rates: The investment cycle is past its peak, and conditions are ripe for deleveraging using free cash flow. We are seeing early positive signs, and if global GDP growth continues to allow for robust revenue growth, de-leveraging can happen fairly quickly. In addition, a key characteristic of the recent borrowing has been that SOEs have extended maturities significantly. Longer borrowing terms imply that the immediate impact of rising rates will be less severe, providing a runway for managements to prepare. Lastly, our deep dive into most troubled SOE credits finds that the balance sheet weakness is a direct function of misguided industrial policies pursued by respective governments, rather than irresponsible management behavior on the face of low borrowing costs.
In the second part of our research, we pose the following question: Can the global rising rates bring about a liquidity “sudden stop” (say, as a result of a trade spat turning into a serious global trade war) to otherwise solvent quasi-sovereigns, leaving them bankrupt? On this question, a potential liquidity freeze should be of greater concern than incrementally costlier interest payments, but this is less of a risk for quasi-sovereigns than it is for privately-owned corporates. This is because SOEs are better positioned to withstand liquidity events than their peers, both in the emerging and developed markets, largely owing to their two unique advantages: First, rather than borrowing from occasionally flighty international capital markets, they borrow primarily from local banks that offer a stricter form of financing. Second, they enjoy privileged access to the local state-owned banks where stressful times lead banks to recalibrate their credit risk appetite in favor of SOEs.
Finally, if state-owned banks can cushion against a potential SOE funding “sudden stop,” we ask if these financial institutions can withstand financial shocks on their own. On this front, the main take-away is that the credit fundamentals of the state-owned banks are strong, and this is good news both for debt investors who make investments in quasi-sovereign banks and in other SOEs that these banks serve.
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