Lessons Unlearned? Corporate Debt in Emerging Markets
Ugo Panizza, Professor of International Economics and Pictet Chair in Finance and Development at the Graduate Institute, and others have published a NBER working paper on the corporate debt in emerging markets and firm vulnerability to financial distress after the global financial crisis. By comparing the situation to similar events during the Asian financial crisis, they have some good (and some not so good) news. More details with Professor Panizza.
What gave you the idea to write this paper?
Over the last five years, corporations in emerging market countries have been borrowing heavily, especially abroad. This is a major source of concern for organisations such as the Bank of International Settlements and the International Monetary Fund. They worry that if interest rates in the United States go up or there is a change in sentiment, currency depreciations will occur and the corporations will not be able to roll over or repay their debt, which will potentially lead to a crisis in these countries. It would be a replay of the Asian financial crisis (AFC), which was also driven by significant foreign currency borrowing by corporates. However, the AFC, unlike the typical emerging market crisis, was driven by private sector borrowing and not by public sector borrowing.
Now, it happens that I am part of the Committee on International Economics and Policy Reform, which every couple of years writes a report, and had written a report on this issue. But it’s very hard to examine what these corporations do because they are not regulated, unlike banks that must comply with reporting requirements and are highly regulated so that regulators tend to understand what’s going on. We don’t know exactly how much they borrow, what the structure of the debt is and what potential vulnerabilities it could cause. That was the background for our reflections when we started writing this paper.
If I understand correctly, the paper is only on non-financial corporations.
Exactly, because if you look at the data, these were the largest players in the recent increase in foreign borrowing in emerging market countries.
Could you explain the method you used and your main findings?
We thought we would proceed in three steps. First of all, we say there was a crisis before, which had a corporate nature. So we compare the state of corporate balance sheets now with the state of corporate balance sheets during the AFC. Is the leverage now higher or lower than during the AFC? Is profitability higher or lower? Etc. This purely descriptive step compares the situation now with the situation then in the hope of tracking down elements that enable us to say whether there is a vulnerability or not. That’s what we call the benchmarking exercise. Of course it doesn’t tell us much, because one of the reasons why the AFC erupted was that many of these corporations had debt in foreign currency. So it was not so much the amount of debt as the composition of the debt that was of interest, but that composition is exactly what we cannot see through balance sheet data. In the case of the AFC, we realised this ex post but not ex ante. We do see that the leverage is similar – if a bit lower – but we know that regarding the AFC the problem was dollar leverage, whereas we don’t know for emerging markets as we cannot observe the composition of the balance sheet.
The second step consists in a set of indirect tests. We say, well, we don’t have data on the composition of the balance sheet, but we know that if there is a high dollar debt, we should observe a correlation between some measure of firm health and the interaction between the leverage and the movement of the exchange rate. Indeed, if your debt is only in local currency and your exchange rate moves, this should not affect your vulnerability, but if your debt is all in dollars and the exchange rate starts moving, then this is reflected in the health of your firm. So we apply these indirect tests, and we find that the situation seems to be better now than at the time of the AFC because the sensitivity of our measure, which is called “distance to default”, to the interaction between leverage and exchange rate movement, is lower now than during the AFC, which is sort of good news.
But then we move to our third step. We say, at the time of the AFC all firms were borrowing in dollar. Banks in Thailand, for example, would borrow in dollar and would lend to Thai firms in dollar. For everybody it was relatively easy to borrow in dollar. One of the lessons we learned from the AFC is, you should not let banks do this. Now, it’s much more difficult for a medium-sized firm based in an emerging market country to borrow in dollar as it cannot simply go to a bank but must issue bonds in New York. Issuing bonds in New York has fixed costs, which means that you need to have a certain size. The difference between now and the AFC period is that today the firms with dollar leverage are large whereas they were of all sizes during the AFC. This makes us wonder if there is something special about large firms. We use recent research by Xavier Gabaix, which shows that shocks to large firms are important drivers to shocks to the overall economy. People in the past thought that shocks to individual firms are not truly important because they average out each other, but Gabaix shows that actually large firms are very important. This may seem trivial ex post but it was not easy to demonstrate. Gabaix used data for the United States alone. We are the first to apply his methodology to other countries, and especially to emerging market countries, and we show that his result carries on to our sample. Finally, we go back to our leverage and foreign currency debt question and find that large firms are actually less leveraged than small firms, which is good considering their importance, but they seem to have a worse type of leverage as they have more dollar leverage. So again the sensitivity – the way in which firm outcomes react to the interaction between exchange rate movements and leverage – seems to be much larger for large firms than for small firms.
To sum up our findings, leverage is not as high as during the AFC, which is good. Firm outcomes are not so reactive to the interaction between leverage and exchange rate movements, which is good as it points to less dollar leverage. But dollar leverage seems to be concentrated in large firms, which is not so good as large firms are very important for the economy. These are the three messages of the paper.
What could be the policy implications of those messages for emerging market governments or regulators?
Regulation has costs, so one should be very careful when one suggests regulations. There is though a policy implication that would have limited costs and could help us understand more about the question at hand. It basically consists in increasing the reporting requirements of non-financial corporations. When they publish their balance sheet, they shouldn’t report only total debt, but also the composition of debt, how much of it is in domestic currency and how much in foreign currency, how much is hedged and how much is not hedged. This would entail no costs for these corporations because they internally know all these facts and would simply add three lines to their report. This very low-key intervention on regulation would greatly increase transparency and help regulators monitor vulnerabilities.
Do you think there is any further research that can be done in this area, using for example Gabaix’s work?
As Gabaix covered only the United States, it could be interesting to do more extensive studies across countries, including other advanced economies, but this is not quite our purpose.
There is an important, but very hard, task ahead. The data on debt composition actually does exist; it is just very difficult to collect. Firms do report such data, not in the standard balance tables, but in the written form of their balance sheet. This means that you would have to read the balance sheets of about 20,000 firms In order to collect the information! One could think about some clever use of text analysis or machine learning to try to extract this data that so far has been impossible to obtain.
Full citation of the paper: Alfaro, Laura, Gonzalo Asis, Anusha Chari and Ugo Panizza. Lessons Unlearned? Corporate Debt in Emerging Markets. NBER Working Paper 23407, National Bureau of Economic Research, Cambridge, MA, 2017. doi:10.3386/w23407.