Commentary & Analysis

According to Professor Michael Pettis, the primary cause of crises in emerging markets (or less developed countries—LDCs) flows primarily from a mismatch within a country’s capital structure. He refers to this as the capital structure trap.

Prof. Pettis’ capital structure trap idea aligns closely with economist Hyman Minsky’s “financial instability hypothesis.” Pettis explains it this way:

“Minsky sees an economy as a system in which endogenous processes can generate ‘incoherent states.’ ‘Cycles and crises,’ he says, ‘are not the results of shocks to the system or of policy errors. They are endogenous [having internal cause or origin].’”

So, accordingly, Minsky argues that crises are not caused “because of external events or bad policy choices force a revaluation of asset values but are instead determined inside the system.” Pettis utilizes this framework built by Minsky to argue that a country’s capital structure is vitally important to how it reacts to external shocks and if country’s funding strategy does the following two things it is more exposed to crises:

1. It links financial or debt servicing costs to the economy in an inverted way.

2. More dramatically, it locks the borrower and its creditors into a self-reinforcing behavior in which small changes, good or bad, can force a players to behave in ways that exacerbate that changes.

Thus…

“The capital structure trap consists of an inverted liability structure in which an external shock can force both the borrower’s revenue and its debt servicing expense to move sharply in an adverse direction. This occurs to such a degree that it forces a sharp increase in the probability of bankruptcy, which, by changing the behavior of investors, then forces the capital structure to move even more strongly in an adverse direction. This is what makes the trap different from an ‘ordinary’ badly designed capital structure. A typical badly designed capital structure simply fails to take advantage of risk-reduction structures—in itself it does not add volatility. The capital structure trap, on the other hand, exists when the capital structure itself incorporates a feedback mechanism that causes the domestic impact of the external shock to feed on itself until the debt burden spirals out of control.

Michael Pettis, The Volatility Machine

So what major external shock has been delivered to emerging markets? The same that has hit all countries: the credit crisis of 2007-2008. But it has been particularly vicious for emerging markets as:

1. The price of EMs key export component—commodities—have plummeted since Apr 2011; after the initial rebound from the credit crisis (as the cost of dollar funding has risen)…

2. Demand for their goods from both the developed world and China has fallen…

So, the profitability of EM-based corporations and cash flow to EM governments continues to fall, even as its debt levels and corporate leverage continue to soar….

This is from The Bank of International Settlements 5 February 2016 [my emphasis]:

“The growth of debt in the emerging economies has been dramatic, as shown in Graph 1 [below]. The left-hand panel shows the level of private credit as a proportion of GDP in the emerging economies compared with that in advanced economies. We see that although the level of private credit is higher in the advanced economies, the growth trajectory in the emerging economies has been very steep. Since 2009, the average level of private credit as a proportion of GDP has increased from around 75% to 125%. The slightly declining line of the advanced economies’ non-financial private sector debt hides significant differences among countries. Among the G20 economies, two have decreased private debt by 20 percentage points of GDP or more, while seven countries have increased debt by 20 percentage points of GDP or more. The centre panel of Graph 1 plots the steep upward trajectory for the growth of private credit as a proportion of GDP for Brazil and China. The trend is especially striking for the debt taken on by nonfinancial companies (Graph 1, right-hand panel). The debt of non-financial companies in emerging market economies (EMEs) has grown so rapidly that in 2013 it overtook that of advanced economies, as a proportion of GDP. Since then, the corporate debt of EMEs as a proportion of GDP has pulled ahead of that in the advanced economies even further.”

And on the EM corporate side of the fence, leverage is rising as profitability is falling…

“As we see from Graph 2, corporate leverage in emerging economies has risen in general. This does not only reflect the increased debt of commodity producers, as seen by the fact that the leverage of companies producing non-tradable goods has risen even more than that of those producing tradables (centre panel). Moreover, the increase in leverage is most marked in the highly indebted segment – the 75th percentile in the graph. This is presumably the lower-rated segment. Increased leverage would be less of a concern if debt is used to finance productive and profitable investments. However, the profitability of EME non-financial companies has fallen. Traditionally, EME firms have been more profitable than their advanced economy peers, but this is no longer the case, as we see in the right-hand panel of Graph 2. The profitability of EME corporates has fallen markedly in recent years, and has fallen below that of advanced economy firms.”

And though the graph below is a bit old, as of June 2014, EMs were sitting on about $6 trillion of US dollar credit [graphic below far right]. Yikes! 

…and that dollar credit cost is rising as the US dollar appreciates and US market interest rates creep higher. Additionally, it’s not going to be easy to replace this dollar credit with euro funding as the Eurozone has its own host of troubles, not the least of which is Deutsche Bank.

I think this qualifies as a capital structure trap as defined by Mr. Pettis. If so, the question is when will the crisis begin? 

So far, the level of complacency seems amazing as investors continue to bid up emerging market stocks and bonds:

Sound financial analysis is likely not the driving force of investor complacency in emerging markets; I think we can chalk it up to the ubiquitous stretch for yield. Thanks again Janet & Company. 

From a currency perspective, there has been a fairly decent positive correlation between emerging market stocks and commodity currencies as you can see in the chart below:

So, if you suspect emerging markets are vulnerable, but you also like the yield produced by holding the Comdols (Aussie and Kiwi more specifically), beware. If the good professor is correct, Comdols are due for another bath it would seem.

Jack Crooks