Back in October we brought you “Chinese Cash Flow Shocker: More Than Half Of Commodity Companies Can't Pay The Interest On Their Debt,” in which we highlighted a report from Macquarie that contained the following rather disconcerting data point: “...more than half of the cumulative debt in the Chinese commodity sector was EBIT-uncovered in 2014.”
That’s right, “more than half,” and before you say “well, it is commodities and it is China after all,” consider that for the entire universe of CNY22 trillion in corporate debt, the "percentage of EBIT-uncovered debt went up from 19.9% in 2013 to 23.6% last year.” So, nearly a quarter.
In November, we revisited the idea (presented in these pages more than 18 months ago), that China may have reached its dreaded Minksy Moment, as Chinese corporates are set to take out some CNY7.6 trillion in new loans this year just to pay interest on their existing borrowings. As Morgan Stanley put it last year, China looks to be reaching “the point at which Ponzi and speculative borrowers are no longer able to roll over their debts or borrow additional capital to make interest payments.” You know what happens next, and we’re already seeing it as the number of onshore defaults accelerates.
This is part of a wider discussion about EM corporate debt in a world where EM FX has plunged and investor confidence in the space is rapidly deteriorating in the face of low commodity prices, a strong USD, a looming Fed hike, and a series of idiosyncratic political risk factors playing out from Brasilia to Ankara to Kuala Lumpur.
With that in mind, Deutsche Bank is out with a new special report on EM debt which has quite a bit of useful color on exactly where things stand for corporate borrowers across a variety of emerging economies.
“Demands for EM debt are on a declining trend, as the outlook for both portfolio flows into EM economies and funds flows into EM debt funds remain lackluster due to slow growth, worse credit fundamentals, and expected rise in US yields,” Deutsche begins, adding that “EM corporates need to cope with continued rise in leverage and eroding cash buffers.”
Private capital outflows were negative this year for the first time since the crisis. “Even during the peak of the crisis in 2008, EM outflows were a small fraction of the losses we expect in 2015,” Deutsche notes.
Next, Deutsche moves to consider the corporate debt picture, where most of the EM re-leveraging has been concentrated. Specifically, “while EM government debt levels have only moderately increased over the past few years, non- financial EM corporate debt has seen a dramatic rise [jumping] from a level of around 60% of GDP in 2008 to the current level of close to 90% of GDP.”
Here’s where it gets interesting. Although Deutsche (repeatedly) describes the situation as “benign”, it’s pretty clear that the trend in EBITDA coverage is moving in the wrong direction - and fast for LatAm HY and CEEMA investment grade:
“Interest coverage has been declining among EM corporates due to lower growth and weaker commodity prices [but] EM corporates’ solvency is unlikely to be challenged as an asset class in 2016, in our view,” Deutsche says, cheerfully. Well that’s good - Deutsche Bank doesn’t think the entire EM corporate sector is likely to become insolvent in the next twelve months. See? There’s always a silver lining if you just look for it.
However, when we look out to 2017, the outlook worsens. In short, the space will benefit from a sharp drop in USD-denominated debt maturities in 2016, but that reverses course the following year:
After a rather rosy assessment of the outlook for next year, here’s what Deutsche says about 2017:
The liquidity picture for EM corporates in 2017 looks less appealing, due to a 38% yoy increase in USD bond maturities (to USD122bn) and lingering uncertainty on commodity prices (an important component of the corporate sectors’ cash flow) and FX (a headwind for domestic-oriented players). A further depletion in cash buffers and reduced appetite for certain portions of the EM corporate universe may lead to increased refinancing stress in 2017 – especially if inflationary pressures build and domestic liquidity conditions also have to be tightened.
When Deutsche looks at what the bank says is a representative sample of corporate borrowers across LatAm and Ceemea, they find that only 14% of the sample is "in danger" based on net debt-to-EBITDA and cash-to-short term debt. However, when the bank uses 9%+ bond yields as a proxy for "oh shit," it turns out that a whopping 27% of the LatAm sample is in trouble. Specifically, Brazil has some $89 billion in USD bonds trading above 9% (a large chunk is Petrobras paper). Here's the full breakdown: Petrobras (USD37bn), USD20bn of industrials, USD15bn of banks (mostly subordinated), USD6bn of rigs, USD3bn of royalty-backed bonds and USD8bn of other sectors.
So ultimately, this is a question of where EM goes from here and as we've said on any number of occasions, the answer to that question is likely "nowhere good." Turkey is at war with the PKK and is about to be at war with Russia while Erdogan is busy establishing what amounts to a police state. Brazil has descended into a depression while the government is coming apart at the seams. No one knows if China will be able to keep it together in the midst of a currency conundrum, a collapsing economy, an acute overcapacity problem, lingering equity market volatility, and a looming credit crisis. Malaysia has its own political battles still to fight, and to top it all off, the Fed is about to hike which will invariably put further pressure on EM FX and accelerate outflows. Meanwhile, the outlook for commodities is nothing short of grim.
So it's difficult to see how the picture improves for a universe of EM corporates that's 50% more leveraged today than in 2008 and is likely to have more trouble servicing debt going forward especially if the dollar soars post-liftoff.
Throw in the fact that global growth and trade are likely to be stuck in the doldrums for the foreseeable future and China may not be the only major EM to have a Minsky Moment over the next three to five years.