World Economy

Rising Sovereign Risk From EM Forex Debt

Rising Sovereign Risk From EM Forex Debt Rising Sovereign Risk From EM Forex Debt

Fitch Ratings says in a new report that the rapid rise in private-sector debt in emerging-market countries, particularly that denominated in foreign currency, in conjunction with extensive depreciation of EM currencies, has increased downside risks to their economies, financial systems and sovereign creditworthiness at a time of heightened global uncertainty. 

The report presents new estimates for non-financial private-sector foreign-currency debt in eight of the largest EMs: Brazil, China, India, Indonesia, Mexico, Russia, South Africa and Turkey, Reuters quoted Fitch Ratings Report as saying. 

The data updates and augments the data Fitch compiled in late 2015 for "wide private sector debt".

This broad definition of private-sector debt includes domestic bank credit to households and corporates, securities issued in the domestic and international markets, and other external debt of the corporate sector. 

Fitch estimates median foreign-currency debt of the eight countries' private sector was 20% of GDP at 2Q15, out of total (local- and foreign-currency) private sector debt of 90% of GDP. This implies foreign-currency debt accounted for 22% of total debt.

Foreign-currency debt was highest as a share of GDP in Turkey, at 41% (including indexed debt), and Russia, at 37%, and lowest in China, at 10% of GDP, and India, at 17%. It was highest as a share of total private debt in Turkey, at 46%, and Russia, at 41%. 

The agency estimates that currency deprecation between June 2015 and March 2016 will have raised the private-sector foreign-currency debt burden by around a further 8% of GDP in Russia, 4% in Brazil and South Africa, and 2% in Turkey and Mexico. 

Debt denominated in foreign currency is more risky than local-currency debt as exchange rate depreciation raises debt and debt-service ratios of sovereigns, households or corporates that lack foreign exchange incomes or assets. Foreign-currency debt, which is usually sourced from abroad, is typically more vulnerable to liquidity risk. 

Depreciation Pressure

Currency risk can materialize at—and exacerbate—times of economic stress as this is when depreciation pressure often emerges. Private-sector debt, particularly for state-owned enterprises, can migrate to the sovereign balance sheet. Corporate borrowing in foreign currency partly reflects the need to finance international trade and investment. 

However, it can also reflect an underestimation of exchange rate risks and the effects of "original sin": EMs' limited ability to borrow in their own currency at long maturities, or a high cost of doing so, owing to a record of high inflation and weak monetary policy credibility, or a low level of domestic savings and shallow domestic capital markets. 

High foreign-currency debt is a weakness for sovereign ratings. The share of EM government debt denominated in foreign currency (median for 76 Fitch-rated EMs) rose to 58% at end-2015, from 50% at end-2013, after falling from 64% at end-2001. 

In contrast, EM foreign exchange reserves in US dollars have fallen since 2013. High foreign-currency debt may also constrain policy flexibility. Foreign-currency debt risks help explain the strong correlation between a stronger dollar and weaker EM sovereign ratings. Total (foreign- and local-currency) private-sector debt increased to 78% of GDP in June 2015 from 71% at end-2014 (average of the eight EMs excluding China, which skews the numbers), partly reflecting falls in the US dollar value of GDP. 

Total sovereign and private sector debt (foreign and local currency) at 2Q15 was highest in China at 243% of GDP, followed by Brazil at 162%, and lowest in Indonesia, at 79%. 

Total sovereign and private-sector foreign-currency debt was highest in Turkey at 53% of GDP. 

Fitch's estimates on foreign-currency debt should be used with caution. They are compiled from a variety of data sources and, where no data are available, rely on plausible assumptions on the currency breakdown of corporate external debt. Therefore they should be regarded as estimates rather than hard data. 

However, they provide a far more comprehensive picture than readily available data on international debt securities alone—which are often the focus of market commentary. Fitch estimates these account for only 6% of non-financial private-sector total debt and 22% of non-financial private-sector foreign-currency debt (on average for the eight large EMs in this study).