Although there are no obvious signs of trouble yet in the local financial markets, outside the slightly unreal idyllic world of the Philippines there is apparently a growing concern the region is getting in over its collective heads with respect to large-scale debt.
At the very end of last month, a report by Morgan Stanley sketched out a disturbing picture of Asia’s debt burden: In emerging Asia (which by Morgan Stanley’s definition is everyone but Japan, Korea, and Singapore), foreign debt has grown from $300 billion to $2.5 trillion in a decade – or put another way, has doubled roughly every 15 months – in the last 10 years.
This, along with an even greater expansion in local currency debt, has pushed Asia’s overall credit-to-GDP gap to 15 percent, which has set off alarm bells; the previous peak was 10 percent in 1997 just before the Asian financial crisis.
The credit-to-GDP gap is an important early warning signal of a possible banking crisis, because it measures the difference between credit growth and the growth trend of the underlying economy. In other words, Morgan Stanley’s analysis is saying that credit growth in Asia is growing about 15 percent faster than the overall regional economy; at some point, the economy will no longer be able to support the weight of all that debt, and the whole shaky framework will collapse, just like it did in 1997. Or rather, worse than it did in 1997 since the scale of the discrepancy between assets and liabilities is so much greater this time around.
The end of the US “quantitative easing,” or QE, this month is already a potential problem, since it is likely to dry up hot money inflows. Regional financial markets, however, have had time to prepare themselves; when the tapering of the program towards its eventual end was first announced in May of this year, it set off a small panic; the Philippine Stock Exchange index quickly fell off its peak, for example, and has taken until now to readjust itself, a pattern that has been followed by most regional markets. Investors have seen that the end of QE is perhaps not as disastrous as they first feared it would be, and have gradually found their balance again.
While the Fed did help prevent a sudden shock to emerging economies by “tapering” the QE program instead of just ending it all at once, one of the policies it has maintained in order to soften the blow may come back to haunt the regional economy. While the taper has been in place, US interest rates have been kept low, which have led to low borrowing costs everywhere. Thus, credit growth has continued. In terms of foreign debt, Morgan Stanley suggests there are two serious risks that might be manifested at the same time: Along with the ending of QE the Fed has announced higher interest rates are on the horizon, and these could lead to a credit crunch as borrowing costs rise with them. This in turn can create an “exchange rate squeeze” on short dollar positions because higher borrowing costs tend to retard the flow of dollars into the local financial system and drive the local currency higher.
The big difference between now and the period leading up to the Asian Financial Crisis in the late 1990s is that much more of the debt is in local currencies rather than dollars. Morgan Stanley points out most Asian countries have large foreign reserves and have sourced most of their sovereign debt through domestic channels, which insulates government finances to some extent. But the investment house also noted some concerns expressed in an earlier report by the Bank of International Settlements (BIS), which concluded vulnerabilities may be emerging due to the rapid expansion of corporate debt (where most of the region’s foreign currency debt is concentrated) and the sensitivity of local currency debt to interest rate shocks.
This is where the Philippines comes into the picture, because of another assessment published this week by credit ratings agency Standard & Poor’s, which shows that Philippine corporate debt is expanding at the fastest rate among all the Asean economies. The problem is that revenues for these corporations, while still very healthy, are not keeping up with the growth in debt. Between 2008 and the end of 2013, the median ratio of net debt to EBITDA (earnings before interest, tax, depreciation, and amortization expenses) rose from 1.9 to 3.5; median revenue growth, which hit a high of about 17 percent in 2010, has since halved to 8 percent.
S&P, to its credit, was careful not to overplay the issue in its assessment, pointing out that revenue growth for Philippine corporations was still “sound” compared with their Asean counterparts, and that only about a third of the companies now have what should be considered “heavy” debt loads.
What S&P didn’t point out, however, is that the biggest part of the debt growth has been in the real estate sector; according to September’s Asian Bond Monitor published by ADB, in the second quarter of this year, the sector’s share of the local currency bond market increased 2.1 percent from a quarter earlier—the only sector, in fact, that grew in a quarter in which roughly P7 billion of outstanding debt were taken out of the market. This has again encouraged the BSP to make some noise about checking credit growth in the real estate sector, although no specific measures to follow up the roll-out of lender stress tests in June have been announced.
And as this paper pointed out in a special report a few weeks ago, efforts to moderate the credit exposure of the real estate sector are limited because between 60 and 90 percent of that exposure is carried by the property companies themselves through in-house financing. That raises the specter of a US-style mortgage crisis if other economic shocks increase defaults, even among just one company’s customers, because of the growth of trade in “contract-to-sell” (CTS) derivatives.
Alarmists will say that all these are signs of imminent doom; those with vested interests in the debt and investment markets, on the other hand, will respond the same way they do to all “bubble” warnings, with flat denial. At present, neither point of view is entirely correct. There is no immediate crisis—with the inflation rate easing and the peso’s recent decline seeming to have stabilized a bit, the near-term seems relatively stable. But conditions are certainly less than ideal, and particularly so in a country with growing environmental vulnerabilities and rapidly eroding political and social stability. As the BIS pointed out, debt creation activity and overall economic policies resemble the pre-Asian crisis period, and are still apparently based on the shaky assumption that limitless liquidity will continue to be available. Policymakers and business strategists shouldn’t panic, but they would be wise to familiarize themselves with the use and true meaning of the word “contingency” if they want to reduce the risk of being taken by surprise.