International Monetary Fund warns about risks of Fed rise

The International Monetary Fund has warned that emerging economies and bond markets need to prepare for an increase in corporate failures if and when the US Federal Reserve and other central banks in advanced economies begin raising rates.

The IMF, which has urged the Fed to wait until next year to raise rates for the first time in almost a decade, and others have expressed concern about the surge in dollar-denominated debt in emerging economies and the potential impact that a sudden increase in rates would have. The issue is likely to be among the most discussed when the world's central bankers and finance ministers convene for next week's annual meetings of the IMF and World Bank in Lima, Peru.

In a chapter of its Global Financial Stability Report prepared for those meetings and released on Tuesday, IMF economists warn a surge in corporate leverage has preceded many emerging market financial crises in history.

Fed by the cheap cost of money, over the past decade the corporate debt of non-financial companies across major emerging market economies more than quadrupled from $4tn in 2004 to more than $18tn in 2014.

Key risk

In the same period, the average ratio of emerging market corporate debt to gross domestic product grew by 26 percentage points, the IMF said.

Although by some other measures those corporate debt levels remained below historical peaks, the prospect of an increase in rates and consequent debt servicing costs meant that the looming end of a post-crisis era of cheap money posed a “a key risk for the emerging market corporate sector”, the IMF said.

That in turn posed a broader threat for emerging economies.

“As advanced economies normalise monetary policy, emerging markets should prepare for an increase in corporate failures and, where needed, reform corporate insolvency regimes,” IMF economists wrote.

Among the IMF’s concerns is the significant share of emerging market banks’ assets tied up in corporate debt. That means any shocks to the corporate sector could quickly spill over to banks and cause them to stop lending, in what would be another drag to the already slowing growth in many emerging economies.

A growing portion of corporate debt in emerging economies also trades in the bond market, the IMF said. In 2004 only 9 per cent of the total corporate debt in emerging economies was made up of bonds. That figure had almost doubled to 17 per cent in 2014.What is unclear, the IMF said, is how active companies have been in hedging their exposure to foreign exchange swings, such as a stronger dollar.

Equity bull run

It also warned that as the main reason for the surge in corporate debt had been “external factors”, less attention had been paid to the risks posed by individual countries or companies in recent years. As a result “markets may have been underestimating risks”.

The IMF said: “If rising leverage and issuance have been predominantly influenced by external factors, firms are rendered more vulnerable to a tightening of global financial conditions.”

It came amid signs that US and global equities are heading for their worst quarterly showing since 2011, with investors rattled by China’s economic slowdown, uncertainty over Federal Reserve policy and growing pessimism about corporate earnings.

With an array of sectors slumping since the start of July, the global equity bull run of recent years is now facing a major challenge.

Investors have become increasingly unsettled by signs of weakening global growth and are now questioning the US earnings outlook as the largest economy prepares to raise rates for the first time in nearly a decade.

– The Financial Times Limited