The popular myth is that EM debt is less risky than Developed country debt because many EM countries have less debt as percentage of GDP than Developed countries have. However, this is not correct because the qualitative nature of debt trumps the simple numerical quantity of debt. For example a poor person getting $20,000 a year of welfare benefits may have a stable income and if they incur a debt payment that is 10% of income that may be smaller percentage than an engineer earning $140,000 with a debt payment that is 40% of income. However, the loan to the engineer is safer than the loan to the poor person because as a person’s income grows they can afford to commit to spending a greater percentage of income on debts. In addition a more affluent borrower may have greater human capital in terms of job skills, relatives, deep pockets, self-discipline, planning ahead skills ad this also reduces credit risk. Similar problems occur with nations where many Third World countries such as Argentina repeatedly get into too much debt and can’t pay even though the countries may be resource rich.
EM countries rarely have debt that is investment grade. They present an interesting scenario of lower debt to GDP than Developed countries, yet a lesser quality credit rating. If having lower debt service ratios is a good sign then why does the corporate debt of EM countries (and some sovereign debt) have debt that is usually rated below investment grade? There are several reasons:
1. EM countries lack a commitment to have a fair system of bankruptcy and liquidation so their system is biased in favor of borrowers, especially if the lender is a rich foreigner. Few countries offer good protection for lenders that is as good as in the English speaking countries. Many countries apparently just don’t want to face up to how to deal with massive bankruptcies so there are insufficient legal systems to facilitate returning funds to creditors. Many countries outside of English and northern Europe seem to have banking systems dominated by “policy banks” where the banks implement government policies of issuing loans to undeserving unqualified borrowers who are operating in the national interest by creating jobs at an unneeded business. It is hard for the court systems and legislatures to say no to these type of borrowers during a time when businesses can’t afford to pay their loans.
2. EM countries usually have to pay back loans in dollars but they earn money in local currency. During a local recession their currency drops in value, exacerbating the difficulty of repaying and making it harder to rollover existing debt, thus triggering a default.
3. EM countries two big ways to earn money are to either take advantage of a commodities boom or to offer cheap labor for goods exported to Developed countries in a non-proprietary, commoditized format where profit margins are slim and volatile. Both of these methods are risky ways to earn money and the ability to earn is what enables both local companies and the government (through taxes) to pay back the loan. EM countries method of earning a living is more volatile and risky and thus could be thought of as having a lower Sharpe ratio and a higher probability of default. Thus the qualitative nature of EM debtors means they have a lower capacity to service debt than developed countries.
4. The G7 Developed countries governments, especially the U.S., have the “Exorbitant Privilege” of being able to “print and pay” where they simply print money in their own currency to pay back debt and further, they can get the market to accept a rollover of debt so that they simply pay interest-only on the debt with no principal payment. The unique nature of “print and pay” means that this component of debt should be viewed in a different light than traditional metrics of debt such as a human or corporate ability to repay debt as a percentage of income.
In addition, many corporations in Developed countries have excellent credit ratings and simply borrow for arbitrage and not because they need to. Mortgage lending after 2009 in the U.S. and business loans are now very strictly underwritten so what debt that does exist is relatively low risk.
EM countries such as Brazil have to pay very high interest rates, making it much harder to afford the loan. Some credit cards in Brazil are at 221% interest. Many EM countries lack a 30 year mortgage and instead have more intermediate term debt which requires a higher monthly payment to amortize the principal in a few years, while also paying high interest rates. Simply comparing loan balance to income is not enough. One must look at monthly payments, income stability, currency stability, creditor protection.
Ironically the worse things get for the world the more that global savers will flee into the safety of G7 countries sovereign debt, making it harder to raise G7 rates and making it harder for EM countries to repay loans on time due to devaluation and rising EM rates.
Of course one must be vigilant against the risk that Developed countries will continue to create expensive welfare programs, especially government paid medical care, resulting in massive deficits. Also one must consider that someday rates in the U.S. may be much higher for short term Treasuries, resulting in significantly higher government debt service costs. Hopefully higher rates will correlate with higher economic growth and higher tax collections.
Investors should seek independent financial advice about the hidden risk of EM bonds. I wrote an article “EM bond crash the catalyst for a bear market”.

 

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