The Wall Street Journal recently had a lead article with the headline “Higher Rates A Risk for Emerging Markets.” The implication of the headline—and of much of the article—was that a general rise in interest rates—even a small one such as the Fed soon may generate—poses a danger to EM nations and companies.
Frankly, that idea totally misses the point: EM nations and companies have borrowed in dollars and euros that they may not be able to repay in a slower global economy where they will not earn the foreign exchange they will need in order to so. The result is a classic credit risk problem.
The Fed may raise short-term rate by a quarter percent—maybe even by a quarter percent a couple of times. Those quarter percents mean nothing when the interest rate on existing borrowings is LIBOR plus 3 and the new credit conditions may require the EM nation or company to pay LIBOR plus 4 or 5—or even more—in order to get credit at all. Brazil, for example, has been downgraded to junk by S&P. That is not interest rates rising; that is the Brazilian economy going in the tank.
The WSJ article itself tells us that the issue is credit risk. It has a nice set of graphs at the end (the beginning in the online edition) that it discusses hardly at all. The graphs show that for EM loans in its sample, the margin over LIBOR is 2.5 percentage points, up from 1.2 in 2005. By contrast, six-month LIBOR itself has moved only from .5% in 2013 down to a little over .3% in 2014, back to a little over .5% now. Basically, nothing has happened to general interest rates. It is credit risk that has been changing—and that will continue to change, perhaps at an accelerating pace. The loans were made when EM economies looked strong and the financial world was reaching for yield. Now the EM economies look weaker. Simple story.
Real market turmoil comes from credit risk. We might see some of it.
Photo: Global Panorama