By drilling one level further down, it becomes apparent precisely how much total USD lending to corporates in emerging markets has actually grown. Before the GFC, USD lending to non-bank corporates in emerging markets totalled about $1.5 trillion. As of the latest count, it now stands at $3.3 trillion (chart 4).

The rising leverage across emerging markets has begun to worry the central bankers at Bank for International Settlements (‘BIS’). As Jaime Caruana said, when he gave a speech on the topic at the London School of Economics in early February:

“Increased leverage would be less of a concern, if debt was used to finance productive and profitable investments.”

However, as he also pointed out, profitability of EM corporates has been declining in recent years and is now below that of DM corporates (chart 5).

And it doesn’t stop there. The combination of falling oil prices and a steep fall in the value of most EM currencies v. USD will have a knock-on effect on sovereign creditworthiness too. As many oil companies are state owned, and as most countries with large state owned oil companies depend on oil revenues to finance the government budget, low oil prices translate directly into large public deficits and hence falling sovereign credit ratings.

The sinners

So here is what I think is actually happening. Because:

• commodities are the single biggest export article of most EM countries;

• many corporates have borrowed a lot in U.S. dollars in recent years; and

• the U.S. dollar on a trade-weighted basis has been very strong more recently (chart 6);

servicing the rapidly growing mountain of debt has proven a great deal more expensive than expected. Corporates have simply been forced to sell their commodities at increasingly deflated prices to service their rising debt. What many thought were exceedingly good borrowing terms now prove to be anything but, once currencies are taken into account.



Obviously, if the commodity in question is priced in U.S. dollars, the corporate involved will also generate income in USD, but that income has fallen steadily as prices have declined, so it is only a partial hedge.

I alluded to the link between rising leverage and falling commodity prices in the January Absolute Return Letter (which you can find here), where I wrote the following:

Almost all of the increase is due to a rise in corporate debt, and much of it has been borrowed in U.S. dollars as a result of the extraordinarily benign borrowing conditions in the United States since the outbreak of the GFC. As the Fed has now embarked on a cycle of rate hikes, which is likely to drive the dollar to new heights, and because commodity prices tend to be very negatively correlated with the dollar, I would expect the fall in commodity prices to continue well into 2016.

[...]

The combination of rising debt servicing costs and falling commodity prices is outright poisonous for the many EM companies that make a living out of exporting commodities to the rest of the world. If the U.S. dollar continues to appreciate (as we expect it to do) and commodity prices sink to new depths, the overall conditions for EM exporters can only deteriorate further.

Let’s just leave it at that. No need to elaborate any further.