There has been much discussion about how external debt concerns are likely to weigh heavily on developing countries in their attempts at economic recovery in the wake of the Covid-19 pandemic. Most of this discussion has centred on emerging markets in Latin America and developing countries in Africa, some of which are already experiencing severe problems in debt servicing. Argentina and Ecuador are both currently trying to restructure some of their external debt; other countries (particularly in Africa) are also seeking debt relief and some have benefited from moratoria on interest payments.
There appears to be less concern about external debt problems in developing Asia. This may be because of the perception that while the debt to GDP ratios in the region are high and have grown rapidly in the past few years, most of this debt is to internal creditors and in the domestic currency. Also, in the past few years, while cross-border net debt flows decelerated across the developing world, developing Asia experienced the sharpest slowdown. However, the latest Consolidated Banking Statistics from the BIS suggest that the region is much more vulnerable to the external debt shocks that may be in the offing.
Dollar-denominated debt
Most of developing Asia’s external borrowing is denominated in US dollars. Chart 1, which considers only dollar-denominated debt, suggests that while net debt flows into developing Asia and the Pacific increased between 2016 and early 2018 — when the flows were negative to other developing regions — the pattern has since reversed. Indeed, for 2019 as a whole, net flows into the emerging Asia-Pacific were negative, and net claims on the region overall declined by 2 per cent, even as they rose slightly for developing countries as a group.
However, the recent accretion of external debt is only one indicator of potential vulnerability. The global financial crisis has already indicated some indicators to watch out for, that can quickly generate stress and domestic problems. Two such indicators are the extent to which non-resident creditors (as opposed to domestic creditors) dominate in claims on debt denominated in a foreign currency, and the maturity structure of debt.
Obviously, claims held internationally can be more volatile, especially as they in turn tend to be backed by short-term wholesale funding, which can disappear during a crisis. Similarly, if more claims are short-term in nature, they can simply not be rolled over in periods of stress and heightened risk aversion.
By contrast, even when aggregate debt levels are large, if they are held by local residents in longer-term assets that are denominated in the local currency, they are more likely to be stable even through periods of disruption in global markets.
By those criteria, Asia is actually worse off than other developing regions. Within total debt claims denominated in foreign currency, international claims accounted for nearly two-third at 64 per cent, compared to 57 per cent in Latin America. Also, several important economies in the region show a higher share of short-term maturities than elsewhere.
Financial integration
The composition of these claims is also of significance. Chart 2 shows that non-financial corporations have been the biggest recipients of bank credit, such that by the close of 2019, they accounted for 57 per cent of net cross-border claims while “unaccounted” non-financial recipients were nearly 40 per cent. By contrast, households are the net holders of claims or creditors abroad, to the tune of $28 billion. This reflects the growing integration of Asian financial markets with global markets, as more and more domestic savings of households get routed abroad through activities of pensions funds and other mutual funds.
When China is excluded, the situation in the rest of developing Asia looks even more serious. Claims on non-financial corporations are as much as 63 per cent of the total net debt, and those on unaccounted non-financial residents are 54 per cent. Meanwhile, banks, non-banking financial institutions and households are all net creditors abroad.
This high degree of financial integration can be a major source of fragility for emerging markets, which are not only buffeted by tendencies in global markets that may have nothing to do with internal economic trends, but are also more likely to show very rapid movements in response to shocks and any adverse domestic developments.
The relatively rapid expansion of bond markets in the developing Asia-Pacific region was until quite recently a cause of congratulation, until it became evident that these bond markets can become an even greater source of external vulnerability. Even for local-currency denominated bonds, it has been observed that when they are held by non-residents, there can be significant sales in times of stress that cause their yields to rise, and these sales can also impact the foreign exchange market if the sellers choose to exit.
Issuers of debt
A growing proportion of Asia’s debt is in the form of bonds, and non-financial corporations in particular have displayed significant appetite for issuing such bonds. Given the active secondary market in these debt securities, it is obvious that there can be rapid movements in these markets in the wake of any bad news, and therefore this is a potent source of financial fragility.
Chart 3 shows the total outstanding international debt securities (IDS) over the last three quarters for which data are available, for China and for the rest of developing Asia-Pacific. These have continued to increase even into the first quarter of 2020.
What is particularly striking is the difference between resident and national issuers of debt. According to the BIS, “nationality refers to the ultimate obligor, as opposed to the immediate borrower on a residence basis, and is linked to the consolidation of assets and liabilities for related entities.” This allows us to better understand the links between borrowers in different countries and sectors, and to determine the holders of the ultimate liability. For example, the debts of an offshore subsidiary of a Chinese bank may be guaranteed by the Chinese bank.
It is worth noting that this is a common, practice especially with respect to tax havens: thus we find that outstanding IDS for the Cayman Islands, Ireland, the Netherlands and the UK are substantially lower on a nationality basis than on a residence basis. However, outstanding IDS for China and India (and incidentally Brazil and Russia) are more than twice as high on a nationality basis.
It is evident that the external debt problems of developing Asia are both more complex and more subterranean than is immediately evident. How that will play out during this pandemic and global depression is thus still open to question.