The Dollar Debt of Companies in Latin America: the warning signs

Our recent discussion paper (Giraldo and Turner (2022)), with the same title as this blog post, uses data from 160 Latin American companies to document the many warning signs of macroeconomic and financial instability in the region from such indebtedness.

Six clear warning signs are identified:

• Currency mismatches of non-financial corporations have increased.
• The corporate sector has become more leveraged. For firms in the tradable sector, higher leverage and increased dollar borrowing tend to move together.
• Greater leverage has not enhanced the return on equity. Despite significant depreciation in the real effective exchange rates, profitability has declined in the tradable sector.
• Capital expenditure has been cut.
• The narrowing in credit risk premia across companies in the face of a sizable increase in the leverage of the most-indebted companies suggests credit risks are being under-priced.
• Even as global interest rates fell, interest payments took a larger share of profits. The increased interest burden of the weakest firms is a particular concern.

A bright spot for Latin American companies is that near-term dollar liquidity pressures have been eased as long-term bond finance has significantly displaced short-term (or floating rate) bank loans. They are now less vulnerable to sudden reversals of external finance. Their borrowing costs depend less on the Fed funds rate and more on the yield on long-term US government bonds. Access to longer-term finance is an unquestionable benefit as it gives companies and the authorities time to prepare for adverse shocks.

With profitability declining and debt increasing, the traditional indicators of rising solvency risk are flashing red. The debt-at risk-indicator for the tradable sector has risen sharply in the past decade.  When interest rates were still low and liquidity abundant, this indicator suggested that 33% of debt in 2019 was at risk. This indicator rose to 40% in 2020. Although  the continuing impact of COVID-19 and sharp rises in commodity prices make it hard to assess the current situation., this indicator warrants monitoring,

The storm clouds are gathering. Dollar interest rates will rise. New international rules for non-bank financial institutions and bond market practices are under discussion. This is likely to increase the credit and liquidity spreads cost of bond issuance by smaller companies whose bonds are in any case illiquid.

Such a scenario would make it all the more important for the authorities in borrowing countries to develop macroprudential rules for non-financial companies borrowing dollars in international capital markets. Bank regulators in Latin America already have in place extensive macroprudential rules for currency mismatches in banks . And measures to curb the foreign currency exposures of banks have helped to constrain the build-up of non-financial corporate leverage . But tougher rules on banks in the major financial centres have actually pushed risks into capital markets. The lack of regulatory tools directed specifically at nonbank financial institutions is a major policy gap.

What needs to be done? Greater transparency is one suggestion. An almost perennial recommendation is that the public disclosure of corporate currency mismatch risks of EME nonfinancial companies needs to be improved. Yet even the simplest statistical building blocks are still missing. The breakdowns of a company’s liabilities and financial assets into those denominated in foreign currency and those in domestic currency are not generally available. Nor do we know the exports/home sales split of its gross revenues.

Secondly, more light is also needed on the greater role of companies in financial intermediation. Much more needs to be known about the destination of financial resources raised in global bond markets. Finally, the size and nature of their business dealings with domestic banks (as wholesale depositors, as beneficiaries of credit lines, as counterparties for derivative contracts and so on) could change quickly when conditions deteriorate in global financial markets.

This global financial environment is changing in two big ways. The monetary policy shift has been well advertised. Markets are aware that dollar interest rates are going to increase, but no one knows how much.  A regulatory shift that is also coming gets less attention. The authorities in the main financial centres know that the current prudential oversight of nonbank financial institutions and capital market practices are, to quote the head of the BIS, not “fully fit for purpose”. How and when the rules will be tightened remains to be seen.

The statistical evidence marshalled in the paper, imperfect as it is, is strong enough for everybody involved (companies, creditors, credit rating agencies and the authorities) to take a hard look at non-financial corporations in Latin America with large dollar debts and ask: what happens when monetary and regulatory policy action in the United States tightens financial conditions in dollar bond markets?

Almost twenty years ago, Goldstein and Turner (2004) noted that the international regulators argued that improved transparency was the way to handle risk oversight of private nonfinancial companies. But they also noted that this “hands-off” approach had not worked in the Asian financial crisis. In any event, audited public disclosure by companies of their currency exposures was too poor for transparency to work effectively. In addition, the lack of comparable data across companies and across countries made analysis difficult.