A Macro take on EM corporate analysis:

By: Seng Liew

April,13th, 2021

When we look at corporate credits, 3 risks are:

? Market risks.

? Interest rate risks.

? Credit risks.

Let us focus on Market Risks for this topic. Too often, we place too low a priority about the environment which the corporate operates in, i.e., Market Risks. Market risks can be exogenous or endogenous. The biggest impact is the exogenous which is beyond the control of the corporate credit. In corporate analysis it is always top down first before we go bottom up. It comes down to your Sovereign Analysis.

Sovereign Analysis:

Emerging markets is the ultimate macro analysis. There are many checklists when we look at a sovereign. Demographics, debt service ratio and debt maturity profile are some of the important issues that come to mind. The policy and management of the country sets the tone for the corporate. Let us look at this from a different perspective. In EM, all problems circled back to 5 tenets that haunt every EM country. 

5 Tenets faced by all EM countries:

? Twin deficits

? Inflation

? Artificially high interest rates

? Currency valuation

? Lack of room to maneuver in monetary and fiscal policies.

Twin Deficits:

This is a function of the government budget and its current account balance. The pandemic has blown out every budget in EM land. The financing has since hit new records for most countries with the avalanche of sovereign issuances. Fiscal stress in evident along with ratings downgrade. The situation is tenuous with high probability of policy missteps going forward. The varying speed on vaccination rollouts also hinder the return to normality. This also suggests that there is no synchronized global recovery. It is inevitable that more sovereign rating downgrades will be forthcoming. Corporate EBITDA generations are down over the course of the pandemic with leverage up 0.5-1.75X. Please refer to my previous article about the “Rule of 200” where in a downturn, one can easily expect a drop as much as 45% in US$ terms in EBITDA generation.  

Inflation:

In developed markets, we tend to look at inflation excluding food and energy. In EM, food and energy tends to be sticky and easily find its way into core inflation. The US Dollar is the anchor currency in EM. Any move in the US$ has profound effects on EM inflation. A stable US$ gives more room for EM central banks to maneuver. EM Central Banks tend to be overly cautious on inflation. It stems from historical economic mismanagement and being caught in a quagmire of limitations in monetary policy implemented with little to no help from fiscal policy front. Periods of low inflation have less impact on currency compared to periods of high inflation where currency impacts are magnified. Given the size of the economy in EM, the feed thru or economic lag cycle is much faster. Inflation also affects the costs base for the corporates especially where union power is more pronounced. The import of raw materials also impacts the margin with the US$ being the commodity currency.

Artificially high interest rates:

EM interest rates tend to be 150-450bps over the inflation rate. Whilst nuances exist in different countries, EM Central banks are somewhat limited to what actions they can take in monetary policies. Central Bank policies are usually guided and limited by the US Fed actions and are more reactive than proactive. Current US interest rate normalization opens the door for EM Central Banks to hike rates to combat higher inflation. It is still a balancing act for EM Central Banks between acceptable inflation and currency valuation. Corporates have local banking relationships and higher local rates raises their cost of financing. Higher costs mean lower margin. Interest rates have a high correlation to the FX rate with inflation amplifying any moves.

Currency Valuation:

EM currencies have been hammered over the pandemic with devaluation as high as 30% in some cases. A weak currency has fast feed thru effects on inflation. EM Central Banks now pushing for rate hikes where possible to support the currency and to stall inflation, but the downside risks for artificially high rates is stifling growth when it is most needed. On the flip side, when currencies were stronger beware of swaps and hard currency accumulation by the central banks. Remember when Brazil had close to $450bn in reserves which helped Brazil gained its investment grade. This type of policy overstates the country’s reserves and when the 2008 debacle hit forcing Brazil to unwind their hard currency accumulation, with real reserves were closer to $220bn.

Lack of room to maneuver in monetary and fiscal policies:

Most, if not all, EM countries run a deficit in their fiscal policy. There is an annual refinancing issue on maturing debt along with new additional financing like over this pandemic. There are limitations as to how much a country can borrow. Debt service sustainability given the country’s economic structure. Most EM countries are based on a mixed economy. The split between private and public sector plays a major role in economic growth of the country. The heavy skew towards the public sector becomes an overbearing cost like in Argentina. Economic policies favoring private sector growth becomes more important since the public sector tends to be more of a cost center than a revenue center. Government subsidies are another economic stress point amplified by the pandemic. Inefficient tax collection also hinders debt service.

Over the last 25 years, there has been waves of reform talks, more talks than reforms. Hence, all EM countries are unrestructured economies. Reforms, if any, have been cosmetic. Labor reforms continue to be the biggest hindrance to growth in EM. The rule of law and its inconsistent interpretation obstruct the growth in the availability of long term capital for investment. 

Conclusion:  

The above subject is diverse and in-depth. This writeup does not by adequately cover the whole spectrum of sovereign analysis. It only serves to put one on the right track when looking at how policies affect the environment the corporates are operating in.