Occasionally we see a chart that makes us really stop and take note. The chart below, published by JP Morgan and sourced from the Bank of International Settlements, illustrates the level of credit extended to the non-financial corporate sectors of developed markets (“DM”) versus emerging markets (“EM”) over time.
Expressed as a percentage of GDP, we can see that since the global financial crisis, developed market corporates have essentially been deleveraging, albeit slowly. Emerging market corporates, on the other hand, have been gearing up; and quite aggressively since 2012 – most of which has been driven by Chinese corporates.
There are a number of concerning aspects to this chart. The first is that the level of credit to emerging market corporates is now higher than the peak observed in developed markets. So if history is any precedent, we are getting close to dangerously high levels.
The second relates to the assets that are backing much of the debt that has been extended. To the extent these assets are of high quality, then the quantity of credit is no problem. To the extent these assets are deteriorating, however, then loans may well need to be written down – the losses of which will be borne by shareholders in emerging market banks, among other participants. We have already observed a clear deterioration in China’s banking assets, details of which can be explored here.
The third relates to the apparent decline in productivity of new credit. Since 2012, emerging market corporate credit has been growing rapidly; yet, over this time economic growth has slowed dramatically. In this sense, the economy is getting less bang for buck of new credit – likely because much of the new credit extended is simply being used to refinance existing credit rather than funding new productive assets.
Finally, the major concern relates to the eventual deleveraging process that will need to happen. A process of deleveraging is usually deflationary. When the money supply contracts, there are fewer dollars (or perhaps Renminbi in this case) chasing the same quantity of assets, so prices typically fall. Falling asset prices can result in a negative wealth effect and delayed consumption – both of which are negative for real economic growth.
The timing of how this plays out is impossible to predict, but the setup is clear. There is a lot of credit on the balance sheets of emerging market corporates. And the combination of high leverage and deteriorating demand growth can be a dangerous one.