Beware: the dangers of dollar-denominated debt

Every day we are presented with a myriad of economic statistics that can drown all but the most discerning of readers. Occasionally, however, we see one number that is so important and so significant in terms of potential future implications that it is worth pausing for some reflection.

A few weeks ago, The Wall Street Journal (WSJ) published an article titled “The New Bond Market: Bigger, Riskier and More Fragile Than Ever.” Within this piece was the following quote:

“Dollar credit to nonbank borrowers outside the U.S. hit $9.6 trillion this spring, the BIS said, up 50% from 2009.”

This is referring to debt that is denominated in US dollars and held by non-US, non-bank borrowers. And to put this $9.6 trillion into perspective, consider that the GDP of the entire Chinese economy in 2014 was $10.4 trillion, according to the World Bank. Put simply, this stock of dollar-denominated debt incurred by non-US borrowers is enormous!

The Bank for International Settlements breaks out the components of this debt by source region, as shown below. Perhaps not surprisingly, a full third of this debt has been incurred by emerging market borrowers – far more than what has been incurred by any other region.

Screen Shot 2015-10-23 at 9.46.36 am

Source: Bank for International Settlements

The thesis behind emerging market borrowers incurring US dollar-denominated debt was simple: US interest rates were low, and emerging market currencies were increasing. So the borrower wins on both the repayment of interest as well as the repayment of principal.

But as the Fed looks to tighten monetary policy in the US and emerging market economies begin to deteriorate, this strategy is starting to backfire. Instead of emerging market currencies appreciating, many have started to plummet against the US dollar. Just take a look at the Brazilian Real; or the Russian Ruble.

As the WSJ went on to note:

“Repaying those loans and bonds will become costlier in local-currency terms should the dollar rise, as it often does, when the Fed goes ahead with tightening, potentially stressing large borrowers such as emerging-market companies.”

Frankly, this is why the Fed is deeply concerned about the consequences on emerging market economies of potential monetary policy tightening. What are the potential consequences of defaults on US dollar denominated debt on global financial markets and real economies? This risk is surely one that was implied when the Fed stated it was “monitoring developments abroad” in September.

Screen Shot 2015-11-11 at 12.08.48 pmAndrew Macken is a Portfolio Manager with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.

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Our Montgomery Global strategy strives to act as a core, high conviction, global portfolio holding. Consistent with the long portfolios in our Montaka strategies, this offering is focused on owning the world’s high quality, undervalued businesses – and cash when appropriate – to outperform its benchmark. Branded as “Montgomery Global” in Australia to reflect a key.

Our Montaka Active Extension strategy strives for maximised return over the long-term. Owning the Montaka long portfolio typically scaled up to approximately 130 percent - and the Montaka short portfolio typically scaled down to approximately 30 percent – this strategy results in a net market exposure of approximately 100 percent most of the time.

Our Montaka variable net strategy strives for significant downside protection – but with minimal upside reduction. Focused on owning the world’s great and growing businesses when they are undervalued, while managing a portfolio of short positions in businesses that are deteriorating, misperceived, and overvalued, this strategy is our flagship long-short