Market report June 2021
Current debt restructuring efforts are likely to fall short of their goals although the IMF’s new USD650 billion SDR allocation is a start in the right direction. The G20/Paris Club Debt Service Suspension Initiative (DSSI) has the distinction of bringing China into a coordinated debt reduction initiative for the first time.
The changing public debt creditor landscape (Eurobond holders, China, India, and some Middle Eastern countries) has created a “race to seniority” and increased debt sustainability risks – the shift from traditional (concessional) debt to private and commercial debt complicates debt restructuring and leaves less room for debt forgiveness.
Despite the global economic rebound that is already starting (+5.5 percent in 2021, the quickest recovery in the last 40 years), we anticipate further debt distress in EMs, particularly LDCs, in the next two years, as well as additional sovereign downgrades and possible defaults – Low-income nations will require at least USD450 billion to ramp up their expenditure in response to Covid-19, recover or retain foreign currency reserves, and counteract the long-term effects of the crisis.
The IMF-coordinated “Common Framework” seeks to offer the same restructuring terms to all creditors, including private creditors, on a case-by-case basis – coordination, transparency, and acceptability will be the main challenges in reaching a satisfactory debt restructuring agreement with all stakeholders. Given the vast majority of Eurobond holders, official creditors are actively advocating for private sector participation in debt restructuring to achieve “fair” burden sharing.
The most notable insights are:
The debt repayment burden has widened the gap between advanced and developing nations over the last decade. Furthermore, Covid-19 adds to the already rising interest loads.
The disparity between AEs and LDCs’ debt payment expenses grew in particular in 2020, rising to 9.5 percentage points from 7.4 percentage points in 2019.
Following Covid-19, many emerging and low-income nations may become caught in a low-growth, high-debt cycle. Most developing nations were unable to engage in large-scale fiscal stimulus to stimulate post-Covid19 development due to limited fiscal headroom and a fundamentally poor revenue base.
Probably none of the present attempts will garner enough support to solve the developing world’s financing shortages. Furthermore, it is unclear how to incorporate Eurobond holders and China in the restructuring negotiations. The IMF’s fresh USD650 billion SDR allocation is on its way, but the question remains whether it will be adequate.
We do not expect a comprehensive solution to be agreed in 2021 to provide a way out for debt-ridden nations in the current international environment. Nonetheless, debt forgiveness provides only temporary relief, whereas fostering private-sector-led growth may be the long-term solution.
China’s corporate debt
With 18% of worldwide outstanding debt presently yielding negative, investors are increasingly seeking yield-enhancing possibilities in higher risk Emerging Market assets. Given its strong economy, stable currency, and reasonably liquid fixed income market, China has emerged as a major capital hook in this setting. Despite the initial withdrawals in March 2020, investors have continued to ship capital offshore, focusing on Emerging Market (EM) assets, which provide an intriguing yield-enhancing opportunity due to their greater risk profile and non-core currency denomination. The CNY government bond market has gained increasing investor attention across many areas of the Chinese fixed income market, owing to its steady yet attractive rates and currency components, and has been included in numerous worldwide indices. Recent high-profile defaults, however, have damaged investors’ confidence in the state’s implied put protection. Consider the case of China Huarong Asset Management Company, a key SOE that indicated it would be unable to reach the fiscal year 2020 deadline. Following the failure of the release, a debt sell-off occurred, causing bond values to fall to 60 cents on the dollar. As a result, numerous well-known Chinese investment grade corporations, including Tencent, paused new debt issuance, while several other SOE and financial bonds traded at a broader range. Huarong is China’s largest (RMB1.7 trillion) and one of only four state-appointed distressed debt managers, resulting in a tight relationship with several onshore financial institutions. Huarong and its subsidiaries owe USD23 billion in foreign currency and USD19 billion in local currency. Because of the company’s relatively substantial debt volume, many local and foreign investors are directly or indirectly engaged in it. Given its operational character and history, Huarong is also regarded as systemic in China’s financial system.
Chinese authorities have finally revealed their intentions regarding Huarong, indicating that they want to secure the company’s strategic role so that it can continue its core business of distressed asset management, as well as reform it by selling non-core assets and business lines, as a sign of the country’s determination to further clean up bad debt and ensure financial stability. From a broader perspective, maintaining financial stability has been and continues to be the top priority for the Chinese government, which undoubtedly has a strong desire and the necessary tools (high level of FX reserves and manageable level of public debt, mostly owned by domestic entities) to avoid any increase in systemic risk.
In the medium to long term, the risk-return profile of Chinese credit remains quite appealing. As previously stated, this is especially true given that the Chinese fixed income market is a trillion-dollar-plus market with an average BBB grade and greater than 3% yield compensation in both local and hard currency terms. When compared to other key EM markets, this remains quite appealing, particularly given the present low-yield environment. The broad and consistent local investment base, a relatively constant FX rate, and a determined government body all contribute to China’s economic attractiveness. The Chinese authorities were able to tighten the policy mix as early as Q4 2020, ahead of the global trend, because to the rapid economic recovery (GDP rose by +2.3 percent in 2020, while it fell in most other major economies). All of this contributed to the CNY’s good performance in 2020, with a 6.5 percent gain versus the US dollar and a 3.7 percent gain against a basket of currencies (CFETS RMB Index) during the year. China has a long-term structural reform strategy in place to ensure a seamless transition from high potential growth to lower potential growth as the economy ages. Allowing underperforming SOEs to default eliminates the government’s implied assurances, which creates moral hazard. China is committed to accelerating the development of a low-carbon, circular economic development system. The State Council, China’s cabinet, issued guidelines in February 2021 that set a 2030 deadline for peak carbon dioxide emissions and a 2060 deadline for carbon neutrality.
Summer on the horizon
Many of the world’s leading economies are loosening social restraints this summer, and expansionary fiscal policy has aided development. Consumers, loaded with cash from postponed spending and robust income assistance measures, are expected to engage in some ‘catch-up consumption,’ and early signs of this increased demand are emerging. On the supply side, there is evidence of tightening labor markets in economies where social restraints are loosening. Job postings in the United States have reached new highs, and more individuals are changing occupations, yet hiring numbers remain restrained, implying a labor shortage. Goods demand is also high, with many businesses still restocking in the aftermath of the trade war between China and the United States before to the epidemic. Supply and demand have become much tighter as a result of production bottlenecks and the Suez Canal blockade earlier this year. Inflation is already occurring as a result of the combination of high demand for products and services and constrained supply of commodities and labor. Producer price inflation in China reached 9% yearly, prompting the government to interfere in several raw resources markets. Wages in the United States increased by 0.5 percent in May, despite an unfavorable mix impact caused by the reemployment of many more low-wage workers. Inflation rates in the world’s major economies vary, but they are all growing. While inflation is increasing, predicting how long it will persist is challenging. Furthermore, big changes in the global economy may be underway, which might have a huge impact on inflation. The aging population, rising automation, the greening of the economy, and deglobalization might all play a role.
Higher inflation is a result of the rebound in economy, as is the assumption that monetary policy would tighten over time. Bond yields rise when interest rates rise, and bond prices decrease as a result, putting pressure on fixed income performance. Because interest rates are used to assess a company’s future earnings, this might jeopardize its stock prices. Companies in growth industries have been more vulnerable to these changes, as a larger amount of their value is based on strong future growth projections. Shares, on the other hand, are exposed to the economy, and forecasts for higher economic development should enhance profit expectations. We continue to favor industries and areas that are vulnerable to cyclical upswings in the economy.
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The views expressed in this document do not constitute research, are not investment or commercial advice, and do not necessarily reflect the views of all management teams. They change over time