he global economy has faced no shortage of challenges in recent years. Now, a new set of headwinds has emerged, with banking stresses flaring up in the US (AAA stable) and Europe. The economic backdrop has shifted in recent weeks, with near-term financial stability concerns posing downside risks to the global growth outlook. As growth slows and credit risks rise, questions over the ensuing impact on emerging market (EM) corporate borrowers’ balance sheets remain front and center.
To assess the risks to credit quality, rating migration, and defaults in these uncertain times, we conducted a scenario analysis drawing lessons from previous downturns while also incorporating the many changes in the EM credit landscape in the years since these downturns.
Downside risks for EM corporates have risen as inflation remains higher for longer. Since the beginning of March, downside risks to our baseline scenario for global economic growth have increased, with a higher probability that tighter financial conditions and a reduction in credit availability could weigh on global demand. Continued strength in the US economy, sticky core inflation, and uncertainty about the extent of stress in global banking systems have combined and together complicate the interest rate path for the Federal Reserve and other central banks, including those in emerging markets.
While EM corporates have emerged from the recent twin crises of Covid-19 and the Russia-Ukraine conflict in generally robust financial health, their revenue, profitability, cash flow, and leverage will all still be challenged by any negative events emanating in developed markets.
To better understand the potential impact of a US recession on EM corporates, we have analysed two downside scenarios. The first is a deep recession akin to the 2008-09 global financial crisis (GFC). In the GFC, what started as a banking crisis culminated in a severe credit crunch, which filtered through to the real economy as lending dried up.
At the start of the crisis, US household debt was already very high, and the fall in home valuations exacerbated the overall debt burden. The impact on growth during the GFC was severe, with US GDP falling 4.3 percent from peak to trough while EM GDP declined 4.7 percent. Commodity prices fell by an average of 30 percent, including oil which fell by 15 percent. EM non-investment-grade corporate default rates spiked at 13 percent compared with a long-term average of 5 percent.
Our second scenario is a milder recession, more akin to that of 1991, which followed the savings and loan (S&L) crises in the 1980s and 1990s. The recession that followed the bursting of the dot-com bubble in 2001 was of a similar magnitude. In both episodes, US GDP fell by around 1.5-2 percent, EM GDP by around 1 percent, and commodity prices by 18 percent.
The spike in default rates was more severe in the 2001 episode, reaching 18 percent, but this was largely because it was combined with the 2002-03 Argentine sovereign debt crisis, and the majority of corporate defaults in that period were domiciled in Argentina Severely negative GFC-like scenario poses downside risks for EM corporates. By the end of the global financial crisis in 2009, the overall impact on EM GDP was not dissimilar to the US.
Regionally, however, the differences were stark and generally reflected the extent to which economies were coupled to developed markets. In the Asia-Pacific region, GDP fell by only 5.5 percent and was arguably boosted by the proximity of the main economies to China (A1 stable), which expanded credit and investment significantly following the crisis. In contrast, peak to trough, economies in Emerging Europe deteriorated the most (by 13.7 percent), reflecting their close ties with Western Europe.
Meanwhile, the peak-to-trough GDP declines in LatAm (8.3 percent), the Middle East (2.3 percent), and Africa (1.9 percent) were more in the middle, reflecting the limited level of interconnectedness with developed markets, offset by their exposure to much lower commodity prices.
Property, capital goods, and commodity-driven corporates most exposed to GFC-style downturn Similarly to their global peers, many EM corporates with exposure to primary and secondary industries saw significant revenue declines during and following the recession that followed the GFC with falls of up to 40 percent in some instances (in US dollar terms). While the changes in EBITDA margins and leverage between 2008 and 2009 were relatively limited for the then cohort of EM corporates, there was significant regional and sectoral differentiation.
At the sectoral level, at the onset of the GFC, weakened demand combined with deteriorating industry conditions and low credit growth had a large and negative impact on metals & mining, property, agriculture, and transportation companies in particular. For these sectors, margins fell by 6 percent-9 percent on average while leverage increased by 1-2x. In contrast, the more consumer-facing industries such as consumer products and technology, media, and telecoms saw leverage remain relatively stable and margin decreases of around 1 percent. Regionally, the impact followed both the change in country-specific GDP and the sector mix of rated EM companies within each country. In APAC, margins fell by less than 3 percent on average, with leverage rising by a modest 0.6x. By contrast, in Latin American (LatAm)margins fell by close to 10 percent while leverage increased by more than two times.
Rating trends were also uneven across sectors and regions. In 2009, the property, transportation, and business and consumer services sectors had the most negative rating drifts and the highest rating volatility, consistent with their deteriorating financial profile, with a decline in drift of 143 percent, 90 percent, and 83 percent, respectively, between 2008-09. Drift and volatility were well correlated, indicating that most rating actions were taken in the sector with the highest number of downgrades. Regionally, rating drift peaked at 184 percent in Emerging Europe, with issuers in APAC and LatAm relatively more resilient to the downturn, with peaks at 93 percent and 45 percent, respectively, reflecting stronger fundamentals among issuers in the region.
EM corporates will face potential downside scenarios with stronger balance sheets While it is tempting to draw parallels between the current period and the GFC, we firmly believe that most EMs will enter any crisis in a materially stronger position than at any time in the recent past, including the GFC.
Throughout the challenging period of 2022, key indicators such as the value of EM currencies against the US dollar held up well and demonstrated the higher levels of structural protection that EMs have sought to build. For the most part, EMs have increased their utilisation of local currency financing by developing their own domestic capital markets and reducing their dependency on hard currency. In addition, EMs have accumulated meaningful foreign exchange buffers to withstand short-term volatility in financial flows. EM external imbalances have also been more financed by foreign direct investment (FDI) flows, which tend to be more stable than the volatile portfolio flows that prevailed in the post-GFC era.
Over the past two decades, the average credit rating of EM companies has also improved, with a higher number of predominantly investment-grade issuers in China driving the expansion of the rated EM universe. In contrast, in the last 12-18 months, and following both the wave of defaults in the China property sector and the loss of ratings from sanctioned Russian entities, there has been a reduction in the number of lower-rated EM corporates. Since 2008, our rated coverage has increased by 145 percent. We have also seen the credit quality of issuers improve during this period, as more than half (54 percent) of our total rated EM corporates are investment-grade, compared to only 35 percent in 2008.
Reflecting this, and despite the numerous headwinds of rising input costs, a tight labour market, and higher funding costs, EM corporates have entered the rising rate environment with generally robust liquidity, having undertaken prudent refinancing and liability management. While leverage is still somewhat higher, at around 0.5x debt/EBITDA, this is absorbed by the larger size, scale, and diversification of EM corporates compared with 2007, which provides for a higher debt-carrying capacity than in the past.
We, therefore, believe that in a severely pessimistic scenario, EM defaults will be below those experienced during the GFC and will also be below those in the US high-yield sector. At the sectoral level, the mix of defaulters will be somewhat different than in the GFC, with the exception of the property sector, owing
to the turmoil in the Chinese property sector, where 40 percent of our issuers are rated CAA and below. This sector also registered one of the highest number of defaults during the GFC. The default risk remains high now for transportation and energy because, after property, the majority of CAA and below issuers are located in these sectors. At the regional level, LatAm and APAC had the highest corporate defaults during the GFC, while now the highest percentage of lower-rated issuers is in APAC, the majority of which are related to the Chinese property sector.
EM corporates can easily weather a 1991 or 2001-style recession.
During the milder recessions of the 1990s and early 2000s, US real GDP contracted on average by 2 percent and EM real GDP by 1 percent. Under a similar scenario for 2023-24, we would expect a more benign impact on EM economies. The current rating mix also suggests a less severe default trajectory if the next downturn resembles the 1991 or 2001 recessions, producing a milder default peak, albeit still above the long-term average.
In the 2001 default spike, all defaults occurred in the non-financial sector, while the banking sector remained relatively robust. Nevertheless, the period encompassing the deterioration in credit quality was relatively long-lasting, with default rates remaining elevated for more than two years after the end of the recession and exacerbated by the 2002-03 Argentine sovereign debt crisis.
Similarly to the GFC, the impact at a sectoral and regional level was comparable, albeit more benign, with the brunt of the reduction in margins and the increase in leverage felt within the commodity and capital goods industries. In contrast, during the 1991 recession, and similar to the GFC, the additional complexity of stress in the banking system meant a higher impact on the real estate sector. (