Macro Series

Seeds of the next financial crisis – EM dollar borrowing

John Llewellyn

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Report Contents

( 12 mins)
  • Dollar bond issuance by non-US corporates has dominated forex borrowing since 2008.
  • In many EMs, both leverage and currency mismatches have increased.
  • Both increase the risk of corporate insolvencies.
  • And they create new and growing threats to the balance sheets of local banks.


Sizable changes in foreign currency borrowing from abroad always warrant a close look. Foreign
interest rates can change rapidly, as can the availability of such credits. Powerful feedback effects
between interest rate and foreign currency risk exposures have often made episodes of financial
stress harder to manage, with implications not only for borrowers but also for investors.
Large-scale dollar borrowing by non-banks. Foreign currency-denominated debt has been rising strongly, relative to world GDP, for nearly two decades. While this rise was interrupted by a sharp contraction following the global financial crisis (GFC), it has continued since the pandemic, and has perhaps accelerated. The domination of the dollar has become more pronounced. By mid-2020, US dollar credit to non-banks outside the US exceeded $12 tr, about 14% of world GDP, up from less than 10% in 2007. (See Figure 1)

Most of this increase in foreign currency credit has come from borrowing not from banks, but from
the capital markets – encouraged by low long-term rates (and a negative term premium), and
reinforced by the post-GFC determination of regulators to oblige banks to de-risk. Increasing dollar debts by issuing bonds rather than taking bank loans has made borrowers less vulnerable to short-
term refinancing pressures. And companies can use especially favourable conditions in international markets to borrow more than needed for new spending or for refinancing maturing
bonds. Their Treasury operations have thereby become more significant, both in earning profits
and also in generating financial risk exposures not directly related to their core businesses. The
converse of long-term bonds reducing liquidity risks for borrowers is that they increase liquidity
and market risks for investors.
The impact of large movements in US Treasury yields over the past year or so on Emerging Market
(EM) yields has been magnified by wider credit spreads. That global ‘risk-off shocks lead to larger
risk premia for EMs and wider interest rate differentials was amply demonstrated in March 2020. 

Sources of risk

The many, and diverse, channels of capital market intermediation create systemic risks that have always been difficult to manage. There are various sources of risk. 


Seeds of the next financial crisis – EM dollar borrowing 1.   Seeds of the next financial crisis – EM dollar borrowing 2









Liquidity illusion in bond funds. Bond funds allow investors to build more diversified portfolios
based on illiquid individual bond issues that they may not understand. Because investors demand
liquidity, open-end funds (mutual funds) offer a daily price even when the underlying assets are
illiquid. Several episodes of severe dysfunction of even core bond markets (most recently in March
2020 and February 2021) has given new urgency to tackling this issue at the international level.
The Financial Stability Board (FSB) is at present reviewing mutual funds and non-bank financial
intermediation more generally.
Domination of dollar-denominated credits. This is more extreme than before the GFC. Because
the share of debt denominated in US dollars is much larger than the borrowing countries’ share of trade with the US (or with dollar-based economies), a rise in the exchange rate of the dollar vis-à- vis third currencies, such as the euro, adds to the burden of borrowing countries’ foreign debt without necessarily improving their international competitiveness. Local-currency devaluations may thereby prove to be contractionary: increased local currency payments on dollar debt reduce national disposable income, and can lead companies to cut investment.
Fragility of foreign exchange hedging markets. Companies in many EM economies hedge their
long-term dollar debts with short-term instruments (e.g. 3-month swaps), counting on being able
to renew them easily. But in periods of financial stress, when the demand for dollars usually rises,
the terms of such hedges tend to turn against firms that are short dollars. Sudden changes in pricing,
or even the disappearance of foreign exchange hedging instruments for some currencies, can
destabilise indebted companies.
Over the past fifteen years or so, the markets for forex derivatives have grown rapidly, and now
cover many more currencies. By mid-2020 the notional outstanding foreign exchange contracts
had reached almost $94 tr, compared with $37.5 trillion at the end of 2005. Currency swaps have
reached $26 tr (compared with $9.7 tr at end-2005). At the same time, liquidity strains have
become more frequent. One indication of such strain is the widening spreads (cross-currency basis)
in foreign exchange swaps markets. A good proxy for global foreign exchange hedging pressures is
the IMF’s calculation of the median of 22 currencies. Before 2007, this median was close to zero
(indicating that covered interest parity was generally satisfied). Since the GFC, however, the dollar
cross-currency bases of many currencies have become more volatile. In a forex crisis, many EMs
have found that the cross-currency basis turns against them (making hedging more expensive)
when they raise interest rates.

Figure 2 above shows that the median widened in the March 2020 COVID-19 panic to 55 basis
points (70 basis points for emerging market currencies). A dollar liquidity crisis was averted only
by the rapid activation of the Fed’s dollar swap lines with other central banks. Such action
narrowed the cross-currency basis for the currencies of swap-line countries, but not for those of
non-swap-line countries.

The threat to financial stability

Taken together, these risks from the increased foreign currency borrowing by EM corporates
amount to a significant, and growing, risk to financial stability.
The scale of the threat depends on the size of their currency mismatches. It is not enough to look
only at aggregate international bond debt: account also needs to be taken of: foreign currency
assets, which have also risen strongly; any offsetting reductions in other forms of foreign currency
liabilities (such as bank loans); and foreign currency earnings (exports). Data here are however
scanty. Figure 3 below shows, for a sample of major medium-sized EMs, that the ratio of aggregate
net foreign currency assets – that is, foreign currency assets minus all foreign currency liabilities –
has fallen as a proportion of exports.8 The dotted line shows that the country aggregate is still
positive, rather than negative as it was in the late 1990s. Hence a currency depreciation could still
be expected to improve the local currency value of country’s external balance sheet, and thereby
reinforce the stabilising effects of currency depreciation on the current account.
However, this ratio has fallen over the past decade, so aggregate balance sheet protection has
thereby become smaller than it was before the GFC. Vulnerability consequently is greater, given
the large net debts in foreign currencies of the non-official sector, which reached around 40% of
annual exports by end-2017.
The scale of dollar-denominated debt, the component that gets most attention, differs
substantially across geographic areas (Figure 4 below). China’s dollar debts rose to 20% of exports by end-2019, compared with 6% at end-2008. The ratio was much higher in South East Asia – 70%,
up from 24%; and higher still in Latin America – 106%, up from 70%.

Ways in which crisis could unfold

There are three ways whereby large net foreign currency debts of companies could have systemic
Destabilising foreign exchange market dynamics. Since the mid-2000s, an increasing number of
EM firms without dollar revenues have borrowed dollars without fully hedging their foreign
exchange exposures. And many firms pursued financial engineering strategies that involved
borrowing ‘cheap’ dollars to invest in higher-yielding assets, for example denominated in their own
local currency. Companies with unhedged dollar debts tend to buy dollars (directly or by
purchasing hedges) whenever the local currency comes under pressure in foreign exchange
markets. This can set off a destabilising market dynamic: a drop in the exchange rate makes their
dollar debts even harder to service, inducing further dollar purchases and thereby a still weaker
Magnification of corporate fragility from leverage. Higher leverage has increased the financial
fragility of EM companies. Such fragility is magnified by foreign currency debts, especially for firms
in non-tradable industries. This can have macroeconomic consequences as firms with dollar
debts cut business investment.
Damage to local banks. If companies find it harder to borrow dollars abroad, they may react in
ways that transmit the shock to local banks. They may activate under-priced credit lines and
squeeze out other borrowers. They might reverse the carry-trade borrowing of dollars, and cut
their wholesale local bank deposits. Banks may be hit just when a downturn has already impaired
their loan book. Thus when international financial conditions tighten, local banks can be obliged to
reduce lending just when the export markets of their clients are shrinking.

A new challenge for monetary policy

When domestic companies have large dollar debts, the exchange rate constraint on monetary
expansion tightens. At the onset of the pandemic, many EMs faced a classic quandary: how to ease
monetary policy to counter recession without triggering a large currency depreciation that might
cripple companies with dollar debts. Cutting the policy rate beyond a certain point in such
circumstances might be contractionary, because of the damage done to corporate balance sheets.
(This is akin to the ‘reversal rate’ of Brunnermeier and Koby13 whereby ever-lower or negative
short-term rates damage the earnings of banks and thereby nullify the desired expansionary effect.)

Seeds of the next financial crisis – EM dollar borrowing 3     Seeds of the next financial crisis – EM dollar borrowing 4

The strategy followed by some central banks (e.g. Indonesia, the Philippines, South Africa) was to
keep the policy rate up in order to protect the currency, but at the same time to buy government
bonds. New legal charters were introduced to allow some Latin American central banks to buy
public and private securities in secondary markets. Many central banks used quantitative easing
(QE) without reaching the zero lower bound on interest rates. This change in monetary policy
implementation has favoured more government borrowing.
The remarkable development of local financial markets, often with a deeper local investor base,
has given EM central banks new possibilities for balance sheet policies. Foreign investor demand
for government bonds denominated in local currency was stimulated by a decade of low yields on
advanced-economy government bonds.
There is a drawback however: the greater importance of EM local currency bonds in the portfolios
of foreign investors has also increased the foreign exchange market/bond market interactions,
magnifying the domestic consequences of external financial shocks. Foreign investors learned from
the 2013 ‘taper tantrum’ that an EM currency crisis often goes hand-in-hand with a bond market
crisis. Foreign investors without foreign exchange hedges are thereby doubly exposed.
The larger stock of government bonds and other financial assets that trade in open markets
nevertheless means that the central bank asset purchases can be more ambitious. In addition, QE
can be supported by official measures (such as regulatory relaxation, offering investors hedges that
put a floor under future bond prices, and so on) to encourage local banks and other domestic
investors to buy government bonds that foreigners are selling.
Measures to remove the tail risk of a bond market collapse help to stabilise the domestic financial
system because bonds serve as a safe asset for banks, and as reliable collateral for borrowing. They
also reassure foreign investors, and thereby support the exchange rate. This challenges the
orthodox view that QE tends to weaken the exchange rate. The sharp rises in EM bond spreads in
March 2020 have been decisively reversed, exchange rates have risen, and many corporates have
issued more dollar bonds.

Action needed in three areas

New policy frameworks are required in three areas to address the financial risks of much higher
EM corporate debt in dollars. None will be easy.
First, repeated episodes of bond and derivatives market turbulence point to major gaps in the
international regulatory framework covering bond markets. The strong warning by the chairman
of the Financial Stability Board (FSB) about the underlying fragility of the more diverse and
interconnected non-bank sector globally suggests that regulatory action is, finally, high on the
international policy agenda. There seems to be strong political support from the US Treasury under Yellen.
Second, macroprudential policies in borrowing countries – which have to date been focused almost
entirely on banks – have often failed to cover the risks from excessive leverage, as well as currency and maturity mismatches created by non-bank financial institutions. In 2017, the ECB Vice-President warned that new financial crises would be inevitable unless macroprudential policies covered capital markets more effectively. It would be wise for EM central banks to develop new macroprudential tools to discourage the risky borrowing strategies of non-financial companies, and to contain any collateral damage to domestic banks.
Third, EM central banks face more complex monetary policy choices. On the one hand, their ability
to fight recessions by cutting their policy rate is constrained by the substantial dollar debts of their
companies. On the other hand, larger and deeper domestic financial markets have made QE a more
effective policy tool, both to stabilise the domestic banking system and to support aggregate
demand. How well QE works depends on the fiscal position; and on the degree of confidence that
a credible and independent central bank will keep inflation low and avert a flight to dollars or euros.
All too often in EMs, government attempts to hobble the central bank have made crises
worse. Turkey is a current case in point.


Risks from the dollar borrowing of EM companies have become more opaque; they have migrated
to less regulated entities; and they are often hedged in ways that can magnify contagion.

Risk migration has made the dollar bonds of many, different, EM companies vulnerable to any
major liquidity shock originating in global markets. This risk is likely to be greater when dollar bond
yields are rising than when they are low and falling. The growth of bond funds may have
accentuated contagion across EM bonds. The liquidity such funds apparently offer may prove to
be an illusion.

Watch fors

Key developments to watch for include:

  • Larger-than-expected increases in dollar bond yields.
  • Tensions in currency hedging markets.
  • International regulatory action.
  • Macro prudential actions in individual countries.
  • Hobbling of EM central banks.
  •  Stressed banks.