Why are developing country corporations more susceptible to the vicissitudes of international finance?

Abstract

About USD7 trillion of quantitative easing funds has flooded emerging markets since 2008. These funds, created to stimulate a recovery in the Organisation for Economic Cooperation and Development and to stabilise financial markets, ended up mostly as emerging markets’ corporate bonds and loans (often after being leveraged into many multiples of their original value). Not for the first time, emerging markets became the financial markets of last resort. These funds were then either mainly invested (Asia) or used (as in Latin America and South Africa) for almost anything except for creating additional productive capacities. Enquiries into these issues, especially how corporations financed their investment, were subjects that fascinated economist Ajit Singh. He was the first to find out that corporations in emerging markets relied much more on external finance than those in the Organisation for Economic Cooperation and Development (where retained profits played a major role). The implication was that they were likely to be more susceptible to the vicissitudes of financial markets, and these have become even more weird since quantitative easing, as Northern ‘investors’, in search for elusive yields, have been happy to take on ever higher risks, leverage and illiquidity in the South. This is a key difference between current global financial fragilities and those at the onset of the current global financial crisis in 2007. The stakes for emerging economies and international financial markets could scarcely be higher, but unfortunately these huge new challenges occur at the worst possible time, as our social imagination has seldom been so barren.

When you combine ignorance and leverage,

you get some pretty interesting results.

Warren Buffett (2008)

The problem is that the new theories, the theories embedded in

general equilibrium dynamics […] don’t let us think about […]

financial crises and their real consequences in Asia and Latin America.

Robert Lucas (2004: 23)

The question of how corporations finance their investment was important in the work of economist Ajit Singh. While his work mainly examined the role of finance in corporate behaviour in industrialised countries, Corporate Financial Structures in Developing Countries (Singh et al., 1992) looked at how corporations in developing countries finance growth. He found a consistent pattern: these corporations relied much more on external finance than those in industrial economies (where retained profits played a major role). The implication was that corporations in emerging markets were likely to be even more susceptible to the vicissitudes of financial markets. And as these have become ever more weird owing to ever greater financialisation (the almost inevitable outcome of reckless de-regulation cum excess liquidity), Ajit and I often discussed issues such as the relentless increase of ‘short-termism’ in corporate and financial affairs; one example of this in the UK and US is that the average holding period of shares has fallen from around 6 years to less than 6 months (Haldane, 2015).

The core of the issue is that although corporations generate a large proportion of investment all over the world, they tend to finance this very differently north and south of the Equator. In emerging markets, corporations (in aggregate) tend to absorb the net savings of other sectors of their economies (including the foreign one), thereby helping to generate both aggregate demand and a dynamic supply. In the developed world, however, retained profits not only tend to finance corporate investment to a much larger extent, but currently – as profits are so strong and real investment so remarkably weak – the corporate sector has become a net financer of the other sectors of the economy (such as the public and household ones). ¹ Therefore, absurdly high levels of debt can now be easily financed, including huge public sector deficits and household debts. In 7 years from mid-2007, the public sector debt of just eight Organisation for Economic Cooperation and Development (OECD) countries increased by more than USD20 trillion (World Bank, 2015), and the global liabilities of private households increased by nearly USD10 trillion (Allianz, 2015). Also readily financed are practically any type of mergers and acquisitions (M&A), share buybacks, executive pay, bonuses, political contributions and corporate-sponsored retirement plans (in the US, the retirement assets of just 100 CEOs add up to as much as the entire retirement account savings of more than 116 million people at the bottom of the pay scale) (Anderson and Klinger, 2015). ² Furthermore, the combination of low levels of corporate investment and rising corporate net saving is one of the main factors driving the growing mismatch in financial markets between abundant liquidity and a relative shortage of solid financial assets, making the ease of performing a transaction in a hollow security or instrument the trademark of the current process of ‘financialisation’.

The Fed (Federal Reserve Bank) has finally acknowledged its bewilderment at the existence of these combined trends in the G7 (swelling corporate net lending vs dwindling investment rates) (Gruber and Kamin, 2015). However, for those working in the general area of the dynamics of financialisation, these twin-trends in the North were already clear well before the 2007/2008 global financial crisis, as was the perverse logic leading to them. It was clear that these combined trends could be key contributors to an imminent major debacle, as financial markets became convinced that they could keep extracting an ever-increasing amount of rents from the real economy in a sustainable way. ³

One key difference between current global financial fragilities and those at the onset of the 2007/2008 global financial crisis is that the financial balances of the corporate sector in the industrialised countries and in emerging markets have now moved in opposite directions even further – in fact, probably further than ever before.

In the case of corporate balances in the North, while in the early 2000s they were (as one would have normally expected) in negative territory – approximately minus 4% of gross domestic product (GDP) in the US and about minus 5% in most countries of the Eurozone and in the UK – now corporate net saving runs up to (plus) 8% of GDP in Japan and at about (plus) 3% of GDP in the rest of the G6 (except for France). Not the soundest scenario for sustainable productivity-growth, as an ever-increasing amount of funds has been diverted from doing something socially useful to areas such as speculative finance.

In the case of emerging markets economies, particularly in Asia, the corporate net-saving move has been in the opposite direction, and this has not been the result (as has happened in the past) of falling profit rates swelling corporate deficits. ⁴ However, it is important to emphasise that there is a crucial difference among them: in many Asian countries, this has been led by high levels of real investment, both in the build-up of too much capacity (the products of which are now flooding markets at a time when demand is faltering) and in a remarkable property boom. By contrast, in Latin America, an exploding corporate debt has not been associated with increasing capacity-enhancing expenditures. In fact, the share of investment in GDP has not only remained low and relatively stagnant, but also a large proportion of that disappointing investment rate has been made up by residential construction (which, no matter how positive it may be, it does not enlarge productive capacities). Indeed, even through the recent period of export bonanza, real investment per worker in Latin America (in constant dollars) has been on average systematically below its 1980 pre-economic-reforms level – commodity price boom and all. And that level was not particularly high to begin with. In the meantime, in this period, China has increased this statistic by a multiple of 26, India by 5, Korea by 4 and so on. ⁵

In fact, in Latin America, the rate of investment has struggled to reach even 20% of GDP since the beginning of economic reforms – less than half of China’s recent levels; meanwhile, its GDP-share of household consumption – mostly the result of the exuberance of the few and the ever-increasing levels of debt of the many – is currently twice that of China. Needless to say, both China and Latin America (and none more than Brazil) now urgently need to rebalance their growth, but in opposite directions.

The almost inevitable slow-down of China (an economy desperately needing to put some order into its corporate finances, as well as to re-orient its growth towards the domestic market) has caused jitters in international financial markets. One of the many concerns relates to the effect of this slow-down in commodity prices as over-liquid, and often imaginatively challenged financial markets have sought refuge in commodities because of the shortages of minimally solid financial assets in which to park excess liquidity. Unwinding from this has been a major contributor to the collapse in global commodity prices. In emerging markets, this has hurt corporations across the board and has brought many of their resource-rich economies to a sudden halt – and some, like Brazil, into deep recession (and Banana Republic–style politics).

In emerging markets, however, the main force behind current financial fragilities is the inevitable repercussions of the unprecedented surge of financial flows from the North. Quantitative easing (QE) is not only distorting the underlying performance of advanced economies but also driving hot-money flows to poorer (but higher yields) parts of the world.

According to the Bank for International Settlements (BIS), between 2009 and 2014, overall credit provided overseas in US dollars through bank loans and bonds hit the staggering amount of nearly USD10 trillion (Avdjiev et al., 2015; McCauley et al., 2015). The irony of it all is that exploding emerging markets’ borrowing was fuelled by funds that were initially released by the Fed’s QE programme (followed later by the Bank of England, the European Central Bank, the Bank of Japan and others). By some estimates, up to USD7 trillion of QE funds flooded emerging markets since the Fed began buying bonds in 2008 (Lynch, 2010; Wheatley and Kynge, 2015). Those funds, allegedly created to stimulate a recovery in the high-income OECD economies and to stabilise international financial markets, ended up in significant amounts as emerging markets’ corporate debt (often after being leveraged into many multiples of their original value; see, for example, Lavigne et al., 2014; McCauley et al., 2015). These funds were either mostly invested (Asia) or used (as in Latin America and South Africa, Africa’s honorary Latin American country) mostly to finance capital flight, a variety of deficits, M&A and all sorts of financial deeds – including as fuel for any conceivable asset bubble. That is, the little that was used productively there was concentrated in residential construction and in financing a build-up of productive capacities in commodity extraction – although, due to lack of industrial policies, corporations were often merely interested in investing in activities that would allow commodities to reach only the bare minimum level of processing required for exports. What a difference with what was going on in Asia!

In the words of the President of the Federal Reserve Bank of Dallas, QE was stubbornly going its own way:

In my darkest moments I have begun to wonder if the monetary accommodation we have already engineered might … be working in the wrong places. Far too many of the large corporations I survey … report that the most effective way to deploy cheap money raised in the current bond markets or in the form of loans from banks, beyond buying in stock or expanding dividends, is to invest it abroad … (Fisher, 2010)

QE was not just working ‘in the wrong places’, but also for those large corporations it seems that the only way to deploy cheap and abundant QE money was just by ‘buying in stock, expanding dividends, or speculating with it abroad’. The idea that the extra liquidity generated by QE could conceivably be used to finance investment at home – that is, to be used to expand domestic productive capacities – does not even appear to be an option for those corporations.

There were several routes by which QE money emigrated to emerging markets. One involved the Fed buying US Treasury bonds from financial corporations such as pension funds, which hold them as long-term assets with low but dependable yields. By doing this, the Fed raised bond prices and lowered yields, sending restless asset managers in search of higher yields in the tropics, such as in emerging markets’ corporate debt. When international financial markets find themselves with excess liquidity and shortage of solid financial assets, developing countries usually become their ‘financial market of last resort’ and commodities their ‘financial assets of last resort’ (Palma, 2012a).

At the same time, by buying so many Treasuries from commercial banks, the Fed pushed them to lend at least part of their newly acquired cash to the hedge funds that like to play edgy games with emerging markets’ money-market instruments. Some of that cash was also lent to leveraged funds that use their leverage capabilities to increase the (often highly destabilising) ability of speculators to navigate shifting emerging markets with bull and bear flexibility.

This sudden (and totally distorting) easy access to finance has changed the financial landscape of the South beyond any recognition:

… corporate debt of nonfinancial firms across major emerging market economies [has] increased from about US$4 trillion in 2004 to well over US$18 trillion in 2014. The average emerging market corporate debt-to-GDP ratio has also grown by 26 percentage points in the same period … (International Monetary Fund (IMF), 2015)

Is there anyone still left of the house of neo-liberalism who thinks that this corporate debt outburst could possibly be the outcome of something that resembles some sort of sustainable ‘equilibrium’ (even a sub-optimal one)? In fact, these days, there do not even seem to be many practitioners who have benefited from it who think so. According to one,

There’s always this nagging doubt that the money may leave [emerging corporate bonds markets] as quickly as it arrived; [so], the potential for volatility if there is a real reason to rush for the exit is much, much greater. (Cited by Mustoe, 2015)

And when there is such market turbulence, not surprisingly, insiders ask the obvious: ‘it begs the question: who is the dealer of last resort?’ (Mustoe, 2015).

Well, in today’s world, with so many States fully endorsing the principle of ‘subsidiarity’ – a principle that has its real roots in the fact that subsidies, subsidies, and further subsidies are all that governments can think of at the moment when having to address a financial market’s folly – there is an easy answer to the question of who is going to be the dealer of last resort:

Aberdeen [Bank] Asset Management chief executive Martin Gilbert called for central banks to consider stepping in should the corporate bond market collapse, thus performing a similar role to its lender of last resort for banks. (Mustoe, 2015)

In fact, speculators, rentiers and traders need not worry, as these days ‘investors’ are rarely disappointed, as central bankers now seem to think that ‘not upsetting the markets’ is the only policy-tool left for them.

In terms of the problems of domestic absorption in emerging markets economies of foreign funds brought in by corporate bonds and loans, Central Banks, by taking these foreign assets on to their balance sheets, also had to create liabilities. So they printed money and sometimes sold bonds to sterilise. But when fresh cash made its way into the local banking system, they could then lend more – actually, they could lend multiples of those amounts (about 4 times in Brazil, 8 times in Malaysia and 10 times in Chile).

Also, foreign direct investment (FDI) was another route for QE to find its way into emerging markets. In 2014, 40% of Brazil’s FDI took the form of intra-company loans. In China, about the same percentage took the form of ‘other capital flows’, including intra-company loans and payments (Avdjiev et al., 2014). As opposed to Latin America (and South Africa), in Asia some of this did end up increasing productive capacities significantly, but inevitably some just added liquidity to China’s shady shadow banking. In the case of Latin America, the QE-related surge of FDI just continued the well-established path of previous FDI flows, which (in constant 2010 dollars) have resulted in USD2 trillion of FDI inflows since the ‘Brady Bonds’ having had little or no impact on investment rates (Palma, 2010, 2012b). In fact, Latin America’s average investment rate actually fell as a percentage of GDP during this QE-related tsunami of FDI. So, not much evidence of over-capacities is being built in Latin America (as in Asia) by this tsunami of (so-called) foreign direct ‘investment’ or by the massive build-up of corporate debts. In fact, if one excludes oil economies, according to the economic complexity index (ECI), given the levels of income per capita, Latin American economies are now among the least diversified in the World, and none as much as Chile (Hausmann et al., 2014).

Although these huge FDI inflows, as well as foreign bank loans and portfolio inflows, may have had a negligible positive impact on investment rates, they did have, however, a major negative one on the current account of the balance of payments. Taking into account only those associated with FDI since 2002, when commodity prices began their meteoric rise, a full USD1 trillion (in constant 2010 dollars) has left the countries of the region in the form of profit repatriation by multinationals (Palma, 2012a).

In the case of Chile, for example, in the 12-year period between 2002 and 2014, profit repatriation by FDI (mostly copper multinationals) was seven times higher than during the previous, similar length one (1990–2002) – USD186 billion and USD27 billion, respectively (constant 2010 dollars). In fact, profit repatriation by FDI in this 12-year period (2002–2014) was six times higher than that of the whole previous 33-year period (1980–2002). In terms of the GDP of each interval, while the figure for the former is equivalent to 8% of that aggregate, the one for 1980–2002 is just 2% of GDP.

From another perspective, the amount that FDI took out of Chile in the form of profit repatriation only between 2002 and 2014 was larger than the stock of the entire retirement account savings of all Chilean workers (about 10 million people) that have little choice but be affiliated to the (draconian) private pension fund system (AFPs) – about USD190 billion versus about USD160 billion, respectively).

Most of that massive profit repatriation was due to copper multinationals taking out of Chile in just 12 years an amount larger than the whole of the Marshall Plan – the one in which the United States gave USD13 billion (approximately USD130 billion in current dollar value) in economic support to help rebuild Western European economies after the end of Second World War. And all that for the great inconvenience of exporting copper concentrates – a mud with a metal content of about only 30%, which is the result of a rudimentary flotation of the pulverised raw copper ore. So, why bothering to do much processing at source if one can manage these colossal returns for doing so little? All this gives a whole new meaning (and one that is a bit more magic realist) to the concept ‘picking the low-hanging fruit’.

Furthermore, the high levels and huge volatilities of portfolio inflows took a new lease of life since QE, bringing a remarkable (and gratuitous) extra degree of macroeconomic uncertainty, especially to exchange rates.

Therefore, the inevitable question is always the same: what did Latin America do with these additional funds? In this milk and honey part of the world, the answer is always the same: not that much was done with them that could be considered socially useful.

All in all, in emerging market economies, private sector debt (corporations and households) is estimated to be already well over 100% as a percentage of GDP (Wheatley and Kynge, 2015). Therefore, it is now greater than in developed markets in the build-up to the global financial crisis. In fact, according to the Institute of International Finance (IIF, 2015), when all is said and done, overall emerging market debt is now probably fast approaching 200% of GDP.

Thus, the so-called ‘Keynesian’ QE-policy from the Fed and other central banks (Keynes must be turning in his grave at the crude exploitation of his name, as QE in the US, and later in the European Union (EU), was (and in the latter case still is) basically an attempt by monetary authorities to keep financial dinosaurs on life support) has left a legacy of all sorts of financial fragilities in the South such as a highly futile over-financialisation in Latin America and South Africa, from which it will take many years to unwind. It has also left a legacy of over-capacities in Asia, but at least there is something to show for their high levels of debt (even if at the margins there are some bizarre white elephants, as in China).

From this perspective, the paradox is that QE was designed to help reduce systemic risks in the world economy and specifically to facilitate an orderly process of deleveraging in industrialised countries. Instead, it has made possible the build-up of a huge debt-bubble in emerging markets in both cross-border lending and bank lending, with the former now at serious risk of currency mismatches (especially concerning corporations operating in non-tradable activities) and the latter at one of liquidity mismatches. Accordingly, a new credit crunch could mean a corporate dollar-debt crisis due to the former and a domestic banking one due to the latter.

Stating the obvious, we should not expect a demand-led recovery of the global economy to come from this end of the world anytime soon, especially from commodity-exporters in Latin America or Southern Africa.

Furthermore, we should not expect a demand-led recovery to come from the North either unless a robust set of linkages between financial markets and the real economy is re-established (à la FDR). As Keynes (1930 [1972]) said at the time of the 1930s crash,

… there cannot be a real recovery, in my judgment, until the idea of lenders and the idea of productive borrowers are brought together again … Seldom in modern history has the gap between the two been so wide and so difficult to bridge. (p. 146)

The late Carlos Díaz-Alejandro (Ajit’s great friend and mine) once said – following the intellectual lead of our common mentor, Charles Kindleberger (see, for example, Kindleberger, 2000) – ‘Good-Bye Financial Repression, Hello Financial Crash’. This is especially true in a negative real interest rate environment, as speculators, in their desperate search for elusive yields, inevitably take on more risk, more leverage and more illiquidity. This is precisely a vital (yet implicit) ingredient of the peculiar ideas behind super-accommodative monetary policy, but the downside (among many) is that this policy is likely to bring more volatile asset prices globally (including commodities) and more financial fragilities all over. Closer regulatory scrutiny worldwide, therefore, should have been an intrinsic part of such risky reflationary policy. But try to get speculators, traders and rentiers (or politicians in need of donations for that matter) to understand something, when their (short-term) earnings, bonuses, share options and corporate-sponsored retirement plans depend on their not understanding it.

Latin America tends to be the worst in this respect, with its close relative in southern Africa not far behind. There is little doubt that this context also punishes real investment, productive diversification, technological absorption and industrialisation. In Latin America, productivity has hardly increased since pre-economic reforms with the customary cycles and significant diversities, such as in Chile in the 1990s, output per worker in the region has been on average stagnant since 1980 (with an annual rate of growth of just 0.1% for this 35-year period). Since 1990, it has grown by just 0.9% per year. In the meantime, in China, these statistics reach 7.1% and 8.2% per annum, respectively; in Korea, 4.2% and 3.5%; in Taiwan, 3.9% and 3.4%; in Vietnam, 3.5% and 4.4%; in India, 3.4% and 4.1%; in Thailand, 3.7% and 3.3% and so on (Groningen Growth and Development Centre (GGDC), 2015).

So, again, the unavoidable question arises: Where has all that exploding corporate debt gone in Latin America? Especially in countries like Chile, which now ranks number 3 among all emerging markets economies in terms of swelling corporate debts since 2007 as a percentage of GDP (only after China and Turkey). And in Brazil (which now ranks number 4)? And in Peru (number 6)? And in Mexico (number 8) or Colombia (number 12)? In the case of Chile, the increase in corporate debt was equivalent to about 20% of GDP, in Brazil and Peru about 15% and in Mexico and Colombia about 10% (IMF, 2015). In the meantime, if private investment (despite a commodity price boom and easy finance due to QE liquidity) managed to raise much above 15% of GDP, the capitalist élites of the region started experiencing feelings of vertigo. ⁶ And what about those USD2 trillion of FDI flows (in dollars of 2010 value) that have come in since the onset of economic reforms in 1990 – and especially the surge of (so-called) FDI since the Fed began buying bonds in 2008? All this is a stark reminder of how little we really understand about what has been happening inside Latin America since our (remarkably unsophisticated and highly corrupt) neo-liberal economic reforms. Not least due to the (somewhat garciamarquean) intricacies involved.

And for those who still believe that total factor productivity (TFP) is the key, in Chile, for example, a country that is so often highlighted as the best performer of the region, the average annual rate of growth of this statistic since 1995 has actually been nil (Corporación de Fomento de la Producción de Chile (CORFO), 2013)! The average TFP-growth rate for the whole region has been zero for much longer − in fact, on average, it has been so for the 34-year long period since 1981 (i.e. the end of the previous development strategy of State-led industrialisation) (Economic Commission for Latin America and the Caribbean (ECLAC), 2013). Nor do the prospects for the region look very promising. Evidence like this sometime makes me wonder how those who carried out the economic reforms that have characterised the region since – and take this statistic (TFP) so seriously – can still argue (with a straight face) that what is needed is more of the same neo-liberal reforms. As Einstein is reputed to have said, ‘Insanity is doing the same thing over and over again and expecting different results’. There is little doubt that during the 1980s, much re-engineering was needed in the region as far as development strategy was concerned, but the chosen one seems to have had more to do with pure ideology − and conflicts of interests − rather than with social reality.

In a context such as that of Latin America, inequality is as much a twin of inefficiency as the law of gravity is of the apple. Emerging markets that are such a paradise for (domestic and foreign) rentiers, speculators and traders can only be a purgatory for their real economies and consumers. Douglas North’s last major contribution to Economics (North et al., 2007), with its notion of ‘limited access order’, in which political elites divide up control of the rents, each gaining a share of the economy, attempts to look in this direction.

In sum, Ajit Singh was right; corporations in developing countries tend to be even more susceptible to the vicissitudes of international finance than their counterparts in the developed world. In fact, and not surprisingly, unregulated and over-liquid international financial markets have proved to be as destructive and self-destructive as one could have ever imagined. The idolisation of finance – that is, the worship of a thing: rentier money – has dominated the desire to create life-producing economic activities, and rent-seeking accumulation has dictated the path of other creative, innovative activities – and has inevitably placed a straitjacket on them.

Ajit would have surely agreed that it is certainly time to make a margin call to the guardians of financial de-regulation in ever-more liquid financial markets, asking them to put a lot more substance into their arguments. The stakes for emerging markets’ corporations, their real economies and financial markets, and wider society (and everybody else in the world for that matter) could scarcely be higher – as (quoting the great Portuguese poet Camoes) we are now definitely ‘em mares nunca dantes navegados’ (across never before sailed seas).

But unfortunately (and as opposed to that post-war era that brought us a good deal of civilisation − the one characterised by the consolidation of the New Deal-type economics, the Bretton Woods agreements, The Marshall Plan, declining inequality, the British National Health Service and the Welfare State), this new challenges are happening at the worst possible time, as our current social imagination (North and South of the Equator) has seldom been so barren (see Palma, 2014).