Sovereign-backed corporate debt stirs

JPMorgan’s main index of dollar-denominated sovereign bonds puts it at a quarter of market

Close to $100 billion (Dh367 billion) of debt linked to emerging market governments is being camouflaged by the growing use of quasi-sovereign bonds sold on international markets with the implicit backing of the state.

While official debt burdens of countries such as India, Russia and China remain low by developed nation standards, at less than 65 per cent of GDP, the scale of debt issued by state-owned entities and sub-sovereign borrowers suggests potential liabilities are far higher.

According to JPMorgan’s main index of dollar-denominated sovereign bonds, quasisovereign bonds now account for a quarter of the market.

“This has been a source of worry for some time,” said Lee Buchheit, a partner at Cleary Gottlieb and expert on sovereign debt default.

“In part because it does not always appear on government balance sheets.”

Quasi-sovereign bonds allow borrowers to raise capital on the strength of a country’s credit rating, with explicit or implicit backing, at a rate often lower than corporate borrowers pay and their use has jumped in the years since the financial crisis.

Definitions vary, with JPMorgan’s main index considering only 100 per cent state-owned borrowers, such as Mexico’s Pemex, and investors such as Charles de Quinsonas at M&G regarding it as anything in which a government owns more than 50 per cent of the equity or has more than 50 per cent of the voting rights — a description which encompasses Brazil’s Petrobras.

The market is dominated by financial and energy sector organisations in Brazil, Russia, China and India, which have suffered from vanishing capital flows and rising borrowing costs in 2015 thanks to the strengthening US economy, weakening commodity prices and fears of slowing China growth.

However, the lack of a sharp sell-off in emerging market debt suggests investors feel relatively calm about the danger of a sovereign debt crisis, in part because so many governments have paid down dollar-denominated sovereign debts and increased domestic currency borrowing. In Brazil, the government’s foreign debts are equal to just 2.4 per cent of GDP, according to the central bank.

S&P downgrade

Yet Standard & Poor’s and Fitch, two of the world’s three big credit rating agencies, cut Brazil’s sovereign foreign currency rating to junk in 2015 in part, analysts say, because sovereign risk has been transferred to the private sector and, in the case of the quasi-sovereigns, the sovereign may still be on the hook.

“What can really break the dam is the quasi-sovereign element in EM external debt,” says Gary Kleiman of Kleiman International, an emerging market investment consultant. “People have always assumed there is an implicit backing, but that capacity has not been called into question explicitly.”

During previous emerging market debt crises, governments from Mexico to Russia to South Korea stepped in to save indebted quasi-sovereigns.

“Today, the scale of the problem is much greater and the fiscal power of emerging governments is much less,” Kleiman said, who points to Petrobras, the crisis-stricken Brazilian oil group, PDVSA, its Venezuelan counterpart, and Eskom, the South African electrical utility, as sources of particular concern.

“A company like Petrobras getting into deeper trouble would represent a workout problem more complex than a sovereign workout because of the multiple jurisdictions involved,” he says.

“And what progress has been made in terms of local bankruptcy and solvency procedures leaves a lot to be desired.”

Of 181 quasi-sovereign bonds included in JPMorgan’s EMBI Diversified index, only 19 offer investors an explicit sovereign guarantee.

What can really break the dam is the quasisovereign element in EM external debt. People have always assumed there is an implicit backing, but that capacity has not been called into question explicitly.”

Gary Kleiman

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Kleiman International