Jaimini Bhagwati: Credit cycle downturn ahead?

As US economic growth remains at current levels or dips, developing country firms could be affected adversely.

In the last few months, the sub-prime mortgage market in the US has shown increasing weakness as defaults grow. The literally trillion-dollar question is whether this will lead to a slump in the housing sector in the US. This article looks for clues of a downturn in the credit cycle in the US and other developed economies and possible implications for emerging markets. The two indicators chosen for analysis, out of the many available publicly, are forward interest rates derived from swap yield curves, which reflect the borrowing costs of AA credit-rated banks, and credit default swap (CDS) spreads. These indicators capture a representative cross-section of market opinion since the underlying debt securities are traded heavily.

It can be seen from the table that currently the spot swap curves for the US$ and euro are flat and mildly upward-sloping, respectively. Forward rates 10 years out i.e. as of April 10, 2017, are about flat for the US$ and euro. In comparison, the pound sterling spot and forward swap curves are inverted. The US$ and pound sterling curves have been flat or inverted for almost a year and this reflects a bearish view on corporate creditworthiness in the US and UK. In contrast, the Indian rupee (INR) and Japanese yen spot and forward curves 5 or 10 years from now are flat to upward-sloping. This indicates that creditworthiness will be sustained at current levels or even improve in these two countries. 

SPOT AND FORWARD STARTING SWAP INTEREST RATES (% per annum)
	3 months	1 year	5 year	10 year	20 year	30 year
INR Spot - 10/4/07	12.06	9.45	8.315	8.36	n/a	n/a
Forward - 10/4/12	8.28	8.34	8.43	n/a	n/a	n/a
Forward - 10/4/17	n/a	n/a	n/a	n/a	n/a	n/a
US$ Spot - 10/4/07	5.35	5.24	5	5.18	5.37	5.39
Forward - 10/4/12	5.12	5.24	5.41	5.54	5.57	n/a
Forward - 10/4/17	5.49	5.6	5.71	5.7	5.62	n/a
Pound Spot - 5/4/07	5.64	5.89	5.61	5.37	5.02	4.79
Forward - 10/4/12	5.27	5.33	5.06	4.87	4.53	n/a
Forward - 10/4/17	4.76	4.81	4.62	4.45	n/a	n/a
Euro Spot -11/4/07	3.94	4.2	4.25	4.37	4.51	n/a
Forward - 10/4/12	4.16	4.23	4.44	4.56	4.6	n/a
Forward - 10/4/17	4.54	4.63	4.72	4.72	4.62	n/a
Yen Spot - 9/4/07	0.66	0.78	1.34	1.81	2.31	2.5
Forward - 10/4/12	1.93	2.02	2.33	2.59	2.79	n/a
Forward "" 10/4/17	2.61	2.68	2.89	2.96	n/a	n/a
INR: Indian upee                                                                            Source: Bloomberg

In the light of the perceived weakness of the US economy, analysts at Goldman Sachs and Merrill Lynch have commented that the US federal funds rate (overnight interest rate at which US depository institutions lend to each other) will fall from 5.25 per cent to 4 per cent by mid-2008. Economists at Bear-Stearns and Barclays hold an exactly opposite view, namely that the federal funds rate is likely to go up to 5.75 per cent or even 6 per cent in a year's time.

The other indicator under review in this article is credit-default swap (CDS) spreads, which tell a somewhat different story. Hedge funds or other investors with directional views on credit cycles take long/short positions in CDS markets. The market-makers, typically investment banks, provide protection against default to investors, particularly for higher-yield securities, by charging a premium. The spreads on CDS increase when there are concerns about the creditworthiness of issuers. As of end March 2007, CDS spreads for US corporates have been around the lows for the entire period 2001-07 and spreads for emerging market sovereigns were marginally lower. For BB-rated corporates, CDS spreads for emerging markets were lower than for US counterparts (source: BIS Quarterly Market Review, March 2007).

On balance, despite the US Federal Reserve's decision to keep its funds rate unchanged at 5.25 per cent and its announcement on March 21, 2007, that the US "economy seems likely to continue to expand at a moderate pace over coming quarters" it is likely that credit quality will take a downturn in the US in the next 12 months. Based on the two measures which have been examined, there are indications of a weakening of credit quality in the UK too but not necessarily in emerging markets.

This could be the beginning of de-linking of credit quality in the US from that in select developing countries, including India. However, at the macro level it is somewhat of a con-game as the US continues to roll over its ever-growing borrowings from Asian countries and Russia to fund its deficits. The US$ is the dominant reserve currency and despite the depreciation of the US$ foreign exchange surplus economies have not yet figured out, individually or collectively, alternative investment avenues for their burgeoning hard currency reserves. For India, the stocks of outward investments in US government debt and inward foreign institutional investor (FII) portfolio investments are relatively large. Effectively, even though there are indications of credit quality de-coupling at the corporate level, India remains vulnerable to higher interest rates in the US and a reversal of FII flows.

Notwithstanding the recovery in the equity market following the sell-off triggered by the RBI's monetary tightening as of 30 March, 2007, there is concern that higher-cost loans would affect the Indian growth story negatively. On the contrary, some have argued that better-managed firms would be able to readily access funds from external sources. This argument is simplistic since such borrowings are similar to the yen carry trades, i.e. borrow in a lower nominal interest rate currency and hope that exchange rate appreciation of the lower interest rate currency does not wipe out the savings in interest expenses.

To sum up, as US economic growth remains at current levels or dips and the US$ continues to weaken, developing country corporates dependent on US demand could be affected adversely. For firms in countries such as India some de-linking of the credit cycle from the US and some OECD economies has already happened. However, it would be premature to celebrate. Along with sophisticated risk management practices which include value at risk evaluations and scenario analysis at 3 or even 5 standard deviations to include worst-case outcomes, i.e. fat tail distributions it would be prudent to keep the old adage in mind""hope for the best but prepare for the worst. In other words, expect a credit cycle downturn in the US starting around end 2007.

j.bhagwati@gmail.com