The emerging markets are at risk of "damaging feedback loops" once the world's central banks start reining in their monetary policy and raise rates, the Bank for International Settlements (BIS) warns.
BIS, known as the central bank of central banks and one of the few organizations to foresee the global financial crisis of 2008, believes that non-financial companies from emerging economies have been encouraged to increase leverage and overseas borrowing but might have been left inadequately hedged and susceptible to currency risks.
"These factors have increased the risks facing these companies, implying the existence of 'pockets of risk' in particular sectors and jurisdictions", Michael Chui, Ingo Fender and Vladyslav Sushko said in the organization's new quarterly report released on Sunday.
"If these risks were to materialize, adding to broader (emerging market) vulnerabilities, stress on corporate balance sheets could rapidly spill over into other sectors, inflicting losses on the corporate debt holdings of global asset managers, banks and other financial institutions."
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This could be a source of "powerful feedback loops" in the event of an exchange rate or an interest rate shock, the three economists warn.
The concerns come after a so-called "taper tantrum" in May 2013, when the minutes of a Federal Reserve policy meeting sparked fears the central bank could start tapering off its $85 billion-a-month bond purchasing program. Emerging market currencies tumbled on the news as investors started to bring their dollars back to the U.S. in anticipation of higher interest rates.
This gave a short and sharp insight into what could happen overseas if the yields on U.S. Treasurys suddenly spiked higher, although most expect the normalizing of interest rates to be facilitated at a smooth pace with the Federal Reserve managing market expectations and being alert to financial risks.
BIS has warned in the past about the effects of ultra-loose monetary policy, arguing that it has "retarded" economies. In Sunday's report, it says that capital inflows into emerging economies have brought economic benefits but added that they could also make these countries more vulnerable to external shocks, especially if unchecked surges in credit and asset prices were to raise the specter of renewed boom-bust cycles.
Research by the organization indicatesthat private sector borrowers in major emerging markets issued internationaldebt securities worth almost $375 billion in 2009–12, which it says was morethan double their issuance in the four-year period before the financial crisis.
The three economists conceded that limitations in data mean that it's quite hard tofully assess the vulnerabilities that these higher levels of borrowing have on these private companies, but added thatvarious measures point to rising leverage on corporate balance sheets.
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In particular, it credits analysis from the Bank of America Merrill Lynch which says that Chinese corporates (especially property developers) now appear to be quite highly leveraged, in comparison with their emerging market peers.
"They may find it challenging to manage these debt levels in an environment of slowing growth and tightening profit margins," the report said.