Corporate debt in emerging economies

[saurabhpal49]

Hi David,
Could you please explain the below para
"Second, in an environment where the EME sovereigns have issued a significant quantity of domestic-currency debt, a high stock of foreign currency corporate debt may increase the incentive for fiscally stressed sovereigns to default on domestic currency debt rather than engage in currency depreciation. Knowing this, investors will drive up the sovereign risk premium. If domestic banks hold substantial volumes of domestic-currency sovereign debt, the result will be losses in the mark-to-market value of some of their assets, a reduction in their capitalization, and an increase in systemic risk"

Thanks

 

[David Harper CFA FRM]

Hi @saurabhpal49 I had to check the referenced paper (Schreger and Du, he actually typos the authors, their paper is here at https://www.dropbox.com/s/tp5w9n3621w51sp/schreger_jmp.pdf?dl=0 ) and the source Current Issues text is copied below. Here is what I think is meant: it is conventionally understand that a monetary sovereign (like the US) can avoid defaulting on its debt by "printing money" but at the cost of inflation. If this is true, it would seem that a monetary sovereign would always prefer to inflate currency (print money) rather than default. The authors here are saying that is not always the case: that sometimes default is preferable to currency inflation. The reason would be when its own private company have borrowed in a foreign currency. So imagine we are talking about Japan (hypothetical, i don't think Japan has ever defaulted) who is a monetary sovereign and many of its private companies do borrow US dollars (i.e., the foreign currency debt). The argument is that, Japan can inflate to avoid default, but that domestic inflation implies yen depreciation and dollar appreciation (relative to the yen, anyways), which in turn is a direct loss to those unhedged corporate borrowers (ie., if they are borrowing dollars, as we know from Saunders FX, that is being short the dollar currency, such that unhedged dollar appreciation is a loss to them). So, to summarize: domestic inflation is domestic currency depreciation (e.g., Yen) which is relative foreign currency appreciation (USD) and that hurts domestic companies who are short the foreign currency (USD) due to borrowing in it. The argument is that such pain to those companies might be sufficient to incent the sovereign to prefer actual default. Interesting, thank you for asking so I get a chance to think about this!!

Second, as highlighted by Schreger and Wu (2014), in an environment where the EME sovereigns have issued a significant quantity of domestic-currency debt, a high stock of foreign currency corporate debt may increase the incentive for fiscally stressed sovereigns to default on domesticcurrency debt rather than engage in currency depreciation. Knowing this, investors will drive up the sovereign risk premium. If domestic banks hold substantial volumes of domestic-currency sovereign debt, the result will be a loss in the mark-to-market value of some of their assets, a reduction in their capitalization, and an increase in systemic risk.