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NEW YORK, Dec 15 (Reuters) - Emerging market companies with debt in dollars and revenue in sinking local currencies could struggle as the U.S. Federal Reserve begins what is expected to be a series of interest rate increases after years of easy money policies.
The combination of weakening emerging market currencies, rising U.S. rates and a strengthening dollar could create a "perfect storm" of conditions to lead some emerging market companies to sell assets and others to default in 2016.
"There has been a tremendous amount of emerging market debt issued in dollars over the last decade, yet these same corporations don't have revenue in dollars," Bonnie Baha, lead portfolio manager at DoubleLine Capital told the Reuters Global Investment Outlook Summit in New York in November.
The currency mismatch - lots of dollar-denominated debt and a low percentage of revenues in the U.S. currency - increases the likelihood of a company failing to service its debt, managers said. Some managers say this inability to pay off dollar debt could spark the next emerging market crisis.
Year-to-date, emerging market financial and non-financial corporates as well as sovereign debt issuance totaled $792 billion, according to the Institute of International Finance. MSCI's broadest emerging market index is down 19 percent this year.
"As U.S. liquidity growth continues to slow, those emerging market countries and corporations that are reliant on U.S. dollar capital inflows for funding that have not undertaken the necessary structural reforms will be unable to continue to finance themselves, let alone repay the considerable amounts of U.S. dollar debt that they have accumulated post-financial crisis," said Atul Lele, chief investment officer at Deltec International Group.
Managers who spoke with Reuters said they are reducing allocation to emerging market companies that are heavily exposed to commodities and energy in Brazil, Russia, Turkey and South Africa.
"We've seen this play out before. Last year, when the West put sanctions on Russia, Russian companies couldn't access U.S. and European markets and had to pay debt due in the upcoming year while the rouble was weakening," said Sammy Simnegar, manager of Fidelity Investments' $3.4 billion Emerging Markets Fund.
Simnegar is one of many managers who expect the Fed's initial rate hike to only have a minimal effect on emerging markets as the increase has been expected for several months and priced into markets, shifting focus to how emerging market corporates fare after subsequent rate hikes.
"What matters most to these countries is the pace of dollar appreciation because that will impact interest, and that interest has to be paid in dollars," said Luciano Siracusano, chief investment strategist for WisdomTree Investments in New York.
As of August, with revenue exclusively in reals, Brazilian mall operator General Shopping's < GSHP3.SA> dollar debt equaled 7.1 times earnings before interest, tax, depreciation and amortization. That was the highest in a group of 90 Latin American companies with large dollar debt exposure, compiled by Bank of America Merrill Lynch.
The Brazilian real has declined 46.17 percent year-to-date, according to Thomson Reuters data, and is expected to keep falling through 2016.
"We have adjusted considerably in Brazil over the last year or two given the twin deficits and political risk. Our investments there are tactical or deep value based, but we are considerably underweight," said Joel Wells, portfolio manager of the Emerging Markets Real Estate fund at Alpine Woods Capital Investors. Alpine Woods' funds own about $650,000 in the company and Wells' fund has just 5bps worth of General Shopping. Wells manages $600 million.
To be sure, some managers said they don't expect many emerging market corporates with dollar-denominated debt to default or even come close to defaulting because the Federal Reserve will forecast rate increases.
"From what we're hearing from (Fed Chair Janet) Yellen, the Fed will pursue increases at a slower pace and won't go above one percent in 2016 because they realize the impact it'll have," said Roger Aliaga-Diaz, senior economist at Vanguard in Malvern, Pennsylvania.
Additionally, many governments are creating laws that limit external borrowing with the intention of lessening default risk. Brazil and Russia raised rates in an attempt to reduce capital outflows while the Turkish central bank cut short-term foreign exchange borrowing and Indonesia introduced new rules that make it harder for corporations outside the financial sector to issue foreign debt. (Reporting by Tariro Mzezewa; Editing by Nick Zieminski)