To paraphrase writer Robert Louis Stevenson, financial markets have “a grand memory for forgetting”.
Multiple Latin debt crises and the 1997/1998 Asian emerging market crisis have been forgotten. Now, the risk of an emerging market crisis is very real.
Investors have been romancing emerging markets, exemplified by the dalliance with the BRIC economies (Brazil, Russia, India and China), a term coined by Goldman Sachs’ Jim O’Neill in 2001. Apparently, the infantile CRIB was rejected in favour of the solid constructivist BRIC.
Subsequently expanded to BRICS to include South Africa as the original grouping lacked an African member, the acronym became a symbol of the perceived rise of emerging nations and their increased economic power. The underlying logic and mathematics were vague, beyond the usual marketing platitudes about population size, large land area and resources.
In reality, the growth of the BRICS and other emerging markets was driven by: the low starting point or base of development, unutilised workforce, cheap labour, low cost structures (because of minimal regulation and lack of environmental controls), (in some cases) commodity wealth, high domestic savings and favourabledemographics.
In the 1990s and early 2000s, strong debt fuelled growth in developed economies, such as the US and Europe, was catalytic in driving emerging markets. Strong demand for exports combined with relocation and outsourcing of production to low cost emerging markets drove growth.
A rapidly growing China emerged as a major market for commodities, boosting resource rich emerging countries. Smaller emerging economies, especially in Asia, became integrated into new global manufacturing supply chains centred on China. As author David Rothkopf wrote in Foreign Policy: “Without China, the BRICs are just the BRI, a bland, soft cheese that is primarily known for the wine that goes with it“.
A self-fulfilling virtuous cycle drove emerging market growth, improving living standards at least for some of citizens.
The 2007/ 2008 global financial crisis marked an end to this phase of development. Slowing economic growth in developed economies resulted in a sharp slowdown in emerging economies. To restore growth, emerging markets switched to development models more reliant on credit. Double-digit annual credit growth drove economic activity in China, Brazil, India, Turkey and many economies in Asia, Latin America and Eastern Europe.
The credit driven revival of emerging economies entailed domestic credit expansion, directed by governments to finance investment and consumption growth. This was augmented by foreign capital inflows, driven by the perceived superior economic fundamentals of emerging markets.
Loose monetary policies in developing countries – low or zero interest rates, quantitative easing and currency devaluation- encouraged capital inflows into emerging markets, in search of higher returns and currency appreciation. Banks, awash with liquidity, sought lending opportunities in emerging markets. International investors, such as pension funds, investment managers, central banks and sovereign wealth funds, increased allocations to emerging markets.
Foreign ownership of emerging market debt increased sharply. In Asia, 30-50% of Indonesian rupiah government bonds, up from less than 20% at the end of 2008, are held by foreigners. Approximately 40% of government debt of Malaysia and the Philippines is held by foreigners.
Capital inflows drove sharp falls in emerging market borrowing costs. Brazilian dollar-denominated bond yields fell from above 25% in 2002 to a record low 2.5% in 2012. After averaging about 7% for the period 2003-2011, Turkish dollar-denominated bond yields sank to a record low 3.17% in November 2012. Indonesian dollar bond yields fell to a record low 2.84%. Local currency interest rates also fell.
Increased availability of funds and low rates encouraged rapid increases in borrowings and speculative investment. Asset prices, particularly real estate prices, increased sharply.
The effect of capital inflows was exacerbated by the relative size of the investment and local financial markets. A 1% increase in portfolio allocation by US pension funds and insurers equates to around $500 billion, much larger than the capacity of emerging markets to absorb easily.
The Band Stops Playing…
In the last 12 months, investor concern about developments in emerging markets has increased, reflecting slowing growth and a potential reversal of capital inflows.
China’s growth has fallen below 7%. India’s growth is below 5%. Brazil growth has slowed to near zero. Russian growth forecasts have been downgraded repeatedly to under 2%. The slowdown reflects economic stagnation in the US, Europe and Japan. In addition, slowing Chinese growth affected commodity demand and prices, in turn affecting producers like Brazil. The slowdown flowed through the supply chains affecting suppliers to Chinese manufacturers.
The growth slowdown is now attenuated by capital outflows, driven by fundamental concerns about emerging market economies but also changing US policy dynamics.
Improvements in American economic conditions have encouraged discussion about ‘tapering’ the US Federal Reserve’s liquidity support, currently US$85 billion per month. US Treasury bond interest rates have increased, with the 10 year rate rising by nearly 1.00% per annum, in anticipation of stronger growth, inflation and higher official rates. Rates in other developed countries such as Germany have also increased sharply.
As investors shift asset allocation back in favour of developed economies, especially the US, there have been significant capital outflows from emerging markets, resulting in sharp falls in currency values and rises in borrowing rates. In 2013, the Brazilian real declined around 13%, the Indian rupee has fallen around 15%, the Russian rouble is down around 8%, the Turkish lira has fallen around 10%, the Indonesia rupiah around 12%, the Malaysian ringgit around 7%, the Thai baht 4% and the South African rand has fallen by around 18%. The falls have accelerated in the last three months.
Ability to raise debt has declined. The cost of funding has increased. Brazilian dollar-denominated bond yields have risen to around 5%, well above the lows of 2.5% last year. Turkish dollar-denominated have risen to nearly 6% from a low of 3.17%. Indonesian dollar bond yields are above 6.00%, up from lows of 2.84%.
Emerging market central banks, excluding China, have seen outflows of reserves of around US$80 billion (around 2% of total reserves). Over the last 3 months, Indonesia has lost around 14% of central bank reserves, Turkey has lost 13% and India has lost around 6%.
Like an outgoing tide that reveals the treacherous rocks that lie hidden when the water level is high, slowing growth and the withdrawal of capital is now exposing deep seated problems, especially high debt levels, financial system problems, current and trade account deficits and structural deficiencies.
As a result the romance with the BRICs has fallen to BIITS (the acronym coined to describe the current most vulnerable emerging markets – Brazil, India, Indonesia, Turkey and South Africa).
Cheap Money, Expensive Problems…
Debt levels in emerging markets have risen significantly, with total credit growth since 2008 in the range 10-30% depending on country. Credit growth has been especially strong in Asia. Total debt to Gross Domestic Product (“GDP”) above 150-200% of GDP is now common. Credit intensity has also increased sharply. New credit needed to generate each extra dollar of GDP has doubled to around US$4-8 for each dollar of GDP growth.
Bank credit has increased rapidly and is above the levels of 1997 (as percentage of GDP) in most countries. There has also been rapid growth in debt securities issued by emerging market borrowers, in both local and foreign currencies.
Borrowing varies between sectors, depending on country. Consumer credit has grown strongly in many Asian countries and also in Brazil. Consumer debt in Malaysia and Thailand has increased to around 80% cent of GDP, up sharply from levels in 2007. Economic growth is strongly linked to growth in consumer credit. Higher borrowing by lower-income households adds vulnerability. In Thailand, debt payments are equivalent to over 33% of income, roughly double that in the US before the 2008 financial crisis.
Borrowing by corporations also varies. Many corporations in China, South Korea, India and Brazil are highly leveraged. Combined gross debts at India’s biggest ten industrial conglomerates having risen 15% in the past year to US$102 billion. Many borrowers are over-extended with inadequate cash flow to meet interest and principal payments, especially in a weak economic environment.
Growth in local debt markets means that companies can borrow in local currency, reducing currency risk. Nevertheless, emerging market borrowers have significant hard currency debt, attracted by very low coupons. Brazil has US$287 billion of outstanding dollar loans (12% of GDP). Turkey has outstanding dollar loans of around US$172 billion (22% of GDP). India has outstanding foreign debt of around 20% of GDP.
With notable exceptions like China and India, government debt levels are not high. However, state involvement in banks and industry mean that effective level of government obligations is higher than stated.
Sustainable levels of public debt are lower for emerging market countries, given lower per capita income and wealth. Emerging nations also characterized by an ‘inverted debt structure’ (a term attributed to Michael Pettis in his book The Volatility Machine); sovereign borrowing levels increase rapidly when the economy encounters problems.
Banks and investors with exposure to emerging markets are at significant risk. Borrowing has been used, worryingly, to finance consumption, investment in infrastructure projects with uncertain rates of return or speculation.
With around US$ 20 trillion of all governments bonds (around 48% of outstandings) yielding less than or around 1%, bond investors have supported increasingly marginal emerging market borrowers, under-pricing risk.
A 10 year US$ 400 million bond issue by the African state of Rwanda with a coupon of 6.875% was nine to ten times oversubscribed. The funds raised (around 5% of GDP) were intended to finance a convention centre in Kigali, Rwanda. Panama issued 40 year bonds at 4.3%, a remarkable result given that US Treasury bonds have only traded below the coupon level for 10% of history. Honduras was able to issue 10 year bonds to raise US$500 million despite the fact that its faces significant difficulties in meeting its obligations.
In many emerging countries, quasi-government bank officials have financed projects sponsored by politically connected businesses and elites. Lending practices have been weak, helping finance expensive property and grand vanity projects with dubious economics.
Many borrowers will struggle to repay the debt. Losses are currently hidden by an officially sanctioned policy of restructuring potential non-performing loans. Bad and restructured loans at Indian state banks have reached around 12% of total assets, doubling in the past four years. In Brazil, the solvency problems of former billionaire Eike Batista and his various businesses will result in large losses to lenders as well the state owned Brazilian development bank.
Short term foreign capital inflows have financed external accounts, masking underlying imbalances.
The current account surplus of emerging market countries has fallen to 1% of combined GDP, from around 5% in 2006. The deterioration is greater, as large trade surpluses of China and energy exporters distort the overall result. The falls reflect slow growth in export markets, lower commodity prices, higher food and energy import costs and domestic consumption driven by excessive credit growth.
India, Brazil, South Africa and Turkey have large current account deficits, which must be financed overseas. India has a current account deficit of around 6-7% and a budget deficit (Federal and State government) approaching 10% which requires funding. Countries dependent on commodity exports are also vulnerable, given the fall in prices and anaemic global economic growth.
Emerging countries require around US$1.5 trillion per annum in external funding to meet financing needs, including maturing debt. A deteriorating financing environment combined with falling currency reserves, reduced cover for imports and short term borrowings, declining currencies and diminished economic prospects have increased their vulnerability.
Trouble at Home…
The difficult external environment has highlighted long standing structural weaknesses.
Investors fear that many emerging markets may be caught in a middle income trap, where countries experience a sharp slowdown in economic growth when GDP per capita reaches around $15,000.
Emerging economics remain highly linked to developed economies, through trade, need for development capital and the investment of foreign exchange reserves, totalling in excess of US$7.5 trillion. Weak growth in developed markets and decreasing credit quality of developed country sovereign bonds may adversely affect emerging markets. Emerging countries have also lost competitiveness, as a result of rising costs, especially labour.
Investors are concerned about mal and mis investment. Trophy projects, such as the 2008
Beijing Olympics (costing US$40 billion), Russia’s 2014 Sochi Winter Olympics (US$51 billion) and Brazil’s 2014 football World Cup and 2016 Olympics, have absorbed scarce resources at the expense of essential infrastructure.
Income inequality, corruption, hostile and difficult business environments, excessive concentration of economic power in heavily subsidized state corporations and political rigidities increasingly compound the problems of debt and capital outflows. Political instability exacerbates economic problems, for example in Brazil, Turkey, South Africa and India.
These concerns have resulted in a new acronym for the more vulnerable emerging markets – BIITS (Brazil, India, Indonesia, Turkey, South Africa). It seems the BRICS are now falling to BIITS!
Moment of Truth…
Battle weary policy makers do not want to believe that an emerging market crisis is possible. Like former US Secretary of State Henry Kissinger, they believe that: “There cannot be a crisis next week. My schedule is already full.”
But there are striking resemblances to the 1990s. Then, loose monetary policies pursued by the US Federal Reserve and the Bank of Japan led to large capital inflows into emerging markets, especially Asia. In 1994, Federal Reserve Chairman Alan Greenspan withdrew liquidity, resulting in a doubling of US interest rates over 12 months.
In the 1994 ‘Great Bond Massacre’, holders of US Treasury bonds suffered losses of around US$600 billion. Trading losses led to the bankruptcy of Orange County in California, the effective closure of Kidder Peabody and failures of many investment funds. It triggered emerging market crisis in Mexico and Latin America. It precipitated the Asian monetary crisis, requiring International Monetary Fund (“IMF”) bailouts for Indonesia, South Korea and Thailand. Asia took over a decade to recover from the economic losses.
Many now fear a re-run, triggered by rapid capital outflows and a rising US dollar. The basic trajectory is familiar – old ways are frequently the best way.
Weaknesses in the real economy and financial vulnerabilities will rapidly feed each other in a vicious cycle. Even if the reduction of excessive monetary accommodation in developed economies is slow or deferred, the fundamental fragilities of emerging markets – the current account deficits, inadequate investment returns and high debt levels- will prove problematic.
Capital withdrawals will cause currency weakness, which, in turn, will drive falls in asset prices, such as bonds, stocks and property. Decreased availability of finance and higher funding costs will increase pressure on over-extended borrowers, triggering banking problems which feed back into the real economy. Credit rating and investment downgrades will extend the cycle through repeated iterations.
Policy responses will compound the problems.
Central bank currency purchases, money market intervention or capital controls will reduce reserves or accelerate capital outflow. Higher interest rates to support the currency and counter imported inflation will reduce growth, exacerbating the problems of high debt. India, Indonesia, Thailand, Brazil, Peru and Turkey have implemented some of these measures.
A weaker currency will affect prices of staples, food, cooking oil and gasoline. Subsidies to lower prices will weaken public finances. Support of the financial system and the broader economy will pressure government balance sheets.
The ‘this time it’s different’ crowd argue that critical vulnerabilities -fixed exchange rates, low foreign exchange reserves, foreign currency debt- have been addressed, avoiding the risk of the familiar emerging market death spiral. This is an overly optimistic view. Structural changes may slow the onset of the crisis. But real economy and financial weaknesses mean that the risks are high.
While local currency debt has increased, levels of unhedged foreign currency debt are significant. Where the debt is denominated in local currency, foreign ownership is significant, especially in Malaysia, Indonesia, Mexico, Poland, Turkey and South Africa. Currency weakness will cause foreign investors to exit increasing borrowing costs and decreasing funding availability.
Fundamental weaknesses and a weak external environment limit policy options. The IMF’s capacity to assist is constrained because of concurrent crises, especially in Europe.
At the annual central bankers meeting at Jackson Hole in August 2013, Western policy makers denied the role of developed economies in the problems now facing emerging markets, arguing that the policies had ‘benefitted’ emerging markets. But developed economies now face serious economic blowback.
Since 2008, emerging markets have contributed around 60-70% of global economic growth. A slowdown will rapidly affect developed economies. Demand for exports which have boosted economic activity will decrease. Earnings of multi-national businesses will fall as earnings from overseas operations decline. Investment losses will affect pension funds, investment managers and individual investors. Loans and trading losses will affect international banks active in emerging markets.
Emerging markets have around US$7.4 trillion in foreign exchange reserves, invested primarily in US, Japanese, European and UK government securities. If emerging market central banks move to sell holding to support their weak currencies or the domestic economy, then the sharp rise in interest rates will attenuate the increase resulting from the reduction of monetary stimulus. This will result in immediate large losses to holders. It will also increase financial stress, adversely affecting the fragile recovery in developed economies.
Emerging market currency weakness is driving a rise in major currencies, such as the US dollar. This will erode improvements in cost structures and competitiveness engineered through currency devaluation by low interest rates and quantitative easing. The higher dollar would truncate any nascent recovery.
Over time, the destabilising effect of national actions and complex policy cross currents may accelerate the move to closed economies, damaging the global growth prospects.
In reality, developed economies sought to export more than goods and services, shifting the burden of adjustment necessitated by the 2008 crisis onto emerging economies. Like a drowning man grabbing another barely able to swim, the policies may ensure that both drown together.
© 2013 Satyajit Das
Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money