12 wilmott magazine

M ultiple Latin debt crises and the 1997/1998 Asian emerging market crisis have been for-

gotten. Now, the risk of an emerging market crisis is very real.

Real BRICs…Investors have been romancing emerging markets, exemplified by the dalliance with the BRIC econ-omies (Brazil, Russia, India, and China), a term coined by Goldman Sachs’ Jim O’Neill in 2001. Apparently, the infantile CRIB was rejected in favor 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, unutilized work-force, cheap labor, low cost structures (because of minimal regulation and lack of environmental con-

trols), (in some cases) commodity wealth, high domestic savings, and favorable demographics.

In the 1990s and early 2000s, strong debt-fu-eled 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 centered 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.

To paraphrase writer Robert Louis Stevenson, finan-cial markets have “a grand memory for forgetting”

The 2007/08 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 cred-it growth drove economic activity in China, Brazil, India, Turkey, and many economies in Asia, Latin America, and Eastern Europe.

Unreal BRICs…The credit-driven revival of emerg-ing economies entailed domestic credit expansion, directed by govern-ments to finance investment and con-sumption growth. This was augment-ed 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 liquidi-ty, sought lending opportunities in emerging markets. International investors, such as pension funds, invest-ment managers, central banks, and sovereign wealth funds, increased allocations to emerging markets.

Since 2009, in excess of US$3 trillion flowed into emerging markets.

Foreign ownership of emerging market debt increased sharply. In Asia, 30–50 percent of Indonesian rupiah government bonds, up from less than 20 percent at the end of 2008, are held by foreigners. Approximately 40 percent of the gov-ernment debt of Malaysia and the Philippines is held by foreigners.

Satyajit DasOld Ways Are the Best Ways – Emerging Market Crisis Redux

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Capital inflows drove sharp falls in emerging market borrowing costs. Brazilian dollar-denomi-nated bond yields fell from above 25 percent in 2002 to a record low of 2.5 percent in 2012. After aver-aging about 7 percent for the period 2003–2011, Turkish dollar-denominated bond yields sank to a record low of 3.17 percent in November 2012. Indonesian dollar bond yields fell to a record low of 2.84 percent. 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 finan-cial markets. A 1 percent increase in portfolio allo-cation by US pension funds and insurers equates to around US$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 percent. India’s growth is below 5 percent. Brazil's growth has slowed to near zero. Russian growth forecasts have been downgraded repeatedly to under 2 per-cent. 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 chang-ing US policy dynamics.

Improvements in American economic condi-tions have encouraged discussion about ‘tapering’ the US Federal Reserve’s liquidity support, cur-rently US$85 billion per month. US Treasury bond interest rates have increased, with the ten-year rate rising by nearly 1.00 percent per annum, in antic-ipation 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 favor

of developed economies, especially the US, there have been significant capital outflows from emerg-ing markets, resulting in sharp falls in currency values and rises in borrowing rates. In 2013, the Brazilian real has declined by around 13 percent, the Indian rupee around 15 percent, the Russian rouble around 8 percent, the Turkish lira around 10 percent, the Indonesia rupiah around 12 per-cent, the Malaysian ringgit around 7 percent, the Thai baht 4 percent, and the South African rand

around 18 percent. The falls have accelerated in the last three months.

The ability to raise debt has declined. The cost of funding has increased. Brazilian dollar-denom-inated bond yields have risen to around 5 percent, well above the lows of 2.5 percent last year. Turkish dollar-denominated bond yields have risen to nearly 6 percent from a low of 3.17 percent. Indonesian dollar bond yields are above 6.00 per-cent, up from lows of 2.84 percent.

Emerging market central banks, excluding China, have seen outflows of reserves of around US$80 billion (around 2 percent of total reserves). Over the last three months, Indonesia has lost around 14 percent of central bank reserves, Turkey has lost 13 percent, and India has lost around 6 percent.

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 are now exposing deep-seated problems, especially high debt levels, financial system problems, current and trade account deficits, and structural deficiencies.

Cheap money, expensive problems…Debt levels in emerging markets have risen sig-nificantly, with total credit growth since 2008 in

the range 10–30 percent, depending on country. Credit growth has been especially strong in Asia. Total debt to gross domestic product (GDP) above 150–200 percent 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 borrow-ers, in both local and foreign currencies.

Borrowing varies between sectors, depending on country. Consumer credit has grown strong-ly in many Asian countries and also in Brazil. Consumer debt in Malaysia and Thailand has increased to around 80 percent of GDP, up sharply from levels in 2007. Economic growth is strongly linked to growth in consumer credit. Higher bor-rowing by lower-income households adds vulnera-bility. In Thailand, debt payments are equivalent to over 33 percent 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 percent in the past year, to US$102 billion. Many borrowers are overextended, with inadequate cash flow to meet interest and prin-cipal 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,

In the last 12 months, investor concern about developments in emerging markets has increased, reflecting slowing growth and a potential reversal of capital inflows

Old Ways Are the Best Ways – Emerging Market Crisis Redux

rachel ziemba

attracted by very low coupons. Brazil has US$287 billion of outstanding dollar loans (12 percent of GDP). Turkey has outstanding dollar loans of around US$172 billion (22 percent of GDP). India has outstanding foreign debt of around 20 percent of GDP.

With notable exceptions like China and India, government debt levels are not high. However, state involvement in banks and industry mean that the effective level of government obligations is higher than stated.

Sustainable levels of public debt are lower for emerging market countries, given lower per cap-ita income and wealth. Emerging nations are also characterized by an ‘inverted debt structure’ (a term attributed to Michael Pettis in his book, The Volatility Machine); sovereign borrowing levels increase rapid-ly when the economy encounters problems.

Bad banking…Banks and investors with exposure to emerging markets are at significant risk. Borrowing has been used, worryingly, to finance consumption and investment in infrastructure projects with uncer-tain rates of return or speculation.

With around US$20 trillion of all governments bonds (around 48 percent of outstandings) yield-ing less than or around 1 percent, bond investors have supported increasingly marginal emerging market borrowers, underpricing risk.

A ten-year US$ 400 million bond issue by the African state of Rwanda with a coupon of 6.875 percent was nine to ten times oversubscribed. The funds raised (around 5 percent of GDP) were intended to finance a convention center in Kigali, Rwanda. Panama issued 40-year bonds at 4.3 per-cent, a remarkable result given that US Treasury bonds have only traded below the coupon level for 10 percent of history. Honduras was able to issue ten-year bonds to raise US$500 million, despite the fact that it faces significant difficulties in meeting its obligations.

In many emerging countries, quasi-govern-ment bank officials have financed projects spon-sored by politically connected businesses and elites. Lending practices have been weak, helping finance expensive property and grand vanity proj-ects 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 percent 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.

Trouble abroad…Short-term foreign capital inflows have financed external accounts, masking underlying imbalances.

The current account surplus of emerging mar-ket countries has fallen to 1 percent of combined GDP, from around 5 percent in 2006. The deterio-ration 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 exces-sive 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 percent and a budget deficit (Federal and State government) approaching 10 percent which requires funding. Countries depen-dent on commodity exports are also vulnerable, given the fall in prices and anemic global econom-ic 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 eco-nomic growth when GDP per capita reaches around US$15,000.

Emerging economics remain highly linked

to developed economies, through trade, need for development capital, and the investment of foreign exchange reserves, totaling 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 com-petitiveness, as a result of rising costs, especially labor.

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 dif-ficult business environments, excessive concentra-tion of economic power in heavily subsidized state corporations, and political rigidities increasingly compound the problems of debt and capital out-flows. Political instability exacerbates economic problems – for example, in Brazil, Turkey, South Africa, and India.

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 mar-kets, especially Asia. In 1994, Federal Reserve Chairman Alan Greenspan withdrew liquidity, resulting in a doubling of US interest rates over 12 months (from 3 percent to 6 percent per annum).

In the 1994 ‘Great Bond Massacre,’ holders of US Treasury bonds suffered losses of around US$600 billion. Trading losses led to the bank-ruptcy of Orange County in California, the effec-tive closure of Kidder Peabody, and failures of many investment funds. It triggered the 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

SaTyajIT DaS

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over a decade to recover from the economic losses. Many now fear a rerun, 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 econo-mies is slow or deferred, the fundamental fragil-ities of emerging markets – the current account deficits, inadequate investment returns, and high debt levels – will prove problematic.

Capital withdrawals will cause currency weak-ness, 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 overextended borrowers, triggering banking problems which feed back into the real economy. Credit rating and investment downgrades will extend the cycle through repeat-ed iterations.

Policy responses will compound the problems. Central bank currency purchases, money mar-

ket 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, exacerbat-ing the problems of high debt. India, Indonesia, Thailand, Brazil, Peru, and Turkey have imple-mented 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 curren-cy, foreign ownership is significant, especially in Malaysia, Indonesia, Mexico, Poland, Turkey, and

South Africa. Currency weakness will cause for-eign investors to exit, increasing borrowing costs and decreasing funding availability.

Fundamental weaknesses and a weak exter-nal environment limit policy options. The IMF’s capacity to assist is constrained because of concur-rent crises, especially in Europe.

Economic blowback…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 ‘benefited’ emerging markets. But developed economies now face serious eco-nomic blowback.

Since 2008, emerging markets have contrib-uted around 60–70 percent of global economic growth. A slowdown will rapidly affect developed economies. Demand for exports which have boosted economic activity will decrease. Earnings of multinational businesses will fall as earnings from overseas operations decline. Investment loss-es 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 destabilizing effect of national actions and complex policy cross-current may accelerate the move to closed economies, damag-ing 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.

For the moment at least, 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).

© 2013 Satyajit Das All Rights Reserved.

SaTyajIT DaS

Over time, the destabilizing effect of national actions and complex policy cross-current may accelerate the move to closed economies, damaging the global growth prospects

about the authorSatyajit Das is a former banker and author of Extreme Money and Traders Guns & Money.