Like most diseases, emerging market crises follow well-known paths. The current problems have been building for more than a decade and, in some respects, longer.
The rise of emerging markets has dominated recent history. They constitute 49 percent of current global GDP and have contributed 67 percent of growth over the decade to 2021. They also account for nearly 45 percent of global exports. This has been pivotal in lifting more than a billion people out of poverty and improving the lives of many more.
Underlying this are several interlocking factors. Over the last decades, advanced economies shifted production to emerging markets. The self-serving aim was to lower costs, by accessing cheaper labour but also circumventing domestic environmental, work safety and other regulations.
Since 2008/9, low, zero, or even negative interest rates (in the case of Japan and Europe) and extraordinary monetary expansion in developed nations created excess liquidity which flowed into emerging markets. Investor motivation, unsurprisingly, was additional return and better investment opportunities.
The rapid growth of China into the factory of the world created supply chains of inputs running through other emerging markets for raw materials and components. Through its Bricks and Roads Initiative (BRI), originally known as the New Silk Road, China also became a significant supplier of capital to some emerging markets.
The process created a virtuous and self-sustaining cycle of emerging market growth. As economies prospered, improved living standards drove consumption, investment and greater tax revenues allowing further expansion. Advanced economies found new markets in the rapidly growing emerging markets, where purchasing power increased. Modest deregulation and domestic initiatives also boosted emerging markets' activity.
There were individual differences. Nations rich in commodities expanded production. Some concentrated on low-cost production, others on services (IT exports in the case of India and business process outsourcing for English-fluent jurisdictions). Populous Asia benefitted from remittances sent home by nationals working in foreign countries.
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Over time, the position of individual developing countries shifted. As living standards and wages rose in one location, factories and plants shifted to cheaper sites; plants moved from China to Mexico, Vietnam, Bangladesh or Haiti. Moving through the stages of development, nations sought to upskill into more advanced products and services.
… and Fall
These factors are now reversing. Focus on sovereignty, security and the backlash against migration of jobs overseas has created a new climate that will see retrenchment of the aggressive globalisation of the last few decades. The move to re-, near- or friend-shoring will diminish opportunities for many emerging nations.
At the same time, developed countries are belatedly withdrawing monetary stimulus, increasing interest rates and tightening money supply. These actions reduce the availability of capital and increase its cost affecting growth in emerging markets. The sharp increase in US dollar interest rates is, in part, driving instability in currency markets. Given large dollar borrowings by borrowers in developing countries, the combined effect of higher interest expense and currency losses compound the pressure.
China faces several challenges: disruptions from its zero-Covid policy, the unwinding of a large property debt bubble and a trade war with the US. A Chinese slowdown reduces demand globally; for example, the Middle Kingdom consumes 50 percent or more of global production of many commodities. It also decreases foreign investment into many countries.
These pressures are exacerbated by stagnant growth of advanced economies and global inflation pressures, which have especially affected food and energy prices. Climate change induced extreme weather events and geopolitical factors add to the stresses.
The identified external shocks may trigger a crisis, ruthlessly exploiting underlying weakness.
Traditional emerging markets' economic problems typically include budget and external account deficits. Financial vulnerabilities entail high levels of debt, especially short-term foreign currency borrowings, a weak banking system, and inadequate currency reserves. Structural shortcomings include narrowly based industrial structures, overreliance on few exports, skill and infrastructure constraints, institutional shortcomings, corruption as well as poor leadership. Today, a survey of emerging markets shows that many countries exhibit familiar susceptibilities.
Out of current total global debt of over US$300 trillion, emerging markets debt is over US$90 trillion (approaching 250 percent of GDP), up from US$21 trillion (145 percent) in 2007 and US$63 trillion (210 percent of GDP) in 2017. Around 80 percent of recent total worldwide debt increases were in emerging markets, primarily in China.
The average ratio of emerging markets' public debt to GDP rose to a record 67 percent in 2021, up from 52 percent before the Pandemic. Many advanced economies, such as Japan and the US, have higher levels of government borrowing but their economic base and repayment capacity is stronger. Borrowings by non-financial corporations and households have gone up sharply. While much of this credit expansion is domestic, emerging markets foreign currency debt (primarily denominated in dollars) has doubled in absolute terms since 2008.
India's debt levels are high and likely to increase. Government debt-to-GDP ratio is currently around 90 percent. Non-government non-financial debt is over 80 percent of GDP, with business debt at around 50 percent and household debt at around 35 percent. India has foreign currency borrowing equivalent to around 20 percent of GDP.
High twin deficits (budget deficit and current account deficit as percentage of GDP) are a sign of economic deterioration. In June 2022, Fitch Ratings forecast that more than a quarter of emerging markets will experience budget and current account deficits of at least 4 percent of GDP in 2022, reflecting higher budget deficits caused by the Covid-19 pandemic and larger current account deficits from rising energy and food prices. India is currently running budget deficits of around 7 percent. The current account deficit is around 1 percent.
Other familiar failings are also evident. Structural problems such as over-reliance on one activity (tourism) or one market (China) are apparent. There is over-investment in Ozymandias-like projects unlikely to ever generate adequate returns, extension of credit and contracts to favoured cronies, generous subsidies and handing out public money to buy votes and friends. Naturally, there are profligate ideologically based monuments and initiatives to feed monstrous political egos.
On the other hand, there is a failure to invest in health, education, transport and other infrastructure to expand the growth potential of economies.
External shocks trigger emerging markets crises which then progress through continuous and accelerating feedback loops. Central to this process are currency weakness and changes in capital flows.
Emerging market currencies have fallen by around 10 percent since the start of 2022. Eastern European currencies, the Turkish Lira and Argentine Peso have fallen by more. Asian currencies, including the Rupee (which has fallen by around 6 percent to record lows), have experienced smaller but significant declines.
Reduced economic activity and declining growth and earnings drive a fall in asset prices, such as bonds, stocks and property. This is accompanied by currency devaluation which, in turn, leads to capital withdrawals. Decreased availability of finance and higher funding costs further reduces growth. It also increases pressure on over-extended borrowers, triggering banking problems that feed back into the real economy. Credit rating and investment downgrades extend the cycle through repeated iterations.
Policy options are limited. Public balance sheets are over-stretched because of pandemic-related health costs and related expenditure to support the economy. Higher interest rates to support the currency may be ineffective and risk worsening the slowdown. Lower interest rates pressure the currency and import inflation reducing growth and aggravate problems of servicing debt denominated in foreign currency.
There are other inter-relationships. With its larger footprint and complex trade and financial linkages, if risks stemming from emerging markets materialize, then advanced economies, especially Europe and Japan, would be adversely affected which would feed back the other way.
Problems in one developing country tend to quickly affect other emerging markets, irrespective of their specific circumstances. Advanced economies' investors frequently see emerging markets as a single investment asset class, often insufficiently distinguishing between nations, which they struggle to locate on maps.
This problem has been accentuated by the shift to direct investments which broadly track emerging markets equity and debt indexes. Investors, with uncertain staying capacity, are now 'index tourists', purchasing diversified portfolios to replicate emerging markets without detailed analysis of individual securities.
Recent speculation that India would be added to JP Morgan’s widely used emerging-market bond index boosted the price of debt as inclusion would lead to billions of dollars (an estimated $ 30 billion of passive investor inflows) flowing into the country’s domestic market. But these investors may exit upon discovering their exposures from media headlines. Redemptions, downgrades and market value changes force funds to liquidate to raise cash.
The increased tendency for emerging markets to borrow directly from investors, via the issuance of bonds, alters risks. Unlike banks who tend to hold exposures to term, investors may react to unrealised, mark-to-market value changes. This creates the ‘common lender channel' phenomenon, where investors simultaneously withdraw or refuse to provide new capital to all emerging markets.
Currently, losses for emerging markets investors are increasing. Serial defaulter Argentina is once more in trouble. Sri Lanka has defaulted. Some are being forced to restructure their debt. Others are slipping slowly towards a point of no return. Investors are pricing in around US$130 billion in losses on Chinese property developers' overseas debt with two-thirds of the more than 500 outstanding dollar bonds issued by Chinese developers now trading below 70 cents on the dollar. These losses have led to a diminution of access to markets for all emerging markets borrowers.
In the words of Mexico's Treasury Secretary José Angel Gurría describing the effect of the 1998 Russian default: "Ninety percent of Mexicans have never heard of the Duma, and yet the exchange rate and interest rates that they live with every day were being driven by people with names like Kiriyenko and Chernomydrin and Primakov."
Pathogens identify and attack individuals with compromised immune systems, mutating and spreading through populations. In a similar manner, exogenous economic and financial shocks seek out vulnerable nations and work their way through others in the cohort. Even the prudently managed risk being affected by economic conditions elsewhere.
The risk of a widespread emerging markets crisis is perhaps greater today than probably at any time since the Asian Monetary crisis and Russian default of the late nineties. There are echoes of the 1980s Latin American debt problems when higher oil prices and interest rates triggered problems. Such a crisis would reverse hard-won, generational gains for many nations and their citizens.
Second part | No way back for emerging markets now, India may at best muddle through
Satyajit Das is a former banker and author of numerous works on derivatives and several general titles: Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006 and 2010), Extreme Money: The Masters of the Universe and the Cult of Risk (2011), A Banquet of Consequences RELOADED (2021) and Fortune’s Fool: Australia’s Choices (2022). His columns have appeared in the Financial Times, Bloomberg,WSJ Marketwatch, The Guardian, The Independent,Nikkei Asia and other publications. This is part of the web-only series of columns on newindianexpress.com.
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