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Satyajit Das: Is an Emerging Market Crisis Coming?


Many now fear a rerun of 1994's Great Bond Massacre, which triggered emerging market crises and a 10-year setback to many Asian economies.

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.

BRICs on Credit

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.

Slowing economic growth in developed economies following the 2007/ 2008 global financial crisis 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.

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 the 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 borrowing and speculative investment. Asset prices, particularly real estate prices, increased sharply.

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 favor 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 bond yields 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 three 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.
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