Emerging markets displace Europe as fulcrum of world risk
By Ambrose Evans-Pritchard
8:17PM BST 05 Jun 2013
There is a wicked double edge to the emerging-market boom that has so enthralled us for the past decade. The economies of these rising powers are by now big enough to shake the entire world if they come off the rails.
The US hedge fund Long Term Capital Management was caught $100bn (£65bn) short as bond spreads surged in Club Med, and equities plunged. The threat of a chain reaction was serious enough to force emergency rate cuts by the Fed. The crisis abated.
Indeed we do. My fear is that a China-led BRICS shock will transmit a wave of deflation across the planet, pushing the West over the edge into another downward leg of trade depression.
The eurozone polity cannot withstand such a blow. Youth unemployment is above 40pc in Italy, Spain, Portugal and Greece, and “nominal” GDP is contracting across the four countries, meaning that high debt is rising on a shrinking base.
Another twist of the deflation knife will be lethal.
America is in better shape, but it is hovering near stall speed. The ISM manufacturing gauge fell below the “boom/bust line” of 50 in May. The most draconian fiscal tightening in half a century is starting to bite.
Whether or not the EM slowdown is an inflexion point, or just a refreshing pause, is now a neuralgic issue. What we know is that manufacturing PMI indices are flirting with contraction across much of Asia, with Latin America and Africa not far behind.
China’s PMI index turned negative in May, despite 20pc credit growth in the first quarter. The extra GDP generated by each yuan of credit has dropped to a ratio of 0.17 from 0.85 four years ago. The debt cycle is exhausted.
Societe Generale’s Beijing analyst Wei Yao warns that China may be on the verge of a “Minsky Moment”, the tipping point when the debt pyramid collapses under its own weight. “The debt snowball is getting bigger and bigger, without contributing to real activity,” she said.
She claimed the debt service ratio of companies has reached a “shockingly high” 30pc of GDP – the typical threshold for financial crises. “The logical conclusion has to be that a non-negligible share of the corporate sector is not able to repay either principal or interest, which qualifies as Ponzi financing," she said.
The scale is huge. Fitch Ratings says total credit has grown from $9 trillion to $23 trillion in four years. The increase alone is equal to the US banking system.
The EM bulls retort that China and the rising powers are protected this time by $10 trillion of foreign reserves, 80pc of all sovereign gold and currency holdings. This will indeed shield them against a currency attack. There will be no exact replay of 1998, when debts were in dollars and fixed exchange pegs blew up.
Yet it will not protect them against the deflationary shock as the Fed withdraws global liquidity, or against their own credit busts. These reserves are a Maginot Line. If China tries to repatriate the money to prop up its own economy, it would push up the yuan, aggravating the contractionary squeeze.
Nor are dollar and euro debts trivial, though this time they are private. The IMF’s José Viñals said foreign borrowing “has been growing at a rapid pace, exposing them to currency risk and leverage”.
Standard & Poor’s said EM firms raised a record $301bn in fresh debt this year to April, up 42pc from last year.
The bearish notes are coming thick and fast. HSBC is liquidating much of its EM debt and retreating into US Treasuries, “the least bad apple in the barrel”, fearing that the global credit cycle has rolled over.
“We are out of virtually all our EM bonds. It is the end of the bull market," said Benoit Anne from Societe Generale. He is expecting “real money” investors to follow hedge funds out of the door. “When and if this kicks off, it will fuel another massive wave of correction,” he said.
Behind the fading EM story is a relentless loss of competitiveness as reform slackens and productivity growth slows. Nowhere is that clearer than in Brazil, left high and dry with a half-reformed, dirigiste economy when iron ore prices crashed. It faces stagflation, with growth of 0.9pc last year. Manufacturing output is down 3pc below its pre-Lehman peak.
The stock of foreign capital flows into emerging markets has soared from $4 trillion to $8 trillion since 2008, a big enough sum to cause global ructions if the mood turns. That has clearly begun in such countries as South Africa and Turkey, where there is a toxic mix of political risk and current account deficits above 6pc of GDP.
What has set the retreat in motion is fear that the Fed will turn off the credit spigot, draining the dollar liquidity that fuelled the booms. This is what happened under the Volcker Fed in the early 1980s, triggering the Latin American crisis.
You might well ask why the Fed’s Ben Bernanke would “taper” monthly bond purchases (QE) if there is such a risk of global deflation. But the Fed can be insular at times and is clearly having to pick between poisons.
The latest minutes of its Federal Advisory Council warn of an “unsustainable bubble” if QE continues, and suggest the policy is doing more harm than good in any case. The criticisms are getting under the skin of Fed insiders. Even the Boston Fed’s ultra-dove Eric Rosengren now talks of tapering soon.
Mr Bernanke will not be deterred by a shake-out on Wall Street, for that is what he wants – to curb excess and rein in moral hazard. The rest of the world can only pray that he does not push his point too far.