The average cycle time between financial crashes is ten years. A decade is about as long as it takes for bad debts to be purged, for financial risk-taking to swing from appetite to aversion and back to appetite again. In other words, the world is about due for some trouble. The only question – usually – is where the epicentre will be. But that’s easy: it will be in the emerging economies.
For most tastes it may seem a little soon for another financial meltdown, given that the last financial meltdown is still playing out in the developed economies in the form of depressed growth just about everywhere (only the US and the UK are growing at anywhere near trend). But the fact is that the last one and the next one are connected. A post-crisis combination of policy and circumstances led to an ocean of money flowing into the emerging economies, stoking the biggest investment boom in history, and setting up the global economy for its next crash.
An investment boom in the world’s poorer economies may sound like an entirely good thing, but it’s not. Investment always overshoots, and this boom in corporate and industrial investment had overshoot written all over it right from the start.
Consider: the last financial crash left the rich world with low growth and low investment returns. The policy response was to cut real interest rates to nothing (which spelled more low returns), and to create liquidity through ‘quantitative easing’ (essentially the creation of money on central bank balance sheets). The quantitative money did what hot money always does and went looking for high return, and seemed to find it in emerging economy investment. Some of that investment was simply wasted, as happens with boom money. Some of it went to build productive capacity for global demand that – it is becoming increasingly clear – does not really exist. In short, the policy response to a weak economy provoked a round of investment that could only be profitable in a strong economy. Now that the expected strong rebound of demand in the developed world has not happened, it is easy to see how this ends badly.
The size of the investment boom can be seen in the private borrowing of emerging economy companies. According to the IMF’s latest Financial Stability Report, corporate borrowing in the bigger emerging economies grew from $4 trillion in 2004 to $18 trillion by the end of last year. Almost two thirds of that borrowing is in one country, China. Most of it is in bank loans, although the proportion in traded corporate bonds has been growing. The borrowing ratio (measured by the proportion of debt to total equity) has been rising in most sectors, but the biggest rise in indebtedness has been in construction – roads, bridges, and above all residential real estate.
Borrowing is not a bad thing when there is demand to support it. Unfortunately, demand is weak, and over the last two quarters most forecasters have been consistently reducing their expectations for both developed and emerging economies, but especially for emerging economies. Yet it remains likely that the exceptional US will feel the need to raise interest rates soon, quite possibly before the end of this year, and the exceptional UK will follow. And that is the what could provide the catalyst for an emerging economy crunch.
When US interest rates go up (or when it is merely expected they will go up), people buy dollars. The value of the dollar against other currencies – especially emerging economy currencies – tends to rise. Suddenly all that emerging economy corporate borrowing comes under pressure. Even if the borrowing is not denominated in dollars (probably around half of all emerging economy corporate debt is in dollars or euros), the shift of capital out of the emerging world and back into suddenly more attractive currencies of the developed world puts emerging companies under financial stress, making it more expensive to raise new capital or ‘roll over’ existing debt. The IMF points out that when in 2013 financial markets got a fright about the winding down of US quantitative easing stimulus – the so-called ‘taper tantrum’ which hammered equity prices and kicked up corporate lending rates in emerging markets – the effect was just as negative for supposedly safer local currency bonds as for exposed foreign currency borrowing.
One may well ask, why should we in the industrialised West worry too much about some companies in places like Asia or Africa and Latin America going bust? These are private corporate borrowers who chose the risks they took, and ought to bear the consequences. Plus, it’s all a long way away.
Actually, it’s not. The transmission of financial stress around the world is astonishingly rapid. Lehman Brothers collapsed on Monday September 15, 2008. By Friday of that same week the skies above Shenzhen in China were clear, for the first time in a decade or more. As the financial system froze, factories throughout Asia closed their production lines and container ports fell still and silent. Credit – or the lack of it – travels at the speed of light.
A squeeze on emerging market borrowers could turn into a global, systemic crisis in more ways than one. Demand from emerging economies will fall – further. The four BRIC economies alone now account for two fifths of global GDP: if demand from the BRICs and the rest of the emerging world falls sharply, most of the world’s growth drive will have disappeared. Failing companies and large scale financial defaults will hurt emerging economy banks; some will go to the brink, and may have to be bailed out, turning a private sector crisis into an official government crisis, which in turn will have to be bailed out by international lending. And developed economy lenders are implicated too, especially UK lenders. Last month a Bank of England report said that emerging market risks were now the biggest threat to the stability of British banks – it is believed that HSBC and Standard Chartered are particularly exposed.
An emerging market led recession is not merely a scenario – it has already happened, when the Asian financial crisis of 1999 transmuted into the stock market crash of 2000. But that time around the emerging market crisis was set against a fairly strong developed country growth. This time both sides of the emerging-developed axis are weak. This time it is more dangerous.
The worst case is that interest rate expectations – and it is always expectations that move financial markets – are handled badly, and the global slowdown that is already a reality becomes entrenched. But the worst case is avoidable – so long as governments grasp that the world is potentially entering a depressive no-growth phase. As investment pros often say, the biggest risk you have is the risk you don’t know you have. Right now, it is not clear that everyone understands the risks.