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The Problem of Debt

Sameer Massis, MSc., CIM, CFA

The global economy might be springing back to life, but debt looks set to be a major problem for emerging economies.  

Even as the global financial crisis finally passes into the history books, a peculiar dichotomy remains. If stock markets around the world are back to full health, then why do many individual economies remain so fragile? The strength of an economy is often reflected in the strength of its currency. The latest currency victim is India −an emerging market heavyweight with a $1.9 trillion GDP– which saw the value of its rupee dive by nearly 20 percent since May. Should other emerging economies be worried, or will India be a one-off victim?

It might be hard to remember now, but the financial crisis began in 2008 with the collapse of the Lehman Brothers in the United States. This sent shudders around the global economy, with a concomitant swift collapse of the commodities prices. In reaction to the global meltdown, the U.S. lowered their interest rates to historical lows at the near-zero, and initiated a three-part money printing process called quantitative easing. We’re now in the third phase, Q3, which involves a series of $85 billion monthly purchases that have helped boost the general stock market and economic confidence. Since Q3 was dubbed “quantitative easing to infinity,” the market seemed hooked on this artificial support which also helped boost corporate profits. Thus, when outgoing Federal Chairman Ben Bernanke announced back in May the possibility of tapering, the market was only shaken over weeks, and quickly regained its strength in months as economic optimism remained abound. Even though US economic GDP growth haven’t returned to its normal post-World War II average of 3 to 3.5 percent, there are clear signs of economic recovery:  US national house prices are up nearly 16 percent from the post-bubble low; the percentage of underwater residential mortgages has decreased to 14.5 percent from a peak of 26 percent; unemployment stands at 7.3 percent; and the stock market has hit a multi-year high.

Following the US Federal Reserve, other developed nations also orchestrated their own versions of quantitative easing, the latest of which was Japan’s relatively large $78-billion-a-month economic stimulation program. This was an essential part of the growth-focused initiatives dubbed “Abenomics,” which helped boost the Japanese stock market to a 38 percent rise on a year-to-date basis as of mid-September. The main price of this was a concomitant fall of the Japanese yen by 22 percent over the same period.

Even in Europe, positive economic signs have become more apparent as the core economies of Europe –the UK, Germany, France, Sweden, and Switzerland– are showing signs of a nascent economic recovery, with an average of growth of 2 percent in the second quarter of this year compared to the same quarter in 2012.

This was reflected in the currency markets as both the euro and US dollar index remained mostly in positive territory during this year, while the Chinese yuan continued its steady strengthening. In contrast, it was a different story for the currencies of other emerging markets.


Emerging Market Currencies

In general, emerging economies benefited over the past few years from the flow of investments which took advantage of their export driven economies. However, hardly any emerging economy took this opportunity to undertake adequate reforms that moves away from the old model of a leveraged and export-driven economy, towards a more disciplined and locally-driven economy. Thus, since highly indebted countries meant a higher risk of default, investors were quick to exit countries such as Brazil, Indonesia, and India when the US Federal Reserve hinted at tapering back in May. Why? Because as the United States initiates its taper, it would be expected that the 10-year Treasury Bonds would be less in demand, so rates would increase, and the US dollar would continue to strengthen as investors would convert their currencies to the dollar.

One main measure of country risk is a consideration of the twin deficits, trade and fiscal. Among emerging economies, India stands out as being in worst shape. India has a current account deficit of 6 percent of GDP, and net government borrowing of 8 percent of GDP. Add to this that India’s debt is nearing 60 percent of its GDP, so it was not surprising that investors initiated a quick exit from the country back in May. India’s currency was not alone in this, as it had joined Indonesia’s rupiah, and Brazil’s real in a spate of tough economic times for developing countries with large account deficits. However, whereas Brazil and Indonesia were able to slow down the fall of their currencies by raising interest rates, India couldn’t afford to do the same to slow down the outflow of capital. Now that Fed Chairman Ben Bernanke surprised the market last month by delaying the tapering, more volatility is likely to continue in the emerging currency markets as the market tries to second guess timing of this pivotal move.

A Fragile Recovery

Before the crash, global economic growth was led in a large part by China’s demand for commodities, which drove up prices to the benefit of the countries that exported them. Suffice to say that China remains the world’s largest commodities buyer, as it consumes in excess of 60 percent of the world’s iron ore, 42 percent of the world’s copper, and 47 percent of the world’s coal. The Chinese stronger than expected industrial output reinforced other signs that China’s economy was stabilizing after slowing for the previous two years. With its own factory output recently hitting a 17-month high, and a fast pace of retail sales growth during the summer, China stands stronger than the other emerging economies when the US Federal Reserve tapering takes full throttle. In fact, Deutsche Bank raised its most recent forecast on China’s GDP to 7.9 percent for Q3, and 8.0 percent for Q4 of 2013. Other global investment banks were equally upbeat in their views on China’s economy, and optimistic on advanced reforms expected to be launched in the upcoming party meeting next month in November.

However, it seems different this time that China is unlikely to lead a global recovery as it is more likely to be held back by the other emerging economies. As the chief economist of the Organization for Economic Developmen, Pier Carlo Padoan, stated recently to Reuters: “The bottom line is that advanced economies are growing more and emerging economies are growing less.”

What remains disconcerting is what the Bank for International Settlements just said in its latest quarterly review. It said credit to emerging markets had reached the “highest level on record.” On a consolidated basis, credit provided by foreign banks’ offices in emerging markets had increased to $2.4 trillion. It’s these local companies in emerging countries that risk the most as they stand to repay their foreign loans with a devalued emerging country currency.

Copyright © 2016 Sameer Massis

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