Tuesday, April 15, 2014

China’s Debt Vulnerability...

Author: Satyajit Das     

Western understanding of China has never greatly progressed beyond Charles de Gaulle’s statement that: “China is a big country, inhabited by many Chinese”. Despite constant analysis of developments in China in excruciating detail, economists seem to have only recently its identified debt problems. In fact, the country has had a 35-year addiction to cheap credit.
Quantum Without Solace…
Since the 2007/2008 global financial crisis (“GFC”), China has experienced strong credit growth.
The crisis and the resulting rare synchronous recessions in the developed world exposed China’s economy, especially its export sectors, to a large external demand shock, slowing growth.  Beijing deployed massive resources to restore growth to counter the economic and social impact of the slowdown.
In late 2008, China announced a fiscal stimulus package of Renminbi 4 trillion (about $600 billion) over 2 years, a budget deficit of around 2.2% of Gross Domestic Product (“GDP”). The modest fiscal measures  were augmented by a significant expansion in credit (known as TSF (total social financing) covering a mix of loans, bonds, bills and even some equity financing) via the large policy banks, which are majority government owned and controlled.
Post GFC, new lending by Chinese banks has been consistently around 30% or more of GDP. Around 90% of this lending was directed towards investment in building, plant, machinery and infrastructure, especially by State Owned Enterprises (“SOE”). According to the World Bank, almost all of China’s growth since 2008 has come from “government influenced expenditure”.
This expansion led to a rapid increase in the level of debt. Due to unreliable data and measurement problems, the exact level of debt remains unclear. Most estimates now put Chinese government (including local governments), corporate and household debt at around 200-250% of GDP, up from around 140-150% in 2008.
According to a 2013 report from China’s National Audit Office (“NAO”), Chinese government debt, including local government debt is around 55% of GDP (around US$5 trillion), an increase of around 60% from 2010.
The NAO argues that this figure includes around US$ 1.6 trillion of contingencies (debts of government owned financing vehicles) of which the government in the worst case would only have to cover a small portion (say 20%). This would reduce the actual public debt to around 39% of GDP.
Official Chinese government debt figure may not be complete, as it may exclude debts from local governments and central departments outside the Finance Ministry. It may also exclude debt of large state owned enterprises, state-owned policy banks and special purpose asset-management companies that hold nonperforming loans purchased from state-owned commercial banks, which all trade on the basis of an explicit or implicit government support. For example, China’s Railways has debt of US$270 billion, which may not include, despite the fact it is run by a central government ministry.
If these items are included, then China’s government debt including contingent liabilities would be higher, perhaps 90% of GDP.
There has been a parallel increase in private sector debt. Business and household debt levels have reached around 150-170% of GDP, a large increase from around 100-115% in 2008. Corporate debt has increased sharply, approaching 150% of GDP. Historically, Chinese governments have supported many large, strategically important or politically well-connected private corporations meaning that some corporate borrowing may end up as public debts.
Traditionally considered compulsive savers, Chinese household have increased borrowing levels from around 20-30% to 40-50% of GDP. Household debt has been driven by inflation. Sharply higher home prices require greater borrowings. The devaluation of purchasing power encourages debt fuelled consumption.
In a little more than 5 years, total credit in China has expanded from around US$9-10 trillion to US$20-25 trillion, effectively replicating the entire US commercial banking system.
Beijing City Limits…
There is now belated concern about the sustainability of Chinese debt. Analysts’ behaviour recalls George Eliot in Middlemarch: “We are all humiliated by the sudden discovery of a fact which has existed very comfortably and perhaps been staring at us in private while we have been making up our world entirely without it.
Whilst high, China’s debt level is lower than developed economies, allowing government officials to claim that it is at a “safe level”. But developed economies may not be an appropriate benchmark as generally emerging nations, like China, have lower debt capacity reflecting shallower and less developed financial markets which are in the early stages of “financial deepening”.
If all debt is included then the China overall debt is high, especially when benchmarked against comparable emerging markets. Many Asian emerging markets had lower debt and higher per capita GDP prior to the Asian monetary crisis of 1997/ 1998. Interestingly, China has similar debt levels but lower per capita income as Japan prior to the collapse of its bubble economy in the late 1980s.
Private sector debt levels are lower than that in developed markets such as the US or UK (200% of GDP) but is much higher than the 50-80% levels common in emerging markets. Household debt remain well below personal debt levels in the US or Europe (above 100% of GDP) but are increasing.
Corporate debt levels are above developed countries (averaging around 90% of GDP) and well above those of firms in other emerging markets (less than 100% in Brazil, around 80% in India and 60% in Russia).
The high debt levels are exacerbated by an inverted debt structure (described by Michael Pettis in his book The Volatility Machine). In emerging nations, when the economy slows debt levels, both direct and contingent, increase rapidly.
In addition to the absolute levels, the rapid rate of increase in debt is also concerning. There are a number of empirical measures.
An increase in debt of around 30% of GDP in 5 or less years is regarded as problematic. Several economies – Japan in the late 1980s, South Korea in the 1990s, the US and UK in the early 200s – experienced such rapid growth in credit resulting in serious financial crises. China has experienced a similar expansion in debt. Such consistent above trend increases in borrowing levels have historically provided early warning of problems.
Another measure is the credit gap – the difference between increases in private sector credit growth and economic output. Research studies have found that 33 countries with credit gaps experienced a subsequent rapid slowdown in growth, typically by at least 50%. In China, the credit gap since 2008 is over 70% of GDP.
Chinese credit intensity (the amount of debt needed to create additional economic activity) has increased. China now need around US$3-5 to generate US$1 of additional economic growth, although some economists put it even higher at US$6-8. This is an increase from the US$1-2 need for each dollar of growth 8-10 years ago. The increased credit intensity reflects the use of funds.
Debt can be used to finance investment, consumption or on assets that already exist. Consumption or investment contributes to economic activity. Purchase of existing assets does not add directly to economic activity.
In China, debt has primarily financed investment but increasingly to fund purchases of existing assets. Chinese data measures two different types of investment – gross fixed capital formation measures investment in new physical assets which contributes to GDP and fixed-asset investment measures spending on already existing assets including land. In 2008, gross fixed capital formation and fixed interest investment were roughly equal. Today, gross fixed capital formation has fallen to about 70% of fixed-asset investment, consistent with increasing turnover of already existing assets at frequently rising prices.
Investment in new assets is heavily focused on frequently large scale infrastructure and property. The major concern is that many of the projects will not generate sufficient income to service or repay the borrowing used to finance the investment.
Stories, some apocryphal, abound about wasteful expenditure. Significant investment in politically driven super-fast trains, new airports and express roads is likely to prove unproductive. Excessive investment has created significant over capacity in many heavy industries, such as steel.
China has also benefitted from a large expansion in residential construction in recent years, resulting in a glut of properties. Official data estimates that unfinished housing stock is equivalent in value to more than 20% of GDP. The most infamous is the “ghost city” of the Kangbashi district of Ordos in Inner Mongolia, which at one stage had apartments to shelter a million persons, about four times its current population.
But other less obvious but equally troubling examples are available. The city of Tiajin, about a half hour by high-speed train southeast of Beijing, has invested more than US$160 billion in an effort to create a financial centre. The amount spent is almost three times the amount spent on China’s Three Gorges Dam, one of China’s costliest projects. Changde, a city of 6 million in Hunan province in Southern China, has raised more than US$130 million in debt to finance amongst other things an international marathon course, following the 2008 Beijing Olympics.
Increased debt fuelled investment in dubious projects reflects the need of ambitious government officials, especially in the provinces and at the municipal level, to meet centrally set growth targets. As Yuan Zhou, then mayor of Guiyang, capital of the south-western province of Guizhou, stated in a radio interview in 2011: “We need to struggle for GDP. Only with higher GDP will people’s lives be improved.”
The increased level of debt and the often uneconomic projects financed has led to increasing concern as to whether the debt can be serviced.
A 2012 Bank of International Settlements (“BIS”) research paper on national debt servicing ratios (“DSR”) found that a measure above 20-25% frequently indicated heightened risk of a financial crisis. Using the BIS, analysts have estimated that China’s DSR may be around 30% of GDP (around 11% goes to interest payment and the rest to repaying principal), which is dangerously high.
The debt problems are compounded by other factors. A large portion of the debt is secured over land and property, whose values are dependent of the continued supply of credit and strong economic growth.
A high proportion of debt may be short term, with around 50% of loans being for 1 year, requiring refinancing at the start of each year. As few Chinese borrowers have sufficient operating cash flow to repay loans, new borrowings are needed to service old ones.
Around one-third of new debt is used to repay or extend the maturity of existing debt. With a significant proportion of new debt needed to merely repay existing debt the amount of borrowing needs to constantly increase to maintain economic growth. The process is not seamless and the requirement for regular refinancing exacerbates the risk of financial problems.
The concern is that debt fuelled investment has created economic growth but in the medium to long term will result in rising bad debts and financial problems.
Economist Hyman Minsky identified three phases of finance during periods of prosperity, with financial structures become progressively more risky. Hedge financing is where income flows can meet principal and interest on debt used as finance. Speculative financing is where income flows cover interest payments but not principal, requiring debt to be continually refinanced. Ponzi finance is where income flows cover neither principal nor interest repayments, with the borrower relying on increasing asset values to service debt.
China observers now worry about whether the high absolute levels of debt, rapid increases in borrowing, increasing credit intensity, servicing problems and the quality or value of underlying collateral are likely to result in a financial and economic crisis – a Minsky Moment.
© 2014 Satyajit Das
Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money
- See more at: http://www.economonitor.com/blog/2014/04/chinas-debt-vulnerability/?utm_source=contactology&utm_medium=email&utm_campaign=EconoMonitor%20Highlights%3A%20A%20Coiled%20Spring#sthash.bGynLwhX.dpuf

Tuesday, February 25, 2014

The European Debt Crisis: Karlsruhe & Quantum Physics...

Satyajit Das

Interpreting the Karlsruhe based German Constitutional Court’s February 2014 ruling on the legality of the OMT (“Outright Monetary Transactions”) program requires knowledge of German, Germany’s basic law and (a little) quantum physics. Whatever the interpretation, its potential effect on the evolution of Europe’s debt crisis is being underestimated.
Don’t Know BUT!
Announced in 2012, the OMT would theoretically allow the European Central Bank (“ECB”) to make unlimited purchases of government bonds issued by Euro-Zone members under specified conditions, providing funding and lowering borrowing costs. In conjunction with the austerity plan to reduce budget deficits and public debt and the banking union, the OMT has underpinned the relative stability of European financial markets over the last 18 months.
Prompted by a petition filed by 37,000 Germans, the Constitutional Court reviewed the OMT’s legal status. Following several months of consideration and often heated hearings, the court did not decide the matter, referring it to the European Court of Justice (“ECJ”) in Luxembourg.
The court ruling was by a 6-2 majority. The two dissenters ruled that the suit should be dismissed on the grounds that it was outside the court’s jurisdiction.
The court requested that the ECJ clarify several issues: the legality of the conditions of the OMT, the absence of any limit on purchases, the ECB’s ability to selectively purchase bonds of only some members, the lack of consideration of the credit quality of the bonds, the ability to purchase in the primary market, the need to hold the bonds to maturity and the interaction between the OMT and other ECB and European Union (“EU”) programs.
But the Court also stated that the OMT may be incompatible with German basic law. It found that the program exceeds the ECB’s limited monetary policy mandate, infringes upon member states and also circumvents the prohibition of monetary financing of Euro-Zone members. The Court found that the program was an act of economic policy, beyond the powers of the ECB.
Interestingly, the German court announced that it would rule separately in March 2014 on the European Stability Mechanism (“ESM”), the fund set up to aid distressed Euro-Zone members.
Endless Possibilities
The referral creates an intriguing set of potential outcomes.
If the ECJ agrees with the court that the program is illegal, then the ECB program cannot be implemented.
The ECJ may agree with the German court that it is not legal in its current form, leaving the way open for a compromise left open by Karlsruhe. This would entail a more limited OMT program with a limit on the quantity of bond purchases, protection of the ECB from loss in a debt restructuring, imposition of the same conditions applicable to ESM aid recipients to issuers benefitting from the bond purchases and no interference with market prices where possible.
If the ECJ rules that the OMT is legal in its present form, then the program would theoretically be legal under European but not German law. Should the OMT be utilised, it is not clear if the Bundesbank, the German central bank, could participate.
The way the issue would arise is clear. Potential users of the OMT have to apply for a conditional credit line from the ESM, which requires government approval. If the German government and parliaments approve the credit line, then a legal challenge is likely.
Based on its current position, the constitutional court would have to declare the program illegal under German law. But the constitutional court would then be in violation of EU treaties for not accepting the ECJ ruling. It is unclear whether this would lead to initiation of treaty infringement proceedings against Germany.
This would trigger a legal crisis, preventing Bundesbank participation in the OMT, withdrawing German support for various rescue programs or, theoretically, forcing Germany to exit the Euro and the EU itself.
Defender of the Commons
The decision has a political dimension.
The constitutional court’s decision is predicated on protecting democratic rights, establishing “legal boundaries” to the powers of the ECB mandate and strengthening “the guarantees provided by [the German] constitution“.
It reflects the court’s increasing concern that the German government, parliament and the EU may not protect German citizens from the exposure created by the ECB and various policies to rescue beleaguered Euro-Zone members. It also reflects concern about the abrogation of German voter’s rights on economic and budgetary policy.
The court is also concerned about the secretive process underlying much of this decision making. The court sought information regarding the ECB’s OMT programs but was rebuffed on the ground that details are “classified”.
Complementarity and Uncertainty
Financial markets have generally remained unmoved by the court’s ruling.
In part, this reflects the view that the OMT was never activated and may be no longer needed. It also reflects an exaggerated view of the powers of the ECB. One banker dismissed the court as “the crimson-robed weirdos in Karlsruhe”.
But if the European debt problems re-emerge, then the court’s decision may restrict the ability of the ECB to act.
European politicians, especially those favouring ECB intervention, and non-German central bankers are also frustrated by the constitutional court. They believe the authority for the OMT lies properly with parliament, government or the central banks. With the European Parliament elections due in May 2014, they also fear that the decision will strengthen the political position of Euro sceptics, making future intervention in support of weaker member nations more difficult.
In physics, the Complementarity Principle, suggested in 1928 by Danish physicist Niels Bohr, posits that the behaviour of phenomena, such as light, exhibits both wave and particle properties at the quantum level. Suggested by Bohr’s pupil Werner Heisenberg, the related Uncertainty Principle states that it is impossible to exactly measure simultaneous values of the position and momentum of a physical system. These quantities are calculable with characteristic ‘uncertainty’.
Complementarity and Uncertainty define the ultimate limitations of physical property and actions.
The Court’s decision embraces Complementarity. OMT proponents claim that it supports the ability of the ECB to undertake OMT program. Opponents claim that it actually prevents the ECB from engaging in such purchases. The decision also fits with the Uncertainty principle as its effects are impossible to quantify, other than in a probabilistic manner.
Whatever happens, the debate about the scope of the ECB’s powers, which underpins the Euro and the fate of many deeply indebted European countries, has not been settled. It highlights the unstable confluence of politics, finance and law that lies at the heart of the Euro-Zone crisis.
© 2014 Satyajit Das
Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money
- See more at: http://www.economonitor.com/blog/2014/02/the-european-debt-crisis-karlsruhe-quantum-physics/?utm_source=contactology&utm_medium=email&utm_campaign=EconoMonitor%20Highlights%3A%20The%20Winter%20of%20Our%20Discontent#sthash.6tQxvcnL.dpuf

Tuesday, January 14, 2014

The Next Industrial Revolution...

50 Years of Warnings About the Next Industrial Revolution. Are We Ready?

Summary:  Today we look at three early predictions about the 3rd Industrial Revolution, now upon us. We have sufficient warning (and the experience from the first two industrial revolutions), and should be able to navigate through it without massive suffering — to a prosperous future. This is the latest in a long series about what might be the major economic event of the 21st century (links to earlier posts at the end).
On September 23 {William the Conqueror’s} fleet hove in sight, and all came safely to anchor in Pevensey Bay. There was no opposition to the landing. The local fyrd had been called out this year 4 times already to watch the coast, and having, in true English style, come to the conclusion that the danger was past because it had not yet arrived had gone back to their homes.
— From History of the English Speaking People by Winston Churchill
Danger, Construction AheadThere is a safe path to the future.
“Danger, Construction Ahead” by Kay Sage (1940)
  1. Preparing by closing our eyes
  2. James Blish: science fiction warning
  3. Jeremy Rifkin’s bleak forecast warns us
  4. David Noble looks at the politics of the 3rd industrial revolution
  5. For More Information
(1)  Preparing by closing our eyes
As our world has grown richer and our technology more powerful, our ability to anticipate troubles increases. Yet that’s so only if we make the effort to do so.  Too often we fail to even try. Extreme weather (i.e., hundred-year events), climate change, peak oil, and the next Industrial Revolution all show this sloth at work.
All of these are visible problems, long forecast. Yet rather than make use of this warning time, which allows gradual, careful preparation, we interpret failure of the event to arrive as evidence that it will not come.
In the past we could not well anticipate, mitigate, or avoid large-scale changes in the world. Plagues, droughts, floods were the natural course of life, often devastating regions — even destroying civilizations. Social and economic changes, like the first two Industrial Revolutions, brought greater wealth — but its poor distribution created massive suffering from pollution and poverty.
That was then, but need not be so today. We can do better. Too often in America we’re not.
Coastal cities such as New York should have defenses against typical storms like Sandy (details here), as do many of the great cities of Europe. Sea levels have been rising for thousands of years, and the world has been warming for two centuries (until roughly 1950 largely from natural causes), with obvious effects that should shape public policy.  Building cities in the desert without assured water supplies courts disaster. Developing new energy sources prepares us for Peak Oil and It’s a long list.
Too often we squander the time provided by advance warnings for the most feckless of reasons: the problems are coming but not yet arrived.
Which brings us to our issue for today: the 3rd Industrial Revolution is upon us. Below are some of the earlier forecasts of its effects during the past half-century. We have no excuse for being caught unaware, destabilizing our society and causing widespread suffering. With modest planning we should enjoy it fantastic benefits without pain. As with driving, reacting without planning might mean more pain than gain.
A Life for  the Stars
(2)  Science fiction then, but fact for the future
The effects of automation have been visible to some people many years. Such as science fiction authors An early example is in this from James Blish’s A Life for the Stars (1962, second of his Cities in Flight series):
The cab came floating down out of the sky at the intersection and maneuvered itself to rest at the curb next to them with a finicky precision.  There was, of course, nobody in it; like everything else in the world requiring an I.Q. of less than 150, it was computer-controlled.
The world-wide dominance of such machines, Chris’s father had often said, had been one of the chief contributors to the present and apparently permanent depression”  the coming of semi-intelligent machines into business and technology had created a second Industrial Revolution, in which only the most highly creative human beings, and those most fitted at administration, found themselves with any skills to sell which were worth the world’s money to buy.
(3) Jeremy Rifkin’s bleak forecast warns us to prepare
The End of Work
The End of Work by Jeremy Rifkin (1995) — From the Introduction:
The Information Age has arrived. In the years ahead, new, more sophisticated software technologies are going to bring civilization ever closer to a near-workerless world. In the agricultural, manufacturing, and service sectors, machines are quickly replacing human labor and promise an economy of near automated production by the middecades of the twenty-first century.
The wholesale substitution of machines for workers is going to force every nation to rethink the role of human beings in the social process. Redefining opportunities and responsibilities for millions of people in a society absent of mass formal employment is likely to be the single most pressing social issue of the coming century.
… We are entering a new phase in world history-one in which fewer and fewer workers will be needed to produce the goods and services for the global population. The End of Work examines the technological innovations and market-directed forces that are moving us to the edge of a near workerless world. We will explore the promises and perils of the Third Industrial Revolution and begin to address the complex problems that will accompany the transition into a post-market era.
… In the past, when new technologies have replaced workers in a given sector, new sectors have always emerged to absorb the displaced laborers. Today, all three of the traditional sectors of the economy agriculture, manufacturing, and service — are experiencing technological displacement, forcing millions onto the unemployment rolls.
The only new sector emerging is the knowledge sector, made up of a small elite of entrepreneurs, scientists, technicians, computer programmers, professionals, educators, and consultants. While this sector is growing, it is not expected to absorb more than a fraction of the hundreds of millions who will be eliminated in the next several decades in the wake of revolutionary advances in the information and communication sciences.
… The restructuring of production practices and the permanent replacement of machines for human laborers has begun to take a tragic toll on the lives of millions of workers.
(4)  Politics of the next industrial revolution
Progress Without People
Progress Without People: New Technology, Unemployment, and the Message of Resistance by David F. Noble (1995). See his Wikipedia bio. The opening chapters are from his 1983 series of articles in Democracyabout “Present Tense Technology”:
  • Part 1:  “Technology’s Politics“, Spring 1983
  • Part 2:  “Explorations”, Summer 1983
  • Part 3:  Fall 1983
The series opens with this stark warning:
“There is a war on, but only one side is armed: this is the essence of the technology question today. On the one side is private capital, scientized and subsidized, mobile and global, and now heavily armed with military spawned command, control, and communication technologies. Empowered by the second industrial revolution, capital is moving decisively now to enlarge and consolidate the social domination it secured in the first.
… Thus, with the new technology as a weapon, they steadily advance upon all remaining vestiges of worker autonomy, skill, organization, and power in the quest for more potent vehicles of investment and exploitation. And, with the new technology as their symbol, they launch a multi-media cultural offensive designed to rekindle conīŦdence in “progress.”
On the other side, those under assault hastily abandon the field for lack of an agenda, an arsenal or an army. Their own comprehension and critical abilities confounded by the cultural barrage, they take refuge in alternating strategies of appeasement and accommodation, denial and delusion, and reel in desperate disarray before this seemingly inexorable onslaught —- which is known in polite circles as “technological change.
What is it that accounts for this apparent helplessness on the part of those whose very survival, it would seem, depends upon resisting this systematic degradation of humanity into mere disposable factors of production and accumulation?
For More Information about the 3rd Industrial Revolution
These posts link to a wealth of information and speculation, helping you to prepare for what is to come.
(b) Dynamics of the robot revolution
  1. The coming big increase in structural unemployment, August 2010
  2. The coming Robotic Nation, 28 August 2010
  3. The coming of the robots, reshaping our society in ways difficult to foresee, 22 September 2010
  4. Economists grapple with the first stage of the robot revolution, September 2012
  5. The coming big inequality. Was Marx just early?, 27 November 2012
(c) First signs of the robot revolution appear
  1. The Robot Revolution arrives & the world changes, Apr 2012
  2. In Friday’s job report you’ll see early signs of the robot revolution!, 5 December 2012
  3. Krugman discovers the Robot Revolution!, 9 December 2012
  4. How do we respond to the Robot Revolution?, 11 December 2012
  5. 2012: the year people began to realize the robots are coming, 3 January 2013
  6. Journalists reporting the end of journalism as a profession, 19 March 2013
  7. The next step of computer evolution: becoming bloggers, 20 March 2013
  8. A book about one of the trends shaping the 21st century: the next industrial revolution (robots), 29 December 2013
  9. The promise and peril of automation, 6 January 2014
  10. Looking at America’s future: economic stagnation, or will computers take our jobs?, 7 January 2014
- See more at: http://www.economonitor.com/blog/2014/01/50-years-of-warnings-about-the-next-industrial-revolution-are-we-ready/?utm_source=contactology&utm_medium=email&utm_campaign=EconoMonitor%20Highlights%3A%20Growth%20Isn%27t%20Getting%20the%20Job%20Done#sthash.k66zGF8Q.dpuf

Tuesday, October 01, 2013

The Return of the Emerging Market Crisis...

Author: Satyajit Das

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.
Real BRICs…
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. Apparently, the infantile CRIB was rejected in favour of the solid constructivist BRIC.
Subsequently expanded to BRICS to include South Africa as the original grouping lacked an African member, the acronym became a symbol of the perceived rise of emerging nations and their increased economic power. The underlying logic and mathematics were vague, beyond the usual marketing platitudes about population size, large land area and resources.
In reality, the growth of the BRICS and other emerging markets was driven by: the low starting point or base of development, unutilised workforce, cheap labour, low cost structures (because of minimal regulation and lack of environmental controls), (in some cases) commodity wealth, high domestic savings and favourabledemographics.
In the 1990s and early 2000s, strong debt fuelled growth in developed economies, such as the US and Europe, was catalytic in driving emerging markets. Strong demand for exports combined with relocation and outsourcing of production to low cost emerging markets drove growth.
A rapidly growing China emerged as a major market for commodities, boosting resource rich emerging countries. Smaller emerging economies, especially in Asia, became integrated into new global manufacturing supply chains centred on China. As author David Rothkopf wrote in Foreign Policy: “Without China, the BRICs are just the BRI, a bland, soft cheese that is primarily known for the wine that goes with it“.
A self-fulfilling virtuous cycle drove emerging market growth, improving living standards at least for some of citizens.
The 2007/ 2008 global financial crisis marked an end to this phase of development. Slowing economic growth in developed economies 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.
Unreal BRICs…
The credit driven revival of emerging economies entailed domestic credit expansion, directed by governments to finance investment and consumption growth. This was augmented by foreign capital inflows, driven by the perceived superior economic fundamentals of emerging markets.
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 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 borrowings and speculative investment. Asset prices, particularly real estate prices, increased sharply.
The effect of capital inflows was exacerbated by the relative size of the investment and local financial markets. A 1% increase in portfolio allocation by US pension funds and insurers equates to around $500 billion, much larger than the capacity of emerging markets to absorb easily.
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 favour 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 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 3 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.
As a result the romance with the BRICs has fallen to BIITS (the acronym coined to describe the current most vulnerable emerging markets – Brazil, India, Indonesia, Turkey and South Africa).
Cheap Money, Expensive Problems…
Debt levels in emerging markets have risen significantly, with total credit growth since 2008 in the range 10-30% depending on country. Credit growth has been especially strong in Asia. Total debt to Gross Domestic Product (“GDP”) above 150-200% of GDP is now common. Credit intensity has also increased sharply. New credit needed to generate each extra dollar of GDP has doubled to around US$4-8 for each dollar of GDP growth.
Bank credit has increased rapidly and is above the levels of 1997 (as percentage of GDP) in most countries.  There has also been rapid growth in debt securities issued by emerging market borrowers, in both local and foreign currencies.
Borrowing varies between sectors, depending on country. Consumer credit has grown strongly in many Asian countries and also in Brazil. Consumer debt in Malaysia and Thailand has increased to around 80% cent of GDP, up sharply from levels in 2007. Economic growth is strongly linked to growth in consumer credit. Higher borrowing by lower-income households adds vulnerability. In Thailand, debt payments are equivalent to over 33% of income, roughly double that in the US before the 2008 financial crisis.
Borrowing by corporations also varies. Many corporations in China, South Korea, India and Brazil are highly leveraged. Combined gross debts at India’s biggest ten industrial conglomerates having risen 15% in the past year to US$102 billion. Many borrowers are over-extended with inadequate cash flow to meet interest and principal payments, especially in a weak economic environment.
Growth in local debt markets means that companies can borrow in local currency, reducing currency risk. Nevertheless, emerging market borrowers have significant hard currency debt, attracted by very low coupons. Brazil has US$287 billion of outstanding dollar loans (12% of GDP). Turkey has outstanding dollar loans of around US$172 billion (22% of GDP). India has outstanding foreign debt of around 20% of GDP.
With notable exceptions like China and India, government debt levels are not high. However, state involvement in banks and industry mean that effective level of government obligations is higher than stated.
Sustainable levels of public debt are lower for emerging market countries, given lower per capita income and wealth. Emerging nations also characterized by an ‘inverted debt structure’ (a term attributed to Michael Pettis in his book The Volatility Machine); sovereign borrowing levels increase rapidly when the economy encounters problems.
Bad Banking…
Banks and investors with exposure to emerging markets are at significant risk. Borrowing has been used, worryingly, to finance consumption, investment in infrastructure projects with uncertain rates of return or speculation.
With around US$ 20 trillion of all governments bonds (around 48% of outstandings) yielding less than or around 1%, bond investors have supported increasingly marginal emerging market borrowers, under-pricing risk.
A 10 year US$ 400 million bond issue by the African state of Rwanda with a coupon of 6.875% was nine to ten times oversubscribed. The funds raised (around 5% of GDP) were intended to finance a convention centre in Kigali, Rwanda. Panama issued 40 year bonds at 4.3%, a remarkable result given that US Treasury bonds have only traded below the coupon level for 10% of history. Honduras was able to issue 10 year bonds to raise US$500 million despite the fact that its faces significant difficulties in meeting its obligations.
In many emerging countries, quasi-government bank officials have financed projects sponsored by politically connected businesses and elites. Lending practices have been weak, helping finance expensive property and grand vanity projects with dubious economics.
Many borrowers will struggle to repay the debt.  Losses are currently hidden by an officially sanctioned policy of restructuring potential non-performing loans. Bad and restructured loans at Indian state banks have reached around 12% of total assets, doubling in the past four years. In Brazil, the solvency problems of former billionaire Eike Batista and his various businesses will result in large losses to lenders as well the state owned Brazilian development bank.
Trouble Abroad…
Short term foreign capital inflows have financed external accounts, masking underlying imbalances.
The current account surplus of emerging market countries has fallen to 1% of combined GDP, from around 5% in 2006. The deterioration is greater, as large trade surpluses of China and energy exporters distort the overall result. The falls reflect slow growth in export markets, lower commodity prices, higher food and energy import costs and domestic consumption driven by excessive credit growth.
India, Brazil, South Africa and Turkey have large current account deficits, which must be financed overseas. India has a current account deficit of around 6-7% and a budget deficit (Federal and State government) approaching 10% which requires funding. Countries dependent on commodity exports are also vulnerable, given the fall in prices and anaemic global economic growth.
Emerging countries require around US$1.5 trillion per annum in external funding to meet financing needs, including maturing debt. A deteriorating financing environment combined with falling currency reserves, reduced cover for imports and short term borrowings, declining currencies and diminished economic prospects have increased their vulnerability.
Trouble at Home…
The difficult external environment has highlighted long standing structural weaknesses.
Investors fear that many emerging markets may be caught in a middle income trap, where countries experience a sharp slowdown in economic growth when GDP per capita reaches around $15,000.
Emerging economics remain highly linked to developed economies, through trade, need for development capital and the investment of foreign exchange reserves, totalling in excess of US$7.5 trillion. Weak growth in developed markets and decreasing credit quality of developed country sovereign bonds may adversely affect emerging markets. Emerging countries have also lost competitiveness, as a result of rising costs, especially labour.
Investors are concerned about mal and mis investment. Trophy projects, such as the 2008
Beijing Olympics (costing US$40 billion), Russia’s 2014 Sochi Winter Olympics (US$51 billion) and Brazil’s 2014 football World Cup and 2016 Olympics, have absorbed scarce resources at the expense of essential infrastructure.
Income inequality, corruption, hostile and difficult business environments, excessive concentration of economic power in heavily subsidized state corporations and political rigidities increasingly compound the problems of debt and capital outflows. Political instability exacerbates economic problems, for example in Brazil, Turkey, South Africa and India.
These concerns have resulted in a new acronym for the more vulnerable emerging markets – BIITS (Brazil, India, Indonesia, Turkey, South Africa). It seems the BRICS are now falling to BIITS!
Moment of Truth…
Battle weary policy makers do not want to believe that an emerging market crisis is possible. Like former US Secretary of State Henry Kissinger, they believe that: “There cannot be a crisis next week. My schedule is already full.
But there are striking resemblances to the 1990s. Then, loose monetary policies pursued by the US Federal Reserve and the Bank of Japan led to large capital inflows into emerging markets, especially Asia. In 1994, Federal Reserve Chairman Alan Greenspan withdrew liquidity, resulting in a doubling of US interest rates over 12 months.
In the 1994 ‘Great Bond Massacre’, holders of US Treasury bonds suffered losses of around US$600 billion. Trading losses led to the bankruptcy of Orange County in California, the effective closure of Kidder Peabody and failures of many investment funds. It triggered emerging market crisis in Mexico and Latin America. It precipitated the Asian monetary crisis, requiring International Monetary Fund (“IMF”) bailouts for Indonesia, South Korea and Thailand. Asia took over a decade to recover from the economic losses.
Many now fear a re-run, triggered by rapid capital outflows and a rising US dollar. The basic trajectory is familiar – old ways are frequently the best way.
Weaknesses in the real economy and financial vulnerabilities will rapidly feed each other in a vicious cycle. Even if the reduction of excessive monetary accommodation in developed economies is slow or deferred, the fundamental fragilities of emerging markets – the current account deficits, inadequate investment returns and high debt levels- will prove problematic.
Capital withdrawals will cause currency weakness, which, in turn, will drive falls in asset prices, such as bonds, stocks and property. Decreased availability of finance and higher funding costs will increase pressure on over-extended borrowers, triggering banking problems which feed back into the real economy. Credit rating and investment downgrades will extend the cycle through repeated iterations.
Policy responses will compound the problems.
Central bank currency purchases, money market intervention or capital controls will reduce reserves or accelerate capital outflow. Higher interest rates to support the currency and counter imported inflation will reduce growth, exacerbating the problems of high debt. India, Indonesia, Thailand, Brazil, Peru and Turkey have implemented some of these measures.
A weaker currency will affect prices of staples, food, cooking oil and gasoline. Subsidies to lower prices will weaken public finances. Support of the financial system and the broader economy will pressure government balance sheets.
The ‘this time it’s different’ crowd argue that critical vulnerabilities -fixed exchange rates, low foreign exchange reserves, foreign currency debt- have been addressed, avoiding the risk of the familiar emerging market death spiral. This is an overly optimistic view. Structural changes may slow the onset of the crisis. But real economy and financial weaknesses mean that the risks are high.
While local currency debt has increased, levels of unhedged foreign currency debt are significant. Where the debt is denominated in local currency, foreign ownership is significant, especially in Malaysia, Indonesia, Mexico, Poland, Turkey and South Africa. Currency weakness will cause foreign investors to exit increasing borrowing costs and decreasing funding availability.
Fundamental weaknesses and a weak external environment limit policy options. The IMF’s capacity to assist is constrained because of concurrent crises, especially in Europe.
Economic Blowback…
At the annual central bankers meeting at Jackson Hole in August 2013, Western policy makers denied the role of developed economies in the problems now facing emerging markets, arguing that the policies had ‘benefitted’ emerging markets. But developed economies now face serious economic blowback.
Since 2008, emerging markets have contributed around 60-70% of global economic growth. A slowdown will rapidly affect developed economies. Demand for exports which have boosted economic activity will decrease. Earnings of multi-national businesses will fall as earnings from overseas operations decline. Investment losses will affect pension funds, investment managers and individual investors. Loans and trading losses will affect international banks active in emerging markets.
Emerging markets have around US$7.4 trillion in foreign exchange reserves, invested primarily in US, Japanese, European and UK government securities. If emerging market central banks move to sell holding to support their weak currencies or the domestic economy, then the sharp rise in interest rates will attenuate the increase resulting from the reduction of monetary stimulus. This will result in immediate large losses to holders. It will also increase financial stress, adversely affecting the fragile recovery in developed economies.
Emerging market currency weakness is driving a rise in major currencies, such as the US dollar. This will erode improvements in cost structures and competitiveness engineered through currency devaluation by low interest rates and quantitative easing. The higher dollar would truncate any nascent recovery.
Over time, the destabilising effect of national actions and complex policy cross currents may accelerate the move to closed economies, damaging the global growth prospects.
In reality, developed economies sought to export more than goods and services, shifting the burden of adjustment necessitated by the 2008 crisis onto emerging economies. Like a drowning man grabbing another barely able to swim, the policies may ensure that both drown together.
© 2013 Satyajit Das
Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money
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