Yves here. Our long established and finance-oriented readers will recognize the name Satyajit Das. For those new to him, Das is a well-recognized derivatives expert who wrote one of the discipline’s important early textbooks as well as popular works, notably Traders, Guns and Money and Extreme Money: Masters of the Universe and the Cult of Risk.
One of Das’ many important observations: “No money is ever really made in financial markets. Markets merely transfer wealth.”
This article give a fine if disheartening description of how decades of tailwinds propelled growth of emerging market economies, resulting in them accounting for half of global GDP. Supply chain breakages, reshoring and the pernicious interaction of high global inflation and high emerging market debt levels look set to kick off crises in many countries.
By Satyajit Das, a former financier whose latest books include A Banquet of Consequences – Reloaded (March 2021) and Fortune’s Fool: Australia’s Choices
The risk of a widespread emerging markets crisis may be greater today than at any time since the Asian Monetary crisis and Russian default of the late nineties. There are echoes of the 1980s Latin American debt problems when higher oil prices and interest rates triggered problems. Such a crisis would reverse hard-won, generational gains for many developing nations and their citizens as well as advanced economies.
Emerging markets now constitute 49 percent of global GDP and have contributed 67 percent of growth over the decade to 2021. They also account for nearly 45 percent of global exports. This has been pivotal in lifting more than a billion people out of poverty and improving the lives of many more. For advanced economies, it has provided cheap products and services as well as export opportunities
Underlying this are several factors. Over the last 30+ years, advanced economies shifted production to emerging markets to reduce costs, by accessing cheaper labour alongside access to inexpensive raw materials. In part, developed nations also circumvented domestic environmental, work safety and other regulations.
Since 2008/9, low, zero, or even negative interest rates (in the case of Japan and Europe) and extraordinary monetary expansion in developed countries created excess liquidity which flowed into emerging markets seeking additional return and better investment opportunities.
The rapid growth of China into the world’s factory created supply chains running through other emerging markets. Through its Bricks and Roads Initiative (BRI) China also became a significant supplier of capital –over $800 billion– primarily to emerging markets.
The process created a virtuous and self-sustaining cycle of emerging market growth. As economies prospered, improved living standards drove consumption, investment and greater tax revenues allowing further expansion. Advanced economies found new markets where purchasing power increased. Modest deregulation and domestic initiatives also boosted emerging markets activity.
These factors are in reversal. Focus on sovereignty, security and the backlash against migration of jobs overseas has created a new climate which will see retrenchment of the aggressive globalisation of the last few decades. The move to re-, near- or friend-shoring will diminish opportunities for some emerging nations.
At the same time, developed countries are belatedly withdrawing monetary stimulus, increasing interest rates and tightening money supply. These actions reduce the availability of capital and increase its cost affecting emerging market growth. The sharp increase in US dollar interest rates is, in part, driving instability in currency markets. The dollar has risen 14 percent since the start of 2022 reaching a 20-year high against a basket of currencies. Given large dollar borrowings by borrowers in developing countries, the combined effect of higher interest expense and currency losses compound the pressure.
China faces several challenges: disruptions from its zero-Covid policy, the unwinding of a large property debt bubble and a trade war with the US. A Chinese slowdown reduces demand globally; for example, the Middle Kingdom consumes 50 percent or more of global production of many commodities. It also decreases foreign investment into many countries.
These pressures are exacerbated by uneven growth of advanced economies and global inflation pressures, which have especially affected food and energy prices. Climate change induced extreme weather events and geopolitical factors add to the stresses.
These external development have implications for emerging markets, many of which exhibit familiar susceptibilities.
High twin deficits (budget deficit and current account deficit as percentage of GDP) indicate economic deterioration. In June 2022, Fitch Ratings forecast that more than a quarter of emerging markets will experience budget and current account deficits of at least 4 percent of GDP in 2022, reflecting higher budget deficits caused by the Covid-19 pandemic and larger current account deficits from rising energy and food prices.
Out of total global debt of over $300 trillion, emerging markets debt is over $90 trillion (approaching 250 percent of GDP), up from $21 trillion (145 percent) in 2007 and $63 trillion (210 percent of GDP) in 2017. Around 80 percent of recent total worldwide debt increases were in emerging markets, although this is distorted by China which represents a substantial portion of the increase.
The average ratio of emerging markets public debt to GDP rose to a record 67 percent in 2021, up from 52 percent before the Pandemic. Many advanced economies, such as Japan and the US, have higher levels of government borrowing but their economic base and repayment capacity is stronger.
While much of this credit expansion is domestic, external debt to GDP has increased from 23 percent in 2008 to 31 percent in 2021. Emerging markets foreign currency debt (primarily denominated in dollars) has doubled in absolute terms since 2008. There has also been a rise in private short-term debt which reached around 26 percent of total external debt in 2020, up from 16 percent two decades ago. Measures such as external debt servicing to export or government revenues have weakened, especially amongst weaker developing economies.
Other familiar failings are also evident. Structural problems such as over-reliance on one activity (tourism) or one market (China) are apparent. There is over-investment in Ozymandias-like projects unlikely to ever generate adequate returns, extension of credit and contracts to favoured cronies, generous subsidies and handing out public money to buy votes and friends. Naturally, there are profligate ideologically based monuments and initiatives to feed monstrous political egos. On the other hand, there is a failure to invest in health, education, transport and other infrastructure to expand the growth potential of economies. Corruption and weak governance have never gone away.
Central to any emerging market crisis is currency weakness and changes in capital flows.
Emerging market currencies have fallen by around 10 percent since the start of 2022. Eastern European currencies, the Turkish Lira and Argentine Peso have fallen by more. Asian currencies have experienced smaller but significant declines.
The trajectory is well-known. Reduced economic activity and declining earnings drive falls in asset prices, such as bonds, stocks and property. This is accompanied by currency devaluation which, in turn, leads to capital withdrawals. Decreased availability of finance and higher funding costs further reduces growth. It also increases pressure on over-extended borrowers, triggering banking problems which feed back into the real economy. Credit rating and investment downgrades extend the cycle through repeated iterations.
Policy options are limited. Public balance sheets are over-extended because of pandemic related health costs and related expenditure to support the economy. Higher interest rates to support the currency may be ineffective and risk worsening the slowdown. Lower interest rates pressure the currency and import inflation and aggravate problems of servicing debt denominated in foreign currency.
There are other inter-relationships. With its larger footprint and complex trade and financial linkages, if risks stemming from emerging markets materialize, then advanced economies, especially Europe and Japan, would be adversely affected. This creates new rounds of any crisis.
Problems in one developing country tend to quickly affects others, irrespective of their specific circumstances. Foreign investors frequently see emerging markets as a single investment asset class, often insufficiently distinguishing between nations which they struggle to locate on maps.
This problem has worsened due to the shift to investments which broadly track emerging markets equity and debt indexes. Investors, with uncertain staying capacity, are now ‘index tourists’, purchasing diversified portfolios to replicate emerging markets without detailed analysis of individual securities.
The changing nature of creditors has exacerbated the problem. Emerging nations increasingly borrow directly from investors, via issuance of bonds – around 51 percent of all long-tern private debt, a rise from 27 percent and 33 percent in 2000 and 2009 respectively. Unlike banks who tend to hold exposures to term, investors may react to unrealised, mark-to-market value changes.
This creates the ‘common lender channel’ phenomenon, where investors simultaneously withdraw or refuse to provide new capital to all emerging markets. This is problematic because financial markets operate under the working assumption that emerging debt will not be paid back but will need to be constantly refinanced. Around $3 trillion of emerging market debt must be rolled over before the end of 2022. In addition, around $10 trillion must be redeemed or refinanced in 2023 and 2024.
Currently, losses for emerging markets investors are increasing. As of 29 August, 2022, the IMF found 8 countries to be in debt distress, 29 countries at high risk, and 25 countries at moderate risk. Mozambique, Lebanon, Ecuador, Sri Lanka, Suriname, Belize, Russia, Ukraine, and Zambia have already defaulted.
The total amount exposed may be in the order of $250 billion. Investors are pricing in around $130 billion in losses on Chinese property developers’ overseas debt with two-thirds of the more than 500 outstanding dollar bonds issued by Chinese developers now trading below 70 cents in the dollar. These losses have led to a diminution of access to markets for all emerging markets borrowers. In the words of Mexico’s Treasury Secretary José Angel Gurría describing the effect of the 1998 Russian default: “Ninety percent of Mexicans have never heard of the Duma, and yet the exchange rate and interest rates that they live with every day were being driven by people with names like Kirilenko and Chernomyrdin and Primakov.”
Commentators assert that many vulnerabilities have been addressed. Certainly, foreign currency reserves have increased. Banking systems have theoretically been strengthened. Fixed exchange rate regimes are less common. More debt is now denominated in local currency. However, whether the measures have increased resilience is debatable.
Reserve coverage (foreign exchange reserves divided by 12-month funding needs for current account, short term debt maturities and amortisation of long term debt) measures the capacity to meet immediate foreign currency obligations.
Emerging markets reserves increased after the 1997/98 Asia monetary crisis rising from around 10 percent to above 20 percent of GDP. Part of this increase reflected the post 2008 increase in global liquidity and the easy monetary policies pursued by developed countries. Subsequently, the pace of reserve accumulation has slowed and become more volatile. Despite improvement, based on the International Monetary Fund’s analytical assessing reserve adequacy (ARA) metric, many countries still have inadequate reserves.
Even where coverage appears adequate, caution is necessary. Reserves can be rapidly reduced by changes in trade balances, capital flows and changes in market conditions, such as monetary policy actions of major economies or rapid changes in commodity, especially food and energy prices. Long term debt becomes short term with the passage of time or an acceleration event. Currency intervention can denude available funds. Reserve positions are also notoriously opaque; in 1997, the Bank of Thailand was found to have grossly overstated available currency reserves.
Reserves may not be readily accessible. A substantial portion of China’s $3 trillion of reserves is committed to the Belt and Road infrastructure initiative and may not be fully recoverable. The ability to liquefy substantial holdings of US Treasury bonds and other foreign assets is limited by liquidity, price and currency effects. US actions to seize Russian central bank assets, restrict trading in securities and exclude the country from international payment systems highlight other uncertainties.
While new regulations have sought to fortify the financial system against losses, problems remain. Emerging market banks, such as those in China and India, face well documented asset quality concerns with the true level of non-performing loans (“NPLs”) likely to be significantly higher than official reported levels. Banks in developing countries hold record levels of government debt. Deterioration in public sector finances, especially where governments are forced to step in to bail out state owned or private debtors, threatens stability. Support of the financial system and economic activity would pressure already weak public finances.
Despite reforms, enforceability of claims against emerging markets borrowers remain untested. Emerging market borrowings are frequently undertaken through offshore special purpose vehicles which then on-lend the borrowed funds to where it is needed. This limits foreign investor access to the underlying real assets or cash flows and potentially subordinates their claims.
Equity investors in Chinese companies, such as Alibaba and Baidu, do not actually own shares but have a stake in a VIE (Variable Interest Entity), which simulates ownership in the Chinese company rather than granting direct title to the underlying assets. Such structures, designed to circumvent prohibitions on foreign investment, may not be legally recognised or effective.
These issues, overlooked or accepted as simply an unavoidable part of emerging markets investing, may be exposed in any downturn with serious financial consequences.
Floating exchange rates and unrestricted foreign exchange movement are not necessarily always positive. In periods of uncertainty, they increase currency volatility and allow rapid capital flight.
Local currency debt has increased but unhedged foreign currency debt remains significant. Where the debt is denominated in the borrower’s domestic currency, foreign ownership, attracted by higher returns, is substantial. While it shifts the loss from devaluation to the investor rather than the borrower, it aggravates capital outflows. Currency weakness and resultant losses cause foreign investors to exit exacerbating currency weakness, increasing borrowing costs and decreasing funding availability.
No Way Back
Irrespective of whether an emerging markets crisis eventuates, the always flaky optimism of the BRICS era has faded.
With a debt overhang, stagnating productivity, an aging population, limited policy options and political paralysis driving economic stagnation in developed countries, emerging markets cannot rely on exports to generate growth or foreign currency income. This is compounded by trade frictions which reflect fierce geo-political and economic competition between the US and China.
For emerging markets, the path out of any crisis is difficult. Weak demand and trade barriers limit the scope for lower income countries to develop through export-oriented industries, such as textiles and manufacturing, reliant on cost advantages. Automation reduces demand for low skilled cheap labour and the cost differences between on- and off-shore production. Only about 18 percent of global goods trade is now driven by labour-cost arbitrage. The less dramatic cost advantages alongside minimising exposure to supply chain disruption, currency fluctuations and political risk make re-shoring more feasible.
Higher income emerging markets must overcome rising costs, labour shortages, infrastructure constraints, industrial shifts and growing restrictions on intellectual property transfer. Asia’s emerging markets remain heavily reliant on manufacturing are weak in services, with some exceptions such as India (ICT).
As recent experience with sanctions against Russia and China illustrate, advanced economies, led by the US, now exert power through their domination of essential technological and financial networks. Current American policy seeks to prevent other countries, primarily China, from becoming a serious technological competitor. Developing nation’s access to technology through acquisitions, partnerships, licensing arrangements or hiring foreign experts has decreased. This limits the ability of emerging markets to increase productivity and move up the value added chain.
The diminished outlook for emerging markets means that the promised improvements in employment and living standards will be harder to realise, at least for large parts of the population. For example, India needs to create around 10 million jobs each year to accommodate new entrants and urbanisation as well as reduce chronic underemployment. The struggle of many educated workers in emerging markets to get jobs consistent with their training and expectations will intensify.
Larger countries with substantial domestic markets, such as China, India, and Indonesia, or rich in resources may muddle through but will fail to reach potential or deliver on promises made to citizens. Most will remain trapped in an unending struggle to not go backwards feeding civil unrest and political and economic volatility.
The last two decades represents a tragic lost opportunity for emerging markets. Policy makers assumed that the favourable conditions would continue indefinitely. The failure reflects short-termism, poor decisions, political expediency and, above all, hubris.
© 2022 Satyajit Das All Rights Reserved
This piece draws on an earlier two–part published in the New Indian Express.