posted June 11, 2018
Emerging Markets’ Perfect Storm’

(Selections from Chapter 3 of ‘Systemic Fragility in the Global Economy’ on Emerging Markets in Crisis. Read my blogpiece, ‘South America’s ‘Made in the USA’ Growing Crisis’ for the update)

“Internal Forces Causing EME Instability

Notwithstanding who is ultimately responsible for the rapid deterioration of EMEs today, it is important to note that the various external causes of that deterioration have set in motion additional internal forces that further exacerbate the EME decline and that, in part, are also the consequence of policy choices made by the EMEs themselves.

In attempting to confront the economic dislocations caused by the external forces, EMEs have had to choose between a number of highly unattractive trade-offs: raising domestic interest rates to slow capital flight, spending their minimal foreign currency reserves to keep their currency from falling, cutting government spending to try to reduce inflation from rising imports; lowering their currency exchange rate in order to compete on exports with AE countries doing the same; and so on. All these choices, however, result in short term and temporary solutions to the external caused forces. The choices almost always lead to a further deterioration of EMEs’ real economy and deepening financial instability.

EME Capital Flight

Capital outflow has multiple negative effects on an economy. First, it means less money available for real investment that would otherwise boost the country’s GDP, create jobs, and produce incomes for workers for consumption. Capital flight also discourages foreign investors from sending their money capital ‘in’ as well. So as capital flight flows out, often capital inflow simultaneously slows or declines. Both produce a double negative effect on money capital available for domestic investment in the EME. More outflow plus slowing inflow also means less purchases of EME stock by investors as they take their money and run. Falling equity values discourage money in-flow still further. A downward spiral thus ensues between capital flight, less investment, a slowing economy, and slowing or declining stock prices.

The scope and magnitude of the capital flight is revealed by recent trends in the EMEs. Net capital inflows for the EMEs were mostly positive prior to the 2008-09 crash, starting at $200 billion in 2002 and rising thereafter. During the 2008-09 crisis, however, there were EME outflows of $545 billion. Starting in late 2009, as the EMEs boomed and benefited from the redirection of the massive liquidity injections by the AE central banks and the concurrent China commodity demand surge, net capital inflows to the EMEs rose rapidly once again. Roughly $2.2 trillion in capital flowed into the EMEs from June 2009 to June 2014.

But that inflow all began to reverse, slowly at first but then at a faster rate, beginning with the ‘taper tantrum’ of 2013 when the Federal Reserve signaled its intention to raise interest rates. EME capital outflow began, but it was temporary, as the Federal Reserve soon backed off in response to the EMEs’ ‘tantrum’. Capital flight resumed again in January 2014 when the Federal Reserve signaled once more its intent to raise US rates. EMEs panicked but net inflows returned as the Fed back-pedaled a second time. But it was to be the last time for the Fed to do so.

By mid-2014, EME net outflows and capital flight resumed with a vengeance, as Chinese growth slowed faster, oil deflation set in, QE currency wars intensified, US interest long term rates starting drifting upward in expectation of Fed policy, and EME real economies and currencies began to slow rapidly. The corner had been turned so far as EME capital outflow was concerned after mid-year 2014.
For example, from July 2014 through March 2015, the 19 largest EMEs experienced net capital flight of no less than $992 billion, or almost $1 trillion in just nine months. And that was only the largest 19. The $992 billion, the most recent available data, represents an outflow of more than twice that occurring during a similar nine month period from July 2008 through March 2009, when a $545 billion net outflow occurred. So the capital flight crisis for the EMEs is twice as serious as during the 2008-09 crash. Not only does the $992 billion represent only the 19 largest EMEs, but the nearly $1 trillion pre-dates the China stock market collapse that began in June 2015 and China’s shift to a devaluation of its currency policy the following August. Therefore, the third and fourth quarters of 2015 will likely show that EME capital flight will exceed the preceding nine months’ $992 billion. A trillion more in capital flight could easily occur in just the second half of 2015. That will mean the five years of accumulated $2.2 trillion inflow will be reversed in just 18 months. That magnitude and rate of capital flight and outflow suggests, in and by itself, a massive economic contraction may be soon forthcoming in the EMEs in 2016 and beyond.

EME Currency Collapse

Currency decline is directly associated with capital flight. The greater the rate of flight, the greater the rate of decline, or collapse. That’s because capital flight requires investors in the country to convert the country’s currency into the currency of another country to which they intend to send the money capital. That involves selling the EME’s currency, which increases its supply and therefore lowers the price of that currency, i.e. its exchange rate. And when many investors are selling an EME currency, it also means a drop in demand for the currency that further depresses its price.

There have been three phases of EME currency decline since 2013. The first during the 2013 ‘taper tantrum’. The second commenced mid-2014 with the collapse of global oil prices and the growing awareness China’s was slowing. The third phase began the summer of 2015, as China’s stock markets collapsed and it subsequently devalued its currency, the yuan. The stock market crash in China quickly set off a wave of similar stock contractions throughout the EMEs. Investors sought to pull their money out and send it to the AEs, as both a haven and in anticipation of better returns. More EME money capital was converted to dollars, pounds, euros and yen, sending those currencies’ values higher (and thus pushing EME currencies still lower).

As an indication of the magnitude of the impact of capital flight and currency conversion on EME currencies, the J.P. Morgan EME Currency Index fell by 30% from its peak in 2011 by July 2015, virtually all of that in the past year, 2014-2015. An equivalent index for Latin America compiled by Bloomberg and J.P. Morgan revealed a more than 40% decline in currency values for that region’s EMEs during the same period.

In just the first eight months of 2015, January-August, some of the largest EME currencies have fallen by more than 20%, including those of Brazil, South Africa, Turkey, Columbia, Malaysia, while others like South Africa, Mexico, Thailand, Indonesia and others dropped by more than 10%.

In yet another vicious cycle, the collapse of currency exchange rates for EMEs causes an even greater momentum in capital flight. No investors, foreign or domestic, want to hold currencies that are falling rapidly in value and expected to decline further. They take their losses, take their money capital out of the country, convert to currencies that are rising (US dollar, UK pound, and even the Euro or yen) and speculate that price appreciation will provide handsome capital gains in the new currencies. Currency decline thus has the added negative effect of provoking a vicious cycle of capital flight-currency decline-capital flight.

One would think that declining currency values would stimulate export sales. But only in a static world. In a dynamic world of ever-changing forces and economic indicators, declining currencies for different EMEs that are occurring in tandem mean a race to the bottom for all. No country gets a competitive export advantage by currency devaluation for long, before it is ‘leap frogged’ by another doing the same, negating that advantage.

In addition, the advantages to economic growth from expanding exports might also be easily offset by declining real investment due to accelerating capital flight, rising domestic interest rates implemented by governments in desperate efforts to try to stem the capital outflow, falling stock market prices associated with the net capital outflows, and slowing domestic consumption for various reasons. The latter developments typically overwhelm the very temporary relative advantages to exports gained from declining currency exchange rates—as has happened, and continues to happen, in the case of the EMEs post-2013.

Domestic Inflation

Currency decline has the added negative effect of directly impacting domestic consumption by contributing to import inflation. When a currency declines, the cost of imported goods goes up. And if imports make up a significant proportion of the EMEs’ total goods consumed, then EME domestic inflation rises. Many EMEs in fact import heavily from the AEs, for both consumer goods and semi-finished goods that they then re-manufacture for consumption or re-export for sale. If consumer inflation is significant, it means less real consumption and therefore slower EME growth; and if producer goods import inflation is significant, it means rising costs of production, less production and again, less EME growth.

Capital flight due to currency decline also contributes to inflation, albeit in a manner different from import inflation due to currency decline. Import inflation affects consumption, whereas capital flight works through investment. More capital outflow translates into less investment, which means less productivity gains, higher production costs and cost inflation. In short, currency decline, capital flight, and EME inflation all exacerbate each other, and combine to have significant negative effects on EME real growth. It starts with currency decline, which accelerates capital flight and reduces investment and also contributes to inflation which slows real consumption as well.

The decline in China that reduced global commodities demand, the deflation in commodities that followed, the subsequent currency decline and capital flight, and the eventual imports-goods inflation together reduced consumption, real investment and economic growth. These elements all began to converge in the EMEs by mid-2014. After mid-2014 additional developments exacerbated these negative trends further—including the global oil deflation, growing prospects of US interest rate increases, intensifying currency wars, and the unwinding of Chinese and EME stock markets.

The multiple challenges faced by EMEs from these developments, intensified and expanded in the second half of 2014 and after, forcing the EMEs into a general no-win scenario. They have responded variously. Brazil, South Africa and a few other EMEs have raised their domestic interest rates to slow capital flight and attract foreign capital to continue to invest, although that choice has slowed their domestic economies more. Another option, using their foreign currency reserves on hand, accumulated during the 2010-2013 boom, to now buy their currencies in open markets to offset their decline, works only to the extent they accumulated foreign reserves during the 2010-13 period. Many EMEs did not. And those who had accumulated have been depleting them fast. Similarly unpromising, they can try to reduce their currency’s value by various means, in order to compete for the shrinking pie of global exports. That means participating in the intensifying global currency war ‘race to the bottom’, in a fight they cannot win against the likes of China, US, Japan and others with massive reserves war chests. What the oil producing EMEs have done in response to the growing contradictions with which they are confronted is to just lower the price of their crude in order to keep generating a flow of income upon which their government and economy is dependent. Others face the prospect of simply trying to borrow from AE banks, at ever higher and more undesirable terms and rates, in order to refinance their growing real debt.

While the EMEs enjoyed a robust recovery from 2010 to 2013, thereby avoiding the stagnation, slow growth, and recessions experienced by the AEs during the period, now the roles after 2013 were being reversed. AE policies began creating massive money capital outflows from the EMEs, slowing their growth sharply, causing financial instability, and leaving EMEs with a set of choices in response that promised more of the same. The case example of Brazil that follows reflects many of the ‘hobson’s choices’ among which the EMEs have been forced to choose, as well as the negative consequences they pose for EME economic growth and financial instability.

Brazil: Canary in the EME Coalmine?

No country reflects the condition and fate of EMEs better than Brazil. It’s a major exporter of both commodity and manufactured goods. It’s also recently become a player in the oil production ranks of EMEs. Its biggest trading partner is China, to which it sells commodities of all types—soybeans, iron ore, beef, oil and more. Its exports to China grew fivefold from 2002 to 2014. It is part of the five nation ‘BRICS’ group with significant south-south trading with South Africa, India, Russia, as well as China. It also trades in significant volume with Europe, as well as the US. It is an agricultural powerhouse, a resource and commodity producer of major global weight, and it receives large sums of money capital inflows from AEs.

In 2010, as the EMEs boomed, Brazil’s growth in GDP terms expanded at a 7.6% annual rate. It had a trade surplus of exports over imports of $20 billion. China may have been the source of much of Brazil’s demand, but US and EU central banks’ massive liquidity injections financed the investment and expansion of production that made possible Brazil’s increased output that it sold to China and other economies. It was China demand but US credit and Brazil debt-financed expansion as well—a s is the case of virtually all the major EMEs. That then began to shift around 2013-14, as both Chinese demand began to slow and US-UK money inflows declined and began to reverse. By 2014 Brazil’s GDP had already declined to a mere 0.1%, compared to the average of 4% for the preceding four years.

In 2015 Brazil entered a recession, with GDP falling -0.7% in the first quarter and -1.9% in the second. The second half of 2015 will undoubtedly prove much worse, resulting in what the Brazilian press is already calling ‘the worst recession since the Great Depression of the 1930s’.

Capital flight has been continuing through the first seven months of 2015, averaging $5-$6 billion a month in outflow from the country. In the second half of 2014 it was even higher. The slowing of the capital outflow has been the result of Brazil sharply raising its domestic interest rates—one of the few EMEs so far having taken that drastic action—in order to attract capital or prevent its fleeing. Brazilian domestic interest rates have risen to 14.25%, among the highest of the EMEs. That choice to give priority to attracting foreign investment has come at a major price, however, thrusting Brazil’s economy quickly into a deep recession. The choice did not stop the capital outflow, just slowed it. But it did bring Brazil’s economy to a virtual halt. The outcome is a clear warning to EMEs that solutions that target soliciting foreign money capital are likely to prove disastrous. The forces pulling money capital out of the EMEs are just too large in the current situation. The liquidity is going to flow back to the AEs and there’s no stopping it. Raising rates, as Brazil has, will only deliver a solution that’s worse than the problem.

Nor did that choice to raise rates to try to slow capital outflow stop the decline in Brazil’s currency, the Real, which has fallen 37% in the past year. A currency decline of that dimension should, in theory, stimulate a country’s exports. But it hasn’t, for the various reasons previously noted: in current conditions a currency decline’s positive effects on export growth is more than offset by other negative effects associated with currency volatility and capital flight.

What the Real’s freefall of 37% has done, however, is to sharply raise import goods inflation and the general inflation rate. Brazil’s inflation remained more or less steady in the 6%-6.5% range for much of 2013 and even fell to 5.9% in January 2015, but it has accelerated in 2015 to 9.6% at last estimate.

With nearly 10% inflation thus far in 2015 and with unemployment almost doubling, from a January 4.4% to 8.3% at latest estimate for July, Brazil has become mired in a swamp of stagflation—i.e. rising unemployment and rising inflation. Brazil’s central bank estimated in September 2015 that the country’s economy would shrink -2.7% for the year, the deepest decline in 25 years. With more than 500,000 workers laid off in just the first half of 2015, it is not surprising that social and political unrest has been rising fast in Brazil.

The near future may be even more unstable. Like many EMEs, Brazil during the boom period borrowed the liquidity offered by the AEs bankers and investors (made available by AE central banks to their bankers at virtually zero interest) to finance the expansion. That’s both government and private sector borrowing and thus debt. Brazil’s government debt as a percent of GDP surged in just 18 months from 53% to 63%. The deteriorating government debt situation resulted in Standard & Poor’s lowering Brazil government debt to ‘junk’ status.

More important, private sector debt is now 70% of GDP, up from 30% in 2003. Much of that debt is ‘junk bond’ or ‘high yield’ debt borrowed at high interest rates and dollar denominated—i.e. borrowed from US investors and their shadow and commercial banks and therefore payable back in dollars—, to be obtained from export sales to US customers, which are slowing. An idea of the poor quality of this debt is indicated by the fact that monthly interest payments for Brazilian private sector companies is already estimated to absorb 31% of their income.

With falling income from exports, with money capital fleeing the country and becoming inaccessible, and with ever higher interest necessary to refinance the debt when it comes due—Brazil’s private sector is extremely ‘financial fragile’. How fragile may soon be determined. Reportedly Brazil’s nonfinancial corporations have $50 billion in bonds that need to be refinanced just next year, 2016. And with export and income declining, foreign capital increasingly unavailable, and interest rates as 14.25%, one wonders how Brazil will get that $50 billion refinanced? If the private sector cannot roll over those debts successfully, then far worse is yet to come in 2016 as companies default on their private sector debt.

Brazil’s monetary policy response has been to raise interest rates, which has slowed its economy sharply. Brazil’s fiscal policy response has been no less counter-productive than its monetary policy. Its fiscal response has been to cut government spending and budgets by $25 billion—i.e. to institute an austerity policy, which again will only slow its real economy even further.

The lessons of Brazil are the lessons of the EMEs in general, as they face a deepening crisis, a crisis that originated not in the EMEs but first in the AEs and then in China. But policies which attempt to stop the capital flight train that has already left the station and won’t be coming back’ will fail. So too will competing for exports in a race to the bottom with the AEs. Japan and Europe are intent on driving down their currencies in order to obtain a slightly higher share of the shrinking global trade pie. The EMEs do not have the currency reserves or other resources to outlast them in a tit-for-tat currency war. Instead of trying to rely on somehow reversing AE money capital flows or on exports to AE markets as the way to recovery and growth, EMEs will have to try to find a way to mutually expand their economic relationships and forge new institutions among and between themselves as a ‘new model’ of EME growth. They did not ‘break the old EME model’; it was broken for them. And they cannot restore it since the AEs have decided to abandon it.

EME Financial Fragility & Instability

Instability in financial asset markets matter. It is not just a consequence of conditions and events in the real, non-financial sector of the economy. Anyone who doubts that should recall that it was the collapse of shadow banks, derivatives, and housing finance practices that not only precipitated the crash of 2008-09, but also played a big role in causing the more rapid and deeper real economy contraction that followed. Financial asset markets have also played a major role in the stop-go, sub normal recovery of the AEs since 2009. Financial assets and markets will play no less a role in the next crash and greater contraction that is forthcoming.

Other examples prior to 2008-09 provide further evidence of the importance of financial forces in real economic contractions. The dot.com tech bust of 2001 and the recession that followed were the result of financial asset speculation. The 1997-98 ‘Asian Meltdown’ crisis was fundamentally about currency speculation. Japan’s crash in 1990-91, prior recessions in the US in 1990, the US stock market crash of 1987, junk bonds and housing crises in the 1980s, the northern Europe banking crisis of the early 1990s—all had a major element of financial instability associated with them. So finance matters.

Declining equity markets are a signal of problems in the real economy, of course. They are also a source that can exacerbate those problems. For example, China’s stock bubble implosion of 2015 is contributing to the further slowing of real investment in China and to the major capital flight now exiting that economy. The capital flight will in turn cause more instability in global currency markets and accelerate financial asset prices in property and other asset markets in the UK, US, Australia and so forth. The China equity market collapse has had, and will continue to have, depressing effects on stock markets elsewhere in the world. The major stock index for emerging markets, the MSCI Index, has declined more than 30% from its highs. Stock markets of major economies like Brazil, Indonesia, and others have all fallen by 20% and more in just the first seven months of 2015. Financial asset deflation is occurring not only in oil commodity futures, but in global equity prices as well.

Falling stock values also mean that corporations may be denied an important source of income—i.e. equity finance—with which to make payments on corporate debt. One of the major characteristics throughout the EMEs is that many of EME corporations have borrowed heavily during the boom and now must continue to make payments on what is now to a large extent ‘junk’ or high yield debt, and high yield debt also borrowed in dollars, from their various sources of income. But raising money capital by means of stock issuing or stock selling is extremely difficult when stock prices are plummeting.

As its currency exchange rate falls for an EME, it means whatever income a company has available now ‘pays less’ of the debt—effectively, the company’s real debt has risen. Rising real debt is therefore an indicator of growing financial fragility as well—there is declining income with which to pay the debt. Falling currency may also make it more difficult for a company to refinance its debt, or force it to do so at an even more expense interest rates. That too reflects growing financial fragility.

Still another financial market is the oil futures market, especially for those EMEs who are dependent on oil production and sales. Oil is not just a product. It is a financial asset as well. And when the price of that financial asset collapses, the income of the oil producer EME also collapses in many cases. Expectations of future oil prices determine current oil prices, regardless of actual supply and demand in the present. So the more prices fall the more professional speculators may drive the deflation further. Creating a global oil commodities trading market has had the result of introducing more financial instability into the global market for oil. Income from oil production may thus be impacted significantly and negatively by financial asset price movements.

Finally, the EMEs are clearly highly unstable with regard to bond markets—both sovereign or government bonds as well as corporate bonds. And in many EMEs much of the corporate debt (and some government debt as in Africa) is denominated in dollars and therefore must be repaid in dollars. As the aforementioned McKinsey Consultant study shows, one half of all the increase in global debt since 2007 has occurred in EMEs and the lion’s share of that has been in private corporate debt. From 2010 to mid-2015 more than $2 trillion in EME bonds have been issued in dollars, with another $4 trillion plus issued in local EME currencies. Asian Bond debt is 113% of Asian economies’ combined GDP, a record high, according to the J.P. Morgan EMBI+ bond index. As more EMEs attempt to address their crisis by raising domestic interest rates, as Brazil and now South Africa have done, that will drive bond prices down dramatically. A general bond price collapse will make stock market declines pale in comparison as to the consequences for global economic stability. And if corporations in the EMEs can’t refinance their mountain of debt at rates they can pay given their declining sources of income, then a wave of corporate defaults will rock the EME and global economy.

Dr. Jack Rasmus
Excerpt Chapter 3, Systemic Fragility in the Global Economy, Clarity Press, January 2016
copyright 2015

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