posted August 14, 2018
Turkey & Emerging Markets Perfect Storm Redux

The global economy is again becoming financially fragile. Financial fragility is an indicator of increasing likelihood of the eruption of a major financial instability event–i.e. stock crash, bond market implosion, housing-commercial property price deflation, sovereign debt defaults, etc. In Chapter 3 of my 2016 book, Systemic Fragility in the Global Economy, I described ‘The Emerging Markets Perfect Storm’. The chapter discussed fragility in the EMEs and explained how emerging markets economies would be destabilized and that destabilization could precipitate the next global economic contraction. The causes of the destabilization lay in US and other advanced economies raising interests rates that would in turn cause the US dollar to escalate and then emerging market currencies to plummet. That would provoke EME capital flight, to which EME central banks would respond by raising domestic interest rates that, in turn, would drive their economies into deep recession. The spreading contraction in the EMEs could thereafter transmit to the US and other advanced economies via debt contagion, stock market contraction, capital flight to US Treasury securities, a credit crunch, and general psychological ‘risk off’ investor attitudes in the advanced economies as well. That analysis, scenario and prediction was made in January 2016 in the book. The emerging Turkey crisis, as it spills over to other EMEs, and then through Italian banks to Euro banks and the US-EU real economies may now be in the early stages of development.

Global and US events delayed the process during 2015-16 during which ‘The Emerging Markets Perfect Storm’ chapter was written. Fed rates stayed low, as the US central bank retreated quickly from its threat to raise interest rates, and the dollar in turn stayed low throughout the Obama period. In the past year, however, that delayed scenario has again begun to emerge, with Fed rates now rising sharp and fast, the dollar steadily escalating, and an increasing number of EME currencies in turn crumbling and collapsing–causing capital flight, domestic inflation, recessions, inability to service external debt, and risks of contagion of the EME crises spreading to other regions of the global economy.

The current case of Turkey’s economy is at the center of this re-emerging process, its currency having plummeted 40% to the dollar just this year. (It has temporarily stabilized this week, but the decline will soon continue once again since the fundamentals have not changed).

But Turkey isn’t the only indicator of growing fragility in the global economy, Other EME currencies are also in sharp decline now at various stages: Argentina, Brazil, South Africa, Indonesia, and India. Russia’s Ruble is also deflating and China’s Yuan, the strongest currency in the EMEs, is nonetheless pushing against its lower band fixed to the dollar, within which it too has deflated by 6-10%. It has been prevented from falling further only due to China central bank’s recent intervention in global currency markets propping up the value of its currency, Yuan/Renminbi, in order to prevent further devaluation. Should Trump continue his trade war with China, however, that intervention could end and the Yuan devalue significantly further. That would ratchet up the emerging global currency war and exacerbate conditions in economies like Turkey,

Rising global financial fragility is rising due to obvious increasing contagion effects. The Turkish LIRA crisis is spilling over to other EME currencies, causing a further decline in those currencies in addition to the already significant forces driving down those currencies. Turkish dollarized debt payment obligations to Italian, EU and US banks are being noted in the business press. Italian bank debt is especially exposed, when Italian banks already sit on $500 billion in non-performing bank loans. The transmission mechanism to a broader European bank crisis might easily occur from Turkey to Italian banks to the general banking system. US banks like Citibank are also exposed to Turkish debt. Other indicators of growing potential contagion from the Turkish fallout are the global currency speculators (hedge funds, vulture investors, etc.) now plowing into short selling of the LIRA, further depressing its price, the rising interest rates on Turkey government and private bonds. The response of other EME central banks in raising their interest rates to try to stem the outflow of capital as their currencies follow the LIRA down. (Argentina being the worst case, as its central bank raises rates to 45%–thus ensuring that country’s current recession will collapse into an even more serious contraction, perhaps even depression). The first phase of the general contagion effects of the LIRA collapse have now occurred. A second ‘shoe’ will inevitably fall within weeks. Financial fragility is rising in the global economy–and will eventually impact the US economy in 2019, thus further ensuring a US recession sometime in 2019 that this writer has been predicting.

For readers interested in my 2016 analysis, ‘The Emerging Markets Perfect Storm’, (Ch. 3 of ‘Systemic Fragility’ book also reviewed on this website), that complimentary Chapter 3 follows here below: (follow my blog, jackrasmus.com, for weekly updates and analyses as the Turkey and other EME crises continue to develop):

Systemic Fragility in the Global Economy
Chapter 3 The Emerging Markets’ Perfect Storm
Copyright 2016 Jack Rasmus

An economic perfect storm is now developing offshore. Its winds of economic destruction are gaining momentum. Where it first makes landfall is unknown for now, but its ‘eye’ is clearly located in the emerging markets sector of the global economy.

Earlier the source of growth that propped up the global economy from 2010-13—preventing an otherwise likely descent into global depression in the wake of the 2008-09 economic crash—the Emerging Market Economies (EMEs) are today the focal point of a continuing global crisis that has not ended, but whose eye has only shifted from the AEs to the EMEs. Both the slowing global economy and the forces building toward yet another global financial crisis are concentrated in the EME sector.

What an accelerating decline of the EME sector, representing 52% of global GDP, means for the rest of the world economy is ominous. Continuing weak growth in the advanced economies (AEs) today does not appear capable of offsetting the EME’s current slowdown and decline. That is a fundamental difference from 2010-2013, when EME growth largely offset stagnation and weak growth in the AEs over that period. In net terms, therefore, the global economy is far weaker today in terms of real growth prospects, and is growing simultaneously more unstable financially as well.

The EMEs are being economically pounded today from multiple directions:

• the slowing of the Chinese economy and China demand for EME commodity exports;
• weak demand for EME commodity and manufactured exports by Europe and Japan;
• the drift toward higher interest rates in the US and UK;
• the escalation of currency wars provoked by QE policies of Japan and Europe and China’s currency devaluation response of August 2015;
• the additional impact of collapsing world crude oil prices for those EMEs whose economic growth and stability is dependent on crude oil production and exports;
• China’s stock market bubble and implosion of 2015.

These are problems external to the EMEs themselves, largely beyond their control, although impacting them severely nonetheless. But external forces that cause EME economic instability in turn exacerbate additional ‘internal’ problems that result in further EME economic contraction and fragility. Moreover, internal and external factors interact and feedback on each other, causing still further instability in both real and financial sectors.

The additional internal factors exacerbating EME economic instability include:

• the collapse of EME currencies;
• escalating capital flight from EMEs back to the traditional advanced economies (AEs) of US, Europe, and Japan;
• rising consumer goods inflation;
• EME policy responses to currency decline, capital flight, and inflation;
• collapsing EME equity (stock) markets;
• a growing threat to EME bond markets issued in dollar denominated debt.

This combination of external and internal problems does not bode well for EME future real growth and financial stability—nor in turn for the global growth or world financial instability in stocks, bonds, and foreign exchange markets.

As for the EME real economy, according to the European mega-bank, UBS, EMEs together grew at only a 3.5% annual rate in the first three months of 2015. But that includes China as an EME, with an official growth rate of 7%. If China is excluded, the 2015 growth rate of all EMEs is only a few tenths of a percent above zero. And if China’s real GDP rate is at 5% or less, as many sources now maintain, it’s probably no more than zero. In other words, EMEs as a group—half of the world economy—have virtually stalled. Moreover, that data only represents conditions as of March 2015. Events which may occur in the near future—such as China’s further economic slowdown, rising US interest rates, and a deeper plunge in global oil and commodity prices—will almost certainly further depress EME economic conditions as a group to recessionary levels.

As for EME financial instability indicators, EME stock prices have fallen more than 30% from their 2011 highs, not counting China’s summer 2015 stock market contraction of more than 40% from June through September 2015. In the even more important bond markets, more than half of the acceleration in global debt since 2007 has occurred in private sector debt in general, of which the EMEs in turn have been responsible for more than half, according to a recent McKinsey Consultants study. Much of escalating EME private debt is of ‘junk’ quality, especially in regions like Latin America and Southeast Asia. That means the debt must be paid back in US dollars, which makes EMEs dependent upon selling more exports in the a global economy where trade is slowing everywhere. Either that, or more must be borrowed at ever higher interest rates to finance the debt. And should income from exports decline further, EME corporate defaults can be expected to rise rapidly. Defaults on government debt are also likely to rise among EMEs, especially where government borrowing has grown in US dollar denominated debt—as is the case in many African EMEs.

EMEs are therefore growing significantly more ‘fragile’, with both governments borrowing in dollars and private sector corporations loading up on dollar denominated junk bond debt. Odds in favor of a subsequent EME bond bust are a growing possibility, following in the wake of the EME stock declines already underway across the sector. The prospect of a double-edged financial instability event—involving both stock and bond markets—would have serious repercussions and contagion effects for the global financial economy at large.

What’s An EME?

Before proceeding in terms of further detail concerning the deteriorating condition of EMEs, some conceptual clarifications may be useful. First, what is an EME?

The International Monetary Fund (IMF) identifies EMEs as the 152 emerging and developing economies. The MSCI Stock Index, in contrast, identifies 51 economies, with 28 of the 51 comprising the very small in GDP terms ‘frontier’ economies and the remaining 23 as larger EMEs. Various other definitions list economies in between in terms of GDP, asset wealth, and other factors.

Economies like Brazil, Indonesia, India, Mexico, Turkey, Argentina, South Africa, and others certainly qualify as EMEs. But it is questionable whether China belongs in that category, as the second largest economy (and largest in PPP inflation adjusted terms). Whether economies like South Korea are EMEs is also r questionable. Chile is considered an EME, and is ‘larger’ in a number of economic ways than Portugal, which is not regarded as an EME. Australia is not regarded as an EME, but exhibits many of the characteristics of one, with its dependence on commodity exports, its ties to China, and its recent currency swings like other EMEs. And where do Russia, Saudi Arabia, smaller Eastern Europe economies, and Singapore fit in the various classifications of EMEs?
The oil producers, like Nigeria, Venezuela, Iran, North African and other middle eastern economies, and again Mexico and Indonesia comprise a special subset of EMEs. A second tier of commodity producing EMEs usually includes economies with strategic materials or services, like Chile-Peru (copper), Singapore (finance). A third tier of EMEs are sometimes referred to as ‘frontier’ economies. The so-called BRICS (Brazil, Russia, India, China, South Africa) are often considered the more important economies within the EMEs, although states like Mexico, Turkey, Indonesia and a few other EMEs are important as well. Still other ways EMEs are classified at times are as ‘commodity producing’ EMEs, or as ‘manufacturing’ EMEs, although a number of larger EMEs share characteristics of both commodity and manufacturing producing.

However one may choose to classify the group, the essential point is that the above spectrum of EMEs constitutes a major bloc in the global economy. Along with China, their growth after 2009 and until 2012-13 kept the global economy from collapsing into depression, at least temporarily. That growth, both real and financial, enabled advanced economy (AE) banks, shadow banks, and investors to recapitalize and realize a new level of corporate profits and AE corporate stock price appreciation. But that was yesterday, which began to end in 2012-13, and at mid-year 2015 has begun to rapidly draw to a close. The temporary surge of the EMEs and China in the immediate post-2009 period has ended convincingly as of late 2015. That phase of development of the global economy and economic crisis is over.

A transition has begun. EMEs are under extreme economic pressure from falling demand for their commodities, oil and semi-finished goods, from accelerating capital flight as US and UK raise rates, from growing currency instability in the wake of Japan-Europe QEs and then China’s currency devaluation, from slowing global trade and slowdown in exports, and from sliding stock markets and growing fragility in their financial markets in general. A wildcard adding additional potential economic stress and disruption is the growing political instability in various EMEs—in particular at the moment in Brazil, Malaysia, Turkey, South Africa, Venezuela, and soon elsewhere.

External Forces Destabilizing EMEs

The China Factor

The Chinese economic slowdown, accelerating in late 2015, produced a collapse in China’s demand for commodities and oil that much of the EME growth of 2010-12 was based upon. That declining commodities demand has had a double negative effect on EME economies: first, it has slowed commodities production and exports from the EMEs to China, and consequently EME economic growth; second, the decline in demand for EME commodities has caused a collapse of commodities prices, i.e. commodities deflation, which in turn has lowered revenues and profits in the EMEs and further dampened production.

With Chinese growth closer to 5% GDP (and some estimate as low as 4.1%) instead of its official 7%, China’s demand for EME commodities has plunged. Formerly absorbing approximately half the global demand for copper, aluminum, and other metals, nearly half of iron and steel, and roughly a third of food commodities, and 12% of world oil—a decline in Chinese demand has had a major impact on EME exports and production.

China’s slowdown is reflected in the Bloomberg Commodity Index (BCOM) of 22 key items which has fallen by late summer 2015 by 40% since 2012, to its lowest point since 1999. As commodities output has fallen, world commodity prices have deflated in the 25%-50% range, and even more for crude oil which has fallen from a $120/barrel high to $40 in a little over a year, from 2014-2015. The greatly lower volume plus the deflating price for commodities translates into a slowing of domestic production of the same and thus of EME growth rates in general.

The slowdown in EME exports is not just a function of China demand, of course. Stagnation in the European economy since 2010 and repeated recessions in Japan have also slowed demand for EME commodities and manufactured goods. And as the EMEs have begun to slow as a group after 2013, demand for commodities EMEs might mutually have sold to each other has slowed as well, adding further to the downward spiral of slowing commodities demand, commodities price deflation, lower EME exports, and ultimately slower EME growth.

According to the independent corporate research house, Capital Economics, in the year between June 2014 and June 2015, EME imports growth slowed by 13.2%. However, EME export growth is slowing even faster. In just the March through May 2015 period, exports growth slowed by 14.3%. In Latin America alone, after having peaked in 2011 at $550 billion, exports from those economies fell to $480 billion in 2014 and are projected to decline to as little as $400 billion in 2015. According to World Trade Organization data, after rising 20% from 2011 through 2013, developing countries (EMEs) combined exports peaked in the first quarter of 2014 and began slowing thereafter. The EMEs most heavily impacted have been Brazil, South Africa, various South Asian economies since 2014 and EME oil producers as well, beginning the second half of 2014.

The AE Interest Rate Factor

Simultaneous with the decline in Chinese demand for commodities, a policy shift began around 2013 in the advanced economies (AEs)—the US and UK initially. The shift involved a retreat from their 2009-2013 policies of QE and zero interest rates. The US and UK QEs were wound down by late 2013. Both US and UK then announced intentions to start raising short term interest rates from their near-zero levels. Just the announcement of their intention to raise short term rates sent long term interest rates drifting upward.

Just the announcement of a rise in US-UK interest rates has had a negative impact on EMEs; the actual rise in short term rates, when it comes, will impact them even more. The process is roughly as follows: rising rates in the core AE economies (US-UK) attract money capital back to the AEs from the EMEs, after having flowed in massive volumes from the AEs to the EMEs in the previous 2010-13 period. The money capital (i.e. capital flight) flows back seeking the higher returns from rising rates in the US-UK, given the expectation of slowing growth in the EMEs from China commodities demand decline simultaneously. Thus the two forces—slowing commodities growth in EMEs and rising interest rates in the AEs—combine to have a doubly negative effect on EME capital available domestically for growth.

When the US Federal Reserve announced in 2013 that it was going to ‘taper down’ and then discontinue its quantitative easing, QE, program this was interpreted by financial markets in the EMEs that the excess liquidity created by the QEs would no longer flow into EME markets and economies as much as before. EME markets reacted, in what was called the ‘taper tantrum’, contracting sharply, and capital flight from EMEs back to the AEs—the US and UK in particular—rose. The Federal Reserve quickly backed off in July 2013, and EME markets temporarily stabilized.

Once QE3 was discontinued in late 2013 by the US, the focus of concern by EMEs shifted to the growing possibility of US and UK central banks’ raising short term interest rates. The US Federal Reserve signaled its rate rise plan in January 2014 and the EME panic returned. Once again the US Federal Reserve backed off from an immediate hike in US rates.

But the prospects of eventual rising rates were already taking a toll on the EMEs. EME capital flight was already happening by 2014, in anticipation of the eventual rise in US-UK rates. EME capital flight then received another ‘shot in the arm’ in June 2014, as global oil prices began to collapse. By the second half of 2014 capital flight was in full swing. And in 2015, further shocks from China’s growth slowdown, stock market implosion, and currency devaluation would accelerate it even faster.

Global Currency Wars

Japan began implementing its first massive QE money injection program in April 2013. That drove down Japan’s currency, the Yen. Japan’s QE action led to the currency wars ratcheting up just as the slowdown in global commodity markets was about to begin and as the US Federal Reserve signaled its intention to raise interest rates—both events increasing downward pressure on EME currencies. Japan’s QE especially depressed its currency in relation to China’s Yuan, which rose by 20% in relation to the Japanese yen.

To compete with Japan for global exports to China, which rose with Japan’s de facto devaluation from QE, many EMEs lowered their currency values. Japan then accelerated its QE program in late 2014. This came just after global oil prices began to slide rapidly the previous summer. Japan’s QE, the Fed’s talking up US rates, and the oil deflation resulted in the beginning of the sharp decline in EME currencies in the second half of 2014 and the associated escalation of net capital outflows and capital flight from QEs.

Currency wars escalated further in early 2015, as the Eurozone introduced its version of an 18 month, $1.1 trillion dollar QE program starting March 2015. Its currency then declined, putting more pressure on already falling EME currency exchange rates to do the same. China initially allowed its currency to appreciate in relation to the Euro by around 20%, as it had in relation to the Yen. Those decisions cost China a significant loss of global export share and global trade.

However, following China’s stock market crash that began June 12, 2015, China reversed its policy and responded to the QE-induced Yen and Euro currency devaluations. In August 2015 China entered the currency wars by devaluing the yuan by approximately 4%. That was to be only the start.

The QE devaluations by Japan and the Eurozone together escalated the global currency war, as slowing global trade volume has led more AEs to attempt to capture a larger share of the slowing global trade pie by devaluing indirectly by QE policies. The currency war, plus rising US interest rates, and then China’s response together required EMES to increase downward pressure on their currencies in an attempt to adjust to the currency initiatives by the AEs. Failure to do so would mean a further decline in EME share of world exports and thus of economic growth at home. But doing so also meant falling exchange rates would add further impetus to already net capital outflows and capital flight, which it did. EMEs thus found themselves circa mid-2015 caught in a vise—of AE/China driven devaluations and rising US-UK rate prospects—and at a time when demand for their commodities globally were in freefall. The most seriously impacted EMEs, would be those whose commodity exports mix was composed, half or more, of crude oil.

Global Oil Deflation

In early 2014 the collapse of global crude oil prices began, yet another major development exacerbating capital outflow. . Since collapsing oil prices are typically associated with a rising US dollar, they have a similar effect as rising US interest rates. Both drive up the US dollar and consequently lower EME currency values.

So what’s behind the collapse in global crude oil prices in the first place? The start to that answer lies in the Saudi and US economies. As the global economy has continued to slow since 2013, not only has it provoked a currency war but also an energy production war. While the currency war was set in motion by Japan and Europe’s ‘dueling QEs’, the energy war was precipitated by the Saudis and emirate OPEC partners as a response to the challenge of US shale oil and gas producers.

From 2008 to 2014 global oil production rose by 80% to 9 billion barrels a day. That supply increase was driven in large part by the boom in China and EME real economies that characterized the second phase, 2010-13, of the global economic crisis. China’s 2009-10 fiscal stimulus, nearly 15% of its GDP, and its accelerating demand for EME commodities that accompanied it, plus the liquidity inflows to China and the EMEs from the advanced economies that enabled the financing of it all—explain much of the 80% global oil supply surge from 2008 to 2014. So when the demand origins of that supply surge began to weaken after 2013 in China and the EMEs, the natural result was an excess of supply and the beginning of oil price decline around mid-2014.

However weakening oil demand is only part of the picture. Simultaneous with the demand decline by 2014 was an augmentation of supply. North American oil production expanded sharply in 2014—as a consequence of the shale gas/oil boom by then in full swing in the US as well as Canadian tar sands production growth. That further weakened oil prices significantly. So did Libya’s quadrupling of its oil output in 2014. And all that was further exacerbated by many independent EME oil producers, whose oil production was more or less nationalized, expanding their output despite the falling price, in order to maintain foreign currency reserves and revenues desperately needed by their governments to keep their budget deficits manageable. Toward the end of 2014, crude oil prices had fallen from $115 a barrel to $70 a barrel.

In retrospect, , it appears the Saudis in 2014 tried to eliminate their new shale oil competitors by increasing their oil output, convinced that if the price per barrel of oil could be reduced to $80, that would be uneconomical for US shale producers, forcing them to leave the market. This would return control to global market oil prices to the Saudis and their friends. But this view proved to be dramatically wrong. US shale producers, whose production is based on new lower cost fracking technologies, were able to reduce costs and remain profitable even at $40 a barrel, according to a Citigroup analysis at the time, by shutting unprofitable wells and expanding output in those which were profitable; their cost cutting made it even more profitable to continue producing at previous output levels. US 2014 oil production rose to its highest level in 30 years. And by November 2014 the global price of crude had fallen by 40%.

It was about to fall much further. Global oil deflation crossed a threshold of sorts with the November 28, 2014 OPEC meeting in Vienna, Austria, at which Saudi Arabia drove a decision by OPEC not to reduce production of crude oil, but to maintain OPEC production at 30 million barrels a day, and thus let the price of oil to continue to drop. Many of OPEC’s non Saudi-Emirate members were clamoring for a cut in production to raise the price of oil. So too were many of the non-OPEC players, like Russia. But the Saudis resisted. The question immediately arises, why would OPEC and the Saudis so decide? Purely business logic would argue OPEC should have voted to cut oil production to support the global price of oil. But they didn’t.

Possible explanations include: First, with $750 billion in foreign currency reserves, Saudis could hold out earning oil revenues at lower levels for some time. Smaller producers like Venezuela, Nigeria and others could not. Second, the stakes were high for the Saudis. They were quickly losing control of global oil prices to the new US driven technology and output surge. OPEC and the Saudis knew that global shale production of oil and gas posed a relatively near term existential threat to their dominance. But there was even more to the story. Saudi Arabia and its neocon friends in the USA were targeting both Iran and Russia with their new policy of driving down the price of oil. The impact of oil deflation was already severely affecting the Russian and Iranian economies. The Saudi policy of promoting global oil price deflation found much favor with certain political interests in the USA, who wanted at the time to generate a deeper disruption of Russian and Iranian economies for to forward their global political objectives.

An immediate impact of the Saudi November 28, 2014 decision was a further fall in global oil prices. Thereafter, the currencies of the other EME oil producers began to decline faster than before. EME and Euro stock markets also contracted. Saudi currency and stock markets were not affected, since they pegged their currency to the US dollar. Further currency decline would also generate more capital flight from the EMEs. To recall, it was the second half of 2014 through the first quarter of 2015 when EME capital flight began to accelerate rapidly, amounting to nearly $1 trillion in outflows over the nine month period. That magnitude of capital outflow, thereafter unavailable for domestic investment in the EMEs, contributed to slowing domestic EME investment and growth that also began to contract in 2014.

In the first quarter of 2015 the US economy’s GDP came to another standstill, which reduced global oil demand further and deflated global oil prices still more. The Eurozone also stalled, prompting the introduction of its QE program. The dollar and Euro weakened, and currencies of many EMEs followed, especially the oil commodity producers like Venezuela, Nigeria, Russia and others. In the spring of 2015 the US Congress then began debating lifting the ban on US oil and gas exports, threatening a further surge of gas and oil supply on global markets. That prospect suggested further downward pressure on oil prices.

Nine months of consecutive negative data out of China by spring 2015 suggested strongly that the Chinese economy was slowing faster than the repeated assurances given by China officials that it would remain at a 7% GDP growth level. Then in mid-June the Chinese stock markets began to implode. That too helped deflate global oil prices. Global oil futures, a financial asset, are influenced by—and influence in turn—other financial assets. The connection between oil futures as a financial asset and equity assets is the global professional investors who speculate in both. When one asset class declines too rapidly it has a negative impact often on other asset classes, as investors retreat from markets in general and wait to see what happens.

In August 2015 oil prices recovered some of their $75 a barrel losses of the preceding year, rising from $38 a barrel lows back to the mid $50s on rumors that the Saudis and friends might agree to some kind of production cut. That sent oil prices scaling upward overnight by 20% and more. They retreated when the rumors proved incorrect. That kind of 20% price swing overnight shows how little oil prices are the result of supply and demand forces, and the extent to which they are determined by professional financial speculators driving the oil commodity futures market. Then August data for China and EMEs showed their real economies were slowing even faster than official reports. And Iran announced it would pump more oil at whatever price. Oil prices fell again. And so did EME currencies, stock markets, and the outflow of capital back to AEs.

What the past eighteen months clearly reveals is that the global oil deflation, already emerging due to a slowing global economy by 2014, accelerated as a result of the competition between US shale oil and gas producers and Saudi-Emirate producers attempting to re-assert their effective monopoly control over the price of world oil. As the Saudis and the North American shale gas producers battle it out over who would dominate the global oil industry, the EMEs continue to pay the greater price.

Both directly and indirectly, global oil deflation has functioned as an accelerator to the growing economic instabilities in the EMEs since 2014. Declining currencies, commodities exports and prices, along with capital flight and currency wars, etc.— are all intensified by the global oil deflation.

Who ‘Broke’ the EME Growth Model?

Like the slowing China commodities demand, AE interest rates, and global currency wars, the global bust in oil prices reflect forces largely out of the EMEs’ control. These are external developments imposed on them over which they have little influence. How they respond to these developments of course is a matter of some choice. However, as the following discussion of ‘internal forces’ (i.e. EME responses) shows, the range of choices available is not all that good. For example, while an EME might choose to stem capital flight by raising its own domestic interest rates, that only slows its real economy even further. Or if the EME responds by trying to expand its exports by reducing their cost of production, that might mean less consumer spending and less domestic growth that in turn encourages further capital flight. Reducing government spending to offset rising import goods inflation has the same effect. And so on.

What all this suggests is that much of the causation for the EMEs’ growing economic problems originates in policies in the AEs and China—just as previously, from 2010-2013, much of the expansion of the EMEs also emanated from those same ‘external’ sources. It’s not that the ‘model’ of growth used by EMEs is ‘broken’, a favorite theme recently in the US-European business press. It is that the AEs ‘exported’ their growth to the EMEs during 2010-2013 through their monetary policy, and now are ‘re-importing’ that growth back by reversing that monetary policy. The current economic weakness of the EMEs might therefore be labeled: ‘Made in the AEs’.

A recent article by Kynge and Wheatley concludes: “The dynamic economic models that allowed developing nations to haul the world back to growth after the 2008-09 financial crisis are breaking down—and threatening to drag the world back towards recession”. But was the model created by the EMEs, or imposed on them by the AEs back in 2010? And is that model now being ‘broken’ as a result of EME decisions made 2010-2013, or is in the process of breakdown due to decisions once again being made in the AEs and, to an extent, by the Saudis?

The interesting and even more fundamental question is why did the AEs focus on the EMEs as their source of initial recovery from the 2008-09 crash instead of their own economies? And why now, in 2014-2015, have AE policymakers decided to reverse that policy? The AEs, in particular the US and UK, made the conscious policy decision in 2009 to generate recovery first by bailing out their banks and financial institutions by means of massive liquidity injections. That injection, and the financial asset investment and speculation that produced financial profits restored banks’ balance sheets. AE policy makers also decided early to accelerate recovery for non-financial multinational corporations by incentives to expand investment and returns in emerging markets, including China, because the returns there promised to be quicker and larger compared to investment in their own AEs. This dual strategy worked for both finance capital and non-finance multinational corporations, both of which recovered quickly and realized record profits. But it left the AEs own economies stagnating for the next five years, as other forms of real investment languished. The AE policy shift that began in 2013 thus in effect represents a refocus on their own economies, by bringing money capital back to try to stimulate domestic investment as they (US and UK) discontinue QEs and raise interest rates, in a desperate attempt to get AE GDP rates back up. But that means at the expense of the EMEs in this phase of the post-2008 crash and continuing slowing global economy.

The preceding four major ‘external’ forces that are now having an increasing negative effect on the EMEs are the result of conscious policy decisions made by the AEs, China, and in the case of the oil deflation, by Saudi Arabia and its petro allies. Of course, deeper conditions have forced all three to make these policy decisions: the AEs have not been able to get their economies back on a reasonable growth path since 2010; China has not been able to make the transition to private investment and consumption driven growth; and the Saudis and friends have decided to try to drive the US shale oil producers out of business to protect their long run strategic control of oil production and oil prices. Nevertheless, the consequences for the EMEs of these conditions and policy shifts in the AEs, China, and the Saudi-Emirate economies have been serious. And the consequences have been growing worse by the day. If the next depression is said to be ‘made in the emerging markets’, it will have been the AE-Chinese-Saudi decisions that ultimately made it.

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.

As the economic problems for the EMEs multiply in coming months, the financial market problems will become more serious, not just for EMEs but for AE banks and investors in the wake of their debt defaults. And when financial markets ‘crack’, they typically lead to a new level of economic crisis in the real economy in turn. Most recently, Oxford Economics research has predictred the EMEs aggregate GDP growth rate will fall to its lowest level since the 2008-09 crisis. Other sources warn the situation is beginning to look more like 1997, when a major financial crisis involving EME currencies erupted. It is quite possible 2016 may witness that kind of real and financial sector negative interaction once again.

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