Multiple Latin debt crises and the Asian emerging markets crisis of 1997-98 have been forgotten. To paraphrase Robert Louis Stevenson, financial markets have “a grand memory for forgetting”.
Now, the risk of an emerging markets crisis is very real.
Investors have been romancing emerging markets, exemplified by the dalliance with the Bric economies (Brazil, Russia, India and China), a term coined by Goldman Sachs’ Jim O’Neill in 2001.
Slowing growth in developed economies following the 2007-08 global financial crisis resulted in a sharp slowdown in emerging economies. To restore growth, emerging markets switched to development models more reliant on credit. Double-digit annual credit growth drove economic activity in China, Brazil, India, Turkey and many economies in Asia, Latin America and Eastern Europe.
Loose monetary policies in developing countries – low or zero interest rates, quantitative easing and currency devaluation – encouraged capital inflows into emerging markets in search of higher returns and currency appreciation. Banks, awash with liquidity, sought lending opportunities in emerging markets. International investors such as pension funds, investment managers, central banks and sovereign wealth funds increased allocations to emerging markets.
Foreign ownership of emerging market debt increased sharply. In Asia, up to 50 per cent of Indonesian rupiah government bonds are held by foreigners, up from less than 20 per cent at the end of 2008. About 40 per cent of government debt in Malaysia and the Philippines is held by foreigners.
Capital inflows drove sharp falls in emerging market borrowing costs. Brazil’s dollar-denominated bond yields fell from above 25 per cent in 2002 to a record low 2.5 per cent in 2012. After averaging about 7 per cent for the period 2003-2011, Turkish dollar-denominated bond yields sank to a record low 3.17 per cent in November 2012. Indonesian dollar bond yields fell to a record low 2.84 per cent. Local currency interest rates also fell.
The increased availability of funds and low rates encouraged rapid increases in borrowing and speculative investment. Asset prices, particularly real estate, increased sharply.
The effect of capital inflows was exacerbated by the relative size of the investment and local financial markets. A 1 per cent increase in portfolio allocations by US pension funds and insurers equates to about $500bn (£312bn), much larger than the capacity of emerging markets to absorb easily.
In the past 12 months, investor concern about developments in emerging markets has increased, reflecting slowing growth and a potential reversal of capital inflows.
China’s growth has fallen below 7 per cent. India’s growth is below 5 per cent. Brazil has slowed to near zero. Russian forecasts have been downgraded repeatedly to below 2 per cent. The slowdown reflects economic stagnation in the US, Europe and Japan. In addition, slowing Chinese growth has affected commodity demand and prices, with a knock-on effect on producers such as Brazil. The slowdown has flowed through the supply chain, affecting suppliers to Chinese manufacturers.
The growth slowdown is now attenuated by capital outflows, driven by fundamental concerns about emerging market economies but also changing US policy dynamics.
Improvements in American economic conditions have encouraged discussion about “tapering” the US Federal Reserve’s liquidity support, currently $85bn a month. US Treasury bond interest rates have risen in anticipation of stronger growth, inflation and higher official rates. Rates in other developed countries such as Germany have also increased sharply.
As investors shift their asset allocations back in favour of developed economies, especially the US, there have been significant capital outflows from emerging markets, resulting in sharp falls in currency values and rises in borrowing rates.
Brazilian dollar-denominated bond yields have risen to about 5 per cent, well above the lows of 2.5 per cent last year. Turkish dollar-denominated bonds have risen to nearly 6 per cent from a low of 3.17 per cent.
Like an outgoing tide that reveals the treacherous rocks hidden by high water, slowing growth and the withdrawal of overseas capital is now exposing deep-seated problems, especially high debt levels, financial system problems, current and trade account deficits, and structural deficiencies.
Satyajit Das is a former banker and the author of “Extreme Money” and “Traders Guns & Money”