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A rate hike by Fed will lead to capital outflows and spillover effect of rising rates globally. Prolonged easy liquidity in US and Europe has created massive buildup of debt in emerging markets and they will now see the end of the boom and beginning of a debt crisis.


According to the Swiss-based Bank of International Settlements (BIS), global total debt ratios are now significantly higher than they were at the peak of the last credit cycle in 2007, just before the onset of global financial crisis. Combined public and private debt has jumped by 36 percentage points since then to 265pc of GDP in the developed economies.

But the bigger problem this time lies in emerging markets, as the total debt there has spiked 50 points to 167pc, and even higher to 235pc in China. According to a JP Morgan study, the ratio of broad emerging market nonfinancial private credit to GDP hit 128% of GDP in Q1, up 51 percentage points from 2007. An article in The Economist mentions “Overall, debt in emerging markets has risen from 150% of GDP in 2009 to 195%. Corporate debt has surged from less than 50% of GDP in 2008 to almost 75%. China’s debt-to-GDP ratio has risen by nearly 50 percentage points in the past four years.”

Such a fast pace of credit growth has almost always preceded major financial crises in the past.

Background – A decade of boom in emerging markets

A decade of robust growth has broadly strengthened emerging market economies but the associated asset price booms and credit surges have increased their vulnerability to crises. Since 2002, emerging economies had enjoyed one of the longest high-growth spells ever, expanding at an average of over 6 percent a year. This rapid growth coincided with financial booms, fuelled by large capital inflows and accommodative monetary policy both domestically and abroad.

Since 2002, gross foreign investment into emerging markets (as a percentage of GDP), has been the highest in over a century. Flows had accelerated as interest rates collapsed in US and euro.

Boom brings troubles

The huge investment flows, rising exchange rates and relatively low interest rates have also created  problems for emerging markets -  since 2004, credit growth in emerging markets has run at around 12 percent a year while real estate prices have increased by 40 percent.
Private sector borrowing in emerging economies has doubled in last two decades to around 120 percent of GDP. Private sector credit levels are well above 10 percent over long-term trends across emerging markets.

End of the boom: Beginning of the debt crisis

This boom is coming to an end. With slowdown in China, there is a global fall in demand, rise in deflationary pressure, and a fall in commodity prices. Energy prices are hitting rock bottom and commodity driven economies are already in shambles. A rate hike and strong dollar will crush the commodities and there will be a surge in capital outflow from emerging markets.

Capital Outflows: Will leave growth engines without power

Though this time emerging nations are much stronger compared to the 1980s and 1990s when they had faced massive financial crisis. But all countries are not equally healthy in financial terms. Those that lack means to bail out imprudent borrowers or to protect themselves from capital flight will face the toughest times. It estimated that capital outflows from China already reached $109bn in the first quarter.

china outflow

Low economic growth and high debt levels are a brutal combination that we are all well familiar since the financial crisis. It’s referred to as a “toxic mix” by the authors of a new HSBC note. It says that the developing world is now exhibiting the same worrying blend.
The easy growth in the emerging world is now behind us, according to the note:
"It is clear that the low-hanging fruits of cheap credit, surging commodity prices and unproductive domestic investments are largely exhausted. As such, EM needs to re-energise via hard work, namely sweeping fundamental reforms to restore competitiveness and to address supply-side bottlenecks. The alternative is EM stagnation with a fairly heavy debt load."

The graph below from BIS clearly shows toxic mix of falling growth and rising debt levels -
03 gra4 
Adding to the toxic mix, off-shore borrowing in US dollars has reached a record $9.6 trillion, chiefly due to leakage effects of zero interest rates and quantitative easing (QE) in the US. Now when the Fed reverses course, there will be a drain of dollar liquidity from global markets.

Dollar loans to emerging markets (EM) have doubled since the Lehman crisis to $3 trillion, and much of it has been borrowed at abnormally low real interest rates of 1pc. Roughly 80pc of the dollar debt in China is on short-term maturities.

Rate Hike in US transmits globally: EM to face spillover effects

A study on financial spillovers in the BIS report found that interest rates in global financial system remain anchored to US borrowing rates, whether or not countries have fixed exchange rates or floating rates.

On average, a 100 point move in US rates leads to a 43 point move for emerging markets and open developed economies, with powerful knock-on effects on longer-term bond rates. "We find economically and statistically significant spillovers," BIS report says.

The grim implication is that emerging economies may face a monetary shock as rates ratchet higher, even if the liabilities are in their own currencies.

ECB may delay the crisis

Dim growth prospects in EU are expected to force ECB for more monetary easing. ECB is in effect displacing the Fed and may delay the outcome.

No savior this time

Fed saved the US economy in 2008, China saved the global economy after that. China and the emerging economies were able to crank up credit after the Lehman crisis and act as a shock absorber, but there is no region left in the world with much scope for stimulus if anything goes wrong now.

There is no savior this time, no “bank of last resort”, and no “investor of last resort”.

Published in Investors Blog

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