Economic Risks From the Emerging Markets
In 2008, troubles in the $10 trillion US mortgage-market were a principal trigger for the Great Global Economic Recession that followed in the wake of the US housing market bust. This has to raise the question as to whether the even greater run-up in emerging market corporate debt since 2008 now poses a fundamental threat to the global economic recovery, as the earlier emerging market economic boom turns to bust. This question becomes all the more pertinent considering the recent weakening in the emerging market economies and the collapse in their currencies.
A striking feature of the emerging market economies over the past five years is the degree to which their corporate sectors have become overly indebted. According to estimates from the Bank for International Settlements, since 2010 overall emerging market corporate debt has increased by $15 trillion to reach its present level of around $25 trillion. This has implied a doubling in the emerging market debt to GDP ratio from 45 percent to 90 percent.
Of particular concern has to be the fact that, over the same period, emerging market corporate foreign currency-denominated debt has increased from $1.5 trillion to around $5 trillion. For the most part, this latter borrowing has not been hedged by those corporations, which makes those corporations particularly vulnerable to foreign exchange rate moves. It also does not help that a large part of that debt is concentrated in a few key emerging market countries like Brazil and Russia, whose economies are now already experiencing deep recessions.
One would have thought that alarm bells should now be ringing in global financial markets considering the high degree of emerging market US-dollar denominated indebtedness and the plunge in the emerging market currencies. According to the JP Morgan emerging market currency index, over the past two years those currencies have now plunged by over 30 percent to their present record low levels. Sadly, there is every prospect that those currencies will continue to plumb new lows as the international commodity bust continues and as the Federal Reserve continues to raise interest rates.
There are at least two reasons why plunging emerging market currencies could cause real financial market stress in those economies. The first is that a currency decline in and of itself directly increases the debt service burden of those companies that borrowed in US dollar denominated debt.
The second is that plunging currencies substantially increase the cost of emerging market imports thereby adding to domestic inflationary pressures. This in turn forces those countries’ central banks to pursue restrictive monetary policies in an effort to prevent inflation from becoming embedded in those economies thereby raising the risk of recession. All of this is hardly good news for emerging market corporate viability, especially at a time that those economies are being hit hard by highly depressed international commodity prices.
If the 2008 US housing bust offers any precedent, it must be only a matter of time before the current emerging market economic bust results in widespread defaults across its corporate sector. It would also only be a matter of time before we find out which financial institutions in the advanced economies were the ones that lent so imprudently in the good times to the overly commodity dependent emerging market economies. Hopefully this time around, when the emerging market chickens come home to roost, the US Federal Reserve will not be caught out as flat-footed as it was in the 2008 US housing market bust.
Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a Deputy Director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.
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