Last week markets fell. Most of the pull back was blamed on turbulence in emerging market currencies. Actually, the fall of EM currencies is nothing new. It has been going on since last May, when US Federal Reserve Chairman, Ben Bernanke, announced the possibility of a taper of the bond-buying program known as QE. Since then currencies of Argentina, Brazil, Chile, India, Russia, Turkey and South Africa have fallen between 10% and 20%. The question is whether this is the beginning of something far more serious?
The reflexive response is to look at the last major meltdown of emerging market currencies. Is the present situation similar to what happened during the Asian crises of 1997? Most commentators would answer soothingly in the negative. They would point out that today's investors look at emerging markets as an increasingly diverse group of economies. Problems with one or two emerging markets may have nothing to do with others. It is true that there is more diversity, but the currency issues hit 4 out of the 5 BRICS countries. This would indicate that the problems are more pervasive among emerging markets.
Emerging markets growth has slowed, but in general they are still in good shape. Advocates point out that they are still growing faster than most developed countries. So despite this recent slowdown they should benefit from a general global expansion. This is a rather narrow view. The US, European and Japanese economies seem to be recovering, but much of the rest of the world seems to be slowing. As I pointed out in my recent piece on the Fragile Five, these economies make up 14% of the world economy. Problems in these countries will have a major negative impact on any nascent global growth.
The big argument against a repeat of 1997 is the question of "original sin." This is the general name for debt incurred by an emerging market entity, either corporate or the state, in a currency other than its own. Unlike 1997, much of the recent borrowing has been denominated in local currency. So the lenders, not the debtors, assume the currency risk. The idea is generally true, but this type of borrowing is still going on. According to a recent article in MoneyLife, "RBI that 60% to 65% of corporates' forex borrowings were un-hedged." I am sure Indian companies are not the only sinners among emerging markets.
The fall in EM currencies at one level does indicate strength. Fewer countries peg their currencies. With flexible currency policies, large reserves and deeper local currency capital markets, EMs should be able the weather the storm far better than in 1997. Since EM equities are relatively cheap, rather than a crisis, optimists regard this pull back as an opportunity to invest.
Or is it? The one major problem with the optimistic case is debt. In order to protect their currency, the Turkish central bank held a special midnight meeting and raised its interest rate. The Turkish central bank ostensibly more than doubled the benchmark from 4.5 percent to 10 percent. But the effective rate on Turkey's interbank rate was already above 7 percent before the rise. So the rise was not as great as it seemed. South Africa also raised rates by 50 basis points, but presented it as a temporary emergency measure. Markets were not impressed by either move and continue the sell off.
But more important than the currency issue is the interest rate. Raising interest rates in any country will further slow the economy. A rise in interest rates in almost all of the emerging markets including China will put pressure on the debtors. This is important because unlike 1997, there has been a large rise in the amount of new debt incurred by the EMs. The easy money policies of the developed countries plus the large loans made by the Chinese financial system has created an ocean of debt. As interest rates rise and currencies fall, the probability of default will explode.
In a blog last Monday, The Economist published an article also comparing the present situation to 1997. They saw two real threats. The first was political instability, which in my view is always with us. The second threat was that there "might be a sense that the emerging economies are fibbing about the state of their financial systems." In short information is the problem. No one really knows how bad the debt situation is.
I can assure the blog's author that the level of bad debts in all emerging markets is far greater than is presently known. Why the certainty? Simple, compare them to developed economies. All of the developing countries have less stringent regulation than the EU. But even with better regulators, it has still taken the European Central Bank years and numerous stress tests to determine the real extent of bad loans. All of the EMs have large state owned banks that have made loans for political purpose. The true state of these loans will also be hidden for the same reason. China carefully controls information, so the probability of getting an accurate number is near zero.
The combination of higher interest rates, economic slowdown and poor information means that the revelation of the true health of EM financial systems will not surface until the problems are too large to hide. By then it will be too late and this week's currency turbulence will look like a summer squall compared to a tsunami.