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The collapse of the emerging markets, especially China, India, and Brazil, will have a huge ripple effect on the rest of the world’s economies, and will plunge most countries back into a global recession.

One of the major drivers of the markets over the past two years has been the "unstoppable" and highly promising future of the emerging markets, especially China. As millions of inhabitants in emerging countries begin to enter the "modern" world and middle class, their consumption and their effect on the economies of countries all over the globe increases. And as millions of people contribute to the growth of China, India, and other countries, they will require extra food, energy sources such as gasoline and oil, cotton for their increased consumption and clothing needs, industrial metals for their new cars and technology, and many other materials that a growing and evolving population needs.

China’s massive growth has also fueled the gold bubble:

[Click all images to enlarge]

According to this data, Chinese demand for gold has grown tremendously as the wealth of its citizens has dramatically increased.

The problem that may emerge, however, is that there is no guarantee that China and other emerging countries will actually meet our lofty expectations. Emerging markets have been growing at such a rapid pace (7-10+ percent compared to 1-3 percent for the U.S.) that their development may actually be setting them up for housing bubbles, high inflation, and uncontrollable growth.

Moreover, with all the enthusiasm over the future growth of emerging markets, investors have piled into stocks and ETFs in hopes of capitalizing on the emerging markets theme. The reasoning behind these moves is that worldwide consumption of food, commodities, and energy will continue as growing and developing populations require more supply. And with more and more people expected to consume at an increasing rate, investors assume food and commodity prices will continue to rise.

Therefore, in order to profit from the expected continued growth in emerging markets, investors have thrown billions of dollars into emerging markets (NYSEARCA:EEM) such as China (NYSEARCA:FXI), India (NYSEARCA:EPI), Brazil (NYSEARCA:EWZ), and others; grains and agriculture (JJG, DBA, DAG, MOO, AGF); steel (NYSEARCA:SLX), copper (NYSEARCA:JJC), silver (SLV, SIL), tin (NYSEARCA:JJT), and other industrial metals; energy (OIL, USO, OIH, XLE); and just about anything else that could rise if global economies continue to expand.

The problem, and it's a major one, with this emerging markets theme that has dominated for the past two years is that all the expectations and projections investors have had may be way too optimistic. With China and others showing very troubling weakness and attempting to slow their growth in order to prevent economic turmoil, a huge economic dip is not out of the question. Add to that the possibility that all the growth is already factored into the commodity and stock prices (that investors have speculated tremendously in all EEM-related themes and that the current prices reflect future expectations), and any stumble or slower growth could send prices plummeting as they attempt to adjust to more realistic growth.

In simple terms, here is the scenario for emerging market growth that many investors have been relying on:

  1. Emerging markets are expected to grow at a rapid pace for the next 50 years.
  2. Rapid growth will require more supplies and more inputs.
  3. As demand grows for food, commodities, and energy, the prices of these inputs will continue to rise.
  4. The plan: buy and invest in emerging markets and commodities in order to take advantage of this continued growth.

And here is the possible scenario that derails economic recovery and hurts emerging markets investors:

  1. Emerging markets have been set up with lofty expectations for growth that will not be achieved due to unsustainable commodity and food prices, as well as unsustainable growth rates.
  2. The double-digit growth rates that many investors have been relying on do not actually materialize. More reasonable growth rates of 5-8 percent do.
  3. Since prices have run up at such massive rates and steep angles, they must come back down to reflect the more reasonable growth rates that have surfaced.
  4. Prices for emerging markets, commodities, food, and energy drop considerably in order to better reflect current conditions and revised future expectations.

In other words, unless emerging markets continue to grow as expected, economies will suffer and investors will see heavy losses as reality sets in and expectations are missed.

Emerging Market Warning Signs

Surging Inflation

Many countries around the world are experiencing surging inflation that could threaten steady growth. With consumer prices rising significantly, especially due to the sharp rise in food and commodity prices, countries like China (6.4 percent annual inflation rate, June 2011) could have major problems. The price of pork, China’s staple meat, soared 65 percent between July 2010 and July 2011.[i] Though many countries have been attempting to cool the inflationary threats, consumer prices have continued to rise. And even if these countries can slow inflation, they may also be halting growth at the same time.

Money Supply

“Speculative manias gather speed through expansion of money and credit.”

-Charles Kindleberger, Manias, Panics, and Crashes [ii]

While most economists and investors have been arguing for the demise of the dollar and the death of paper currency due to government money-printing, many fail to notice that China’s money supply has actually grown at a much more rapid pace than the United States’ money supply. With M2, a broad measure of money supply, rising 15.9 percent by June 2011[iii], the rapid growth of money supply and the devaluing of Chinese currency have fueled asset bubbles in real estate, investments, and gold, and may be setting China up for a very sharp financial crisis as money supply shrinks and credit dries up.

Credit Bubbles

Foreign banks increased their lending to China by 86 percent in 2010.[iv] In addition, off-balance sheet loans have increased by 110 percent and tremendously raise the risk of bank defaults since these loans are not accounted for like traditional loans. It has been estimated that the value of off-balance sheet items for 16 Chinese banks is around $3.5 to $4 trillion, making up 25 percent of total assets.[v] This highly increased leverage, much of which has been achieved through hidden activity and therefore results in understated credit exposure, could easily cause major problems for banks in the event of a credit downturn or liquidity crunch. [vi]

Such massive credit growth is almost a guarantee of future asset bubbles, especially as China has been attempting to cool the overheating real estate market. And if economic growth slows, China’s banks could be left with a toxic portfolio of non-performing loans.

Economist Hyman Minsky developed a model to explain financial crises as a result of cyclical changes in the supply of credit. Minsky pointed out that the supply of credit increased during economic booms and decreased during economic slowdowns. During expansions, investors were increasingly more optimistic about the future and became more likely to borrow. Lenders were also more likely to lend, since the expansionary phase had increased their risk tolerance and also lowered their assessment of the underlying risk. Furthermore, Minsky argued that the increases in credit supply during booms and decreases during busts made financial crises much more likely.[vii]

The emergence of countries like China, India, Brazil and other modernizing areas has coincided with the sudden and rapid growth of credit. Developed markets have had access to credit for decades – from mortgages to credit cards to low down payments and many other forms of credit extension. Emerging markets and developing countries, however, had been on a cash-only basis until only twenty or thirty years ago. The development and availability of credit has allowed individuals within these emerging markets to increase spending and investment. And this increased credit and spending leads to a “domino expansionary effect”[viii] in which the economy grows rapidly due to the large sudden increase in available credit. The growth of credit has an almost immediate positive impact as the expansion of business results in double-digit growth in many sectors of the economy.

Growth can only continue at this pace if credit continues to be available. As the credit expansion reaches a saturation point however, the unsustainable cycle of credit growth begins to weaken. Credit begins to dry up as lenders are less willing to lend, and as loans must be repaid. Individuals and businesses can no longer rely on more credit to fuel their existing loans and activities, and economic growth is hit with a sharp slowdown. The unavailability of credit sharply halts further expansion, and the economy may fall into recession as slow or negative growth takes hold. The massive credit and expansionary cycle can only be sustained through continuous credit growth; but credit can’t grow forever, and economies inevitably must face contractions as growth comes to a halt.

In the case of China and other emerging countries, credit has grown so rapidly and has fueled such massive expansions, that the economic slowdown resulting from shrinking credit availability could be severe. The large asset bubbles in stocks and real estate that have been appearing in many emerging markets are the results of unsustainable credit expansion that will lead to economic shocks as a saturation point is reached and credit growth is no longer possible.

Loan Exposure

Moody’s, the credit ratings agency, recently said that China has underestimated by half a trillion dollars its exposure of state-owned banks’ to local government loans.[ix]

Tightening Monetary Policy

China’s central bank has increased interest rates three times and its reserve requirement rate (RRR) for banks six times in 2011, by the end of July. Tighter monetary policy is an attempt to cool the rampant inflation that has been threatening to spiral out of control. While inflation is generally a sign of growth, very high inflation could be damaging to the economy as prices begin to hurt companies and consumers. Tighter monetary policy has therefore been a method of controlling unwanted inflation. But tighter monetary policy also means slower growth, and putting the brakes on growth can serve as a big shock to the economy. China’s attempt to cool inflation by tighter monetary policy may dry up the massive credit bubble that has allowed the country to grow at such a rapid pace. The dominos may then begin to fall, as high inflation leads to tighter monetary policy to slower growth to investors fleeing, and to the Chinese economic collapse contagion.

Inverted Yield Curves

Normally seen before recessions, inverted yield curves have surfaced in Brazil and India. The inversion of yield curves takes place when short-term rates rise above longer-term rates, signaling that investors will accept lower rates in the future – because they anticipate an economic downturn. Richard Bernstein, formerly a chief investment strategist at Merrill Lynch, pointed to the inverted yield curve as a sign that a “central bank has tightened too much”. Furthermore, “the most inverted yield curves are Greece, Ireland, Portugal, and then comes India and Brazil. There is your warning sign that no one is talking about.” [x] With interest rates at over 12 in Brazil and India, tightening may really hurt the economy as it could sharply halt economic growth. Slowing the economy down by tightening halts growth, but tightening may be the only effective way of preventing future asset bubbles at this stage. Tightening makes credit harder to get, which severely slows expansion and can even act as a negative shock that sends the economy into recession as it returns to equilibrium.

Slowing Growth

Most economists, analysts, and investors expect China and many emerging markets to grow at a nearly double-digit pace. If China and other countries fail to meet expectations, however, markets could crash hard as investments and stocks adjust to new, and less optimistic, circumstances. In fact, a slowdown that leads to very negative reactions could be growth of even 7 percent![xi] Moreover, China’s Flash Purchasing Managers’ Index (PMI), which measures growth in manufacturing activities, fell below 50 in July 2011[xii] – signaling a potential upcoming contraction. With the lowest reading in 28 months, the deceleration in China’s industrial activities should be a severe warning of a broader economic slowdown. If China can’t continue to grow at a rapid pace, while simultaneously controlling inflation, things could quickly spiral out of control.

Inflation Rate Outpacing Savings Rate

With inflation rates over 6 percent in China and other countries, having money deposited in savings accounts that pay approximately 3.5 percent is detrimental to the account holder. When inflation is higher than the return on savings, the money in the savings account is actually losing relative value over time; inflation makes money worth less, and the same amount deposited a year before has less purchasing power as time passes. Since households lose money by keeping it in the bank, individuals in these countries are either losing purchasing power as inflation outstrips their savings rate of return, or they are further adding fuel to the fire by investing their money into other assets that they hope will outperform inflation. And by investing their money into other assets, such as housing or stocks, they are further inflating the asset bubbles that are unlikely to be sustainable over the long term.

Soaring Investment

Investment as a share of gross domestic product (GDP) reached a record 46.2% in 2010.[xiii] Even though the country may still be developing, having investment comprise nearly 50 percent of GDP is a huge sign of risk and unsustainable euphoria.

Real Estate Bubbles

As we recently experienced in the U.S., many emerging markets will soon undergo massive real estate collapses when investors realize that housing prices cannot go up forever. With heavy investment from inhabitants and foreigners into emerging market real estate, asset bubbles have been almost inevitable. The claim has been that the massive population growth and increasing wealth will spur many to search for new homes and apartments. But with residential housing investment making up 9 percent of economic output (3.4 percent in 2003), a three-month unsold inventory of apartments (which means supply has outgrown demand), and massive risk exposure to real estate by banks, the upcoming real estate fiasco could truly derail world economies.[xiv] Even government officials and real estate executives have been warning of housing bubbles, especially in Hong Kong, where home prices have risen more than 70 percent since the start of 2009. [xv]

Ghost towns are appearing, with one city equipped with museums, libraries, suburbs, and four-lane highways and built for 1.5 million people, but only housing approximately 20,000 people.[xvi] It has been estimated that there are currently as many as 64 million empty homes in China.[xvii] So too with the South China Mall in Dongguan (one of 500 malls built in China over the past five years[xviii]), which was built with the capacity for 1500 tenants but has only filled 15 to 20 spots (a nearly 99 percent vacancy rate). [xix]

Overconfidence in Buying

“One of the most natural ways to find overconfidence in market is to look for world record prices, or any type of world record set from an asset perspective. That is usually a sign of national hubris and overconfidence being manifested in the form of buying behavior.” -Vikram Mansharamani, Author of Boombustology

Chinese overconfidence and extreme speculation is evident in the record-setting bidding at art auctions (a Picasso purchased for $110 million), large buying of expensive wines, a dog that was bought for over $1 million, the world’s most expensive racing pigeon, and ‘mutton fat jade’- once used to fill bags to hold back flood rivers – now selling for more than twice the price of gold![xxi]

“Skyscraper Indicator”

As Vikram Mansharamani, Yale lecturer and author on financial booms and busts, points out:

“One of my favorite indicators that combines the credit and psychological filters is the world's tallest skyscraper. Here is an indicator that, if you go back in time, you will see clearly predicts economic slowdown quite dramatically. In New York in 1929 three towers competed for the world's tallest status – 40 Wall Street, the Chrysler Building and the Empire State Building. In the early 1970s we had the World Trade Center and the Sears Tower followed by a decade of stagflation. In 1997, the completion of the Petronas towers in Malaysia came just before the currency crisis swept south-east Asia. In 1999, construction begin on Taipei 101 at the height of the tech boom. And at the height of the credit and commodity bubble of 2007/2008, Dubai took the crown with the Burj Dubai (now renamed to reflect the Abu Dhabi bailout). Today, five of the largest ten towers under construction globally are in China.

Why does this indicator work? Because the world's tallest skyscraper under construction is usually a sign of, first, speculative excesses – remember they are built by developers not the people who plan to occupy them. Second, there is no economic reason to pursue world's tallest status – that’s a simple manifestation of hubris and national overconfidence. And third, easy money – these things are never built with full equity financing – they’re usually built relying heavily on other people's money.” [xxii]

The speculative and arrogant behavior inherent in massive skyscraper construction may be distinct proof that the investment mania and period of rapid growth is nearing its end.

Fraudulent Companies

“One of the characteristics of manias, especially in their final days, is that they are usually riddled with fraud…The uncovering of such dishonesty adds fuel to the downward spiral in prices.” -Martin Pring, Investment Psychology Explained [xxiii]

A number of Chinese companies listed on U.S. and Canadian exchanges have been exposed for committing accounting fraud [xxiv]. It has been relatively easy for fraudulent companies to gain access to U.S. investors and list on foreign exchanges, since the massive euphoria regarding the Chinese economy has created the illusion that nearly all Chinese companies could be profitable. Just like the dot-com bubble in the late 1990s-2000, investors have simply bought almost any company that has any connection to the profitable theme. In 2000 it was any technology company, now it’s any Chinese company. When investors begin to realize that much of their investment has been speculation, especially in fraudulent companies without proven financials or profits, the China theme may come to an end.

Unnoticed Falling Market

One of the biggest threats to global markets is the “invisible” and largely unnoticed declines in the stock markets of emerging markets in 2011. Most U.S. investors still base much of their investment decisions on the assumption that emerging markets are the future for growth, and they refuse to accept most negative news that may disprove the emerging markets thesis. In the meantime, however, emerging countries have seen their stock markets fall by nearly 30 percent! Not only are these drops much greater than the U.S. stock market declines, but the larger failure of emerging markets over US markets could be a very severe warning that the emerging market theme is over. Without emerging markets leading the way for global growth, most investors who based their investment decisions on continued rapid growth will no longer be able to justify their claims. Instead, the economic and financial turmoil that may ensue in countries like China and Brazil could derail the global market.

China’s Shanghai Stock Exchange has not made new highs since August 2009!

Brazil’s Bovespa Index is now in a bear market[xxv] following a drop of over 30 percent since November 2010.

The ongoing and largely unnoticed weakness in emerging markets is a huge threat to continued global growth. Emerging markets may have led the way into the 2009-2010 recovery, but they may also be leading us back into recession as their growth has spiraled out of control and as excess speculation has created asset bubbles across real estate and stocks. If China, Brazil, and other emerging markets continue to show weakness, global economies will likely enter a renewed recession. A renewed recession will not only result in falling stock prices, but will also take its toll on commodities as emerging market growth no longer supports the massive increases we’ve seen in commodity prices. And if commodity prices fall, they will likely drag gold down with them.

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Source: China, Emerging Markets Point To Double-Dip