EM Crisis Can Lead To Global Debt Crisis, Just Like Subprime Did Back In 2007

by: Global Opportunities Analyst


Emerging Market economies are in serious trouble.

Increased US borrowing, which is helping the US economy and its stock market for now, is hurting many other countries' currencies.

Current EM problems can indeed merge into a much larger global debt crisis, just like the subprime crisis became a global financial crisis.

Argentina is on the brink of total economic collapse. Turkey's currency has been steadily falling, recently exacerbated by a Trump tweet. China's Shanghai Composite Index has fallen by more than 20% from its peak early this year (chart below).

News is abound about other Emerging Market (EM) currencies falling against the US dollar. China's yuan has fallen by almost 10% against the dollar since February. The Indian rupee just hit a record-low against the dollar, though the pace cannot be compared to the Argentine peso or the Turkish lira. Many other EM currencies have been doing poorly in recent months.

Europe isn't doing very well either. It seems that the whole world is fluttering while the US is roaring ahead. Why isn't the US economic growth helping others grow as well? One reason may very well be that the US is, at least partially, growing at the expense of many other countries.

Other economic expansions in our recent past seemed to be shared in a more balanced fashion. During the dotcom years, and especially during the mid-2000s housing boom, most countries, EM or Developed Market (DM), were enjoying good times together. Now, it seems there is something that the US is doing that other countries are either unable to do, or they just don't know how to do it. Or maybe, it's rather some kind of a zero-sum game in which the US is winning, just like Mr Trump brags about, and others are losing to the US. There may actually be some truth to this, and not necessarily because the US is causing it intentionally. As the business cycle has matured and money (especially the dollar) has become dearer (because of higher interest rates), there isn't that much room left for growth using debt, because debt has become more costly. And the US is on an unprecedented debt-fueled growth at a time of tightening monetary policy, which is indeed aggravating the situation for many other countries. Let me explain.

A significant portion of the current US economic growth is provided by the US government running a larger budget deficit than any other major DM economy. President Trump has provided the economy with a massive late-cycle fiscal stimulus, cutting taxes deeply. For 2018, it is estimated that the budget deficit will be 4.2% of GDP. It was 3.4% for 2017. It was smaller for 2016, at 3.2%. The 4.2% of GDP deficit for 2018 is around $833 billion. That is a big amount.

The US government has, through its new fiscal stimulus program under president Trump, injected an extra 0.8% of GDP (4.2% minus 3.4%) into the US economy, which has helped improve the economy (growing by an enviable 4.2% recently) and push the stock market to record high levels. Previous economic expansions did not see additional fiscal stimulus when times were good, which is what usually happens toward the final years of a business cycle. As it can be seen in the chart below, year 2000 saw a budget surplus, 2% of GDP, while the boom years of the housing bubble witnessed a shrinking of the Federal deficit until 2007.

It is not possible for many countries to replicate the US recipe of endless fiscal stimulus. Many other countries get into trouble in case they do not balance their budgets and their borrowing over a few years' time.

Europe has serious political issues, hindering the possibility of a coordinated fiscal stimulus program that would be acceptable and appropriate to all those who share the same currency but have very different economic and budgetary conditions. Some of the other countries who could have copied the stimulate-to-the-end recipe of the Trump administration seem to have run out of ammunition already. First ones that come to mind are the ones I mentioned at the beginning, Turkey and Argentina. They didn't have the luxury of owning the world's reserve currency, the US dollar. At some point, their public and private borrowing could not continue without getting their currencies hammered. Just like when a private company, or individual, starts to lose credibility after borrowing too much for too long and their IOU's (their corporate bonds, or their credit scores etc.) start to become worthless. The US on the hand acts rather like a central bank printing IOU's. Its IOU's don't do any harm to the central bank itself but create inflation for everyone else (their goods and services become expensive). Just like increased US borrowing is contributing to higher inflation in other countries.

The US can borrow as much as it wants. The US can, theoretically, run even a much larger deficit than it is running already and its currency would not lose in valuation. A larger US budget deficit doesn't exactly have the ability to push either inflation, or interest rates, much higher in the US, as it does in all the countries who are currently feeling the heat from currency depreciation, inflation and higher interest rates. US short term interest rates are set by the Federal Reserve, which is independent from the government. Longer term US treasury yields (which are the benchmark for other money market instruments), on the other hand, are considered safe haven bets (and with a pretty good yield) for the whole world and any pressure for them to go higher attracts funds from all around the world chasing safe yields. A larger US federal borrowing (and therefore wider Federal deficit), therefore, by attracting funds from other countries, pushes the dollar higher and other countries' currencies lower. The US borrows more but doesn't invest more abroad (which would even out the effects), and this has an upward pressure on treasury yields. Higher US treasury yields attract more funds to the US, which specially weakens currencies of the countries who are also running significant deficits (borrowing more than they are selling/making), and this in turn forces those counties to raise interest rates to defend their currencies. Higher interest rates in those countries (which are always much higher than the US) weakens their economy further, and it all turns into a vicious circle. US long-term rates, as it has been seen from the beginnings of this year, haven't been able to rise much despite record supply of treasuries and also record heavy bets by speculators. The reason being the unique position that the US dollar has, through its ability to attract funds/resources from other economies/countries. Therefore, an increased borrowing by the US has been seriously felt in economies who had hoped to try a similar path (of borrowing), for longer. Because they have lately had a truly ferocious competitor for funds/resources. 10-year yield has been stuck mostly around 2.9% since February (chart below).

It is true that nobody can blame the US for deciding to run a larger budget deficit. But that is one of the reasons EM currencies are falling. The other factor putting pressure on EM currencies is higher rates from the Fed. Of course, it has been reckless policies by many EM countries that have led to their current troubles, but let's not fool ourselves, that exactly the same reckless policies are mostly what is "Making America Great Again". America is running the world's largest current account deficit and the world's largest budget deficit in nominal terms by far. According to the CIA's World Factbook, the US ran a current account deficit of more than $466 billion in 2017, followed by the UK (over $100 billion), India, Canada, Turkey, France, Australia, and then Argentina. Obviously, the only EM countries in the list above, running highest current account deficits, are on the brink of economic collapse, while America is doing great, simply doing the same thing on a much larger scale.

At some point, the US will also run out of ammunition, but not because of a falling currency. It is also quite possible that the US, through its increased borrowing, will push other countries into trouble so badly that their troubles will eventually catch up to the US economy. Every economic cycle reaches its limits at some point and a quickly flattening yield curve (around 0.25 now) is probably the best indicator we are not far from that point. Mr Trump can also decide to raise the stimulus even more - sucking funds from all around the world - and putting pressure on other currencies. The Trump administration has been touting additional tax cuts for months.

However, the main problem, just like with the previous crisis, is too much debt. Last time, it was mostly about too much household debt in the US. This time around, it could be about too much borrowing, on a larger scale, in all sorts of places, from sovereign debt in EM, to corporate debt and household debt in both EM and DM. Emerging Market debt (including China) grew from $21 trillion in 2007 to $63 trillion in 2017. That, combined with the monetary tightening that is taking place in developed economies, is something serious.

In any case, it seems clear to me that, what has been a great year for the US economy and especially the US stock market, has been at least partially to blame for the woes of the rest of the world who have been trying to apply the same recipe Mr Trump has been applying, successfully. I have written before that I expect the US dollar to strengthen further, as neither the US fiscal stimulus nor the Fed tightening will see any reprieve in the coming months. This will put further pressures on weaker currencies.

The gorilla in the room is China. China, just like Japan before it, has been running, and growing, on selling to the rest of the world. It has also been using stimulus on a scale no other country has done until now for so long, and successfully, without being a DM economy. China hasn't had a recession for decades, and it has been able to achieve annual growth rates of more than 10% for many years (chart below). Most of this unequaled success has been achieved through various stimulus activities, pushing total Chinese debt to over 300% of GDP according to some reports (Institute of International Finance).

Most of the growth in China has been achieved through: 1) selling to the rest of the world, and 2) heavy stimulus measures after the financial crisis of 2008. As the Chinese economy has grown, American-style stimulus (lowering interest rates and borrowing more) has become a more necessary method of achieving desired economic growth. It is not unreasonable to assume now that China, just like Turkey or Argentina, eventually risks to run out of ammo if it will not be able to maintain a trade surplus. Of course, we shall keep in mind that Turkish, or Argentinian, economies are peanuts compared to China. China would need serious funding from abroad in case it didn't sell enough to the rest of the world. And, the world seems to be completely unprepared for a China running on foreign money as the US is already sucking in too much, crushing the currencies of other deficit-running countries. However, latest news is not encouraging for China in this regard. China actually recorded a current account deficit of about $28 billion in the first half of the current year, for the first time in 20 years. We don't know how things will proceed in the coming months and quarters for sure, but in case China is not able to return to a current account surplus, I doubt the yuan will be spared the pressures that have started to crush other currencies.

The Trump administration seems to be very serious about its imposition of heavy tariffs on China, and this will surely exacerbate the situation. Another round of tariffs on $200 billion worth of goods can be a serious blow to the Chinese currency as it will materially impact China's ability to sell to the US and maintain its badly needed engine of stability, its export prowess. Tariffs of 25% for $200 billion on Chinese goods might go into effect in a few days.

Back in 2007, almost nobody thought what started as the subprime crisis could turn into a global debt crisis. Almost nobody fears what is now an Emerging Market crisis - which is in reality a debt crisis in the making for those countries - could turn into a much bigger global debt crisis again. But the ingredients seem to be there.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.