The Coming Crunch

From today’s Wall Street Journal Asia

The global credit crunch has now hit emerging economies, including those in Asia, which many had hoped or expected to be able to “decouple” from developed economies. There will be no escape, and even worse, the super typhoon that is now battering emerging markets will in turn deepen the global recession.

The global credit contraction will affect emerging markets in several ways. First, their exports and imports (of raw materials) will fall as excess demand is eliminated in the over-leveraged rich economies of Europe and North America. There will also be a reduction in capital flows to developing economies in all forms (credit, portfolio investment and foreign direct investment) as a result of deleveraging. At the same time, household and corporate wealth will be destroyed as a result of falling liquidity supply from both domestic and foreign sources. Those emerging economies with large foreign-currency bank loans and liabilities face debt deflation, while many corporations in Asia will find it difficult to grow because they are unable to roll over their excessive foreign loans and bonds.

Many emerging-market current accounts will turn from surplus to deficit, private capital inflows will drop precipitously and residents will run down their assets and take their capital out. So these economies will have a huge external financing problem next year. Their foreign exchange reserves will fall sharply along with their currencies and financial assets.

How will all this misery come about? In the great credit boom of the last decade or so, global liquidity took strange new forms. Credit supply and demand were multiplied by the advent of securitized debt and derivative instruments that facilitated almost limitless expansion of credit beyond the traditional balance sheet capacity of lending institutions. This is the phenomenon I call New Monetarism.

The credit bubble was the financial circuitry of excess consumption in many rich economies. Excess consumption was the appetite on which the factory economies of Asia fed. Like Cleopatra’s beauty “they made most want where most they satisfied.” In turn, other emerging markets that produced food and energy benefited from the insatiable appetite created by the economic boom of the factory economies. Thus emerging-market demand for commodities and energy was derived from growth in demand from rich economies.

But now excess credit is being removed. While this is happening, demand in rich economies will fall and savings rates will rise. So developing-world factory economies will see export demand cave in and this will cut their own demand for inputs. It has already fed through into lower commodity and oil prices.

Most emerging markets don’t have sufficiently robust domestic demand to offset the impact of falling exports as well as an overhang of surplus capacity in the export sector. Their domestic economies are just too small. In China, for example, the consumer accounts for only 36% of demand and investment for 42%, much of it export-related. In the U.S., the figure for the consumer is 70%.

Emerging-market exports were not the only beneficiary of excess credit growth. Capital flows were just as important. Excess liquidity flooded into these economies in the form of portfolio and FDI inflows. This boosted currencies and bloated domestic money supply and credit. In turn, this drove up asset prices and so created more wealth and more demand. Unsurprisingly, the private sector in these countries spotted the opportunity to borrow cheap money in weak currencies and built up massive amounts of dollar and yen debts and foreign exchange derivative liabilities.

So excess credit creation in the U.S. spilled over into both capital inflows to developing countries and demand for their exports. The former created big current account surpluses; the latter boosted capital account surpluses. Both sent international reserves, particularly of dollars, through the roof.

The sum of the twin surpluses — trade and capital — was too big for developing countries to absorb. And the rise in international reserves, which was converted into domestic currency by the locals who receive it, was too big to be sterilized by the central banks issuing bonds. So it flowed into the lake of local currency, causing asset prices and inflation to rise.

Emerging-market central banks were accumulating so many dollars they didn’t know what to do with them. If they sold them, the falling dollar could wipe out the value of their existing dollar holdings. So they sent their excess dollars back to Uncle Sam, where they generated even more credit expansion.

But now, as exports fall and inflows of liquidity dry up, the emerging markets’ net external financing requirement — the sum of their current account balance, net FDI and annual net debt repayment — will rocket. From being awash with surplus liquidity, many emerging markets will be parched of it, particularly emerging Europe, Latin America and central Asia.

The international financial institutions will try to avert the worst, but they won’t succeed. The U.S. Federal Reserve has offered $30 billion in swaps to four big emerging markets: Mexico, Brazil, South Korea and Singapore. This is in addition to IMF emergency loans to Hungary and Ukraine and a promise to lend five times their entitlement to emerging markets with a record of sound economic management.

In reality the countries being chosen for such aid are those that are strategically important to the donors. But the international authorities can’t defend even the economies that are considered “strategic.” The cost will be greater than the resources of the International Monetary Fund, World Bank and other agencies.

The thinking behind the bailout is also misdirected. When bubbles burst, asset prices have to find their own level at which they can be liquidated and sold off creditors’ balance sheets. Injecting dollar liquidity into emerging markets will not prevent this because the problem is one of the solvency of excessive private sector foreign currency liabilities. It is an earnings and balance sheet issue, not a currency one.

Moreover, there are many more deficit-ridden emerging markets that won’t be helped. In Asia, they include Indonesia, the Philippines and Vietnam. Globally the big and the ugly who lie outside the “defensive layer” established by the IMF, Fed and European Central Bank include Russia and Argentina. As they get hit, those that are being helped will be re-infected in turn.

The ebbing tide of global liquidity will test the perceived virtues of emerging markets. In reality, the above-average growth rates depended on an unsustainable credit cycle elsewhere that was amplified at home. The huge accumulation of foreign-exchange reserves was just an appendix of excess global liquidity. Budget arithmetic and external accounts were beneficiaries of the same phenomena.

As these winds of good fortune die out in the deserts of recession (or worse), I suspect that many measures of emerging-market fundamentals will prove mediocrity rather than excellence. That means that risk appetite for these assets will be very slow to return.

Mr. Roche is president of Independent Strategy, a London-based consultancy, and co-author of “New Monetarism” (Lulu Enterprises, 2007).

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