Ignacio de la Torre. Professor. IE Business School
6 February 2014
The storm that is breaking in emerging economies bears a striking resemblance to that of February 2007, when the first symptoms of the subprime crisis began to appear.
The subprime crisis did not begin in the summer of 2007, but rather in February of that same year. It was a small announcement of the bankruptcy of a mid-sized mortgage entity that unleashed the great storm. That was when the number of defaults on mortgages started to rocket and began to have knock-on effects on the credit derivatives of many contaminated agents. Given that the rest of the economy continued to grow at a decent pace, with credit working with apparently healthy banks and seemingly stable markets, many gullible people, myself included, suggested that the subprime problem was an isolated incident, and that market jitters would die down.
Therein lay the fatal mistake. Stock exchanges recuperated their initial losses, but the main source of infection had begun to spread. A seasoned financier laughed at us gullible lot when he said the immortal words: “You remind me of the first-class passengers in the Titanic, who happily danced away to the orchestra when the ship struck the iceberg. I was in the boiler room, and I saw the water come gushing in. I knew that disaster was inevitable.”
I have spent years observing this human paradox. I ask myself again and again why so many emerging countries have made the same stupid mistakes committed by the Americans, British, and Spanish. There is probably no answer to the question. It must be for the same reason that thousands of lemmings bought Spanish stamps from Ponzi in Boston in the 1920s, and decades later another lot of Ponzis scammed everyone once again using Spanish stamps.
The emerging markets storm is now breaking, but it has been brewing long since, as I have tried to explain in past articles. The tapering announced last summer already whipped up a storm similar to that of February 2007. The implementation of the tapering process, coupled with bad news on China’s PMI, have unleashed an even stronger storm over the last two weeks. In spite of the optimistic forecasts of many a market economist, I think that this time, the storm is only just getting started.
First, many of these countries have depended far too much on credit spread out over very few years. Credit levels have reached over 30 points of GDP in 4 years, and similar situations in the past have ended very badly.
Second, the growth of GDP in many emerging economies, which in 2000 – 2005 was based on a healthy increase, based in turn on exports and low debt levels, has ended up as a sickly growth rate based on alarmingly high lending intensities (the relation between credit per unit of GDP produced), and a GDP that is very dependent on investments, particularly on construction.
Third, as a consequence of the two points outlined above, a dangerous bubble has formed in large cities, with the relation between house prices and gross income at ridiculously high levels, far higher than those seen in the bubbles in the US, UK, or Spain.
Fourth, as a logical consequence of all the above, banking systems have proceeded to make big increases in loans, fuelled by an economic growth that reduced debt levels and rising real estate prices. As we found out in Spain to our cost, good things turn bad when the cycle changes, and now that it is indeed changing, it will be difficult to prevent a real estate and credit crisis from impacting sovereign risk. If to this vulnerable situation we add the growth of a shadow banking system that is subject to zero controls, as is the case of China, it is not hard to understand why there are some very strong tensions in Chinese interbank markets, and that they will only get worse.
Fifth, many of these countries, which were net exporters to the rest of the world (current account surplus) have seen their competitiveness fall because of steep rises in salary that are not being offset by rises in productivity. As a consequence, their trade figures have got worse, taking many countries towards a current account deficit, as in the iconic case of Brazil. Countries that accumulate high level of debt (stock) and a net need for funding (current account deficit) are in everyone’s sights, just as Spain was in 2008. In order to combat the resulting capital flight, some central banks (Turkey, South Africa) have proceeded to raise interest rates, without any success. The rise in interest rates makes the economy falter even more. The next line of action in the debate will be the introduction of capital controls.
Sixth, many emerging economies have not leveraged their “good” years enough by diversifying their export base, which continues in most cases to be extremely dependent on raw materials. In a scenario with lower marginal demand from China, and greater production as a result of the rising supercycle we have seen in recent years, the prices of raw materials will drop, which will further aggravate the abovementioned dependency that many emerging countries have on their current accounts. This will be the main hub from which contagion of the crisis will radiate from countries like China or Brazil to apparently healthier emerging countries.
Some time ago I wrote about how the finance system is a bit like a game of poker. If we know that one of the players is bankrupt but we don’t know which, the logical reaction for the others players is to stop placing bets, and if nobody is placing bets, then the finance market will dry up, which will lead directly to an economic crisis.
That is the terrible and paradoxical situation currently facing many emerging economies.