Emerging Markets in Another Death-Spiral

With the U.S. stock market flat from 2000 to 2007, emerging-markets were all the rage for investors, led by the China stock exchange’s 330% rise.  But when the Great Recession hit, U.S. stocks fell 50% versus the highly speculative emerging-markets crash led by the Chinese market’s death-spiral that sent prices down 72% in eighteen months.  Motivated by greed and undeterred by pain, Wall Street brokers and money managers have poured $400 billion of their customer’s cash into these treacherous markets since the crash.  But with little investment return and Fitch Ratings recently warning of rising credit risk, the emerging market may be in for another death-spiral.       

The Economist Magazine published “Sleepless Nights” on November 9th, regarding the rising concerns by emerging-market central banks that the combination of slowing growth and rising interest rates could set off another market crash that might rival the 2008 to 2009 blood-bath.  Once known for averaging double digit economic gains from exporting to the developed economies, growth in emerging markets has been steadily falling in the last couple of years to around 4.5% this summer. 

Emerging-market levels of growth would be considered extraordinarily fast in the developed world, where the U.S. economy has been growing at about 2% per year.  But these under-developed nations’ economies are usually highly leveraged with debt that is borrowed in their foreign lender’s currency.  If growth slows, emerging-market borrowers have less cash flow to service debt.  But they get a double whammy, because as their economies slow the exchange rate of their currency tends to fall and it will take more of their domestic currency to make payments on the same amount of foreign debt.

The only tool that central bankers in emerging-markets have to stop their currency from plummeting and causing the cost of their foreign debt to increase is to lift interest rates to strengthen their currency.  But higher interest rates act as a brake on economic growth, quickly causing the borrower’s currency exchange rate to fall further and their cost of paying back debt to rise further. Economists refer to this as a “death spiral” to explain why the securities of emerging-markets are prone to deep and nasty market crashes.   

U.S. stocks are up by 161% since the last stock market crash that bottomed on March 9, 2009, but emerging-market stocks are up by only 14%.  So far this year, U.S. stocks are up by 24% and emerging-market stocks are actually down by 6%.  Both the U.S. and the emerging-market economies have benefited from five years from the United States Federal Reserve (Fed) artificially driving down interest rates around the world by purchasing $4 trillion of bonds through a program known as “Quantitative Easing” (QE).  It seems clear that without QE, emerging-market economic growth would be negative.     

One negative side-effect of QE is that it drives interest rates down so far that savers who rely on stable income to live tend to be forced into higher risk-taking to maintain their lifestyle.  This explains why huge amounts traditionally conservative investors were talked into pouring $400 billion into speculative emerging-markets stocks and bonds.   

The other negative side-effect of QE is that it eventually creates inflation as the artificial cash from the Fed drives up the cost of commodities faster than the economy can grow.  Government statistics for inflation and the measure of its effect on the gross-domestic-product (GDP) in the U.S. are notoriously poor at warning of the rise in the inflationary costs people actually pay for goods and services, until inflation is raging out of control. 

My best early warning system to determine the impact of inflation on “real” GDP is to look at the price of the “Big Mac” as a measure of “real” inflation.  McDonald’s operates in a highly competitive industry and the price it sells a “Big Mac” includes the costs for beef, dairy cheese, wheat bun, labor, and real estate rents.  Since 2009, the price for a Big Mac, adjusted for the government’s reported inflation, had been falling steadily compared to the reported growth of GDP.  But the price of the Big Mac has risen by 9.3% so far this year compared to a 2.8% GDP growth reported in September. 

This tells me that inflation has returned and the Federal Reserve is soon going to end its Quantitative Easing and allow interest rates to rise.  Higher interest rates will slow the U.S. economy, but reduce the demand for imported goods from emerging-market economies much faster.  Those higher interest rates will also increase the exchange rate of the dollar compared to emerging-market economies; forcing emerging-market central banks to raise interest rates to prevent a rise costs in servicing their foreign debt. 

As the Lee Adler at the highly respected Wall Street Examiner has brilliantly reported by tracking the real-time hard data on the growth of U.S. Federal Withholding Taxes, unemployment has been declining at a steady 8% rate over the past two years.  The Labor Department’s November 8th report of “surprisingly stronger” job growth is confirmation that the Federal Reserve is behind the inflation curve.

The Federal Reserve’s summer comment that they may “taper” their QE securities purchases caused emerging-market stock prices to fall by 17%; exchange rates dropped by 20%; and bond yields jumped by 2-4 percentage points as foreign investors dumped emerging-market securities.  The International Monetary Fund even discussed emergency loans to Brazil, India, Indonesia, South Africa and Turkey. 

After the Fed publicly reassured investors that U.S. inflation was less than 2% and any Fed taper of QE would be far off in the future, emerging-markets stabilized and prices recovered.  But sophisticated investors have quietly sold $90 billion of emerging-market stocks and bonds. In the nine times the Federal Reserve has raised interest to fight inflation since World War II; its base lending rate to banks has risen by about 4% over the next two years. Consequently, a normal Fed tightening cycle would more than double interest rates from the current 3.25% in the U.S.

The emerging-market death-spiral appears already be returning as Indonesia's central bank on November 12th raised its benchmark interest rate to 7.5%, after its rupiah currency fell 20% in the last six months.  The Jakarta Composite Index ended down 1.4% as higher interest rates are expected to push up companies' borrowing costs.  Suryo Bambang Sulisto, Chairman of Indonesia's Chamber of Commerce warned, "We already have the highest lending rate in Southeast Asia” … “This hurts our competitiveness, so we hope the government can balance it with pro-business policies.”

Before today’s Indonesian rate increase, emerging-market lending rates to large businesses averaged 12% and small business loans cost more than 20%.  With the Federal Reserve about to tighten interest rates in the U.S.; the emerging-market economies will again be caught in another vicious death-spiral.


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