2017: Be Afraid of the Emerging Market Debt Crisis

The biggest one-day panic in Wall Street history occurred in 1987. The Asian Crisis hit in 1997. The Global Financial Crisis got rolling in 2007, when mortgage lenders Northern Rock and New Century Financial collapsed.

If you’re superstitious, that makes us due for another financial crisis. Next year ends with the number seven, after all…Will the calendar trend continue?

Let’s look at the details…

Should we laugh or cry?

From Bloomberg on 21 October:

The International Monetary Fund may have gotten things about right in its annual Global Financial Stability Report, which was issued in October. It doesn’t sound an alarm but expresses concern.

Short-term risks have actually abated, the IMF says, pointing to rebounding commodity prices, which help some key emerging markets, and the prospect of easier money in developed markets.

But, it says, “medium-term risks continue to build.” It cites the unsettled political climate, which makes entrenched problems harder to tackle; some weak financial institutions in developed markets; and heavy corporate debts in emerging markets.

To say it bluntly: The IMF’s report is far too conservative. Of course, the risks are pushed back into the ‘medium to long term’.

Jim Rickards, our in-house global strategist, believes that the IMF is the world’s worst forecaster.

It’s easy to see why…

The IMF is known to put out ‘rosy’ forecasts. It’s a political institution, with a mandate to calm — not alarm.

Imagine if the IMF gave accurate forecasts. For example, the world economy has been deteriorating for years, and will probably collapse soon. Financial markets, which are driven by confidence, will likely nosedive.

The truth hurts

Unfortunately, despite the IMF’s claim that ‘the short term risks have actually abated,’ we’re powerless to fight the trend in motion.

The threat of a major financial crisis is real.

The world was overleveraged in 2007. The following financial meltdown destroyed tens of trillions of dollars in wealth.

Did we learn any lessons?

Get real!

The world is more leveraged now than it was in 2007. It has created more than US$60 trillion of new debt. US President Barack Obama has doubled the US’ national debt during his two tenures. And the Federal Reserve leveraged its balance sheet by US$4 trillion.

The US isn’t alone…

The collective balance sheets of the six most active central banks (the Federal Reserve, Bank of Japan, European Central Bank, Swiss National Bank, Bank of England and the People’s Bank of China) have grown from around US$3 trillion in 2002 to more than US$18 trillion today according to Pimco, a global bond fund group.

The global financial system is in more danger than at any time in history. To think, there’s roughly US$12 trillion of negative yielding bonds worldwide. That’s right; you pay for the right to invest in these bonds.

Punters are hungry for cheap debt. And the emerging countries are leading the charge…

The Wall Street Journal on 6 October:

Corporate-bond issuance in emerging markets hit a record high for the month of September, even as worries grew globally over soaring debt levels amid tepid growth.

The amount of U.S. dollar bonds issued by companies in emerging countries almost tripled to $34.7 billion in September from the month before as borrowers rushed to lock in cheap funding ahead of an expected rate increase from the U.S. Federal Reserve.

That total, nearly 70% of which came from Asia, is the highest in any September in data going back to 2000, and puts total emerging-market dollar bond issuance in the third quarter at $84.2 billion.

Emerging market debt issuance has been relentless since 2007. You can see for yourself in the chart below.

Source: CreditSights
Click to enlarge

According to the latest IMF Global Financial Stability report, emerging market corporate debt has jumped from $4 trillion in 2004 to $18 trillion in 2014. Looking at the chart above, we can see that this number has probably increased to US$20 trillion.

The emerging market debt crisis

So, there’s roughly $20 trillion of US dollar-denominated corporate debt in emerging markets. That wouldn’t be a huge issue in isolation. But the US dollar bull is starting to gain momentum. The US Dollar Index (a basket of currencies weighted against the greenback) is shown on the chart below.

Source: tradingview.com
Click to enlarge

The US Dollar Index posted a third consecutive weekly gain last week. It finished the week at an eight-month high. The basket of currencies is touching a high of US$98.61 ­— the highest level since February. Following a brief pause earlier in the year, it’s clear that the dollar run is back. A breakthrough of the US$1.00 level could see a massive push to the upside.

If you’re running a manufacturing business in Brazil, India, Indonesia or Turkey, why would you borrow in US dollars?

It’s simple: Interest rates are at near-zero.

Remember, in many emerging market locations, interest rates are off the charts. For example, Argentina’s interest rate stands at 27%!

It’s far cheaper to borrow in US dollar-denominated debt. Because the US is the financial capital of the world — with the dollar acting as the reserve currency — it’s easier to obtain credit. The debt markets are exceptionally liquid.

But there’s one little problem with this picture. The US dollar is getting stronger.

The IMF doesn’t talk about a bullish greenback, the proverbial elephant in the room.

Like it has during every financial crisis in modern times, the US dollar will probably skyrocket during the next meltdown. During the 2008 financial crisis, the US Dollar Index jumped from 72 US cents to 88.2 US cents within months. During the 1997 Asian Crisis, the index jumped from roughly 88 US cents to US$1.02.

The next crisis could unleash the mother of all US dollar rallies, as the world economy and financial markets disintegrate across the board.

Assuming your emerging market business owes money in yuan, Turkish lira, or Indonesian rupiah, that’s great. But if you owe US dollars…as the dollar gets stronger, your debt burden goes up.

Will 2017 cement the fact that years ending in ‘7’ are unlucky? The signals are flashing red. Proceed with caution…


Jason Stevenson,
Resources Analyst, Money Morning

PS: The emerging market crisis may well be the trigger that launches a widespread global sovereign debt crisis. A crisis that will see first one, then many, nations default on their debts. That won’t be good for the stock market…to say the least. But there are some stocks that can deliver gains in almost any market condition. To learn how to prepare for the coming crisis, check out Resource Speculator here.

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