In a striking development, a trend that has remained unchanged since 1988 is now shifting. During that time, the U.S. federal debt totaled a mere $2.6 trillion, but today, we are witnessing a significant reversal in emerging market investments.
According to the Institute of International Finance, for the first time in nearly three decades, capital is flowing out of emerging markets rather than into them. Net outflows are estimated to reach $540 billion in 2015. What could be the reason behind this shift?
Simply put, investors are withdrawing their funds from emerging-market investments at an unprecedented pace. Concerns about instability in countries like China, Russia, and Brazil are prompting a search for safer investment havens. Yet, that’s only part of the story.
From a technical standpoint, emerging market economies are encountering serious issues. The MSCI Emerging Market Index has fallen to a six-year low. Coupled with a strengthening U.S. dollar and declining local currencies, the dollar-denominated debts of these economies are becoming increasingly burdensome.
With already elevated debt levels, servicing these debts in stagnating economies seems increasingly unfeasible. This could potentially lead to a wave of defaults.
Another Cheap Credit Boom
Recently, the International Monetary Fund shed light on the troubling realities confronting emerging market economies. For instance, corporate debt among nonfinancial firms in these regions surged from approximately $4 trillion to over $18 trillion from 2004 to 2014, leading to a 26% increase in the corporate debt-to-GDP ratio during the same period.
This boom, while initially beneficial for these economies, has proven to be far from sustainable. The apparent prosperity was not as robust as it seemed. What began as genuine demand-driven growth has devolved into a frenzy of borrowing facilitated by easily accessible credit.
As the IMF pointed out, “Low interest rates in advanced economies, including the United States, Europe, and Japan, have spurred this borrowing.” This surge in debt often contains a higher proportion of foreign-currency liabilities in firms’ debt-to-asset ratios.
Those firms with the highest levels of borrowing are likely to feel the most significant impact from rising interest rates in advanced economies. Furthermore, local currency depreciations, driven by these rate increases, would exacerbate the difficulties emerging market firms face in managing their foreign currency debts, particularly if they lack adequate hedging strategies. Lower commodity prices further diminish the natural hedges for companies in this sector.
More Monetary Policy Madness
Much of the IMF’s assessment shouldn’t come as a shock. The commodities boom and construction surge of the previous decade was expected to falter eventually; such outcomes are almost guaranteed when interest rates reach historically low levels.
While countries like China and Brazil harbor significant growth potential, they must first navigate through substantial fallout. This situation poses risks not only for emerging economies but potentially for the growth trajectories of advanced economies as well.
It’s evident that advanced and emerging economies are more interconnected than ever. The weakening of emerging market growth is already impacting U.S.-based companies.
Caterpillar has recently announced plans to lay off up to 10,000 workers by 2018 due to dwindling demand for their heavy machinery. Similarly, Schlumberger, a leading oilfield services provider, has seen a workforce reduction of 20,000 this year. The repercussions stretch beyond U.S. companies—they are also reshaping monetary policy.
The latest statement from the FOMC noted that international developments would influence decisions regarding the federal funds rate. Given the challenges emerging economies are facing and the complications arising from a stronger dollar, it seems increasingly improbable that the Fed will raise rates this year. Alarmingly, a federal funds rate near zero is now being perceived as restrictive.
Any objective analysis indicates that the capital misallocations from the boom years must be addressed, and the Fed appears powerless to rectify these issues. It is irrational to expect the Fed to adjust its policies to sustain declining demand for building materials in China. Yet, this seems to be the path that Fed Chair Yellen is advocating for.
Sincerely,
MN Gordon
for Economic Prism
