Next year, the world economy will shrink. Only Europe will have moderate growth. Wealth destruction will produce a growth recession in the US. Japan will continue to emulate an economic black hole in the middle of a time warp. Emergent economies’ growth will be negative.
Lousy economics destroyed Asian and Russian financial markets. But now emerging-market contagion will be a financially transmitted disease. Rich countries will be infected by financial flows more than by trade flows.
Vast swathes of wealth and capital are being destroyed in the global financial system by the collapse of emerging economies. The banking systems of many emerging countries have been wiped out. Those of others, like China, are bankrupt and waiting to fall.
It’s no news that the Japanese financial system is a corpse. Whatever they say in public, European banks are also going to have a hard time lending strongly into a recovery. And American banks are heavily exposed to Latin America, where the next dominoes will fall.
OECD banks have lent more than 140% of their core capital to emerging economies. I calculate that they now risk losing between $300 billion and $650 billion of their core capital, or 1.5% to 2.5% of OECD GDP. They can cover these losses either by writing off 18 to 36 months of profits; or by raising capital worth 25% to 55% of existing core capital; or by cutting $2.5 trillion to $5.5 trillion off current cross-border lending to maintain capital adequacy ratios (that’s 10% to 20% of OECD GDP)! It will probably be a bit of all three. Losses incurred on trading desks and by leveraged investors will make it worse.
The growing banking crisis explains why the yen is beginning to weaken again against the US dollar. The consensus has been too optimistic about a stabilization in the Japanese economy and the application of structural reforms. There’s no hard evidence of economic turnround in Japan – either in demand or on the supply side. And there is little sign of action on the banking sector’s huge bad debts.
Global instability will make Europe huddle together politically and economically. By far the strongest major currency will be the euro. Europe will be less affected by falling equity markets and is at an earlier stage of a very weak economic recovery. Ultimately, the European Central Bank (ECB) may have to cut interest rates to save the world. But it is likely to resist for longer. The euro will also benefit from being a major currency with no external deficits.
Meanwhile, emerging countries will eschew hard economic reforms and pursue easy-option policies (printing and spending money). That means higher inflation and weaker growth.
Take Russia. Winter is drawing in for the regime of oligarchs. Its final, desperate act will be to throw money at every financing gap that’s been built up in the Russian economy. This will send the rouble down to Rb50 to the dollar, from a black-market rate of Rb20 to the dollar today. The most likely outcome will be hyperinflation.
Money-printing will drain foreign currency reserves out of the official system. So the IMF’s second tranche (if it is ever paid) will disappear into the sands of dollarization like the first.
And that would merely drive rouble trade onto the black market – and with it, the trade of all imported goods. Barter will become even more endemic than today (about half of all payments are in non-cash form). And the 40% of federal taxes collected through VAT will disappear completely.
That matters. The Russian government has already started to miss payments on its sovereign external obligations. At today’s black-market exchange rate, Russia’s external debt burden is equivalent to around 100% of GDP. That’s higher than almost any other emerging country. It means that in the medium term, the government is more likely to be pushed towards outright default as its troubles deepen.
Dependence on foreign capital is the Achilles heel of emerging economies caught in this debt trap and it is the drying up of those funds that precipitates the crisis.
Take another emerging economy in deep trouble – Brazil. Measured by its annual net external financing requirement (that’s the current account balance plus repayments on long-term foreign debt plus net flows of foreign direct investment), over the next year Brazil needs about 5% to 6% of GDP from abroad to sustain economic activity and keep the real at current levels. The other major Latin American economies need nearly as much.
This is unfinanceable in today’s world. What will happen is what happened to Asia. Brazil’s public-sector domestic debt is 38% of GDP, with 60% in floating-rate paper. Before its collapse, Russia’s was only 14% of GDP.
It’s a vicious circle that can only be broken if Brazil reduces its dependence on foreign capital by slashing its public-sector deficit and releasing domestic savings for productive investment by Brazil’s dynamic private sector.
President Cardoso will have a new term of office and he plans a programme of fiscal reform. But if investors continue to doubt the government’s commitment, the real will crash. If Brazil goes the way of Russia, there will be a new round of emerging-market contagion. That will spread through the global banking system to the rich world. And imploding financial markets will kill world economic growth.
David Roche is president of Independent Strategy, a research firm based in London.
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