Emerging markets displace Europe as fulcrum of world risk – Telegraph.co.uk

Indeed we do. My fear is that a China-led BRICS shock will transmit a wave of
deflation across the planet, pushing the West over the edge into another
downward leg of trade depression.

The eurozone polity cannot withstand such a blow. Youth unemployment is above
40pc in Italy, Spain, Portugal and Greece, and “nominal” GDP is contracting
across the four countries, meaning that high debt is rising on a shrinking
base.

Another twist of the deflation knife will be lethal.

America is in better shape, but it is hovering near stall speed. The ISM
manufacturing gauge fell below the “boom/bust line” of 50 in May. The most
draconian fiscal tightening in half a century is starting to bite.

Whether or not the EM slowdown is an inflexion point, or just a refreshing
pause, is now a neuralgic issue. What we know is that manufacturing PMI
indices are flirting with contraction across much of Asia, with Latin
America and Africa not far behind.

China’s PMI index turned negative in May, despite 20pc credit growth in the
first quarter. The extra GDP generated by each yuan of credit has dropped to
a ratio of 0.17 from 0.85 four years ago. The debt cycle is exhausted.

Societe Generale’s Beijing analyst Wei Yao warns that China may be on
the verge of a “Minsky Moment”, the tipping point when the debt
pyramid collapses under its own weight. “The debt snowball is getting bigger
and bigger, without contributing to real activity,” she said.

She claimed the debt service ratio of companies has reached a “shockingly
high” 30pc of GDP – the typical threshold for financial crises. “The logical
conclusion has to be that a non-negligible share of the corporate sector is
not able to repay either principal or interest, which qualifies as Ponzi
financing,” she said.

The scale is huge. Fitch Ratings says total credit has grown from $9 trillion
to $23 trillion in four years. The increase alone is equal to the US banking
system.

The EM bulls retort that China and the rising powers are protected this time
by $10 trillion of foreign reserves, 80pc of all sovereign gold and currency
holdings. This will indeed shield them against a currency attack. There will
be no exact replay of 1998, when debts were in dollars and fixed exchange
pegs blew up.

Yet it will not protect them against the deflationary shock as the Fed
withdraws global liquidity, or against their own credit busts. These
reserves are a Maginot Line. If China tries to repatriate the money to prop
up its own economy, it would push up the yuan, aggravating the
contractionary squeeze.

Nor are dollar and euro debts trivial, though this time they are private. The
IMF’s José Viñals said foreign borrowing “has been
growing at a rapid pace, exposing them to currency risk and leverage”.

Standard & Poor’s said EM firms raised a record $301bn in fresh debt
this year to April, up 42pc from last year.

The bearish notes are coming thick and fast. HSBC is liquidating much of its
EM debt and retreating into US Treasuries, “the least bad apple in the
barrel”, fearing that the global credit cycle has rolled over.

“We are out of virtually all our EM bonds. It is the end of the bull
market,” said Benoit Anne from Societe Generale. He is expecting “real
money” investors to follow hedge funds out of the door. “When and if
this kicks off, it will fuel another massive wave of correction,” he said.

Behind the fading EM story is a relentless loss of competitiveness as reform
slackens and productivity growth slows. Nowhere is that clearer than in
Brazil, left high and dry with a half-reformed, dirigiste economy when iron
ore prices crashed. It faces stagflation, with growth of 0.9pc last year.
Manufacturing output is down 3pc below its pre-Lehman peak.

The stock of foreign capital flows into emerging markets has soared from $4
trillion to $8 trillion since 2008, a big enough sum to cause global
ructions if the mood turns. That has clearly begun in such countries as
South Africa and Turkey, where there is a toxic mix of political risk and
current account deficits above 6pc of GDP.

What has set the retreat in motion is fear that the Fed will turn off the
credit spigot, draining the dollar liquidity that fuelled the booms. This is
what happened under the Volcker Fed in the early 1980s, triggering the Latin
American crisis.

You might well ask why the Fed’s Ben Bernanke would “taper” monthly bond
purchases (QE) if there is such a risk of global deflation. But the Fed can
be insular at times and is clearly having to pick between poisons.

The latest minutes of its Federal Advisory Council warn of an “unsustainable
bubble” if QE continues, and suggest the policy is doing more harm than
good in any case. The criticisms are getting under the skin of Fed insiders.
Even the Boston Fed’s ultra-dove Eric Rosengren now talks of tapering
soon.

Mr Bernanke will not be deterred by a shake-out on Wall Street, for that is
what he wants – to curb excess and rein in moral hazard. The rest of the
world can only pray that he does not push his point too far.