‘A Full-Blown Crisis’

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Emerging markets were supposed to save the world with their fiscal responsibility. So much for that.

By Stefan Theil
From the magazine issue dated Nov 3, 2008

Last week seemed to be the nail in the coffin of "decoupling," a theory that said increasingly savvy and solvent emerging markets would no longer march in economic tandem with more-developed nations. As the global financial crisis deepened, South Korea announced a $130 billion bailout for credit-starved banks and companies, Ukraine canceled elections amid a growing national crisis over frozen credit markets and a plummeting currency, and Pakistan asked the International Monetary Fund to arrange emergency financing amid the country's worsening economic meltdown. All this came after a torrent of ratings and outlook downgrades by agencies like Fitch and Moody's on former shooting stars such as India, Vietnam, Hungary and Argentina.

What happened? Only a few months ago, emerging economies were considered islands of stability and rectitude in a largely Western crisis. Some boosters even thought they would save the world from recession. After a series of economic implosions in the 1990s, their governments had shored up their national balance sheets, paid off the IMF and built up Significant rainy-day savings. Now currencies are imploding (the Korean won is down 33 percent against the dollar), capital flows are drying up and central banks from Asia to Latin America are drawing down their reserves to prop up currencies and rescue their credit-starved banks and exporters. Risk premiums on emerging-market country bonds have more than doubled since August, and in some cases, like Iceland and Pakistan, investors have begun to worry about default. Emerging-market equities have gotten clobbered this year relative to the Dow. David Roche, president of the London investment advisory group Independent Strategy, says, "We're heading for a full-blown emerging-markets crisis."

It turns out that vital parts of many countries' economic success have been as unsustainable as an American zero-down, adjustable-rate mortgage. For example, much of their stellar growth has been fueled by an outsize dependency on the foreign capital and credit that is now rapidly drying up. In 2007, this inflow of cash amounted to a record 6 percent of emerging-market GDP, exceeding levels set just before the 1997 Asian crisis. Morgan Stanley chief currency economist Stephen Jen estimates the flow will contract by half in 2009—from $750 billion to as little as $350 billion. As a result, says Jen, these markets will be starved of capital and their currencies pushed down.

Outside the big surplus countries like China and the petrostates, a rising number of nations have been running big trade and capital deficits.

Over the past few years, Korean banks, Brazilian companies and Hungarian homeowners took out cheap loans in dollars or euros to repay with a local currency, betting that the economic landscape wouldn't shift. Tiny Iceland, for example, took up these kinds of loans in amounts worth six times the country's GDP.

The trouble will obviously be felt far beyond national borders as the economic loop circles back to rich countries. European banks especially have lent heavily to Hungarian or Ukrainian debtors that made risky one-way bets on being able to repay their euro loans with a rising currency; now these currencies are under pressure. Austrian banks have outstanding loans to Eastern Europe worth 56 percent of Austria's GDP, and Swedish banks have lent the three tiny Baltic states 18 percent worth of Sweden's GDP. As Hungary faced a credit seize-up last week, the European Central Bank took the highly unusual step of supplying a €5 billion emergency credit line—even though Hungary doesn't even use the euro—in part to protect its own banks from Hungarian defaults.

The traditional lender of last resort, the IMF, has a stash of $200 billion available for bailouts.

But financial power is shifting; China last week lent emergency cash to Pakistan, and Iceland was in negotiations with Russia before the IMF finally stepped in.

The next wave of trouble will come as soon as early next year, when emerging-market companies alone will need to roll over $360 billion in debt. Where they go to get it will say a lot about the state of the global economy.

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