The Turkish lira has slumped in recent days, sending ripples across other emerging market currencies and stoking fears of another financial crisis.
To gauge whether the recent turmoil could develop into a full-blown crisis, let’s take a quick look at some important developments following the global economic disaster a decade ago.
Major central banks, such as those in the United States, Europe, the United Kingdom and Japan, launched various sorts of quantitative easing (QE) measures in the wake of the 2008 financial crisis, thereby injecting enormous liquidity into the market.
As a result, the balance sheets of the four central banks expanded by over US$11 trillion from their troughs during the crisis.
This massive liquidity has flowed into different asset classes, including emerging market debt and securities markets.
Credit to the non-financial sector has soared more than two times from that in 2008, and the credit to GDP ratio also spiked to 193.6 percent at the end of last year from 107.1 percent, according to data from the Bank for International Settlements (BIS).
Such a pace of credit expansion in emerging markets has far exceeded their economic growth, and a large portion of the incremental debt pile is in US dollars.
The combined dollar debt of emerging markets has reached about US$3.7 trillion as of the first quarter of this year, up 1.4 times from late 2008, according to BIS data. Asia and Latin America have taken up the bulk of this debt.
The problem began to surface when the US dollar and interest rates started to climb.
The Federal Reserve ended its QE in late 2014 and started tightening its monetary policy in December 2015.
The US dollar interest rate began to go up. The three-month interbank borrowing rate for US dollars hit a 10-year high of 2.4 percent early this year, from below 0.25 percent. The 10-year US Treasury yield also surged above 3 percent in the first half of this year before edging down a bit.
Higher interest rates have considerably increased the debt financing costs for emerging markets.
Over the last year, the average yield for high-yield bonds has jumped over 100 basis points. And emerging markets need to repay between US$170 billion and US$230 billion in dollar debt and interests annually in the next four years.
The debt burden is poised to increase if the Fed raises rates further, which is quite likely.
The strength of the US dollar has also brought damaging impact on emerging market assets.
The dollar index has recovered nearly 10 percent after touching a trough of below 90 in April.
A strong dollar will hit emerging markets in multiple ways. For example, their debt burden will increase. And as the strong dollar weighs on their currencies, that would also lead to capital outflow.
In sum, the current direction of the US dollar and interest rates could be very harmful to emerging markets, while the US-China trade war could make things worse.
Unless the Fed slows the tightening pace and the trade conflict dissipates, emerging markets are likely to face even bigger pressure.
If things deteriorate further in emerging markets, the Hang Seng Index might tumble below 25,700 points. Investors should prepare for a bumpy ride.
This article appeared in the Hong Kong Economic Journal on Aug 17
Translation by Julie Zhu
[Chinese version 中文版]
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