Since the U.S. Federal Reserve began talking about tapering its bond purchases last year, investors have been forced to separate the emerging-market sheep -- those with well-managed economies -- from the goats, with their poorly run economies.
The goats include the fragile five of Brazil, India, Indonesia, South Africa and Turkey, along with Argentina, the basket-case economy. They all have growing current-account deficits, weak currencies, serious inflation and falling stock markets.
The goats are forced to rely on foreign-money inflows to fill their current-account holes. When the money leaves, as it has in the last year, the goats find themselves in deep trouble, with no good choices.
So far, the goats have raised interest rates to try to retain and attract foreign funds. Higher rates may curb inflation, yet they also depress already-weak economies. Higher rates may also lend strength to currencies, yet strong currencies tend to crimp exports.
Artificially low interest rates and soaring inflation are encouraging Argentinians to spend, not save, for example. Consumers are frustrated because retailers don’t want to sell their goods, knowing they will have to replace inventories at higher prices -- if they can obtain them.
Argentina's attempts to defend its beleaguered peso have only resulted in a drop in foreign currency reserves -- to $29 billion in late January from $53 billion three years earlier. The government allowed the currency to drop 15 percent against the dollar in January, yet the black market values the peso at 13 to the dollar, versus the official 8-to-1 rate. Further devaluations to protect currency reserves and help exports will push up inflation by boosting import prices.
In some ways, though, the emerging-market goats are better off than they were in the late 1990s. Back then, many had fixed exchange rates and borrowed in dollars and other hard currencies. They didn’t want to devalue because that would increase the local currency cost of their foreign debts. Consequently, they were vulnerable -- and fell like dominoes when Thailand ran out of foreign currency reserves in 1997, touching off the Asian crisis.
Today, less foreign borrowing, more debts denominated in local currencies and flexible exchange rates make adjustments easier. Still, recent sharp currency drops are promoting inflation. Raising interest rates to stop inflation, however, depresses economic growth. Either way, it's no-win in goat-land.
What's more, current-account balances globally are a zero-sum game, so if the goats’ current-account deficits improve, other countries’ trade surpluses must weaken. This is difficult in an era of slow growth in global trade.
Who will help out the goats? Certainly not the U.S. Nor is China a likely volunteer now that its growth is slowing. Japan is seeking to spike exports and reverse a negative trade balance and near-negative current account. The euro area is also unlikely to lend a hand, considering its own economic weaknesses.
Apart from the common problems of the emerging-economy goats, specific countries have specific ailments. The Brazilian government, trying to support the middle class in recent years, has hired tens of thousands of new government employees, expanded the welfare system, subsidized auto fuel and electricity prices and directed government banks to promote consumer loans.
From 2009 to 2012, consumer lending increased on average 25 percent a year, but with credit-card interest rates of 80 percent or more, delinquencies are mounting. The earlier commodity boom made the consumer spending and borrowing orgy possible. Now that’s over, and Brazil isn't prepared to face the consequences.
Already, Brazilian consumers are retrenching. Retail sales last year rose 4 percent from 2012, the weakest since 2003. Gross domestic product growth last year was only 2.3 percent, down from 7.5 percent in 2010.
In Turkey, where a sprawling corruption probe has exposed a power struggle in the ruling party, the lira has been under pressure for a year. It is down about a third since last May. But the government has resisted raising interest rates for fear of choking economic growth, which slid from 8.9 percent in 2011 to 2.2 percent in 2012, before reviving a bit in 2013.
The hordes of money Turkey attracted during the Fed’s easy-money days are flowing out and no longer available to finance a huge current account deficit. With inflation heating up, the central bank boosted its overnight rate from 7.75 percent to 12 percent. The lira jumped in response before retreating.
Then there's Russia. “A number of emerging market economies, including Russia, can speak of stagflation,” Ksenia Yudayeva, the Bank of Russia’s first deputy head, said in January. In 2013, Russian real GDP rose 1.2 percent as of the third quarter, down from 7 percent in the early 2000s. Consumer prices rose 6.5 percent last year, above the central bank’s 5 percent to 6 percent range. The economy ministry said growth in the next two decades would be slow since oil, the driver of growth in Vladimir Putin’s reign, is waning and nothing is available to take its place, given the country’s poor investment climate and aging infrastructure.
I thought U.S. Senator John McCain’s recent description of Russia as “a gas station masquerading as a country” was on target. Any economic sanctions resulting from its annexation of Crimea could further hurt an already-feeble economy.
Another goat, Indonesia, is using export controls to deal with a negative and growing current-account deficit. The government also tried to sell $450 million in U.S. dollar-denominated bonds to local investors in November, but was only able to raise $190 million. The aim was to stabilize the currency, which had dropped 20 percent by then, and to fund the current account deficit in dollars. Indonesia has also raised interest rates.
South Africa has suffered from labor unrest, with multiple strikes among workers in the critical mining sector, which accounts for a third of exports. The strikes occur despite a quarter of the workforce being jobless. South Africa suffers from a large current account deficit, which hit 6.8 percent of GDP in the third quarter of 2013. The rand dropped 19 percent against the dollar in 2013 and 4 percent more this year. The country has tiny foreign-currency and gold reserves to support it. Inflation is high and stocks are weak.
For now, all emerging markets are under pressure -- and it will only get worse if China’s slowing economy keeps faltering or its vulnerable shadow banking system collapses.
When the smoke clears, the securities of the sheep economies may be cheap enough to be interesting. Still, I don’t expect growth in North America and Europe to be strong enough to absorb the sheep’s exports.
The goats may not collapse, because their government debt is mostly in local currencies, not dollars and other hard currencies, as was the case in the late 1990s. Their currency fluctuations may also cushion the blows. They are likely to enter a prolonged period of underperformance with no meaningful revivals -- but no collapses either.
(Gary Shilling is a Bloomberg View columnist and president of A. Gary Shilling & Co. He is the author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” This is the second in a two-part Financial Contagion.)
Corrects reference to current-account deficits in second paragraph. This is the second in a two-part series.
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