New Credit Junkies

When America’s subprime financial crisis erupted almost a decade ago, the finance ministers of some emerging-market nations, basking in the knowledge that their countries were the engines of global growth, felt a little smug. After all, China, India, and Brazil, for instance, had largely avoided the craziness of the credit bubble, while also managing to expand their economies.

So as Wall Street squirmed, it was clear that the tables had turned: Emerging markets—not the West—held the moral high ground.

No longer. Although China and India are still posting reasonable rates of growth, many others, such as Brazil and Russia, are in recession. In addition, when it comes to dodging debt bubbles, these saints may very well have lost their halos. While the Western world has been trying to learn the right lessons from the past great financial crisis, emerging-market countries have quietly embarked on a dangerous new credit binge that has gone largely unnoticed by many investors and policymakers. In fact, 2016 could be the year that financial reality—or gravity—finally hits with unpredictable consequences.

The scale of this new debt problem—as well as the source of the risk—can be understood by looking not only at emerging markets, but by scrutinizing the U.S. Federal Reserve. Back in 2009, as the Western world reeled from the subprime shock, the Fed and other central banks embarked on a dramatic effort to stave off recession risks by unleashing unorthodox monetary experiments such as quantitative easing.

This caused the Fed’s balance sheet to hit $4 trillion, a whopping four times its pre-crisis size, with similarly eye-popping expansions in Japan and the United Kingdom. Economists reckon that central banks have pumped the equivalent of $7 trillion more funds into the global system since 2007 via their monetary moves.

Although these trillions sound enormous, the net result has not been quite what the Fed or others expected. Some of this monetary ammunition has helped Western economies rebound. The United States, for example, is now posting growth rates of more than 2 percent.

But real growth has been much slower than expected. When economists look back at what has happened in recent years, it is becoming clear that a large part of this supposedly “Western” monetary injection did not actually end up in Western economies at all, as policymakers had hoped. Instead, much of that stimulus leaked out to emerging markets—or, more accurately, the liquidity that the Fed and others provided was recycled through global bond markets and bank channels to fuel a credit boom in the nonbank corporate sector in China, India, Brazil, and elsewhere.

Judging the scale of these flows is fiendishly hard because the data tend to be patchy and parts of the bond market are very opaque. It is particularly hard for statisticians, for example, to work out what is going on with the type of offshore centers that Chinese companies are increasingly using to issue bonds.

However, last fall Citigroup combed through balance-of-payments data issued by major countries and calculated that there have been around $8 trillion worth of flows from Western countries to emerging markets since 2000, most of which have occurred since 2008. As that money has arrived in the banking systems of those markets, it has been turned into a mountain of new loans and bonds, generating more debt.

Thus, Citi strategist Matt King estimates that in the past couple of years, around $5 trillion of gross new credit has been created in emerging-market countries as companies have taken out more debt. This exceeds the amount of new credit created in the developed world. As I wrote in the Financial Times last October, Citi calculates that “three-quarters of all global private money creation in the past five years has occurred in emerging markets.” It’s little wonder, then, that the International Monetary Fund reckons that emerging-market debt has more than quadrupled in the past decade, from $4 trillion to around $18 trillion. To put it another way: Although Main Street America may have been weaned off debt, the credit binge has moved to emerging markets instead.

Now, if that debt were all being poured into productive activity that would raise the future rate of growth, this might not be alarming. Debt is what enables economies to expand. But this does not seem to be the case; in China, for example, factories are idle because of overinvestment. What is doubly worrisome is the currency composition of the debt.

Back in 2008, the mantra among most emerging-market governments was that they had to avoid what economists like to describe as the “original sin,” the practice of incurring foreign-currency debts that are serviced by local-currency revenues, creating a currency mismatch. After all, during the Asian financial crisis in the late 1990s, this “sin” proved deadly for South Korea, for instance, when companies took out dollar loans they were unable to repay when the Korean won collapsed in value against the greenback. Nobody wanted to repeat that mistake.

But memories are short, and the temptation of “sin” is strong. The Swiss-based Bank for International Settlements estimates that since 2008 the dollar borrowing by nonbank entities in China has quietly quadrupled to over $1 trillion. In India, dollar debt has jumped from around $60 billion to $118 billion, and in Brazil it has risen from around $100 billion to $322 billion. Emerging markets as a whole now have nearly $4 trillion of dollar debt, mostly issued by private entities, according to official data. Some of these borrowers, like energy groups, earn revenues in dollars. But many do not. Once again, asset-liability mismatches loom.

An optimist might argue that there is no reason to worry about this. After all, there have been precious few defaults by emerging-market countries in recent years, and their leaders insist that none need ever occur—not if currencies stay stable, if growth remains strong, and if interest rates continue to be low. But that is a lot of ifs. In a world where the Fed is keen to “normalize” U.S. policy (i.e., raise interest rates), clearly a lot could go wrong: 2016 could easily be the year when the dollar surges, oil prices fall again, and growth slows down.

The message for investors and policymakers is clear: When the markets are obsessively watching the Fed, there is every need to keep watching the murkier details of Chinese, Indian, and Brazilian markets too. At best, the world needs to brace for emerging-market defaults. At worst, 2016 could deliver a new type of credit crisis—one that is likely to happen in some of the most politically volatile parts of the globe.

Illustration by Matthew Hollister