Next Bust Creeps a Little Closer

While the financial system appears inoculated against a global crisis, emerging markets are increasingly vulnerable. And there's at least one scenario where a local crunch could trigger a global crisis, writes MoneyShow's Jim Jubak, also of Jubak's Picks.

How near is the next bust? I raised this question a month ago, and concluded...not very.

I haven't completely changed my mind, but:

• I'm still convinced that a bust of the magnitude of the global financial crisis that followed the Lehman Brothers bankruptcy is very unlikely.
• I hear the growls from the bears that say we're looking at a replay of the Asian currency crisis of 1997. I think a replay is very unlikely.
• But "something like" a smaller version of that crisis does seem to me to be more possible than it was a month ago. Emerging stock markets will bear the brunt of that smaller version—and I don't think the decline in those markets is over yet.
• The biggest danger of a global crisis remains the Eurozone banking system, and that danger is largely overlooked by the current market.

The Asian currency crisis of 1997 is a good place to start any examination of the risks in this market. To be clear, I don't see a replay of the crisis that took the Thai stock market down 75% in 1997, that resulted in a 13.5% drop in Indonesia's GDP, or that required a $40 billion effort from the International Monetary Fund to stabilize the currencies of South Korea, Thailand, and Indonesia.

But I do see a way that some of the conditions of that crisis could re-emerge for a different cast of characters-Brazil, India, and Turkey are more likely participants in this version than South Korea or Indonesia. And the cost could be a retreat of another 15% or 20% in stock prices.

In other words, a deep, painful, but selective bear market in emerging nations, rather than a global financial crisis.

Been Through This Before
Unless the world's central banks make huge errors, a crisis of that dimension wouldn't take down the global economy or global financial markets. And while I wouldn't rule out errors of that dimension, they are unlikely.

The scenario we're looking at is one the central banks have been through before, and that they have traditional central bank tools to handle. But a crisis of that dimension, especially one with echoes of 1997, is enough to produce confidence-shaking volatility that will test central banks, traders, and investors.

The preconditions for the Asian currency crisis were the devaluation of the Chinese renminbi and the Japanese yen, and an increase in US interest rates. Those forces put pressure on the currencies and financial markets of countries such as Thailand that were running current-account deficits, and were dependent on cash inflows from overseas investors to balance accounts.

When money stopped flowing in and started to flow out into the United States in order to take advantage of higher interest rates, the financial positions and currencies of these countries started to unravel.

At that point, some Asian countries had adopted fixed exchange rates in an effort to keep their export economies running at top speed, by making sure that an appreciating currency didn't make the cost of Thai, or Indonesian, or Korean, or Philippine goods more expensive for customers in the United States, Japan, and China. The exchange rate with China was extremely sensitive, since many Southeast Asian companies exported semi-finished goods to China for further manufacturing and export to the United States and Europe.

But as cash flowed out of these economies and currencies, it quickly became not a question of preventing these currencies from appreciating, but instead of preventing their collapse. Traders can count, and looking at the foreign-exchange reserves and the current-account deficits in these countries, they bet that central banks and governments wouldn't be able to defend the value of their currencies.

And indeed they couldn't. The Philippine peso, for example, went from 26 to the US dollar in 1997 to 38 in mid-1999. The Korean won and the Hong Kong dollar came under attack. The volatility was scary enough by itself: Hong Kong's Hang Seng stock market index fell 23% from October 20 through October 24.

Finally, the Thai baht collapsed, taking the Thai stock market with it. Thai stocks fell 75% in 1997. With financial markets essentially shut and currencies collapsing, economies ground to a halt for a lack of financing. The Indonesian economy contracted by 13.5% in 1998.

The International Monetary Fund and global central banks finally stepped in to guarantee liquidity in these markets. But not before the crisis had spread to China. The Chinese government and the People's Bank of China had to take extraordinary steps to guarantee the solvency of the country's banks as a tide of bad loans swept through the economy.

Echoes of an Earlier Crisis
With that history, you can see why raising the specter of the Asian currency crisis might be so scary right now.

There are echoes of the crisis in the drop in the yen that stretched from early November 2012 to mid-May. From November 12 to May 16, the yen dropped 28.6%. And US interest rates have started to rise: in the last month, the yield on the ten-year US Treasury has climbed to 2.14% from 1.88%, an increase of 13.8%.

Seeing this, countries with chronic current-account deficits, such as Indonesia and India, have moved to slow outflows and defend their currencies by moves such as raising interest rates.

Certainly, there are spots of danger that seem reminiscent of 1997. Indonesia and Turkey, two of the hottest emerging markets of 2012, are both heavily dependent on foreign cash flows, and they've both seen big outflows of foreign cash in recent weeks. (Violence in the streets of Istanbul hasn't helped Turkish markets.)

Brazil also looks like it's in trouble, with cash flows out of the country picking up at the same time as the economy is slowing. That, of course, makes it hard for the Banco Central do Brasil to raise interest rates, although with inflation at 6.5% in May-at the top of the bank's range of 4.5% plus or minus two percentage points-the bank is likely to have to raise interest rates sooner rather than later, no matter how slow the economy.

And, of course, Japan, with an estimated debt-to-GDP ratio of 224% in 2012, is clearly nowhere near a sustainable level of debt.

But the differences with 1997 are significant. To me, they add up to volatility, further slowing in the global economy (and a significant drop in growth in some developing economies), a further drop in the price of emerging-market stocks, and big cash flows out of emerging-market debt.

But as painful as these market retreats as likely to be, they don't equal the kind of threat to global financial markets and economies that we saw in the Asian currency crisis.

(Not everyone agrees with me. You can get a good statement of the bear case in this interview with Albert Edwards of Societe Generale at Index Universe.)

What's different? Developing economies are, by and large, in better shape to weather a currency/overseas cash flow crisis than they were in 1997.

Asian currencies that were pegged to the dollar or to some basket of currencies in 1997 now float with relative freedom. That has made adjustment to changing market and economic conditions a gradual process, rather than leaving any change to one big crisis.

Foreign-exchange reserves are also higher than they were in 1997. Indonesia, for example, had foreign exchange reserves as of May equal to 5.8 months of payments on its export bill, versus 3.9 months in 1997. The biggest swing is in South Korea, which had $329 billion in reserves as of April 2013, versus just $8.9 billion in December 1997.

The Most Vulnerable Markets
What this means this time is that central banks in countries that have been dependent on overseas cash flows to fill a current-account gap may have to raise interest rates to encourage capital flows.

Economies in these countries may, indeed, slow. Stocks and bonds will probably tumble. (Markets that look most vulnerable to further declines on this dynamic include Brazil, Indonesia, the Philippines, Turkey, and India.) But the kind of systemic crisis that rocked the global economy in 1997 isn't likely to come out of emerging markets.

The bears recognize this, and the crisis that they're talking about this time is "like" the 1997 crisis, but different. The unsustainable debt this time and the country that won't be able to handle an increase in borrowing costs isn't South Korea or Thailand, but Japan.

Makes sense, right? Japan has a huge debt, 224% of GDP and climbing. Interest rates are an extraordinarily low 0.83% on ten-year government bonds. An increase to 2%, as many bearish scenarios contemplate, would push interest payments to an unsustainable level.

I think it's hard to argue with that in the long run, but the question is when the long run kicks in. Right now, Japanese budget figures say the national debt service takes up 22.4% of the government budget—but that figure includes both interest payments and money paid to redeem maturing bonds. (The government, of course, turns around and sells new bonds to make up for those maturing. It's not like Japan is actually paying down its debt.)

Actual interest payments make up about 10% of the country's budget, Paul Krugman calculates. That puts off the long run for a while. So too does the incredible durability of low interest rates. Despite everything, at 0.83% the yield on the ten-year government bond is only a tad above the 0.85% rate a year ago.

The yen, remarkably given the long-run picture, has actually rallied in the last month. And whatever the long-run picture right now, there's no shortage of demand for Japanese government bonds. In fact, the slight creep upward in yield seems to be related not to any paucity of demand, but to a lack of supply, as buying by the Bank of Japan soaks up new issuance.

One of the problems facing the Bank of Japan and the Abe government is the persistence of deflationary expectations. Japanese savers remain remarkably comfortable with today's low rates because they are still factoring price deflation into their calculations.

Getting them to switch to an expectation for inflation looks likely to take a while—especially if markets remain skeptical of the government's commitment to an inflationary goal.

Worried About the Eurozone
But frankly, one of the reasons that I'm less worried about Japan being the locus for the next crisis is that I'm more worried about the Eurozone. Banks there are much more exposed to losses from any increase in interest rates than their Japanese counterparts are.

Banks in Japan largely hold bonds to maturity, and thus are much slower to show mark-to-market losses in their portfolios that would destroy big chunks of bank capital. European banks, with their huge holdings of sovereign debt, have more of their capital base exposed to rising interest rates and falling prices for sovereign debt.

The base premise of Mario Draghi's promise that the European Central Bank would do "whatever it takes" to defend the euro was that Eurozone governments would use the time that promise bought to enact reforms that ranged from the creation of a Eurozone banking system to reforms of pension systems and loosening of controls on professions in individual countries.

Unfortunately, most of that reform agenda remains unfulfilled-at the same time that the central bank's obfuscations in its defense of its OMT (Outright Monetary Transactions) bank backup program have raised market doubts about the reality of a program that so far isn't even on paper.

Arguing, as the bank has done recently in front of the German constitutional court, that the program is both unlimited in size in theory, and severely limited in size in practice, has left an increasing number of market participants wondering exactly what the program really means for banks and bond rates.

These doubts are important, since the drop in interest rates for Spain, Italy, and peripheral members of the Eurozone, such as Portugal, has been based on faith in the European Central Bank backstop.

The big problem, the one that keeps me worried about Europe, is that the delay in reforms has meant that the dangerous linkage between government debt and the banks that are the biggest purchasers of that debt remains intact.

The Financial Times estimates that European banks still face €1 trillion ($1.34 trillion) in accumulated but hidden balance-sheet losses. If those losses have to actually be declared on bank balance sheets, banks in Europe would have to raise huge amounts of capital from very, very skeptical financial markets.

If you're looking for a mechanism that could turn a local crisis into a global crisis, you don't need to look any further. And if the Eurozone manages to avoid that crisis, I think we're still looking at years of slow to no growth, with all the additional pressure that puts on already stressed governments.

Just because I think the odds of a new global crisis are still relatively low doesn't mean I'm optimistic about global financial markets.

Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. For a full list of the stocks in the fund as of the end of March, see the fund's portfolio here.