Home » Economy » What Blows Up First? Part 3: Subprime Countries

What Blows Up First? Part 3: Subprime Countries

by John Rubino on January 27, 2014 · 21 comments

One of the reasons the rich countries’ excessive money creation hasn’t ignited a generalized inflation is that today’s global economy is, well, global. When the Fed dumps trillions of dollars into the US banking system, that liquidity is free to flow wherever it wants. And in the past few years it has chosen to visit Brazil, China, Thailand, and the rest of the developing world.

This tidal wave of hot money bid up asset prices and led emerging market governments and businesses to borrow a lot more than they would have otherwise. Like the recipients of subprime mortgages in 2006, they were seduced by easy money and fooled into placing bets that could only work out if the credit kept flowing forever.

Then the Fed, spooked by nascent bubbles in equities and real estate, began to talk about scaling back its money printing*. The hot money started flowing back into the US and out of the developing world. And again just like subprime mortgages, the most leveraged and/or badly managed emerging markets have begun to implode, threatening to pull down everyone else. A sampling of recent headlines:

Contagion Spreads in Emerging Markets as Crises Grow

Investors Flee Developing World

Erosion of Argentine Peso Sends a Shudder Through Latin America

The Entire World is Unraveling Before Our Eyes

Chinese Debt Debacle Supports Soros’ ‘Eerie’ Portrayal

Venezuela Enacts “Law of Fair Prices”

Argentina Returns to Villa Miseria

Indian Rupee Falls to 2-Month Low; Joins Emerging Market Sell-Off

Turkey’s ‘Embarrassing’ Intervention Fails to Curb Lira Sell-Off

Prudent Bear’s Doug Noland as usual gets it exactly right in his most recent Credit Bubble Bulletin. Here are a few excerpts from a much longer article that should be read by everyone who wants to understand the causes and implications of the emerging-market implosion:

Virtually the entire emerging market “complex” has been enveloped in protracted destabilizing financial and economic Bubbles. In particular, for five years now unprecedented “developed” world central bank-induced liquidity has spurred unsound economic and financial booms. The massive investment and “hot money” flows are illustrated by the multi-trillion growth of EM central bank international reserve holdings. There have of course been disparate resulting impacts on EM financial and economic systems. But I believe in all cases this tsunami of liquidity and speculation has had deleterious consequences, certainly including fomenting systemic dependencies to foreign-sourced flows. In seemingly all cases, protracted Bubbles have inflated societal expectations.

For a while, central bank willingness to use reserves to support individual currencies bolsters market confidence in a country’s currency, bonds and financial system more generally. But at some point a central bank begins losing the battle to accelerating outflows. A tough decision is made to back away from market intervention to safeguard increasingly precious reserve holdings. Immediately, the marketplace must then contend with a faltering currency, surging yields, unstable financial markets and rapidly waning liquidity generally. Things unravel quickly.

The issue of EM sovereign and corporate borrowings in dollar (and euro and yen) denominated debt has speedily become a critical “macro” issue. More than five years of unprecedented global dollar liquidity excess spurred a historic boom in dollar-denominated borrowings. The marketplace assumed ongoing dollar devaluation/EM currency appreciation. There became essentially insatiable market demand for higher-yielding EM debt, replete with all the distortions in risk perceptions, market mispricing and associated maladjustment one should expect from years of unlimited cheap finance. As was the case with U.S. subprime, it’s always the riskiest borrowers that most intensively feast at the trough of easy “money.”

So, too many high-risk borrowers – from vulnerable economies and Credit systems – accumulated debt denominated in U.S. and other foreign currencies – for too long. Now, currencies are faltering, “hot money” is exiting, Credit conditions are tightening and economic conditions are rapidly deteriorating. It’s a problematic confluence that will find scores of borrowers challenged to service untenable debt loads, especially for borrowings denominated in appreciating non-domestic currencies. This tightening of finance then becomes a pressing economic issue, further pressuring EM currencies and financial systems – the brutal downside of a protracted globalized Credit and speculative cycle.

In many cases, this was all part of a colossal “global reflation trade.” Today, many EM economies confront the exact opposite: mounting disinflationary forces for things sold into global markets. Falling prices, especially throughout the commodities complex, have pressured domestic currencies. This became a major systemic risk after huge speculative flows arrived in anticipation of buoyant currencies, attractive securities markets, and enticing business opportunities. The commodities boom was to fuel general and sustained economic booms. EM was to finally play catchup to “developed.”

Now, Bubbles are faltering right and left – and fearful “money” is heading for the (closing?) exits. And, as the global pool of speculative finance reverses course, the scale of economic maladjustment and financial system impairment begins to come into clearer focus. It’s time for the marketplace to remove the beer goggles.

No less important is the historic – and ongoing – boom in manufacturing capacity in China and throughout Asia. This has created excess capacity and increasing pricing pressure for too many manufactured things, a situation only worsened by Japan’s aggressive currency devaluation. This dilemma, with parallels to the commodity economies, becomes especially problematic because of the enormous debt buildup over recent years. While this is a serious issue for the entire region, it has become a major pressing problem in China.

At the same time, data this week provided added confirmation (see “China Bubble Watch”) that China’s spectacular apartment Bubble continues to run out of control. When Chinese officials quickly backed away from Credit tightening measures this past summer, already overheated housing markets turned even hotter. Now officials confront a dangerous situation: Acute fragility in segments of its “shadow” financing of corporate and local government debt festers concurrently with ongoing “terminal phase” excess throughout housing finance. China’s financial and economic systems have grown dependent upon massive ongoing Credit expansion, while the quality of new Credit is suspect at best. It’s that fateful “terminal phase” exponential growth in systemic risk playing out in historic proportions. Global markets have begun to take notice.

There are critical market issues with no clear answers. For one, how much speculative “hot money” has and continues to flood into China to play their elevated yields in a currency that is (at the least) expected to remain pegged to the U.S. dollar? If there is a significant “hot money” issue, any reversal of speculative flows would surely speed up this unfolding Credit crisis. And, of course, any significant tightening of Chinese Credit would reverberate around the globe, especially for already vulnerable EM economies and financial systems.

No less important is the historic – and ongoing – boom in manufacturing capacity in China and throughout Asia. This has created excess capacity and increasing pricing pressure for too many manufactured things, a situation only worsened by Japan’s aggressive currency devaluation. This dilemma, with parallels to the commodity economies, becomes especially problematic because of the enormous debt buildup over recent years. While this is a serious issue for the entire region, it has become a major pressing problem in China.

The crucial point here is that this crisis is not a case of one or two little countries screwing up. It’s everywhere, from Latin America to Asia to Eastern Europe. Each country’s problems are unique, but virtually all can be traced back to the destabilizing effects of hot money created by rich countries attempting to export their debt problems to the rest of the world. ZIRP, QE and all the rest succeeded for a while in creating the illusion of recovery in the US, Europe and Japan, but now it’s blow-back time. The mess we’ve made in the subprime countries will, like rising defaults on liar loans and interest-only mortgages in 2007, start moving from periphery to core. As Noland notes:

Yet another crisis market issue became more pressing this week. The Japanese yen gained 2.0% versus the dollar. Yen gains were even more noteworthy against other currencies. The yen rose 4.2% against the Brazilian real, 3.9% versus the Chilean peso, 3.5% against the Mexican peso, 3.9% versus the South African rand, 3.8% against the South Korean won, 3.0% versus the Canadian dollar and 3.0% versus the Australian dollar.

I have surmised that the so-called “yen carry trade” (borrow/short in yen and use proceeds to lever in higher-yielding instruments) could be the largest speculative trade in history. Market trading dynamics this week certainly did not dissuade. When the yen rises, negative market dynamics rather quickly gather momentum. From my perspective, all the major speculative trades come under pressure when the yen strengthens; from EM, to the European “periphery,” to U.S. equities and corporate debt.

It’s worth noting that the beloved European “periphery” trade reversed course this week. The spread between German and both Spain and Italy 10-year sovereign yields widened 19 bps this week. Even the France to Germany spread widened 6 bps this week to an almost 9-month high (72bps). Stocks were slammed for 5.7% and 3.1% in Spain and Italy, wiping out most what had been strong January gains.

Even U.S. equities succumbed to global pressures. Notably, the cyclicals and financials were hit hard. Both have been Wall Street darlings on the bullish premise of a strengthening U.S. (and global) recovery and waning Credit and financial risk. Yet both groups this week seemed to recognize the reality that what is unfolding in China and EM actually matter – and they’re not pro-global growth. With recent extreme bullish sentiment, U.S. equities would appear particularly vulnerable to a global “risk off” market dynamic.

To summarize:
Developed world banks have lent hundreds of billions of dollars to emerging market businesses and governments. If these debts go bad, those already-impaired banks will be looking at massive, perhaps fatal losses. Meanwhile, trillions of dollars of derivatives have been written by banks and hedge funds on emerging market debt and currencies, with money center banks serving as counterparties on both sides of these contracts. They net out their long and short exposures to hide the true risk, but let just one major counterparty fail and the scam will be exposed, as it was in 2008 when AIG’s implosion nearly bankrupted Goldman Sachs and JP Morgan Chase.

Last but not least, individuals and pension funds in the developed world have invested hundreds of billions of dollars in emerging market stock and bond funds, which are now looking like huge year-ahead losers. The global balance sheet, in short, is about to get a lot more fragile.

So, just as pretty much everyone in the sound money community predicted, tapering will end sooner rather than later when a panicked Fed announces some kind of bigger and better shock-and-awe debt monetization plan. The European Central Bank, which actually shrank its balance sheet in 2013, will reverse course and start monetizing debt on a vast scale. As for Japan, who knows what they can get away with, since their government debt is, as a percentage of GDP, already twice that of the US.

The real question is not whether more debt monetization is coming, but whether it will come soon enough to preserve the asset price bubbles that are right this minute being punctured by the emerging market implosion. If not, it really is 2008 all over again.

The previous articles in this series:

What Blows Up First, Part 1: Europe

What Blows Up First, Part 2: Japan

* “Money printing” in this case refers to currency creation in all its forms, electronic and physical.

  • Suzanne

    Way back in the 1970s and 1980s… my dad was taking all these seriously “right wing” tabloid publications. One stated clearly that when Japan finally had that BIG earthquake, that they would pull all of their money out of markets all over the world to rebuild and that this would create a global depression.
    Pastor Lindsey Williams says it will be the blow-up of the global derivatives markets that will cause the big stock market crashes.
    Back in the late 1920s, it was the crash of the European markets that led to the big crash in the US stock market a week or so later.
    We’re staring at all of these at the same time … EXCEPT… the US no longer has the industrial base it had back then.

    • MacFly1

      Right now I think a small blade of grass blowing in the wind could cause a crash.

  • http://theyenguy.wordpress.com/ theyenguy

    According to the Apostle Paul in Ephesians 1:10, Jesus Christ is the Operative Genius of the economy of all things, and through His dispensation, that is His administrative oversight for the completion of all things economic and political in every age. In the era of liberalism, He provided social mobility to the wily investor, to those successfully engaged in clientelism, and to a broad number of those lived as beneficiaries of debt trade investing and currency carry trade investing, under the Milton Friedman Free To Choose floating currency system which began in 1971 when President Nixon took the US off the gold standard to finance the Vietnam War.

    The subprime crisis led to the financial system crash of 2008; and it is likened to a fatal automobile crash that killed all the occupants. Regeneration of economic life came through Paulson’s Gift, that being Ben Bernanke’s QE1 and TARP, which traded out “money good” US Treasuries for Distressed Investments, such as those traded in Fidelity Mutual Fund FAGIX.

    Jesus Christ provided liberalism as an economic domain, that is a place for economic experience, where He rules in dispensation. It was trust in Ben Bernanke and his monetary policies, that began liberalism’s terminal phase as both a paradigm and age, where the investor and clients living in clientelism were the centerpiece of economic life, whose experience was shaped by floating currencies in a Zero Interest Rate regime.

    Economic life was through fiat money, defined as Aggregate Credit, AGG, and Major World Currencies, DBV, and Emerging Market Economies, CEW; but it died on October 23, 2013, when Jesus Christ opened the First Seal of the Scroll of End Time Events, and released the Rider on the White Horse, to effect a global economic and political d’etat, which terminated the Creature from Jekyll Island, and birthed the Beast of Revelation 13:1-4, which is rising to rule the world in the new economic domain of authoritarianism.

    Fiat wealth, defined as the output of economic life under liberalism, consisting of World Stocks, VT, Nation Investment, EFA, and Global Financials, IXG, died on January 24, 2013, with the failure of investor’s trust in the monetary policies of the world central banks monetary authority, and the collapse of freedom of choice provided by democratic nation state governance as is seen in numerous places such as the Ukraine.

    • Antiehypocrite

      Are you out of your mind posting religious crap here? Anyone who believes in god is illogical and deserves as much respect as a 22 yr old who believes in the tooth ferry.

      • MacFly1

        Although I agree this isn’t the place for religion per so, I’m sorry, anti, but you’re just as hypocritical as those you attack. You can’t prove there is not a God anymore than anyone else can prove there is a God.

        • Antiehypocrite

          The onus is not on the atheist to prove the existence of god – it is on the person who believes in something that has zero evidence to support the belief.

          If you believe the moon is made of cheese it is not up to me to prove it is not because that is blatant nonsense….

          Just like the absolutely absurd statement that there is some fellow in the sky — who sent us 10 commandments to live by — who if we follow them get to go to paradise — and if we don’t follow we roast in the fires of hell….

          Well that is actually crazy talk no?

          So I’m not about to try to prove to you that is total nonsense — anymore than if some ranting lunatic came up to me on the street and said ‘I am god – I can save you – believe me’

          And like the church asked me for money hahahahaha

          Go post this crap on religiousfanatic.com — the DT is not the place for insanity

          He’s god – he’s all powerful — but he needs money…. go figure

          Religion is a joke — anyone who believes this nonsense deserves ZERO intellectual respect — or about as much respect as someone who believes in the tooth fairy after the age of 5.

          George Carlin had it right http://www.youtube.com/watch?v=gPOfurmrjxo

    • MacFly1

      Ok, yet you’re STILL the Yen guy? Feel free to share any advice you’ve gotten from the above. I keep feeling He’s telling me to buy gold but don’t count on that doing me any good (outside of my faith).

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  • Bruce C

    “The real question is not whether more debt monetization is coming, but whether it will come soon enough to preserve the asset price bubbles…”

    My answer is that no, the asset bubbles won’t be preserved this time. Not necessarily because the central banks won’t initiate even greater debt monetization programs quickly enough, but that this time global investors will interpret that to mean the central banks have lost credibility.

    It should be clear to everyone by now that the creation of more debt is not creating enough economic growth to service existing debts.

    • David Reischer

      Will the CB’s print all the way down anyways? We shall see.

      • arby

        If half the world’s wealth is held by 85 individuals, what is this market about which you speak. The 85 and the next 5000 people with the next quarter of all world assets can pretty much hash this out at Davos.

      • Bruce C

        If they choose to “print” away it will be interesting to see how they do it. I suspect they’ll start buying equities to support the falling stock markets instead of government bonds (even though that is against the law) because sovereign bonds will likely have enough support from scared money seeking “safe havens” to keep interest rates down. It would be nice to see a flight-to-safety to gold and silver instead but that may still be a ways off.

  • Ghandi
    • MacFly1

      This is the End, beautiful friend, the end.
      of everything that stands the end.
      I’ll never look into your eyes again.

  • Dan H

    Guys you have to watch the energy markets to get a real understanding of why we’re in so much trouble.

    The financial system and thus the Fed at the top of the food chain are desperately trying to hide the energy crisis we’re in. After 2008 they went on a QE blitz, lowered rates to near zero and opened up a new desperate front of energy extraction (fracking/shale/tar/deep sea) etc. In effect they’re scraping the barrel. All of this effort and expended energy/money creation has only kept things level. But the supports are crumbling under mounting pressure. It’s being forecast that by 2015/2016 latest, certainly before 2020 US energy will collapse for pure reasons of physics, this will take the entire global economic system down as we know it. In the meantime central banks around the world are printing like crazy, blowing bubbles like crazy to mask the massive deflationary forces.

    The economy is an energy equation and the financial system has evolved to hide the real physics of the world we live in.

    We’ve run out of cheap easy access energy and it’s for this reason we’re in so much trouble. For the record, none of the problems we faced in 2008 have been solved. We turned a private debt crisis into a sovereign debt crisis.

    I think it’s clear that in the next few years, we will face the greatest economic collapse we will ever experience.

    Bernanke/Yellen are tapering and look at the deflationary forces on EMs. QE was propping them up. The 2nd they taper the bubbles burst and contagion spreads throughout the global banking system. The Fed will have little choice but to start printing again in greater quantities.

    Think of it like this. We’re so addicted to the heroin, that withdrawing means instant heart attacks and we’re wired in to everyone else meaning if I go down, I’m taking you with me.

    Because energy costs are increasing all the big oil majors are issuing the mother of profit warnings. If they collapse in a similar fashion to the banks then it’s global chaos and anarchy.

    To understand why this is happening, you need to look at the energy markets carefully. Either that or continue to listen to MSM, politicians that all’s well. You’re all smart enough to realise that since 2008, something has gone horrifically wrong.

    We’ve run out of cheap oil and our system was designed to grow off cheap oil

    • pipefit9

      I pretty much see it like Dan H does. People point to shale oil and gas as some sort of bullish sign of USA energy independence approaching. In reality, it is the opposite. They are producing shale oil because it is economic to do so at $95/bbl.

      But consider this: in 1977, 1980, 1991, and 2000 the price of oil jumped up over $30/bbl and every time the USA fell into recession. Now, oil is at a sustained $90/bbl, and they claim we are NOT in a recession? What gives?

      Well, they are under counting inflation, so there is only nominal growth. Adjusted for inflation (counted honestly), the economy is contracting. This is why the percent of adult Americans with a job is at a multi-decade low.

    • tom

      I agree with you Dan 100%. America didn’t invade Iraq because their biggest resource was asparagus. It’s all about oil. Same with Iran. The Bakken frack zone will peak within 14 months. The cost to extract oil there is now over $80/barrel. Tar sands are far worse. We’ll have enough gas but liquid energy in the form of oil is going to soar in price. Converting gas to oil is very expensive. Oil will have periodic drops as economic growth declines only to shoot up again. Combine the end of cheap oil with a massive credit bubble and you have the makings of worldwide economic disaster. If Iran’s oil comes onto the market it will give us more time but not much. Folks, just ask yourself one question. Would we be fracking expensive oil if better sources were available? Of course not. Gold is highly correlated with oil so if you believe oil supplies will be in decline then the investment decision is simple.

  • Dang

    The main reason there is not a lot of inflation is because the big mega banks with there massive QE injections of 85 million dollars a month an times 10 through fractional reserve banking is they only lent it to the government to buy treasurey bills nobody else wants. This recession would of been over along time ago if the banks would of lent to the American people. The mega banks have an excess of 12 to 15 trillion dollars of loan value they can loan out. and most of it is just setting there idle.

    • robert h siddell, jr

      I think we will see that money and a lot more from overseas get into circulation and there will just be another big boom and bust unless it goes into projects that create sustainable jobs (which are the 64 million dollar question). I’d rather have slow and sustainable growth rather then the elite pump, dump and fleece the sheep over and over until they eat us alive.

  • Al Bondiga

    The BIGGEST subprime country of them ALL and the root of all international financial fraud (not to mention legalized torture, war crimes, kidnappings, drone-bombings of children, corruption, theft, embezzlement, wiretappings, bribery, and coercion ..to name just a FEW) is the USSA! (United Socialist States of Assassinations).

    All the other countries are simply the fuse. They’ll keep burning until the flame reaches the POWDERKEG (that would be YOU Americunt degenerates) after which it’ll be KA-BOOM!

    And GAME OVER.

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