In today’s world of financial globalization, any remote crisis can become an international problem in seconds. That’s the reality of today’s markets.
By Nomi Prins and cross-posted from The Daily Reckoning
Global debt has ballooned since the financial crisis as central banks have distorted markets and fueled debt bubbles in particular.
A lot of the increase in global debt has come from emerging market (EM) economies, especially China. In fact, a record amount of EM debt has accumulated during the past decade, mostly in dollars. A large portion of that debt is therefore denominated in U.S. dollars.
That’s why I’ve long argued that the first shoe to drop in the next crisis would likely be EM debt.
Borrowing is not a problem when dollars are cheap. Low interest rates mean the cost of servicing that debt is low.
The problem starts when the Fed raises rates or the dollar strengthens, even temporarily. The more the dollar rises, the more EM currencies and related markets fall. Dollar-denominated debt then becomes too expensive to repay or service as the dollar rises relative to EM currencies. Before long default becomes the only viable option.
This situation becomes more dangerous than even asset bubbles because debt is required to be repaid on a set schedule. If a country misses a debt payment, it could set off a chain reaction of defaults.
That’s why an EM crisis could quickly become a global crisis. In today’s world of financial globalization, any remote crisis can become an international problem in seconds. That’s the reality of today’s markets. Obviously, it could also have major ramifications for your own finances and investments.
How did we get here?
Because of the Fed’s rate hike cycle and quantitative tightening (QT) stance, the dollar has become much stronger. The dollar has risen 6.8% since late January alone. And that’s put emerging markets under considerable pressure.
Dollars are fleeing emerging market economies as investors are pouring into dollar assets and U.S. Treasuries.
As the Fed itself has warned about such a scenario, “If these risks materialized, there could be an increase in the demand for safe assets, particularly U.S. Treasuries.”
That starts a vicious cycle that only strengthens the dollar and weakens EM currencies further. In other words, emerging markets are being deprived of dollars at a time when they need them most.