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6/17/2013 6:45 PM ET | By Jim Jubak

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 in which a local crunch could trigger a global crisis.
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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. Something like a smaller version of that crisis does seem to me to be more possible than it was a month ago, though. 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.

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The Asian currency crisis of 1997 is a good place to start any examination of the risks in this market. I don't see a replay of the crisis that took Thailand's 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 a re-emergence of some of the conditions of that crisis could cost a different cast of characters; Brazil, India and Turkey are more likely participants in this version than South Korea or Indonesia are. And the cost could be a retreat of an additional 15% or 20% in stock prices. In other words, a deep, painful but selective bear market in emerging stock markets rather than a global financial crisis. MARKET UPDATE US INTERNATIONAL
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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 such errors, they are unlikely. The scenario we're looking at is one the central banks have been through before and that they have traditional tools to handle. But a crisis of that dimension, especially one with its 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, along with an increase in U.S. 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 instead started flowing out and into the United States in order to take advantage of higher interest rates, the financial positions and currencies of these countries started to come unraveled. NASDAQ S&P Russell 2000 10 Yr Note
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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, because many Southeast Asian companies exported semifinished goods to China for further manufacturing and export to the United States and Europe. But as cash flowed out of those economies and currencies, it quickly became not a question of preventing these currencies from appreciating but of preventing their collapse. Traders can count; looking at the reserves of foreign exchange and the current-account deficits in those 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 U.S. dollar in 1997 to 38 to the dollar 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 Oct. 20 to Oct. 24, 1997. 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 those 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.

[BRIEFING.COM] The major averages ended with solid gains as the S&P 500 rose 0.8%. Stocks reached their highs one hour into the session and drifted near those levels into the afternoon. However, equities were rattled by a Financial Times story suggesting Federal Reserve Chairman Ben Bernanke is likely to discuss tapering at his Wednesday press conference. Although the story reiterated the need for improved economic conditions, and did not contain any new revelations, the mere ... More More Market News Stock Ticker In Play Currencies
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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 Nov. 12 to May 16, the yen dropped 28.6%. Further, U.S. interest rates have started to rise: in the past month, the yield on 10-year U.S. Treasurys has climbed to 2.14% from 1.88%, an increase of 13.8%. 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.

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Certainly, spots of danger seem reminiscent of 1997. Indonesia and Turkey, two of the hottest emerging FEATURED markets of 2012, are 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 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, near the top Where to invest as of the bank's range of 4.5% plus or minus two percentage interest rates rise 8 hrs ago 1:56 points, the bank is likely to have to raise interest rates sooner rather than later no matter how slow the economy.
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And, of course, Japan, with an estimated debt-to-gross domestic product 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 causing 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 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.) 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 higher than they were in 1997. For example, as of May, Indonesia had foreign exchange reserves 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.

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The most vulnerable markets

What this means this time around is that central banks in countries that have been dependent on overseas cash flows

to fill current-account gaps 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 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, at 224% of GDP and climbing. Interest rates are an extraordinarily low 0.83% on 10-year government bonds. An increase to, say, 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.
The latest on Right now, Japanese government figures say the national debt service takes up 22.4% of the the Fed 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 that are maturing. It's not like Japan is actually paying down its debt.) Actual interest payments make up about 10% of the country's budget, economist and New York Times columnist 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 10-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 yields 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 government of Prime Minister Shinzo Abe 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.

Most worried about the eurozone

But frankly, one of the reasons 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-tomarket 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 ECB President 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 ranging 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 back-up 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 proceedings 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, because the drop in interest rates for Spain, Italy and peripheral members of the eurozone, such as Portugal, has been based on faith in the ECB 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 euros 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. Updates to Jubak's picks These recent blog posts contain updates to the stocks in Jubak's market-beating portfolios: