Is the next global financial crisis brewing in emerging markets?

With the 10th anniversary of the Lehman collapse just passed, commentators and analysts are casting around for signs of the next crisis brewing. Since Turkey and Argentina have both been in the grip of serious crises in recent months, it is natural to wonder whether emerging markets could be the source of the next downturn. Although matters appear to have calmed down a bit, Turkey and Argentina are in serious difficulties. Both have yawning current-account deficits, running at 6% of GDP for Turkey and 5% for Argentina. And since the start of the year, the Argentine peso is down 50% against the dollar, while over the past five months the Turkish lira is down 35%.

In Argentina, inflation is 34% but will probably rise above 50%; in Turkey, inflation is 18% but it will probably rise to about 25%. It is not surprising interest rates are sky high, at 24% for Turkey and 60% for Argentina. Both will fall into recession.

Of course, domestic politicians put the blame on those supposedly evil operators in the financial markets. But the root of the problem in both countries is that the economy has been run at too high a level of demand. Since 2005, in both countries the average annual growth of private consumption has been 4.5%. The exchange rate has been too strong so competitiveness has deteriorated, hobbling net exports. Recent currency weakness has been necessary to correct this problem, but it carries a heavy short-term cost in the form of higher inflation.

The only real difference between the countries is the root cause of the overheating. In Argentina, it is a classic case of fiscal policy being too loose. The budget deficit is 6% of GDP. This is not the trouble in

Turkey, where the budget deficit is only 2% of GDP. There the source of excessive demand has been the rampant growth of bank credit.

Economic policy-making in most emerging markets has improved.

On the whole, fiscal deficits have been brought under control and most emerging markets don’t run large current-account deficits.

Argentina and Turkey have large external financing requirements, reflecting their current-account deficit and the need to refinance maturing debt. Since 1980, there have been 154 bank and sovereign debt crises in the emerging markets. They have ended up causing little economic impact in the West. The emerging markets in crisis simply weren’t big enough. This remains the case today with Turkey and Argentina. Emerging markets have been more dependent on developed economies for export demand than the other way round. Financial ties are smaller still.

The elephant in the room is China. In 1980, it accounted for less than 2% of global GDP. Today, the figure is over 15%. The reasons to be worried about China are both economic and financial. The economic issue concerns the inevitable sharp slowdown in China’s growth rate — unless it embarks on a programme of radical reform. The financial issue concerns the huge rise in credit. Excluding the financial sector, credit extended to Chinese borrowers has gone from about 130% of GDP in 2007 to 240% today. Whenever countries have experienced such a credit boom, it has ended in a financial crisis.

The good news is the Chinese authorities are on top of this risk and have considerable power over the economy and financial system. Nor is any crunch point in China likely to be reached as a result of mishaps in Turkey or Argentina, or any other emerging market. For China, the economy it is most dependent on is the US. Although US President Donald Trump’s protectionist trade policy, on its own, won’t bring the Chinese economy to its knees, it doesn’t help.

Reasons to be worried about China are both economic and financial

✼ Bootle is chairman of Capital Economics ✼ Ron Derby is away