The Threat of a Third Installment of the Debt Crisis Trilogy

After the crisis in the American real estate market and the European debt crisis, the global economy is threatened by a new, third installment of the debt crisis, which will affect some developing countries, writes the British business weekly The Economist.

It has been almost 10 years since the bubble burst in the American real estate market. It has been six years since Greece’s insolvency triggered the European debt crisis. What connects these episodes is the rapid growth of debt, followed by the bursting of the bubble, writes this esteemed weekly in an article titled “The Endless Story.”

The third installment of the debt chronicle is just being revealed. This time in developing countries. Investors have already reduced their assets in these countries, but the full agony of slowing growth in these economies is yet to come.

Debt crises in poorer countries are nothing new. In some ways, this one will be less dramatic than the bankruptcies and currency shocks recorded during the crises of the 1980s and 1990s. Namely, today most developing countries have more flexible exchange rates, larger reserves, and a smaller share of debt in foreign currencies. Despite this, the burst will harm the growth of these economies more than many expect, writes The Economist.

Too Much Borrowing Too Quickly

In all three installments of this debt trilogy, the cycle begins with capital outflows across borders, causing a drop in interest rates and increased growth in lending. In America, the destination of global savings, primarily from Asia, this spilled over into a crisis of subprime mortgage securities with devastating results. In the eurozone, frugal Germans helped inflate real estate prices in Ireland and excessive public spending in Greece.

And when the bubbles in wealthy countries burst, pulling interest rates down to historic lows, the flow of capital changed direction. Money flowed from rich to poorer countries. It was a good direction, but it caused a new binge: too much borrowing too quickly, and many loans were taken by companies financing unreasonable projects or purchasing expensive assets.

The result – debts in developing countries jumped from 150 percent of gross domestic product (GDP) in 2009 to 195 percent. Corporate debts, on the other hand, soared from less than 50 percent of GDP in 2008 to nearly 75 percent.

However, this surge is now nearing its end. The slowdown in China’s economic growth and low commodity prices have darkened the outlook, while the high dollar exchange rate and the approaching interest rate hikes in the U.S. will reduce the inflow of cheap capital.

The bill is coming due. Some debt cycles end in crisis and recession, as seen in the debacle in the American real estate market and the agony of the eurozone. Others end with a slowdown in economic growth as borrowers stop spending, while creditors seek ways to cover themselves, writes The Economist.

The scale of the credit boom in developing countries shows that the sobering up will be painful. In countries where private sector indebtedness has risen by more than 20 percent of GDP, the GDP growth rate slows by three percentage points in the three years after lending peaked.

However, the extent of the damage will also depend on local factors, such as how much exchange rates have adjusted, and fundamentally, most developing countries can be divided into three groups, The Economist reports.

Three Groups of Vulnerable Countries

The first group includes countries where a longer hangover will follow the credit boom, but not a heart attack. This group includes South Korea, Singapore, and China. These countries still have strong tools to protect against capital outflows, as well as a large current account surplus. Authorities in these countries have the means to assist the over-indebted and show no willingness to allow their bankruptcy.

However, hiding problems under the carpet will not help much. Companies that should fail will put pressure on bank balances, and pressure will also come from excess capacities in certain sectors. All of this will slow economic growth, but a significant crisis should not occur, writes The Economist.

The second group includes riskier countries that do not have the same resources to support over-indebted companies and do not have stronger defenses against capital outflows, with Brazil and Turkey entering this group among larger economies, both of which have current account deficits and large debts in foreign currency.

The third group, which includes India, Argentina, and Russia among others, encompasses developing countries that will either avoid more serious problems or have already gone through them.

If some bright spots are ignored, everything else signals yet another bleak year for the global economy. The International Monetary Fund (IMF), however, expects a pickup in growth for developing economies next year, but lessons from past debt cycles suggest that a slowdown in growth is more likely, writes The Economist.

And the weakness of developing countries, which make up more than half of the global economy, has a significantly greater impact today than before. Weaker growth in these countries means a hit to the earnings of multinational companies and the capital flows of exporters. Low commodity prices help, for example, oil-importing countries, but put strong pressure on the indebted mining sector.

A Fourth Installment of the Debt Crisis?

The European open economy is most exposed to weakening demand in developing countries, which is why further easing of the European Central Bank’s (ECB) monetary policy is expected. However, the dilemma for U.S. authorities regarding policy is more acute.

The difference between U.S. monetary policy and the rest of the world will exert pressure on the strengthening of the dollar, which will harm American exporters and their earnings. And waves of capital could once again seek American consumers, who are prone to borrowing. In that case, global debt crises could end right where they started, concludes The Economist.