THE BRICS HIT THE WALL

Half the world economy is one accident away from a deflation trap. It is not hard to imagine what that shock might be. It is already before us as Turkey, India and South Africa all slam on the brakes, forced to defend their currencies as global liquidity drains away.

The emerging market bloc makes up half the world economy, far higher than in any previous crisis. Roughly $4 trillion of foreign funds swept into emerging markets after the Lehman crisis, much of it by then "momentum money" late to the party.

One country after another is now having to tighten into weakness. The longer this goes on, and the wider it spreads, the greater the risk that it will metamorphose into a global deflationary shock. The International Monetary Fund warns that the sheer weight of these countries’ rate raises could lead to a "blowback" effect that ultimately hits the US, Europe and Japan as well.

Turkey is the latest country in the eye of the storm, no longer able to draw in enough foreign capital to cover a current account deficit of 7.5% of GDP. Reserves have fallen to a wafer-thin level of six weeks’ import cover. The ruling Islamic movement of Recep Tayyip Erdogan is deeply split, while the country faces mounting Sunni-Shia tensions due to a spillover from Syria.

Turkey’s central bank on Tuesday (1/28) night raised interest rates to 12% from 7.75% at an emergency meeting in a bid to defend its currency and halt capital flight.  This will bring the economy to a standstill in short order.

"They are tightening to defend their currency, and in doing so killing the economy. In the end they will be forced to give up. There is the same risk in India," says Lars Christensen from Danske Bank.

Turkey’s move came as India raised rates a quarter-point to 8% to choke off inflation and shore up confidence in the battered rupee, the third rate rise since September. South Africa’s rand hovers near a record low at 11.06 to the dollar.  All are forced to grit their teeth as growth fizzles. Brazil and Indonesia have already been through this for months to stem a currency slide that risks turning malign at any moment.

The global chain reaction resembles what happened in the East Asia crisis in 1997-1998 when domino effects swept the region. However, this time contagion is ricocheting between countries with large current account deficits or political crises wherever they are, while stronger economies such as Mexico are mostly spared.

Neil Shearing from Capital Economics says Brazil, India and Russia are all suffering from the 1970s curse of "stagflation," unable to stimulate their economies to revive growth.

Brazil has already raised rates 325 basis points since April to curb inflation and to defend the real, which has fallen 15% against the dollar since early November. "Brazil will have to raise rates again, and Indonesia may be next in line. They really have no choice since global borrowing costs are going up," he said.

Mr. Shearing said the BRICS bloc (Brazil, Russia, India, China and South Africa) are in worse shape than many of the other emerging market states, but the strains are spreading. "Both Chile and Peru need to cut rates to boost growth, but they can’t risk it," he said.

While every story is different, the common theme for the BRICS is that they have exhausted their catch-up growth models, let credit booms get out of hand and failed to push through reforms while the going was good. Productivity rates have plummeted almost everywhere.

"Emerging economies squandered precious opportunities in the past decade to reform and restructure for the new globalised world. Instead, they rode on the coattails of China and ample global liquidity," explains Stephen Jen from SLJ Marcro Partners, and a former IMF firefighter.

Others are in better shape – mostly because their current accounts are in surplus – but even they are losing room for maneuver.

Russia has a foot in recession but cannot take action to kickstart growth as the ruble falls to a record low against the euro. The central bank is burning reserves at a rate of $400m a day to defend the currency, de facto tightening. As for Ukraine, Argentina and Thailand, they are already spinning out of control.

China is marching to its own tune with a closed capital account and reserves of $3.8 trillion, but it too is sending a powerful deflationary impulse worldwide. Last year it added $5 trillion in new plant and fixed investment – as much as the US and Europe combined – flooding the global economy with yet more excess capacity.

Markets have a touching faith that the same Chicom Politburo responsible for a spectacular credit bubble worth $24 trillion – one and a half times larger than the US banking system – will now manage to deflate it gently with a skill that eluded the Fed in 1928, the Bank of Japan in 1990 and the Bank of England in 2007.

Manoj Pradhan, from Morgan Stanley, says that China’s central bank is trying to deleverage and raise rates at the same time, which "amplifies risks to growth". This is a heroic undertaking, like surgery without anesthetic. It is the exact opposite of what the Fed did after 2008 when QE helped cushion the shock. Morgan Stanley says that 45% of all private credit in China must be refinanced over the next 12 months, so fasten your seatbelts.

Moreover, China is struggling to keep its industries humming at the current exchange rate. Patrick Artus, from Natixis, says surging wages – and falling productivity – mean that it now costs 10% more to produce the Airbus A320 in Tianjing than it does in Toulouse.

The implications are obvious. China may at some stage try to steer down the yuan to hold on to market share, whatever they say in the US Congress, partly to stop Japan stealing a march with its 30% devaluation under Abenomics. Albert Edwards from Societe Generale say this may prove the ultimate deflationary shock, dwarfing the 1998 Asia crisis.

"China’s authorities have an ugly choice to make. They can have a manageable debt crisis now, or a massive one later," said Charles Dumas from Lombard Street Research.

Much of the world has been happily floating along for years now on a flood of easy money from China and the Fed.  As the tide of liquidity from the US and China recedes, we can start to see who was swimming naked.  
 
Ambrose Evans-Pritchard is the International Business Editor of the London Telegraph.