Physics has Newton’s laws, chemistry has the law of conservation of matter, biology has evolution, and economics has the law of bubbles: They eventually burst, and when they do, it isn’t pleasant.
Fueled by unprecedented global liquidity, emerging market asset prices have become totally dissociated from those economies’ progressively deteriorating economic fundamentals. Past bubbles of similar size in some of the same economies have demonstrated that when these bubbles inevitably pop, the shockwaves tend to be global.
U.S. policymakers should be paying close attention to the inflating asset price bubble in the emerging markets. These economies now constitute around half of the world economy, and the current bubble appears to be bigger and growing faster than those that came before it. Compared to the Asian and Latin American debt crises, the bursting of this bubble is likely to have a much greater impact on world financial markets.
To say that the emerging markets—156 countries that include all those that are not classified as advanced economies—have suffered during the COVID-19 economic crisis would be a gross understatement. Hit by a perfect storm of a health crisis, plunging international commodity prices, and shrinking external demand, these economies contracted in 2020 for the first time in the post-war period. According to the IMF, the emerging market economies, excluding China, declined by some 6 percent in 2020. India and Latin America fared significantly worse than the average emerging market economy.
As a knock-on effect, the emerging market’s deep recession has raised serious questions about their governments’ ability to meet their debt service obligations. Even before the pandemic, emerging market government debt levels were at troublingly high levels, particularly in key economies like Brazil and South Africa. In the last nine months, these governments’ deficits ballooned as the recession eroded tax bases and as they ramped up public spending to keep their economies afloat. According to the IMF, budget deficits have exceeded 10 percent of GDP in Brazil, India, Saudi Arabia, and South Africa.
The key emerging market economies appear unlikely to be able to restore public debt sustainability any time soon. The health crisis in these countries has worsened, and it now appears that the United States and Europe, which are the emerging economies’ major export markets, will also see worsening health crises and associated economic slowdowns in the first half of 2021.
In normal times, one would expect that financial market prices would reflect the emerging markets’ deteriorating fundamentals and that capital would flee to safer havens. But the Federal Reserve and the European Central Bank have responded to the pandemic by printing money even faster than they did after the 2008 Lehman bankruptcy. That in turn has pushed world interest rates down to record low levels and has induced investors to stretch for yield by taking on more risk, especially in the emerging markets.
With global financial markets awash in liquidity, emerging market financial asset prices are booming even though the public finances of those economies are going from bad to worse. Capital is flowing in at a record pace. Equity valuations have never been higher, while the interest rates at which the ultra-indebted governments have to borrow (relative to rate at which the United States government borrows) are close to record low levels.
After the 2008 U.S. housing and credit market crisis, Chuck Prince, the former Citibank CEO, explained his bank’s speculative activity during the bubble by noting that “as long as the music is playing, you’ve got to get up and dance”. Today, the music is playing even louder than it was then. U.S. policymakers should be ready with a plan to steady U.S. and global financial markets from the shockwaves of the bursting emerging market asset bubble when the music stops.