Iceberg Dead Ahead

DAVID C. ROCHEWhat were once emerging markets now are submerging ones. So will the emerging-market crisis bring down the world's rich economies? Judging from economists' predictions, the consensus answer is no. The trade and financial flows that link wealthy nations to the emerging economies are too small, they say. Indeed, if economic activity in emerging markets is weak, it could actually boost the economies of the rich world by increasing the supply of cheap imports. That holds down inflation and increases the purchasing power of the dollars in Western pockets. And because cut-price imports deprive United States, European and Japanese producers of pricing power, inflation stays low and so do interest rates. Phew!There are two things wrong, however, with such complacency. The first is that such dreamlike optimism has already pushed stock markets in the U.S. and Europe to giddy levels. It is unlikely to keep doing so. The second is that, when predicting crises, economists usually look the wrong way up the tracks--only to get hit by a train coming from the opposite direction. That train is the massive deterioration in financial balance sheets, which are far more critical than measures of trade flows. Consider the U.S. stock market. Buoyed in part by the market's rise, Americans now maintain a household savings rate equal to just 0.8% of disposable income, one of the lowest levels in the world. Why? Because Americans have little fear of losing their jobs. New paradigm propaganda has convinced them that the U.S. is recession-proof. Why save as long as soaring financial and real-estate markets are increasing wealth faster than anyone could by cutting back on consumption? But it's all precarious: any big fall in the value of stocks would zap enough wealth to throw the savings rate into reverse and stop the economy in its tracks.That process of wealth destruction has already begun--and not just on Wall Street. The decline in stock markets and currencies has wiped about $1.4 trillion off balance sheets of emerging economies. And the recent widening in interest-rate spreads between emerging markets and the U.S. has sliced more than $750 billion off the value of investments in emerging bond markets. Together with equities, these losses add up to the equivalent of 25% of U.S. GDP. The notion that such mammoth wealth destruction will leave world economies unscathed is the stuff of dreams.But how will it hit? The most obvious blow will be to the global banks that lent money to emerging markets that are no longer servicing their debts (even if they have not publicly renounced them yet). If we assume that 40% of these loans are lost, that will have demolished 20% of the value of shareholder wealth in European banks. For Japanese banks, which are virtually bankrupt anyway, it will amount to even more. These figures don't count the massive losses that many banks made on their trading desks by being long the assets of these countries.PAGE 1|All of this matters for two reasons. Emerging markets around the world have seen their financial sectors destroyed. They need the developed world's banks to come in and reliquefy their economies by lending to--and also by buying up--their troubled banks. Without that investment, emerging economies will be without a banking system that can lend. Capital starvation will succeed the capital glut of recent years.Second, the unconfessed bad debts of the developed world's banks are probably bad enough to make banks an instrument of deflation rather than reflation in their home markets. The destruction of so much capital will have to lead to a constraint in lending. In short, the smell of a global banking crisis is in the air. There are plenty of shoes yet to fall. China's banking system is totally bust. And that pillar of global capitalism, the Hong Kong banking system, is sure to get mauled in the last stand of the Hong Kong dollar's peg to the U.S. greenback, a battle that will be fought and lost within months.It is far more likely that financial forces, not trade flows, will drive the next global downturn. The drama has only begun to unfold. Here's why. A few short months ago it cost the average emerging economy around 500 basis points more than U.S. Treasurys to finance growth, and the availability of capital was virtually limitless. Now it costs around 1,500 basis points, and there is a critical shortage of capital for emerging markets. The recent headlines are staggering: Russia's default, Hong Kong's attempted backdoor nationalization of major stocks, Malaysia's decision to expropriate foreign investors and delist itself from global markets.All of this increases the temptation for emerging markets to renege on their debts. And that would surely worsen the global banking crisis. As long as there's no affordable capital to be had, emerging markets have great incentive to renounce their foreign debts and opt for populist development models, operating behind doors closed to world financial markets. Now capital is both unaffordable and unavailable. That is the real significance of what has happened in Malaysia and Russia.In the end, the write-offs at the developed world's banks will deprive the global economy of the capital it needs to grow, not only in emerging markets but in the rich nations as well. Even if the world avoids the worst, which it can do only through coordinated global easing of monetary policy in the U.S., Europe and Japan, the emerging-market dream is over. The roseate future of so many highly rated blue-chip stocks has been based on that dream. But global capitalism is now under threat from the emergent politics of populist economic nonsense, evoking a nightmare scenario of an end to emerging-market investment.|PAGE 2