It was supposed to be a play in three acts. Wall Street banks and the U.S. economy took the first blow from the Lehman crisis. Next, the epicenter of trouble moved to Europe, causing a run on sovereign debt. The overhang of global borrowing was then going to culminate in a big emerging-market fiasco, caused perhaps by a disorderly unwinding of China’s post-Lehman credit bubble.
That denouement never materialized for an underappreciated reason: The forces that hastened Lehman’s demise have steadied emerging markets ever since.
A Longer View
Discussions about the origins of the pre-Lehman exuberance focus too much on bankers shuffling risky subprime mortgages into triple-A-rated securities. They often miss something more fundamental: the Baby Boomer generation’s quest to secure retirement.
A four-year jump in U.S. life expectancy between 1990 and 2015 (to 79 years) gave wings to this motivation at the peak of the boomers’ earning power. Among other things, an oversupply of retirement savings relative to demand crushed the real interest rate the economy could afford to provide savers. A 2-percentage-point decline in the “natural” real interest rate prompted the Fed to keep target rates low, sparking risky financial behavior. Fed chiefs have been criticized for their too-low-for-too-long policies. Demographics, however, may have left them with little choice.
Population pyramids will continue to cast a long shadow on the investment landscape. In developing nations, there still are 12 people in the 25-64 age group for every person aged 70 or more. By 2055, on current United Nations projections, emerging markets will be as old as developed countries are now, with four young and middle-aged workers for every old person.
Pension accumulators in emerging markets will demand new local-currency assets. Those assets will also be chased by rich-nation investors.
Granted, the Fed’s tightening has unsettled things temporarily. The Indonesian rupiah is at its weakest since the 1998 Asian contagion, and the Indian rupee
recently sank to a record low. Russia, South Africa, Brazil, Turkey and Argentina have fared worse. Yet there are good reasons to believe this storm will blow over without permanent damage to emerging markets as an asset class.
To see why, start with the strong dollar.
At first glance it appears to be an outsized threat. At $3.7 trillion, the dollar
debt of non-bank borrowers in emerging markets is about $2 trillion more than its pre-Lehman high.
About half of that $2 trillion increase, however, has been on account of bonds. In the 1998 Asian crisis, emerging markets were overly reliant on flighty cross-border dollar
financing by banks. That’s because back then, 80 percent to 100 percent of the bond holdings of the world’s seven biggest pension systems were squarely in their home countries. But times have changed — and we may have Lehman’s collapse to thank.
Less Reliant on Unreliable Banks
The economic aftermath of Lehman’s failure required a powerful monetary remedy. After years of quantitative easing and elevated asset prices in Japan, the U.S. and Europe, rich-nation pension managers reduced their home bias and flocked to the higher-yielding debt and equity of emerging markets. From a negligible portion of a $12 trillion total in 1997 to generous allocations out of a $38 trillion pile in 2017, pension money from the West, Japan and Australia has become a cushion in emerging markets.
True, unsustainable twin deficits and unstable national politics haven’t gone away. And unreliable bank financing is still 57 percent of the $3.7 trillion non-bank dollar
debt of emerging markets. However, this stock hasn’t grown in two years. Banks are cautious because their own funding, which is often wholesale, has become costlier as the Fed raises rates. A natural brake has been applied.
About 15 percent of banks’ and investors’ dollar
claims are on China. While that may sound like concentration risk to emerging markets as a whole, given the heat the People’s Republic is taking from Donald Trump’s trade war, Beijing is not out of levers for luring foreign capital. Its equity markets have been ghastly this year, but MSCI Inc. is still adding more mainland stocks to its benchmarks. Giving exemptions to overseas institutions from taxes on interest gains may pull more overseas money into onshore Chinese bonds.
Assuming these policies work, and a broadly stable yuan helps the leveraged Chinese economy to hold, can emerging markets still blow up? I wouldn’t bet on it.
The reason is once again pension assets, though not only of rich-country workers. The world’s top seven pension markets may have the lion’s share of the $41 trillion held by the biggest 22 — or for that matter, of the $45 trillion in such savings scattered around 195 countries.
Yet the rising importance of smaller savings pools can’t be dismissed. Asia Pacific pension funds’ assets grew 20 percent to almost $5 trillion last year, outpacing the 15 percent increase at the top 300 funds globally, according to Willis Towers Watson.
At some point, the entire world will be old, and robots will steal earning and saving opportunities from the working class — even in Bangladesh. When that happens, today’s emerging markets might get trapped trying to manufacture returns out of worthless assets. But that, I suspect, will be a whole new play, not just the third act of the Lehman drama.