CreditCrunch

Wednesday, February 5, 2014

8:36 PM

Stand by: EM turmoil sparks credit crunch fears

As economic growth slows in emerging markets like Brazil , India and China , there are fears that
capital outflows out of these countries could be the first signs of a credit crunch and the third
stage of the global financial crisis after the U.S. subprime rout and the euro zone's debt woes.

Investors pulled $6.3 billion out of emerging market equity funds last week and $2.6 billion out of
EM bond funds, according to fund tracker EPFR.

Analysts believe this is part of a longer-term trend, with the Institute of International Finance
forecasting that net inflows into emerging markets fell to $181 billion in the fourth quarter of 2013,
down from $234 billion in the third quarter.

Emerging markets have also seen a drop-off is in stocks and currencies, with the MSCI emerging
markets index down 7.6 percent since the start of the year.

(Read more: Emerging marketsIs it time to bottom fish? )

Alberto Gallo, who heads European macroeconomic credit research at RBS, said the outflows were
indicators that two major emerging market economies, Brazil and China, were already in the early
stages of a credit crunch. Banks create a credit crunch when they become more cautious to lend out
and push up the cost of borrowing, making it harder and harder for companies to borrow to grow
their businesses. A credit crunch is normally a sure sign a country's economy is heading into stormy
waters.

Gallo warned that India and Turkey were also at risk, and that the problem could spread to smaller
EM economies as well.

"We are at the beginning of a credit crunch. Capital flight is the first sign," Gallo told CNBC.

In report last week, RBS pointed to slowing real economic growth, an uptick in default rates and a
decline in mergers and acquisition activity as signs Brazil was in a credit crunch. Brazilian deal
volumes fell 7 percent to $62.7 billion in 2013 from $67.5 billion, according to dealogic.

"The country's rate of inflation was 5.9 percent at the end of 2013, and the government increasingly
has interfered with private transactions. These factors have contributed to reduced interest by
foreign investors in Brazil ," said Paola Lozano of financial law firm Skadden in a research note.

Nicholas Spiro of Spiro Sovereign Strategy said Brazil has been in a "full-blown credit crunch for quite
some time". He said that "credit squeeze" better described the circumstances of countries like China
though.

(Read more: Is copper's swoon a bad omen for China? )

"China is definitely feeling the effects, and suffering the effects, of a credit squeeze. Clearly the
Chinese authorities are desperately trying to manage this as best they can," Spiro said.

"Credit crunch is probably too strong a word (for emerging markets overall)," he added. "Emerging
markets have a number of serious problems right now, some of them idiosyncratic, and some of
them related to being caught in a pincer motion between the withdrawal of monetary stimulus by
the Federal Reserve, and China's attempts to tame its (former) credit boom."

'Third leg of global financial crisis'

Both Gallo and Spiro said the current emerging market turmoil was the "third leg" of the global
financial crisis that struck in 2007.

"This feels and looks like something eerily reminiscent of what Spain and Italy were going through at
the end of 2008 the bond market routs," said Spiro, referring to the heightened euro zone risk
aversion that saw bond yields in some countries spike dramatically.

"That is because this is the third phase of the global finance crisis there was the U.S. sub-prime
crisis, then the euro zone and now we have the emerging markets."

Following the sub-prime crisis, global economic growth fell from a peak of 5.0 percent in 2007 to 2.4
percent in 2008, before shrinking by 1.3 percent in 2009.

World growth was hit again after the euro zone crisis heated up in 2010, slowing in both 2011 and
2012. Despite signs of recovery, unemployment remains extremely high in the worst-hit euro zone
countries, such as Spain, which posted an unemployment rate of 26 percent on Tuesday.

(Read more: Marc Faber: Market volatility will continue, here's why )

Irrespective, other economists believe talk of a credit crunch and a third wave of crisis are somewhat
overblown, stressing that although credit conditions were tightening, they did not yet represent a
credit crunch.

Alberto Ramos of Goldman Sachs said: "So far we cannot argue that some of these systemic EMs
such as Brazil as facing a real credit crunch. What we have seen in most places is the normal
adjustment to a less favourable external backdrop, which entails lower growth in EMs and weaker
currencies."

Ramos cautioned however that rising contagion between EMs meant that credit difficulties in one
country could more easily spread to others.

"We could definitely see some contagion, particularly among countries that share weak
fundamentals, such as sizeable current account deficits and heterodox policies," he said.

(Read more: Global stock selloffRumble or rout? )

Neil Shearing, Capital Economics' chief emerging markets economist, went further.

"There's no credit crunch yet if anything, credit growth is still uncomfortably strong!" Shearing
said.