09.January.2021 – US

The next crisis will come from interest rate hike


I have written an article on how Korean housing market may suffer from potential bubble, and an article on how Japanese stock and housing market bubble burst in the 1990s.


In short, both articles explain that Korean household debt to GDP ratio has crept up to dangerous ratio of 95.5% (US housing crisis began when the ratio was around 98%), and that Japanese stock and housing market bubble burst when Bank of Japan raised interest rate in the 1990s.


After prolonged economic recession since the bubble burst in the 1990s, the asset prices in Japan have remained largely subdued. As more and more Japanese people feel that buying a house comes with a variety of risks and depreciation, not appreciation, many choose to pay rents instead of buying houses.


On the other hand, Koreans have never experienced a large-scale asset bubble burst like Japan, and combined with their belief in “property market never fails” the housing price in South Korea is still skyrocketing.


These two cases show that asset bubble in some of the emerging markets could be in serious danger if and when the interest rate rises.


However, with COVID-19 dampening economic outlook and many countries still suffering from its aftermath, the prospect for interest rate hike seems unlikely in the short run. While it is reasonable to expect that interest rates will stay low for a while in the short run, it is equally unreasonable to expect that such low interest rate will continue indefinitely.


The next economic crisis in emerging markets is likely to begin when the US starts to raise its interest rate, something that resembles the FED tapering in 2013.


When the FED started to gradually raise interest rate and roll back its unlimited quantitative easing in 2013, many emerging countries faced “challenges complicated by huge capital flows that have poured into key emerging markets as a result of the easy money policies pursued by the US Federal Reserve since the 2008 crisis. Those countries that have received big portfolio investment inflows, including fast-moving hot money, are now vulnerable to big outflows,” according to Financial Times.


Not only is the outflow of capital dangerous for emerging markets, but also debt-ridden companies and households will have hard time coping with debt interest payment when the interest rate rises. According to IMF Blog, today’s world is much more debt-ridden than last decades as the graphs below show. The upward trend in the total debt ratio continued unabated, with the majority of the increase in 2018 coming from public debt in the emerging markets.


Debt in emerging markets


All of this point to say that emerging markets’ vulnerability will be much exposed in the next cycle of interest hike.


Most of bubbles in history burst with the rising interest rates. With asset prices skyrocketing in this perennially low interest rate environment, the next bubble burst in emerging markets could come when the US economy recovers from COVID-19 and starts to raise interest rate in the next few years. When it does, it may resemble the magnitude of Japanese style bubble burst if these countries neglect to strengthen their macroeconomy, institutions and lessen its vulnerability on debt and capital outflows.


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