Harvards Reinhart Says Emerging Markets Are in Tougher Spot Than During 08 Crisis

While money managers from Goldman Sachs Group Inc. to UBS Wealth Management still tout investing opportunities in emerging markets, the asset class has one notable critic: Harvard professor Carmen Reinhart.

The Cuban-born economist points to mounting debt loads, weakening terms of trade, rising global interest rates and stalling growth as reasons for concern. In fact, developing nations are worse off than during their two most recent moments of weakness: The 2008 global financial crisis and 2013 taper tantrum, when equities endured routs of 64 percent and 17 percent respectively.

"The overall shape they’re in has a lot more cracks now than it did five years ago and certainly at the time of the global financial crisis," Reinhart said from Cambridge, Massachusetts. "It’s both external and internal conditions."

Here’s what else Reinhart had to say on emerging markets:

On the link between U.S. inflation and emerging-market equities

"The inflation story is really about interest rates. It’s not the inflation per se. It’s what it implies for the reaction of U.S. monetary policy. The bigger the tightening, the more the anticipation that rates will go higher and higher and that has multiplier consequences for emerging markets.""If the U.S. policy becomes tighter and there’s no comparable follow-through by other advanced economies, the dollar strengthens. There you have a double-whammy. Also importantly is what it does to their currency: More than two-thirds of emerging-market debt is dollar-denominated, now even more because of borrowing from China."

On emerging-market vulnerabilities

"EM rebounded super-quick after the great financial crisis and an important element of that had to with they had very little external debt. They were at their low point. You had the Mexican crisis and that generated turmoil in Latin American and then the Asian crisis and the Russian crisis and then Argentina. By then, because of the crises, everyone had deleveraged.""A growth slowdown begins to reveal more vulnerabilities in your fiscal account, such as Brazil. You take countries that were also doing quite well like Chile and Turkey and they’re not doing nearly as well right now for different reasons. In Turkey, there’s the political dimension and in Chile commodity prices are not at what they were in their booming period. Sub-Saharan African countries are in deep water.""This is not gloom-and-doom, but there are a lot of internal and external vulnerabilities now that were not there during the taper tantrum."

On emerging-market default risk

"There’s a whole range of sub-Saharan African and Middle Eastern countries that have become indebted to China. It’s a very opaque area. Countries like Angola, if you factor in Chinese loans, their external debt is 20 percent higher than what official data suggest. It’s to be expected after a decade of ultra-low interest rates when you had a lot of incentives to borrow and now when rates start to rise and there’s the reversal in the dollar again, the vulnerabilities start to pile up.""Lower income EM countries will have a lot of debt servicing difficulties. You’re dealing with China in a lot of these cases and they’re very opaque. You wonder whether they’re already restructuring some debts."

On emerging-market outflows

"If you look at capital flows to EM, it’s also closely connected to volatility. It’s not just that interest rates were low but volatility was non-existent for a while. Volatility is on the rise and neither of those bode well for inflows to EM.""There used to be this larger barrier between internal and external debt. That’s been blurred, as we see with Argentina. Internal debt is increasingly being held by non-residents, making for bigger spillovers."

On Argentina’s talks with the IMF

"When you look back at episodes of turmoil, the countries that want a seal of approval for markets turn to the IMF. What will it do to President Mauricio Macri? That’s a separate issue. But from the market vantage point, it’s a signal from the government that they really want to play by the rules. They’re seeking liquidity support. It’s a form of reassurance.""The part that’s worrisome is the medium-term issue: there’s an internal one and external one. The internal one is chronic. Argentina needs to curb the wages of public employees. Unless it does that, it really becomes the old fashioned wage price spiral and it will be very difficult for them to not only close fiscal accounts but break inflation expectations. The external one is they have a 5 percent current account deficit. I don’t think they’ll get 5 percent of external financing.""It’s hard to see how all this turmoil, even in a favorable outcome, won’t lead to a recession. It’s fairly imminent and will be serious."