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Emerging Markets in Trouble from Oil

Surging oil and energy costs only make this worse for emerging markets...
EMERGING MARKETS are in all sorts of trouble, writes Greg Canavan in the Australian Daily Reckoning, and with the oil price preparing for another Middle Eastern war, centred this time in Syria, their problems are about to get worse.
A collapsing currency combined with a rising US Dollar oil price is a big tax on economic growth, and it comes at precisely the wrong time for the global economy.
But we do feel slightly assuaged that UK Prime Minister David Cameron tells us that the coming conflict is not actually about the Middle East or even Syria, and Gareth Evan's opinion piece in today's Financial Reviewalso provides comfort when he explains that a strong moral case justifies war even though international law doesn't.
That's good to know.
What's also handy to know (especially for these power hungry warmongers) is that the last place where there was an overwhelming moral justification to wage war (based on the suspicion of the presence of chemical weapons, which were never found) was Iraq.
And how's that going? Yesterday, explosions killed 80 people in Bagdad as sectarian violence continues a decade after the West felt morally compelled to improve the prospects of a country that, among other wicked deeds, threatened to price their oil in Euros. 
The Associated Press tells us that:
"A relentless wave of killing has left thousands dead since April in the country's worst spate of bloodshed since 2008. The surge in violence raises fears that Iraq is hurtling back toward the widespread sectarian killing that peaked in 2006 and 2007, when the country was teetering on the edge of civil war."
Whenever a Middle Eastern conflict comes up, it's always about oil and 'strategic' influence. Chemical weapons are just a pretext. And sure enough, the price of oil is on the rise again, despite lacklustre global economic growth.
The chart below shows the price of Brent crude over the past three months. In US Dollar terms, it's up around 15% from the lows of June.
In Aussie Dollars the price of Brent crude is up nearly 25% over the same time frame, while priced in rupees, the fast collapsing Indian currency, Brent is up nearly 40% from the low point reached in April.
Sharply rising oil prices are a problem not only for India, but many emerging nations suffering from a currency falling against the US Dollar. Brazil, Turkey, Indonesia, and Thailand, just to name a few countries, have all just had a major oil tax dumped on them.
Given emerging markets now represent around 50% of global economic growth, this is a big deal.
But you'd be mistaken if you think the prospect of war and subsequent rising oil prices are the reason behind the world potentially slipping into recession. It's a process that is underway regardless of what's happening in Syria.
Capital began leaving the periphery of emerging markets and returning to the core US market months ago. As we showed in Tuesday's Daily Reckoning, emerging stock markets topped out at the end of 2012/early 2013.
Whenever problems arise at the periphery, it's usually a signal that the same problems are heading towards the core. It happened with sub-prime property in the US, it happened with troubles in Iceland, Greece and Ireland in Europe.
Now that the problems are on a global scale, you're seeing these emerging market canaries dropping off like, well, canaries in a gassy coalmine.
Our discussion of emerging markets last week brought a thoughtful response from a long time reader (see below). While we don't necessarily agree with all of it, it is worth contemplating the various issues raised.
Our reader argues that emerging markets will suffer much more than the US in any crisis, and we agree that will certainly be the case as long as the US Dollar remains as the core currency of the global economy.
But if the world does slip back into recession, who is the spender of last resort this time? Developed economies like the US and UK have considerably more debt than they did in 2007, when the last crisis was on the horizon.
Will the market continue to absorb another big increase in government debt and spending, or will such a response this time send bond yields soaring, tightening global liquidity even further?
We don't know of course. It's all guesswork. For all we know, there might be another couple of years of debt fuelled 'growth' ahead of us. Perhaps it's just our personal bias in viewing the whole system as unsustainable that makes us view its demise as a given.
Anyway, we guess the point is that when the system does break down, there will be no winners. Our reader writes: 
"The countries that have funded the US's current account deficits (especially Japan and China) are the ones with the real problem. They have to pour capital into the US (egg by buying US Treasury securities) because the only way to avoid a domestic financial crisis is to have a substantial current account surplus. Those countries do not have capitalistic (i.e. profit-focused) economies, because their systems are built on cultural traditions that are radically different to those in Western societies.
"Having various forms of 'cronyist' / nationalistic financial systems, they cannot afford to have their major financial institutions having to borrow in international markets – which they would have to do unless they suppressed domestic demand by exporting a significant amount of their income (egg to the US).
"It is wrong to view QE in the US (or elsewhere) as simply about maintaining (unsustainable) economic growth in the US. It is about a clash of civilizations which is like the Cold War – but no one mentions it. It has been going on for decades.
"If capital flows to the US are now drying up, I would strongly suspect that countries that had previously supported those flows (egg Japan / China / emerging economies) are encountering systemic financial problems – so they are unable to find capital to invest, rather than because there is no desire to maintain ongoing current account surpluses.
"Demand may thus dry up in the US leading to a recession – but the consequences will be much worse for countries whose financial systems will experience crises unless there is strong US demand to allow them to enjoy current account surpluses."
Well, we should find out pretty soon which of the emerging nations are most at risk. Capital flight followed by an oil price shock is not easy for a financial system to deal with.
But ominously for the US, there are around US$11 trillion in international 'reserves' held mostly by emerging market economies, a large portion of which are US Treasuries. In a real crisis, they can sell these reserves to defend their currencies. And in a real crisis, the US would be issuing Treasuries hand over fist trying to avert a recession.
But if the US's traditional customers (the emerging economies) are selling at the same time, then higher interest rates will be the result.
Higher interest rates might not necessarily signal inflation. Rather, it will warn of a growing lack of trust in the ability of governments to control their finances. What's surprising though is that it would have taken so long for the market to finally realise it.

Greg Canavan is editorial director of Fat Tail Investment Research and has been a regular guest on CNBC, ABC and BoardRoomRadio, as well as a contributor to publications as diverse as and the Sydney Morning Herald.

See the full archive of Greg Canavan.

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