This Region’s Potential Debt Bomb Could Kill Your Portfolio

Belgium, Finland, Germany, Hungary and Denmark deserve a tip of the cap. They are the only major economies that have actually reduced their gross external debt levels over the past two years, according to the World Bank.

Said another way, every other major economy in the world has taken on more debt, either by a moderate amount or a major amount. This is never a good thing, especially at a time of slowing global economic growth.

Why should you care? Because growing gross external debt (which is an aggregate figure for government, corporate and consumer debt), is often the trigger point behind a global economic crisis. For example, the 1997 Asian financial crisis began in Thailand, where debt-fueled growth couldn’t be sustained, and spread across many emerging markets.  Nearly two decades later, the fastest-growing debt burdens are again taking place in Asia.

Asia’s Surging Debt Burden ($ US bill.)
Country Q3 2012 Q2 2014 Rate of Change
Australia $1,323 $1,490 13%
Hong Kong $992 $1,283 29%
India $381 $450 18%
Indonesia $244 $285 17%
Malaysia  $196 $227 16%
Singapore $1,203 $1,343 12%
Thailand $124 $145 17%
Source: World Bank

There’s a simple explanation why these countries are boosting debt levels with each passing quarter: Money is cheap. Billions are being borrowed while interest rates remain low. The governments, companies and consumers in these countries are taking a page right of the American playbook of a decade ago, by borrowing heavily to fund lavish growth plans and lifestyles.

Trouble is, interest rates won’t remain low forever. The U.S. Federal Reserve is expected to start hiking rates in six-to-nine months, signaling the era of cheap money is about to end. And these debt-addicted countries — along with the U.S. and Europe — will find themselves dealing with ever-higher debt service costs.

#-ad_banner-#In a bit of irony, the issue was first brought to light by China’s official news agency Xinhua. China has also been the source of much speculation about intolerable debt levels, and the country is clearly trying to shift focus on the topic elsewhere.

“While all the attention is on China at present, total debt-to-GDP ratios are also higher in Singapore, Japan, China’s Hong Kong, South Korea, and Malaysia. Since 2008, credit has grown especially rapidly relative to GDP in these economies,” noted Xinhua’s writers.

As a subsequent report by Bloomberg News noted, “all this fresh debt leaves Asia highly exposed to financial shocks and economic shifts.” The only panacea in such situations is a surge in productivity growth. If the recently acquired additional debt is put to productive economy-enhancing uses, then these countries can effectively grow their way out of debt burdens. Yet these economies have begun to slow, in large part due to reduced export opportunities to China, Japan and Europe.

Asia Emulates The West
In the years following the financial crisis of 2008, many countries took a hard look at their financial foundations.

The United States pursued high levels of deficit spending, which appeared to stabilize economic activity. Now, the country is now moving closer to a balanced budget.

Scary levels of debt forced Europe to tighten its belts, though austerity programs have kept the continent in an economic slump, and countries, such as France and Italy, have recently been given the green light to borrow more in a bid to fuel growth.

Asia never suffered from a deep slump in 2008, thanks in large part to China, but has subsequently become the new global hot spot for debt growth.

In an August 2014 report by the International Center for Monetary and Banking Studies, the authors found that “contrary to widely held beliefs, the world has not yet begun to delever and the global debt-to-GDP is still growing, breaking new highs.”

The authors single out China as being especially vulnerable to a debt crisis, but add that “the rise of emerging markets in international debt issuance since 2008 has been remarkable.” Although the Asian emerging economies were slow to become addicted to debt, the statistics referenced by the World Bank earlier means that they are quickly catching up. The fact that these countries are so vulnerable to Chinese economic activity is surely worrisome.

Meanwhile, despite rising levels of debt and the ever-present risk that China drags down the region, share prices across Asia have held up. Stocks in Thailand are performing especially well when you consider that it is the country most often-cited as having an unsustainable debt binge, compounded by the fact that a new government is experiencing paralysis in the face of badly-needed reforms.

Country Price 6/30/2012 Current Price Gain/Loss
iShares Australia MSCI (EWA) $19.78 $23.35 18%
iSHares Hong Kong (EWH) $15.37 $21.42 39%
The India Fund (IFN) $17.35 $28.87 66%
iShares Indonesia (EIDO) $27.81 $27.68 0%
iShares Malaysia (EWM) $13.48 $14.14 5%
iShares Singapore (EWS) $11.39 $13.21 16%
iShares Thailand (THD) $65.80 $83.89 27%
Source: World Bank 

Risks To Consider: As an upside risk, China may embark on more robust stimulus if its economy flags, which would help invigorate growth for its key Asian trading partners.

Action To Take –> Emerging markets offer a compelling long-term opportunity, especially in terms of portfolio diversification. But in the short-term, the combination of possible economic troubles in China, paired with a likely rise in global interest rates in 2015, makes Asian emerging economies too hot to handle right now. It’s wise to reduce your portfolio exposure to this region in the near-term.

If a debt-induced crisis does arrive in 2015, then these countries may paradoxically become great long-term bargains. Indeed, it’s best to own emerging markets when the risks are dominating sentiment. Right now, few appear to be focusing on Asia’s rapidly growing appetite for debt.

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