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The conventional wisdom among economists is that emerging markets do not face another 1997 financial crisis situation and that currency and economic volatility in the developing world will be short-lived.

Bank of America equity strategist Ajay Singh Kapur begs to differ and has a far more pessimistic view on emerging markets. Mr. Kapur notes that while governments do not have the outsized foreign currency debt that caused the 1997 emerging markets crisis, regional banks and corporations do.

In the end, Mr. Kapur believes that the end of Fed tapering and a resulting rise in the U.S. dollar could cause another global economic crisis by forcing the unwinding of a $2-trillion (U.S.) carry trade. He writes:

"Since 3Q/2008, the U.S. Federal Reserve QE has unleashed a massive USD2tn debt-driven carry trade into emerging markets, disproportionately increasing their forex reserves (by USD2.7tn from end-3Q/2008), their monetary bases (by USD3.2tn), their credit and monetary aggregates (M2 up by USD14.9tn), consequently boosting economic growth and asset prices (mainly property and bonds). As the Fed continues to taper its heterodox policy, we believe these large carry trades are likely to diminish, or be unwound."

In simple terms, the EM carry trade involved borrowing funds in U.S. dollars at low interest rates, and then investing the proceeds in higher-returning developing world bonds or equities.

From 2009 to 2012, the strategy was extremely lucrative. In Brazil, for example, a bank or other institution could borrow U.S. dollars at interest rates between 1 and 2 per cent, convert them to local currency (reals), and invest in five-year Brazilian bonds yielding between 9 and 12 per cent.

Even better, when it came time to repay the U.S.-dollar loan, odds were that the dollar had weakened in Brazilian currency terms, making the loan cheaper to pay back.

All that changed in May of 2013 when then-chairman Ben Bernanke signalled that the Fed's quantitative easing program was coming to an end. U.S. bond yields and the greenback shot higher, making the carry trade less profitable.

In the Fragile Five countries, the effects were immediate. Local currency investments were sold in order to pay back U.S.-dollar loans. The rupee, Brazilian real and Turkish lira, among others, immediately headed south as foreign investment funds fled the country.

The same problem – U.S. dollar debt – was the root cause of the 1997 emerging markets currency crisis. Then, the severity of the issue was easier to measure because it was governments and central banks doing the U.S. dollar borrowing.

Now, government finances are far healthier in terms of foreign currency exposure. But, as Mr. Kapur notes, a quirk of data reporting has most economists vastly understating the extent of U.S. dollar debt.

Economists generally use national balance of payments reporting to assess foreign currency debt. But this does not include debt issues sold by national bank branches operating in foreign countries. Indian banks, for example, issued $6.3-billion in foreign currency debt on behalf of Indian corporations in the first quarter of 2013 alone through its subsidiaries in London and New York.

Once the foreign currency debt issued abroad is included, total exposure is alarming. For the EM complex as a whole, balance of payments reporting indicates $1.5-trillion in foreign debt. But, add the debt from global subsidiaries and the total jumps 300 per cent to $4.5-trillion. Now we're talking real money.

It's a good thing that a full unwind of the carry trade is unlikely because it would involve a disastrous $3-trillion reduction in EM money supply. But even the partial reversal Mr. Kapur expects will be painful.

The assets pushed higher by excess credit – primarily real estate – will fall. Because these assets are used as collateral for further loans, the potential exists for a downward spiral of loan defaults.

Canadian investors, with an equity benchmark highly connected to the emerging markets, would not be spared if further U.S. dollar strength results in a further unwinding of the carry trade. Emerging markets currencies and bond markets appear stable for now, but any sign of volatility should result in Canadian investors raising cash or buying U.S. assets.

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