Slowing emerging markets face debt hangover China's latest interest rate cut shows Beijing's willingness to contribute to global efforts to ease credit in response to the slowdown induced by the eurozone crisis - just as it did four years ago after Lehman Brothers collapsed. Unfortunately, its results are unlikely to have the same impact as in 2008-9. The wave of credit released then by China and other emerging economies washed around the globe, boosting demand for Chilean copper, German cars, and luxury property from Hong Kong to Rio de Janeiro. Now the world can no longer count on emerging markets to deliver the same. Many have less room for financial manoeuvre owing to the after-effects of the post-2008 easing, including higher levels of credit, fears of real estate bubbles and bad loans, and a legacy of unprofitable boom-time investments. Furthermore, even if governments do release more money, it will have less impact now because good investment projects are harder to find. As David Lubin, head of emerging markets economics at Citigroup, the US bank, says of China: "A side effect of [its] investment push is that investment efficiency collapsed. As a result, it now takes more investment to generate an extra unit of GDP. In the same way, it also requires more credit. China leads the list of emerging-world governments to expand public sector borrowing. Sovereign debt rose from 20 per cent of gross domestic product in 2007 to 26 per cent last year, fuelling a domestic infrastructure boom and increased demand for commodities. Poland also opened the taps, with its debt-to-GDP ratio rising from 45 per cent to 56 per cent. Other governments that went into the crisis with already-high public debt, such as Brazil and India, were more cautious. However, the true credit boom in the developing world has been private rather than public debt, fuelled by low interest rates and willing lenders. In China, private sector credit has risen from 107 per cent of GDP in 2007 to 127 per cent last year, according to Capital Economics, a consultancy. In Brazil, Turkey and Poland, private sector credit has meanwhile risen by as much as 20 percentage points of GDP. Beijing warned on credit There is no question that China significantly increased the leverage in its economy to counter the global financial crisis, writes Simon Rabinovitch. A surge in credit was the single most important part of the government's vaunted stimulus programme: new lending by state-owned banks from 2008-10 was about 60 percent of gross domestic product. Some economists say they are less concerned about how much leverage China has than at the speed of the rise in China's leverage. UBS economist Wang Tao has noted that an increase of 40 percentage points in a country's credit-to-GDP ratio over five years correlates very well with financial crises. In China, there has been an increase of 40 percentage points in the past three years alone. This "needs to stop soon and reverse in the coming few years," she says. For the government to follow a path of sustainable growth, it should ensure that banking sector credit grows by less than nominal GDP, she adds. Put another way, China still has scope to lever up more if it so chooses - but such a choice could lead to big trouble down the road. For much of this year, even as signs of an economic slowdown mounted, Beijing opted for the prudent course and continued its moderate monetary tightening, despite howls of protest from real estate developers and investors. But over the past month, it has again prodded banks to ramp up their lending, a move which is eerily reminiscent of the credit spree that it is just now coming down from. Worried by this possibility, economists have taken to reminding Beijing that it can easily afford a traditional fiscal boost (for example, government deficit spending on initiatives such as health and education) and that it must resist the easy solution of simply calling on the country's banks to pump out credit. "China again has space for a forceful response if necessary, but, this time, on-budget fiscal stimulus should be the main line of defense," the International Monetary Fund has warned. Countries with slower credit growth are the exceptions. South Korea, for example, has held back because of an earlier painful credit boom, and India because of high interest rates induced by persistently high inflation. Elsewhere, though, the credit surge is in full flow. The latest data show private credit grew in April at annualised rates of 20 per cent or more in Colombia, Indonesia, Turkey and Russia. Although these countries are relative latecomers to the credit binge, Brazil has been partying from the start. Private credit is still growing 23 per cent a year, even though borrowers are now struggling, as seen in rising delinquent car loans. Credit growth can be a boon, especially in the emerging world: It speeds development by allowing governments to build infrastructure, companies to construct factories and families to buy homes and durable goods. "I do believe that rapid expansion of credit plays a big part in the rise of the emerging world's middle classes," says Arjun Divecha, chairman of US fund manager GMO. But credit growth rates matter. Rapid rises are often linked to lax controls and property speculation, which can lead to bad debts and unproductive investments. In China, for example, total credit expanded by almost half of GDP in 2009, and again in 2010. Now, some economists say, it may have maxed out. Citigroup calculates that between 2002 and 2008, it took four units of investment to produce an extra unit of Chinese GDP; between 2009 and 2011, that ratio rose to five investment units. By the same token, before 2008 it took 1.8 units of credit to produce an extra unit of GDP. Between 2009 and 2001, this rose to 3.6 credit units. When economies are growing fast, it is easy to gloss over inefficiencies. But with emerging markets now slowing, the true costs of the credit boom will surface. Rapid credit growth "often foreshadows a financial crisis," the Bank for International Settlements (BIS) warned in its annual report this month. The debt service costs of households and companies in Brazil, China, Turkey and India stand at their "highest level since the late 1990s" when the Asian crisis exploded. At the same time, the monetary tsunamis launched by central banks since 2008 have not generated self-sustaining growth in the developed world. This, in turn, is undermining confidence in export-oriented emerging economies. According to the International Monetary Fund, emerging market GDP growth will slow to 5.7 per cent from 6.3 per cent last year. That is well above the 1.4 per cent forecast for advanced countries, but still a hefty discount to the 8 per cent recorded pre-crisis. For borrowers, the differences can be painful: even slight slowdowns can exert a disproportionate impact on sensitive credit-fuelled sectors, such as property. If a few buyers get cold feet, that sentiment can spread rapidly to others, and minor doubts become a crisis of confidence. In the long run, emerging economies still have huge investment requirements - and the capacity to finance them with credit. As Mr Divecha says: "Of course, when you have rapid expansion of credit [in emerging markets], you can also get all the classic problems such as abuse, over-borrowing. But that's not a systemic problem, like Greece, it's a cyclical one. In other words, what many emerging markets need is time to work things out, sort the good investments from the bad, deal with the debt, and carry on. But with the world economy in its current sorry state, time may not be on their, or anyone else's, side.