On 22 March 2015, Christine Lagarde — the managing director of the International Monetary Fund (IMF) — made an important speech in Beijing. Madame Lagarde outlined the dangers of US Federal Reserve tightening for emerging markets. Her warning was stark:

‘The world has yet to achieve full economic recovery. Global growth continues to be weighed down by high debt, high unemployment and lacklustre investment…

‘The recovery remains fragile because of significant risks. One such risk emanates from the expected tightening…of US monetary policy at a time when many other countries are easing…

‘The divergence of monetary policy paths has already led to a significant strengthening of the US dollar. Emerging markets could be vulnerable, because many of their banks and companies have sharply increased their borrowing in dollars…

‘The potential spillovers would affect China mostly through its trade relationships with other emerging markets…Chinese exports would certainly be affected.’.

The problem is that Madame Lagarde has only addressed half the problem for China — the impact on trade. She has glossed over the more dangerous half of the problem — the impact on China’s debt.

The analysis is straightforward. The Federal Reserve has been flirting with tightening policy since Ben Bernanke’s May 2013 speech in which he introduced the idea of reducing, or ‘tapering’, Fed bond purchases.

This led to the infamous taper tantrum of May–July 2013 in which leveraged investors involved with the dollar carry trade dumped stocks and currencies in emerging markets and repaid dollar-denominated debt.

Through late 2013 and all of 2014, the Fed did follow through with its tapering plans, but borrowers in emerging markets did not reduce their dollar debts. The problem now was not US-based leveraged traders, but the emerging-market borrowers themselves. They borrowed US dollars even though their central banks had no ability to print dollars — only the Fed can do that.

The result was what I call the ‘New Big Short’. Emerging-market borrowers are ‘short’ over US$9 trillion…with no ability to print.

A dangerous pictureLagarde’s point was that when the Fed does raise rates, there will be enormous capital flight and financial distress in emerging markets around the world. This distress will hurt the ability of these countries to buy Chinese exports, which will have some negative impact on the Chinese economy.

That’s half right. Distress in emerging markets will hit Chinese exports. But Lagarde ignored the fact that China is itself an emerging market and has one of the most highly leveraged economies in the world, including the largest amount of dollar-denominated debt of any emerging-market borrower.

Here’s a chart showing the recent increase in private leverage in China:

When you add government leverage to private leverage, the picture is even more dangerous:

As the Fed prepares to raise rates, a dual crisis confronts China. Its export markets will dry up, exactly as Lagarde suggests, but it will also face a debt crisis. Blind to the risks