It's not India and Indonesia that keep renowned economist Paul Krugman up at night, amid the dramatic investor rout that emerging markets have suffered over the past few months.
"The place I'm frightened about is China," the recipient of the 2008 Nobel prize for economics told attendees at Swiss bank Julius Baer's Next Generation Summit 2013 in Bali last Friday.
In a forthright speech that took the audience a little aback, Krugman likened China to a giant ponzi scheme as it builds more and more capacity without the prospect of a corresponding and sufficient increase in domestic investor consumption.
Further, while Krugman praises South Korea as one of the great success stories of modern times, he also warns that the country is building high levels of household debt courtesy of high spending on education rather than housing.
To begin with, Krugman noted that all emerging markets had suffered serious outflows in recent months, with investors more bearish on EM equity and debt than they had been for the past 13 years.
India and Indonesia have been hit hardest of all. Investors yanked $2.8 billion from Indonesia's stock market this summer and $3 billion from India's amid a combination of weakening currencies, widening current account deficits, inflation and the US Federal Reserve hinting that it will curb its quantitative easing programme.
Still, Krugman highlighted China as the country that worries him the most. No one denies the country's pace of growth is slowing, to around 7% from double digits previously. While this appears a decent growth rate to many, Krugman pointed to a different set of problems that he argues will see China hit a brick wall.
He referred to China's growth story as "incredible, but not mysterious", with the country having invested enormous amounts of cash and pulled in millions of workers from the countryside.
But he pointed to the "oddities" of the Chinese system "in which not a lot of corporate income is paid to investors or to workers, leading to an economy which has an enormous share of investment in GDP, yet low consumption of GDP".
"In a way, it's almost like a ponzi scheme," he said. "Who's buying enough to make use of all of this capacity? It's largely going to produce investment goods used to make more capacity."
Krugman conceded that the scheme was not necessarily doomed to collapse provided it can continue to grow very rapidly. But that's the point, since it is widely acknowledged now that China cannot continue to grow at the rates it has in the past.
"It has a surplus in labour from the countryside being pulled in and wages are rising," observed Krugman. "But it cannot run at the same growth rate, it has to slow. And as China's growth slows, it will have to consume more and invest less."
By numbers, he noted that he was talking about shifting 20% of its GDP from investment to consumption. "How do you do that? And particularly, how do you do that fast?" he posed. "[China is] hitting the wall quite rapidly, and I don't know of any historical precedent [to compare it to]."
In fact, Krugman anticipates a very ugly transition period rather than a gradual glide from an export-driven economy to a consumption-led one. This transition period he equated to hitting a brick wall. "No one knows what that looks like. But it's kind of scary."
He pointed to two major issues that Beijing has to address: more corporate income must make its way to employees and investors. "[Corporates] need to pay more in wages. Get that money out to the public and the burgeoning middle class and lower class to sustain consumption," he observed.
Secondly, the government needs to build a social safety net so that people no longer have to save out of fear of paying hospital bills. "In China they need to stop the painful sacrifices, and live it up," Krugman said. "But that may not be as easy on a political note."
As for South Korea, Krugman described it as a standout, able as it is to achieve decent GDP growth rates despite already being a wealthy country. Korea's GDP grew by 1.1% in the second quarter this year, and has averaged 1.72% from 1970 through to this year.
"In terms of its innovation and ability to move up the technology ladder, South Korea is truly one of the great success stories of modern times," said Krugman. The country has become known as the global centre of the LCD universe, taking over from Japan.
Yet there are reasons to be cautious, he argued. "One thing I would say as a heads-up – Korea has started to develop high levels of household debt. All of a sudden it's starting to look like Western Europe or the US, oddly not [because of spending on] housing but for education."
Korea's debt-to-GDP ratio exceeds US levels, he said. According to Bank of Korea statistics, the country's household debt, tracked by the amount of household credit, hit W961.6 trillion ($880 billion) in July 2013, a 4.9% year-on-year rise and double that recorded in 2003 (W472.1 trillion).
Further, the share of Korea's household debt to nominal GDP has risen from 72.9% in 2003 to 91.1% in 2012.
But forecasting how Korea's debt issues will impact the country is not easy, since the high levels of debt are largely due to education spending, not housing – as in the case in the US, UK and western Europe. "What is the equivalent to a housing bubble [in education]?" he asked AsianInvestor. "What will that burst look like?"