Highly recommended: Joanna Chung on disappearing developing country debt
I usually talk about the growth of the foreign exchange reserves of key emerging economies, but another feature of the past few years has been the fall in their external sovereign debt. Joanna Chung of the FT not only has the story, but covers it extremely well.
I completely agree with one of the more controversial points she makes. After the crises at the late 1990s (and 01-02 in Turkey and Latin America) the government of emerging economies decided that borrowing abroad, usually in foreign currency, wasn’t worth the risk. Issuing a bond governed by New York was once seen a real achievement, a sign of new found financial strength. Not any more.
The governments of emerging economies are not borrowing — at least not in foreign markets — even through the money is there for the taking. At rather attractive rates too. Chung:
The reluctance to accumulate foreign debt also appears tied to a change in attitude toward global capital markets, which just a few years ago were seen as the quick route to jump starting economic growth. …. [the succession of financial crises from 1982 on] have taught steadily taught developing countries that a reliance on volatile world capital market is has serious consequences. When the world economy is strong and liquidity is plentiful, bankers and bond investors alike have been happy to lend money to developing country governments. But when times have turned tough and when governments have really needed the money, the markets have denied them access to finance.”
The US, as we all know, has no such concerns about its reliance on global capital markets. It borrows in its own currency, which certainly helps. But it also has never encountered a time when it needed money and the market wasn’t there ….
Then again, the US doesn’t really rely on private capital markets. The US has a much bigger official lifeline than the IMF ever provided emerging economies (and I don’t here the Wall Street Journal railing against the resulting moral hazard). The world’s central banks – the key ones — have been willing to finance the US when private markets aren’t willing to do so. Without any conditions, political or economic.
At least so far.
Incidentally, I thought it was interesting that total emerging market debt – expressed as a share of GDP – peaked in 2003 (See the FT's chart). External debt was heading down, but domestic debt was rising (thank Brazil and Turkey … ). The trend didn’t look particularly good. The IMF was worried. And, well, Dr. Roubini and I were worried too. We wrote a book about responding to financial crises in emerging economies. We had the good sense to focus on the vulnerabilities created by domestic liability dollarization and domestic debt, not just external bonds. But we did, well, assume that their would still be crises.
Our timing could hardly have been worse. There haven't been any crises since then. Debt levels have done nothing but fall. Unless something changes, and fast, it looks more likely to serve as a history of how the emerging market crises of 1995-2003 were handled than as a guide for how to handle future crises.
Good that EMs finally learned that external liquidity doesn’t correlate well with domestic needs — plentiful when you least need them and not there when you most. Saving for a rainy day, OTOH, is short term pain and long term gain. In their hearts though, they must be grateful to the Chinese for driving up commodity prices and spreading the its financial gains.
Sure external debt in some emerging countries is decreasing but I am not quite sure total debt is (internal and external). For instance although Brazilian primary superavit is high the interest charge is also high and sometimes even larger. Nowadays total debt in Brazil is about 0.5 trillion since external debt was replaced by internal and also the revaluation of the real did not help.(idem case for argentine)
Guest,
As economies grow, debts will grow and so will assets. Only a question of external or domestic; private or public.
I am not sure, but as a share of GDP, i think Brazil’s overall debt (public) is falling. I can check. Turkey’s sovereign debt (external and domestic) is certainly falling as a share of GDP. Do take a look at the FT’s chart …
There are two obvious reasons why internal debt is falling as a share of GDP: the primary adjustment in brazil, argentina and turkey after 2000, and the absence of any big recent banking crises.
that said, there is still a lot of domestic sovereign emerging market debt out there.
Brad–It is a good news that developing country debt is disappearing. But, of course, this is largely due to the US- and China-led commodity boom, and has as a counterpart the global imbalances.
So, the issue is whether it is sustainable or not. Then, there can be a few possible scenarios, as follows.
1) The global imbalances gradually unwind without creating a global recession, and developing coutries, particularly in Latin America and Africa, do not fall in the same policy mistakes they made before. In this case, deveoloping country debt would nor come back.
2) The global imbalances gradually unwind without creating a global recession, but developing countries make the same mistakes as before. Then, the debt problem will come back to developing countries.
3) The global imbalances unwind dramatically and bring about serious recession to the global economy. In this case, commodity prices collapse, and developing countires except East Asian ones will be in deep deficit, accumulating debt.
There could be more possible scenarios. Yet, the point is that the developing country debt problem may be difficult to eradicate one and for all; it is likely to come back.
HK — as is often the case, i basically agree with you. good points. the commodity boom in particular has played a major role.
that said, turkey imports commodities, and still undertook a major adjustment — there also was a strong response to crises, a “not again” feeling. but rising commodity prices certainly contributed in a big way to the swings in the internal and extenral position of argentina and brazil (recognizing that brazil still runs a fiscal deficit despite its relatively high primary surplus), and a host of smaller countries.
some other eastern european countries though still have significant deficits/ large stocks of domestic debt — as, I think, does india.
“…Building strong and liquid local bond markets is usually a long process but such markets are seen as an important cushion against potential financial shocks, protecting against sudden swings in global exchange rates and market sentiment and allowing governments, companies and banks to broaden their sources of financing. However, Mr Cailleteau warned: “While the long-term objective is clearly positive and the process largely virtuous, it must also be kept in mind that capital markets are a source of financial contagion. Global financial integration exposes local currency debt almost as much as foreign currency debt to spill-over risk…” http://www.ft.com/cms/s/1f74bc9a-b7b2-11db-bfb3-0000779e2340.html
From Doug Noland:
” Unprecedented in size - soon to surpass $225 billion quarterly - and duration, U.S. Current Account Deficits create one of history’s most commanding - and, I would contend, destabilizing - Flows of Finance. Think in terms of a highly integrated Credit system comprised of bank, Wall Street, finance company, securitization, and securities (leveraging) finance. This Credit apparatus freely creates financial claims/purchasing power, and a large portion of these dollar balances flow to the accounts of manufacturers, energy producers, and other exporters from around the world.
Our massive Current Account Deficits have as well spurred lending, liquidity and speculative excess around the world. Our degraded currency has certainly unleashed systemic global Credit inflation, with profligate domestic Credit systems no longer disciplined by the (dollar-anchored) global marketplace. There have been scores of Current Account apologists, from Wall Street to leading academics to the very top of the Federal Reserve System. When will there finally be recognition that ongoing loose Financial Conditions, unparalleled Credit excess, and these massive Current Account Deficits pose a clear and present danger to U.S. and global stability? ”
- Doug Noland
http://www.prudentbear.com/articles/show/62
Wall Street proponents of globalization have long argued that the US current account deficit is not a serious concern since it is being financed by a capital account surplus supplied by Asian Central Banks, providing ample debt financing for the dollar economy. Imports from low-wage countries have kept the dollar inflation rate low, with attendant benefits of low interest rates and high liquidity. This arrangement, which Federal Reserve Board chairman Alan Greenspan proudly calls US financial hegemony in congressional testimony, has kept the US economy booming in the face of recurrent financial crises in the rest of the world.
US multi-national companies are still employing a growing global workforce for the benefit of US consumers through cross-border wage arbitrage and US dollar hegemony, which permits a fiat currency of the world’s most indebted nation to retain the privileged status of reserve currency. The adverse effect of this type of globalization on the US economy is becoming clear. In order to act as consumer of last resort for the whole world, the US economy has been pushed into a credit bubble centered on Housing that thrives on conspicuous consumption and fraudulent accounting.
DC, Some of the “fraudulent accounting” is showing up, see the Mortgage Lender Implode-o-Meter:
http://ml-implode.com/
I have to think a lot of non-US CB’s have bought mortgage backed securities from the US, as well as private parties looking for slightly more juicy returns than T-Bills. There will be a lot of crying at the Wailing Wall very soon. Weak mortgages were sliced, diced, packaged and sold with upgraded Ratings much higher than the underlying promises warranted.
“Our timing could hardly have been worse.” The pure, unfiltered sound of intellectual honesty. Will Brad still be able to write this way when he has Ben B’s job? If there is any justice in the world, the answer is yes.
Guest, I have to admire your succinct summation of the madness. Inuit indeed!
But the picture is not complete without an understanding of the forces that allow this craziness to persist. How can US debt, or dollar debt in general, exceed not only US GDP, but (by orders of magnitude) the number of dollars that actually exist, or that any plausible projection of M0 would project to exist in future, in the world? Why do people persist in holding these instruments, no more than a fraction of which can pay out in actual cash? Does each holder of one of these liabilities believe that he, and he only, has the ticket that will pay off? Surely someone is the sucker in this game…
This impression is entirely misleading. Financially, this entire system is perfectly stable. If it has any instabilities, they are in the political department. No Inuit, with their great hidden hoards of precious metals amassed by generations of bone-wielding shamans whose investing acumen takes no back seat to their mastery of the spirit world, need ride down on their polar-bear cavalry to save the day.
What the hell is debt? As a liability, it is an obligation to produce currency. As an asset, it is the right to be paid in currency. Forget the liability side for a minute and focus on the asset side, because this is after all the question: who holds all these notes? And why?
Debt is a right to future money. At least abstractly, it is no different from a commodity future. The simplest way to think of debt is to model every obligation as a zero-coupon bond; thus, for example, a note which does require regular interest payments can be defined as a complex structure of zero-coupon bonds. The present value of one of these currency futures depends on the face value of the note, the time T after the present at which it will be paid off, and the probability of payment.
In other words, we can define debt (as an asset) as a generalization of currency. Present money, in other words, is a degenerate case of debt.
As T approaches 0, probability must either approach 1 or 0.
In a a closed-loop financial system - an economy where the total quantity of currency is fixed - it should be obvious that the projected debt repayment of no entity or set of entities can exceed that quantity. If banks as a whole - or grocery stores as a whole, or Inuit as a whole, any set will do - are liable to pay at date M quantity Q of currency, and only Q/2 exists in the world, the highest possible market projection of the repayment probability of these notes cannot exceed 0.5.
Unfortunately, we do not have a closed-loop financial system. We have a financial system in which certain trusted entities, “central banks,” may create currency according to their administrative judgment. This is why, without recourse to Inuit, the sum of debt outstanding can so greatly exceed the amount of currency required to pay it.
In other words, this debt is entirely supported by monetization. The trivial case of monetization is when a central bank creates currency and uses it to buy debt. In the general case, however, this transaction may be entirely implicit.
The probability that any note will be redeemed can be inferred from the yield curve on debt of asymptotically negligible risk, and the market value (in present money) of the note. By credibly promising to buy the debt under certain circumstances, a central bank has arbitrary power to inflate the value of the note, and thus to contaminate or destroy the market pricing signal that allows participants to infer the probability of redemption. This promise may be, as it is for example for “agency” debt, entirely implicit and informal.
This is why people buy the “naked puts,” and all the other notes that in a closed-loop system would trade at a tremendous discount. The goal of the financial engineers is to produce a synthetic instrument that pays more interest than a T-bill, and that has, in practice, the same risk. When they do this badly, the result is hedge fund blowups. When they do it well, as most do, the result is an investment that will fail if and only if the financial system itself undergoes a complete collapse. Since central banks have both the legal and actual power to create arbitrary amounts of currency and exchange it for any asset, they have the power to prevent any collapse, and there is no reason at all to suppose that they will fail to use it.
In other words, the current explosion of debt is just a new variation on the old phenomenon of states using currency dilution as a power source. Instead of directing the actions of their citizens by creating present currency and giving it as a reward to those whose actions they favor, they are using the power of dilution to create generalized currency - debt - which is overvalued in present terms. All the details are different, but the basic effect is the same.
This scheme can survive indefinitely without creating any present currency at all. The printing presses just need to be there - they don’t need to run. When these debts do become due, they can be rolled over, that is, replaced by new debt that is similarly overvalued.
As compared to the old royal vice of coin-clipping, the only improvement in this scheme is that the intricacy of the whole operation provides a level of esoteric obscurity that states have always cherished. Secretary Paulson (perhaps he’s the “Anonymous” of our previous thread) can stand up and describe the yen rate as “market determined,” without any serious worry that his nose will put some poor reporter’s eye out.
The last variables to be locked into place in this equation are the cross rates between the various fiat currencies. Once enough brave traders bet on the yen carry trade, for example, that any unwinding of that trade would have political consequences which both the US and Japanese states are unwilling to accept, the merger is achieved and it is permanent. The same will probably eventually happen with the dollar and the euro. BWII is rapidly approaching the status of a global currency bloc.
There are only four risks in this entire system - maybe only two. Since the system is based on transmuting financial into political risk, all these risks are ultimately political.
Risk one is that the enormous productivity improvements of the last two decades, which have allowed gargantuan financial dilution without any apparent increase in the price of many goods and services, will stop for some reason. As a technology enthusiast and a bit of a Kurzweilian, I find this unlikely. And even if it does happen, the CPI is, in the final analysis, a metric of the political risk caused by dilution. The populations of G7 countries, even of China, presently exhibit a level of docility unprecedented in recent memory. Even 10% CPI “inflation” is unlikely to get Americans to burn tires in the streets. It might swing an election or two, but how much do elections affect the Fed? Central banks are probably, if anything, more careful than they need to be in dealing with this risk.
Risk two is that the monetization machine will fail to operate in a crisis. It is after all cumbersome and it takes time to swing into action. A panic in which the financial viability of one or more major debt issuers becomes questionable may be technically difficult to fight, given the complexity of 21st-century financial arrangements. If this is not arrested, a vicious cycle could arise that would put the global financial system in the same condition of widespread and generally accepted insolvency as the Japanese system. Since the resulting “uber-recession” would be politically unacceptable, it would probably be countered by liquidity injections of a broad and unsystematic nature, signaling the general decline of the entire political and financial system.
Risk three is that the monetization machine will progressively overheat as financial entities compete to transfer even more risk to the state, generating so much money that it overcomes the price-lowering effect of productivity. The lines of acceptable risk are constantly slipping, as last year’s aggressive practice becomes this year’s normal practice. If this becomes self-accelerating it could conceivably result in a kind of slow hyperinflation, previously unobserved by history. However, at some point this system would probably take on so much risk that it would break the monetization machine, as described in risk two.
And risk four is that savers will opt out of the entire system and select low-dilution assets other than official currencies as stores of wealth. This is really a political risk, because the main factor preventing savers from taking this action already is their politically-conditioned loyalty to the current regime. The only reason to hold physical hard assets, rather than politically-guaranteed liabilities whose price is marked to those assets (such as commodity futures) is an expectation of political regime change, which is a thought that is hard for any regulated actor to think. It is even a hard thought for a hedge fund. Once institutional investors of any type even begin to think these kinds of thoughts, a time of change will be upon us. But I see no reason for anyone to expect this to happen soon.
admin: the post by a “Guest” I was responding to disappeared - very strange. If you search for “Inuit” in the logs you might find it…
(1) I am wary that some may take away this idea: “Global economic imbalances are good for LDCs since imbalances create demand for their exports and help pay down their debts.”
I’d counter that developed countries are better off seeking synergies with each other than hitching their well-being to American profligacy. South-south economic activity is better poised to continue this welcome trend of reducing LDC debt levels without worrying about the inevitable shoe to drop on US superconsumption. Global rebalancing should make progress on this front more sustainable by ensuring that demand is more evenly spread, perhaps among fellow LDCs.
(2) With a lack of debtors, the IMF is considering selling off some of its stash of gold. Talk about a reversal of fortune. Nowadays, it’s the deteriorating fiscal situation of the IMF that requires “structural adjustment.”
Aargh, I meant “developing” countries in the second paragraph. This has not been my day.
Moldbug–
Nice analysis. A couple of questions…
How long can one expect this to last, the global inflation protection being anchored on production of goods from a fixed-rate currency economy which will one day suffer the political consequences of financially punishing citizens who do not offer themselves up as the cheap labour that produces those goods?
Will the United States be forced to adopt socialism in support of aging baby boomers? The health care issue answers, “yes”, but the how is almost inconceivable.
The probable historical coincidence of the two issues makes one tremble.
And no explaination from admin.
“…Other institutions with potential exposure to the risky category include investment banks such as Lehman Brothers, Morgan Stanley, Merrill Lynch and Barclays Capital, which have bought sub-prime lenders partly to feed their securitisation businesses…” http://www.ft.com/cms/s/9ecd6326-b7de-11db-bfb3-0000779e2340.html
Guest,
I’ve had a post or two get lost here - I’m sure it is quite random. I think it’s pretty clear that bsetser, to his great credit, doesn’t filter for content. (Unlike his egregious namesake, DeLong.)
Charles, the school of economics I follow, the Austrian, doesn’t claim any kind of predictive power. I think anyone of any school would expect that the unraveling of BWII will be discontinuous, and discontinuities are intrinsicially hard to predict - if you could predict them, you could front-run them.
They are paying down foreign debt but doing it by issuing domestic debt. So they are trading the exchange volatility and other risks associated with foreign debt for the crowding out effects of domestic. Let us not imagine that this is a brave new world without problems. The attraction of foreign debt was the ability to finance your expenditures (investments we hoped) at low interest rates without being limited by domestic savings capacity. Now the interest rates will be high and domestic savings capacity soaked up by the government - Hey wait a minute …. isnt that kind of like what WE are doing? …
steve — lots of emerging economies, like the US, have no trouble attracting foreign investors into their domestic debt market, which cuts back on the crowding out … in the new world, the old line between domestic and foreign debt has eroded. foreigners buy domestic and domestic residents (especially in countries with a bit of liability dollarization) but foreign debt (with foreign or domestic debt defined here by the currency of denomination and legal jurisdiction, not residency)
Brad
Indeed it has eroded recently but the potential problem is that the erosion of the line between domestic and foreign debt is reversible. Your statement is somewhat reminiscent of the literature after the Chilean experiment with imagining that there was no difference between foreign and domestic debt. Indeed there wasnt …..until suddenly there was and they were in deep water. Diaz Alejandro wrote a fun piece on this called “Goodbye Financial Repression, Hello Financial Crash”. There were some other things written too, but the point is that you would be foolish to imagine that the way things are is the way they will always be.
Moldbug - The questions were more of a rhetorical device than anything else, but the implication was that political risk has been almost totally removed from the economic/speculative equation (the “peace dividend” de facto) allowing financial markets to operate as if “externalities”, or even the threat of same, no longer existed. But they will return, those being two of the more obvious possibilities.
bsetser - it may be accurate that the line between foreign and domestic debt has disappeared, but that carries no guarantee that it will remain so. Decisions as to levels of participation in all this are still made on the national level and depend greatly on to what extent governments, and people, are willing to sacrifice autonomy on the altar of macroeconomic results. It’s a plan that works only when it pays out.