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When a “Great Deal” Turns Bad

Tuesday August 18th, 2015   •   Posted by Craig Eyermann at 8:37pm PDT   •  

15233320_S One of the biggest news items in the past week was the Chinese government’s surprise devaluation of the nation’s currency, the yuan. This week, Bloomberg‘s Mark Whitehouse reports on the fallout, and the potential disruption it will have on the ability of the businesses and governments of other nations to pay their debts:

The yuan’s depreciation — by almost 3 percent against the U.S. dollar — triggered instability and exchange-rate declines across emerging markets. As of Friday evening in Asia, the Malaysian ringgit was down 3.8 percent from a week earlier. The Turkish lira, Mexican peso and Russian ruble also fell sharply….

The depreciations might help the countries’ exports remain competitive. But they also expose a vulnerability: Over the past several years, borrowers in emerging markets have built up more than $2 trillion in dollar-denominated debt. When the U.S. currency was cheap and the Federal Reserve was holding interest rates close to zero, that debt seemed like a great deal. Now, with the dollar getting stronger and the Fed set to start raising rates, it’s becoming more of a burden….

If investors decide the debts aren’t sustainable, they could pull out en masse, starting a dangerous spiral of declining exchange rates and financial stress that could render otherwise viable companies and governments insolvent.

But surely if that were about to happen, wouldn’t there be lots of early warning signals? In December 2012, Marc Labonte of the Federation of American Scientists summarized what happened to the nations who borrowed more money than they could ever afford to pay back after the investors who loaned them the money decided that their debts were no longer sustainable in recent years, and found that when that happened, things deteriorated far more quickly than the governments and their central banks could move:

The experience of these countries demonstrates that a loss of confidence quickly leads to a vicious cycle—investors demand higher yields on government debt to compensate against the perceived higher risk of default, but these higher yields cause the deficit to spike suddenly, thereby undermining a government’s ability to continue to service its debt. This dynamic causes a country to swing from stability to crisis relatively quickly. Restoring stability has been difficult, and since 2008 GDP has shrunk for three or more years for most of the countries. Falling GDP exacerbates the budget deficit, and vice versa. [Emphasis ours.]

Labonte goes on to identify the similarities that these debt-distressed countries have with the United States.

These countries that have required assistance to finance their deficits have some commonalities with the United States—projections of unsustainably large budget deficits under current policy, a large net foreign debt (with the exception of Italy), asset price bubbles that led to large losses in the financial sector, and large subsequent government outlays to cope with financial sector turmoil.

With those kinds of similarities, and also all of its debt denominated in U.S. dollars, it shouldn’t be much of a surprise that the U.S. government has already implemented the practices of financial repression to help ensure that its supply of “investors” in its debt doesn’t run dry.

Reducing the government’s spending to reduce its need to have such forced investment in the debt securities it issues, doesn’t appear to be an option that U.S. politicians and bureaucrats have seriously considered. Instead, it’s an indication that they’ve become more desperate in seeking to buy time that they hope won’t run out before their own great deal turns bad.

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August 2015