I don’t know where the next debt crisis is going to come from, but I’ve got some good possibilities. When it does come, the big problem will not be the lenders or taxpayers who will get stiffed, more or less, but whether the crisis can be contained. What I mean is that when some kind of borrower, be it a state or a corporation, defaults on its financial obligations (bonds), other lenders will look around, find similar organizations in the same shape, and try to get their loans paid back immediately. This is not likely to be possible, even for the best of borrowers so, like a row of dominos, they will begin to fall and fail. This is called ‘contagion’ in the business. On a global scale, contagion can lead to an economic mess much more serious than the United States crisis of 2008.
There has already been one technical default, by Argentina, but it is an outlier and not contagious. Argentina defaulted a decade and more ago and its creditors eventually agreed to settle for 33 cents on the dollar. A hedge fund bought up some of the original debt at something like this discount, but has been successfully suing Argentina in U.S. courts to pay the hedge fund in full for its portion. Needless to say, the other creditors are not happy. They lose 67% and the hedge fund makes a killing. Argentina says it won’t pay the agreed-upon 33 cents until the hedge fund back down, so it is in default again. Ouch.
What I am focused on are other situations that could seriously rattle the international financial system. The first is a real dilly. Globally, there is something like $3 trillion (with a T) in loans outstanding that are denominated in U.S. dollars. What this means is that the loan was made in, or to, country X, payable in U.S. dollars by someone who had them. The loan proceeds were then converted into the local currency and invested or spent by that country. Such a loan is also repayable in U.S. dollars, but the U.S. dollar began to rise as the U.S. Federal Reserve Bank began to taper down its money-creating stimulus program. The dollar’s rise, relative to other currencies, was due also to the unexpected boost to the US balance of trade by the sudden increase in domestic oil production. In a short time, the U.S. purchases of foreign oil declined significantly.
Consider these changes. The Canadian dollar dropped from U.S.$1.02 in September 2012 to U.S.$0.79 in January 2015, a 20% decline in less than 2.5 years. Someone in Canada borrowing a million U.S.$ in September 2012 could have exchanged it for $1.02 million Canadian right away, but would owe, ignoring interest and some repayment, $1.264 million Canadian in January 2015. This is an extra quarter of a million dollars in local currency that the borrower would have to find, simply because of the relative strength of the U.S. dollar. The same repayment over the same months would cause the Japanese borrower to have to come up with 53% more yen, an Indonesian with 15% more rupiahs and a German with 14% more euros. You get the picture. What if the borrower’s plans did not work out and she can’t pay? What if a lot of borrowers can’t pay? There’s U.S.$ 3 trillion out there, a lot of it picked up from the Fed’s stimulus and shipped overseas to eager borrowers. The Argentinian case mentioned above is mere peanuts next to this.
A second problem is somewhat related to the American stimulus program. The Japanese government debt is the largest relative to the size of the economy (GDP) in the developed world. In order to, hopefully, stimulate the Japanese economy, the central bank is buying back a lot of this debt by just printing money — lots of it. The yen has dropped in value outside Japan, because there is so much yen floating around, but foreign holders are not screaming because 95% of the government bonds are held by the Japanese themselves. All that has happened is that imports have become a lot more expensive. And Japan imports almost everything. The crash in oil prices has masked the looming import problem, but sooner or later, it will bite. Exporters are ok, because their workers have all taken a foreign-exchange ‘pay cut’. For the average Japanese, this makes life harder. For the large numbers of retirees, this is a real blow. The pension system is not that great and Japan has the oldest population in the world, besides maybe the Russians. Can the Japanese succeed at a cheap currency problem? Well, if so, then why doesn’t everyone else play the same game of competitive devaluation? Contagion, anyone?
Then there are the interlinked problems of over-borrowing and austerity. The ratio of debt to GDP in most of the developed world is large. As long as these countries can make their payments on this debt, all is well, maybe. The problem is that making payments on the debt crowds out other demands that the society has. This shrinking of program spending is called austerity and it is not a popular thing for governments to foist on their populations. The Greeks, for instance are in this mess. The bondholders, especially in Germany, want to be paid. The Greek society is riddled with ways to avoid tax payments, so that the EU has insisted that if the Greeks want to continue to be in the Euro zone, they have to tighten up their collection systems and pass along more money. If they do that, then they are taking more money from their citizens and giving nothing but the vague satisfaction of having paid something on their debt. That’s a formula for political disaster. If they don’t do this, then the Greeks may have to leave the Eurozone and maybe the EU entirely, so they can create the new drachma, a basically worthless currency, and stiff their bondholders. How would this go down in the rest of the Eurozone countries where there are high public debt levels, you ask? Well, that’s contagion.
Finally, where does all the money come from that the lenders have available to lend? Thomas Piketty recently wrote a book, Capital, where he suggests that wealth grows by continuous positive returns on the investment of that wealth. Just keep getting a guaranteed 5% real (after inflation) return on your million dollars plus of capital and it will grow and grow, if you’re careful. If this is threatened, you turn to the bankers and the politicians to protect your money. Maybe you hide a lot of it in some offshore accounts, where wealth managers and hedge funds get you your return. You could buy apartments in New York City or Toronto or London — any place where the property market is hot. Of course, government bonds are safe, maybe, or at least you can get a high rate of return on some of the shaky ones and hope you can get out just before they crash. Whatever the approach, you will be a bit paranoid if you find that the bonds you own may lose their value, thus threatening your capital. It’s a tough world out there….and the herd instinct to all run in the same direction is strong….and that’s contagion.
Copyright Jim McNiven 2015
Dr. McNiven has a PhD from the University of Michigan. He has written widely on public policy and economic development issues and is the co-author of three books. His most recent research has been about the relationship of demographic changes to Canadian regional economic development. He also has an interest in American business history and continues to teach at Dalhousie on a part-time basis.
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