Today I want to talk about debt. Not the kind you think about when you see headlines about student loans, credit cards, or the federal budget. No, this is a very special kind of debt, a kind you likely will hear nothing about, but a kind of debt that has a tremendous amount of influence around the world.
Let’s start in broad strokes. If you’ve read my previous blogs, or any article about floating currencies (fiat money, for the gold bugs out there), then you will know my thoughts on the state of the U.S. Dollar. The USD is the most stable currency in the world today, and it gets that ranking from both its Liquidity (the frequency that it is used) and its Notoriety (the amount of people and institutions that recognize its stability, and thus use it). Most
global energy transactions are made in USD, most financial clearinghouse activity is done in USD, and almost every country in Earth recognizes it as, for better or worse, a stable currency.
This blog post is not about America, however. It is about the rest of the world. How do other countries’ currencies compete with the Dollar in a floating currency system? Do other countries attempt the same industrial booms that America had? What about the same debt issuances, fiscal policy, or foreign direct investment?
The answer, as with most things financial, eventually comes back to the U.S. Federal Reserve. The Fed sets monetary policy for the U.S., which either makes the USD stronger or weaker relative to other currencies. When the USD gains strength, more people will want to hold USD, and when the USD weakens, people will want to sell. Recall that a stronger USD means imports to the U.S. will cost less, as a stronger dollar will be able to purchase more of a foreign currency for each dollar spent. However, a stronger USD also makes exports more expensive, as the stronger USD will push up dollar-denominated prices of goods, and other countries will want to buy less. It’s important, though, to think of currency strength not on a numeric scale. One Dollar will only ever be worth one
Dollar. Its strength or weakness is a result of how much in goods, services, or other currency it can purchase. By that metric, currencies can strengthen or weaken as needed to respond to a growing global marketplace and changing resources.
Monetary Policy Overview
For a more in-depth explanation of how all this works, the Federal Reserve sets U.S. interest rates, through the Federal Funds Rate (FFR). The FFR is the overnight interest rate on loans from Bank to Bank, set to an annualized percentage. If JPMorgan Chase, for example, needs to borrow money in anticipation of a large cash withdrawal in a few days, they will want to borrow from the Wells Fargo down the street, but Wells Fargo will not want to lend that money if they do not receive interest in return. That is the FFR in a nutshell, and the Fed raises and lowers it in response to economic strength and weakness, but based on consumer trends.
In a strong economy, theoretically, consumers will have more disposable income and will be spending a healthy amount. The Fed wants to protect against the economy getting too hot (and runaway inflation caused by overspending), so they will raise the FFR, thus pushing up the borrowing costs of banks and businesses, and also pushing up the effective interest rates paid on bonds. Consumers will then, theoretically, want to save more of their money by buying those bonds, and economic activity slows.
Conversely, in a weak economy, consumer spending will be weak, and saving will theoretically be strong. The Fed will lower the FFR in this situation, in order to entice people to save less money, and spend more. Lowering the FFR will lower the borrowing and lending costs to banks and businesses, letting them respond more effectively to consumer trends and letting the economy pick up steam.
The Fed has announced in recent years that their “normal” desired FFR is around 1% higher than the inflation rate, which as of August 2018, has come in at 2.2%.
The Central Issue
The world is an ever more connected place these days, and that includes the financial world. Recall that investors, businesses, and governments from all over the world acknowledge the stability of the USD. Other countries (with the USD as not their local currency) can, for purposes of this blog, be lumped into three groups; Developed Markets, those that have strong currencies of their own and compete with the USD, Emerging Markets, those that have less pronounced, often pegged currencies to the USD, and Tertiary Markets, those with the weakest economies and most volatile currencies. For this blog post, we will focus on Emerging Markets.
Emerging Markets have seen an explosion of economic growth over the past 20+ years, due to a multitude of factors. These include, but are not limited to, easier access for developed-market investors to invest more directly in them, increased media coverage and grouping of certain countries (The African Union, BRICS, ASEAN, etc.) and overall liberalization of eastern markets. But no factor has had as much impact, nor been as lasting to long-term economic success of developing nations, than cheap debt. Loose monetary policy and cheap debt has been a tailwind to global growth for decades, and has allowed otherwise struggling countries, rife with political and economic turmoil, to reap the benefits of virtually unlimited investment, near-free money, and confidence that the good times would keep on rolling.
I often talk about secular trends in western civilization being responsible for lower interest rates, those trends being an aging population and falling birth rate, stagnant or decreasing real wages, and asset prices (stocks, homes, etc.) rising faster than the rate of GDP or wage growth. Think about this in tangible terms. You work as long as you need to, but your income doesn’t seem to rise much year to year. You look around, and everything is financed nowadays. Average home values have climbed in the last 30 years from under $200,000 to over $300,000, college tuition has more than tripled, even your phone costs more than $1,000. Rising costs for such common expenses pushes them to be paid in installments, and those have interest rates attached. As debt levels rise among
citizens of the West, the interest rates necessarily have to decrease in order to keep affordability. Since western economies make up such a large portion of the global economy, this dictates a lower overall world interest rate, and makes debt cheaper.
Emerging markets will want to take full advantage of this situation, because to them, it could not be better. Countries that can experience massive growth rates do so with mass influx of construction and industrial activity (the American way!) and that takes a lot of capital. Some of the most popular emerging markets are Turkey, Argentina, South Korea, and Indonesia, and I’m sure you’ve heard at least a little about the growth they have
experienced in the past few decades. How do you think they achieved it? Massive capital inflows, often, to their long-term detriment, denominated in USD.
Remember when I said the USD was the most reliable, stable, liquid currency in circulation? It holds true even in those emerging markets. Debt can be issued, bought, sold, and paid easiest when it is denominated in USD. It’s how investors in New York can lend money to Turkish construction companies, or South Korean software companies, or even Chinese bank notes. It’s how financial institutions can transact with each other without foreign currency adjustments getting in the way of quarterly earnings. But at its core, it’s most definitely how countries with no vibrant economy or stable currency of their own, can “borrow” one, to prop themselves up and propel massive growth.
Here’s how this works for governments. Say Turkey wants to undergo a massive infrastructure plan involving a lot of companies building new buildings. The project will cost, say, 5 billion Turkish Lira. Turkey does not have the money to cover this cost, and they have a choice to make. They could issue Lira-denominated debt to cover the cost, but that comes with a 24% interest rate paid every year. They could alternatively use their Lira to buy Dollars, and issue Dollar-denominated debt at a 5% interest rate. U.S. monetary policy is loose, and interest rates are still at historic lows, remember? Naturally, Turkey would choose the latter option. The effect is twofold. Dollars exit the U.S. and enter Turkey as a Foreign Exchange Reserve, which buoys the value of the Lira (because, theoretically, Turkey could sell its Dollars to keep its liquidity of Lira) and also allows Turkey to take advantage of the far lower U.S. interest rate. If the debt is rolled over every expiry, then demand for that debt will be high, and Turkey will experience a lot of growth as a result.
It works in a similar way for businesses. Say Turkey wants to infuse its private sector with a ton of cash in order to juice its economy. Countries do this all the time, in the form of tax cuts, tax rebates, sovereign wealth funds, or even helicopter money. Turkey wants to lend its businesses 50 billion Lira. Turkey only has 5 billion Lira, and has a choice to make. It could lend the 5 billion Lira now and accept a lesser result, it could invest the Lira in the hopes of having a larger amount in the future (but not lending it now), or it could buy Dollars with that Lira, issue Dollar-denominated debt to lever themselves and receive many more Dollars, and sell those Dollars to buy the 50 billion Lira it wants to lend. Businesses within Turkey’s domestic economy can only transact in Lira, so they cannot use Dollars. The effect of this is once again beneficial to Turkey. 5 billion Lira used to purchase Dollars results in leverage that allows Turkey to “borrow” the ability to access much more of its currency, as a much lesser cost. Once again, Turkey is taking advantage of lower interest rates and cheaper U.S. debt to grow its own economy.
Sounds like a win for Turkey, right? Seems like a true “miracle” situation, one with no downside, right?
Surely you can see a glaring flaw in all this. The system only works when dollar-denominated debt has a lower interest rate, or put simpler, when the USD is cheaper. For the last 30 or so years, this has been the case, with the massive interest rates of the 1980’s giving way to the Greenspan-led mass lowerings of the 1990’s, the teaser rates of the 2000’s, culminating in the all-time-low interest rates in the 2010’s of 0% – 0.25%. As you can imagine, zero is the “effective lower bound” here, as money cannot get any more free than “free”. But what happens when U.S. interest rates, finally start to rise?
Recall that the Fed raises interest rates to combat inflation and strengthen the Dollar. When the Dollar strengthens, it can buy more foreign currency, and foreign currency can buy less of it. This is where we begin to see the concept of Contagion. In our Turkey examples, for both government and business, growth in Lira terms is being fueled by Dollars, and in both instances, Turkey needs those Dollars to be as cheap as possible so they can keep buying them and issuing debt. If their liquidity dries up, and they can no longer buy as many Dollars with their Lira, then investors quickly lose confidence in the ability of the Turkish government to satisfy its debt obligations, and those investors will not buy Turkish debt. That forces Turkish debt to become more desirable to compensate, and it does this by pushing their interest rate higher. If it gets high enough, then Turkey will not be able to pay its debts, it will lose the ability to attract foreign capital, and its economic growth will flatline.
You’re probably thinking to yourself, surely this isn’t as big a problem as you’re making it out to be? A percent or two of interest won’t make or break an entire country’s economic performance, right? I say to that, look to history as the judge, specifically the events of 2007-2009. The Fed’s Quantitative Easing to combat the Recession had the double impact of shoring up debt markets (by buying distressed mortgages and bonds, eliminating much of the bad apples from the tree) and flooding the U.S. financial system with trillions of new, cheap, accessible Dollars, in the hopes that banks would lend them out and get the economy moving again. The net effect was an all-time-low interest rate (mentioned above), and emerging markets took full advantage of this. Liquidity was so high, and they could afford to borrow so much, that the situation had the look of a Liquidity Trap, when debt costs are so low, and so much is borrowed essentially for free, that when rates finally go up, borrowers have no way of paying it back.
This is what I believe has happened, and what is beginning to finally show, in emerging market economies. U.S. interest rates are about to pass the 2% minimum threshold, and the Fed is continuing to signal that the rate hike cycle is nowhere near over. As the Dollar continues to strengthen compared to more volatile, weaker emerging counterparts, borrowers of Dollars will not have a way to repay their debts. This will lead to massive capital flights from those economies, economic contraction, and continued divergence of the West, and the U.S. in particular, as the sole economic choice of the world’s money. So the next time you turn on the financial news and see the word Contagion, remember what it means, and keep your money close.