To kick off the New Year, the world's largest economies face a massive global debt overhang brought about by the corona-phobia. In round numbers, some $13 trn in debt is coming due and will need to be refinanced in an ultra-low rate environment. Basically, seven top economies plus several major emerging markets "face the heaviest bond maturities in at least a decade, much of the borrowings to dig their economies out of the worst slump since the Great Depression," according to Bloomberg, adding that these governments will need to roll over at least half of this debt in 2021. Although this sounds alarming, I agree with Gregory Perdon, co-chief investment officer at Arbuthnot Latham, when he affirmed that "government debt ratios have exploded, but I believe that the short-term worrying over a rising debt is fruitless." Notwithstanding, I take issue with his other claim that "debt is leverage and assuming it's not abused, it's one of the most successful tools for growing wealth." Undoubtedly debt can be a tool for acquiring or creating wealth. However, when it is government debt that is in consideration, this is only a boon for those well-positioned cronies who have a relationship and are in contact with the legislators or the whole bureaucracy in general. To wit, the largest government debt refinancing will be in the US, with $7.7 trn of debt coming due, followed by Japan with $2.9 trn. To boot, China has $577 bn coming due, Italy has $433 bn, followed by France's $348 bn and Germany has $325 bn. Contrary to popular opinion, the low-rate paradigm is not a product of central banking machinations, but a product of a deflationary economic environment with too much risk for too little reward. Thus, as I stated on the December 30 post, "liquidity has been the top concern for participants in the financial markets (...) Accordingly, investment grade bonds have been an oasis of liquidity during this inhospitable desert that has been the 2020 economy. (...) No matter by how long or how much they do their QEs, credit and "liquidity" facilities, YCC, etc, these are all smoke and mirrors aimed at duping you into believing they possess the mastery over financial markets." Nevertheless, with sovereign yields plunging to record lows, it is only reasonable that governments across the world flood the market with as much debt as possible so as to turn this rebound into an actual recovery - good luck! - or, at the very least, preventing it from rolling over. However, this panorama of ultra-low yields is being experienced almost exclusively among the developed economies. In the emerging markets domain, the contraints on the Eurodollar system, prompted by the colossal loss of activity coupled with tremendous uncertainties about the future, have put these economies under grave peril. In order to have a sense of the vulnerabilities to the current (euro)dollar shortage these countries are carrying, Rabobank has come out with a compelling and succint report on this issue. According to this report, the most important factor explaining the rebound magnitude on Q3 (Q2 in China's case) was the level of containment of the virus. Moreover, the countries' dependency on the tourism sector was also detriment for the economic performance on the third quarter, with Thailand and the Philippines having a lousy Q3 figure. On the flipside, countries that either lifted their restrictions on movement and activities or happened to export a lot of in-demand medical and electronic goods, or a combination of both, underwent a relatively robust rebound. In addition, as you can clearly see, the more sluggish economies tended to be the ones in the southern hemisphere where the third quarter lands on their winter season, rendering the best environment for influenza-like illnesses to thrive. Evidently, economic activity remained very constrained in Q3 mainly because of government imposition. On the left graph (below), in which countries are ordered by their ratios of government debt, Argentina, Brazil and India are the ones that are most in jeopardy of losing control of their finances, solely bearing this indicator in mind - the others being presented by the heatmap above. Seeing that individuals and businesses were in dreadful need of some financial relief, these countries, as was the case all over the globe, have increased their public debt. Among the biggest debtors, Argentina's debt rose 6% of GDP, Brazil 8.4% of GDP and India 8.5% of GDP. In view of the fact that high debt levels are a constraint to future economic growth, they have to be avoided. Furthermore, the governments' capacity to spend could be restricted by higher market-imposed interest rates due to higher default/foreign exchange risks, as well as by a higher share of the government budget that has to be allocated towards debt repayments and not towards "stimulating" the economy. Moving on to debt denominated in foreing currency (below on the right), Argentina, Turkey and Indonesia are the ones most at risk of devaluation of their respective domestic currencies. Even though the writer of the report claims that "[t]his dependence on foreign capital constrains the set of monetary or fiscal mechanisms that can be used to stimulate the economy" and that "cutting central bank interest rates depreciates the local currency, indirectly increasing government debt levels in terms of the local currency", it is better to revisit what I wrote a few weeks ago, on the Christmas day post, to understand the true workings behind these operations and, consequently, comprehend what is wrong with his statement. In the foreign exchange (FX) markets, "these countries' [EM's] currencies are not transacted as much nor are these exalted the same way as the major currencies from the putative developed economies, owing to being less liquid (smaller market with fewer buyers and sellers) and/due to market participants having less confidence and use for these currencies - afterall, this is the Eurodollar system. Hence, the monetary situation in the EMs are extremely dependent on the volume of foreign exchange that goes through their economies, chiefly the US dollar (check out the US vs the World part I and II)." Therefore, the EM central banks are incapable of depreciating their currencies by cutting interest rates. In fact, the plummeting value of an EM currency and lower interest rates are both symptoms of the same condition, the dollar shortage. More of this later on. Among this group of EM countries, and compiling the data from the heatmap, Rabobank developed a vulnerability score for each economy, which was then disposed in a ranking layout (Table 2 on the right). Overall, Asian countries appear to be the most resilient, followed by the East European ones and lastly those in Latin American, which also carry the greatest political risk, albeit low in absolute terms. In order to analyse the chart above, let's once more return to the Christmas day post for it kicks off the explanation rather nicely. Keeping in mind that the monetary conditions of the EM economies are based on the flow of FX - US dollar having the biggest weight - in their monetary/banking systems, "in periods of (euro)dollar shortage resulting from global trade contracting (or perhaps just slowing down) and/or financial institutions that take part in the Eurodollar regime being (even more) unwilling, for whatever reason, to supply these very vital dollars (or euros, yens, etc), the banking activity in the form of credit creation is severely impacted in these developing economies." Too confusing? Perhaps I should have started from the beginning. To make this easily digestable, I am going to keep this simple and brief. As you know, money (or currency or credit, whatever you want to call it) is originated by the banking institutions and to some extent the central banks. What's more, because, like I said before, EM currencies are less liquid, these countries are pushed into using the major currencies that have reached the status of global reserves, with the USD being the supreme one. For the sake of argument, and since this is the Eurodollar system, I am just going to consider the USD, though other major currencies, especially the euro, are rather relevant. All the same, insofar the world economy is growing and the global trade is running smoothly, as well as growth prospects are conducive to make the Eurodollar banking institutions willing to provide credit, the amount of dollars that go through the domestic monetary systems of the EMs balloons, leading to more credit creation and, hence, a larger domestic currency/money supply. In turn, their economies can grow. Now I think you can grasp what I said above. As the keynesian textbooks argue for, central banks should accumulate a cushion of reserves, so that during bad times (dollar shortages) they can use them to fulfill the need for dollars (or euros, etc). In spite of sounding reasonable, there are two problems with this reasoning that I am going to demonstrate afterwards. To conclude the report, Rabobank shows the correlation between its vulnerability ranking and the countries' currencies performance ranking. Unsurprisingly, the more vulnerable ones have also experienced the greatest currency depreciation, in general. Despite the discovery of multiple vaccines and the promise of unlimited fiscal and monetary stimuli, I am afraid things will first get worse before they start to get better. To be clear, I am refering to the economic and social fabric, not the kung-flu per se, obviously, since it never posed any serious danger. Be that as it may, you may already know how the story goes in the media. To spur the economy for it to get back on track, central banks must cut interest rates so as to increase bank credit to support economic growth. Although that is how it is taught in college and pontificated by the press, in reality the story has a completely different plot. Resuming where we left off in the discussion about the reserves cushion of central banks - once again, considering just the USD. As I contended, two dilemmas arise when a central bank liquidates its dollar-denominated assets, which are almost fully made up of US Treasury securities, to dole out to whatever entities feeling the full force of the dollar shortage. Firstly, as soon as the central bank does this to preclude its currency from depreciating against the dollar, the currency does, in any event, fall. Why? Because the central bank is sending a telegram to everyone revealing that the economy is in trouble and its agents (businesses, financial institutions, households and maybe government) are in great distress. Otherwise, if there were no significant woes, the central bank would stay put. Secondly, and more salient one, these dollar reserves account as assets on the central banks' balance sheets. Ergo, when a central bank decides to pursue that effort, the left side (assets) of the balance sheet shrinks. As a result, the right side has to follow, which means the money supply needs to contract to maintain the value of the currency. Alternatively, therefore, if the diminishing monetary aggregate is to be avoided, then the currency value has to drop. If you thought central bankers in the developed economies were powerless, then what to say about their counterparts in the developing countries. At least Powell, Lagarde, Kuroda and the like can pretend as if they possess the mastery of the economy and the markets. Unfortunately (to them), those poor EM central bankers cannot even do that. Despite all of this, the keynesian perscription continues to be shamelessly put forth, by economists and the media, and sadly put into action. According to the most recent Bloomberg’s quarterly review of monetary policy, "[c]entral banks are set to spend 2021 maintaining their ultra-easy monetary policies even with the global economy expected to accelerate away from last year’s coronavirus-inflicted recession." So many things wrong in such a short paragraph - and that was the first one of the article. To be fair, the writers state that accomodative policies have been hard to pursue by EM central bankers, on account of prices soaring within or above their target ranges. This has mainly been the result of the upswing in the dollar during the March meltdown, which struggled to come down, against EM currencies, to its pre-panic level (next graph). Furthermore, these Bloomberg writers, as is the case with the Rabobank report's analyst, are expecting the dollar to keep plunging. But why should it keep on falling? Before I proceed with the explanation, there is a caveat to consider: the divergence in monetary and fiscal policies will be one of the main drivers in relative performance of the EM local currencies. In spite of the monumental magnitude of "stimuli" and the vaccines that will, hopefully, open the economy (if our overlords allow it), the economic depression is going to prolong, for the slowdown - check out part I, II, III and bonus about this - witnessed throughout the summer has extended to the fall, reaching winter to what may turn out to be yet another contraction, particularly in Europe.
At any rate, the EM nations are feeling the stress of the dollar shortage prompted by the economic shutdown and restrictions that followed, with the poorest ones already being in dire straits, as the Washington Post reports. "Thirty-eight low-income countries are either in debt distress, according to the IMF, or at high risk of falling into it. Unless private creditors and wealthy nations step up and agree to concessions or outright debt forgiveness, the pandemic's fiscal shock could hurl some of those, as well as highly leveraged middle-income countries such as Costa Rica, toward catastrophic national bankruptcies." To conclude, and now it all comes together - cue Steve Carell in The Office -, EM economies are stranded between a rock and a hard place. On the one hand, if fiscal and monetary technocrats of some country just sit idly by or close to it, due to being wary of opening the inflation spigots, kind of like China or Russia are doing, businesses and individuals are going to go through a massive insolvency event where they will not manage to service their debts, because they will not be able to obtain the income nor will central banks be inclined to supply the dollars so that the dollar-denominated debt can be serviced. The latter being the essence of the problem being discussed. On the other hand, if the technocrats happen to be overly eager to act, they put their countries at risk of turning into a basket case, like Zambia as outlined in the WaPo article. "The sub-Saharan nation fell into default in November, a result of its high reliance on foreign debt; a pandemic blow to the price of copper, its main commodity; and one of its worst droughts in 40 years. The country is now printing money to survive, forcing a devaluation of the kwacha and creating spiraling inflation that's spreading misery at the worst possible time." Finally, as I proclaimed on Christmas day, there are two ways these countries will end up: "1) a sovereign debt crisis with some high inflation as the ones in Latin America in the 80's or in Eastern Europe in the 90's, or 2) a hyperinflationary crisis of the likes of Venezuela or Zimbabwe that occurred recently." Either way, as you see, culminates in misery and inflation, forget about growth and development. For the time being, though it may last for awhile, that is what the E in EM stands for.
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