capital structure

Fighting Capital Account Whiplash- ‘National Hedging’

On December 20, 1994 the government of Mexico suddenly announced a 13 percent devaluation in the ‘crawling band’ currency peg to the U.S dollar, following intense capital outflows beginning earlier in the year. In doing so, the currency regime organised by money doctors and IMF leaders that had reigned in inflation and expanded domestic liquidity for 7 years, was abandoned. The result of the 1994 devaluation however, was disastrous- setting off what has since been known as the Tequila crisis.

Mexican corporations and the government at this time had borrowed an immense amount of dollar denominated debt, and the devaluation immediately pushed up repayment costs and insolvency pressures. As investor nervousness grew and interest rates soared, the short-term funding strategies of Mexican commercial leaders proved detrimental; turning illiquid corporations into insolvency. Within a week the peso dropped another 19% whilst the large speculator investment base threw the country into a cycle of massive asset sell-offs. Debt burdens grew, and asset values plummeted. In the end, the collective scramble to raise liquidity and protect balance sheets pushed the country into a self-reinforcing disaster.

Such a positive feedback loop has been the subject of much financial analysis, and the Tequila crisis has served as one of the primary empirical bulwarks of Soros’ “Theory of ‘Reflexivity’”. In this context, small exogenous shocks can push nations and markets to brink of collapse without any real change in economic fundamental. Indeed, the same thing is happening today in a number of large emerging markets that have managed to attract foreign capital inflows from the Fed’s QE operations. Just in September last year, Bernanke’s mere announcement of QE tapering (not even an end to ZIRP) was enough to push the Indian Rupee into freefall and crush Indonesia’s dreams of price stability. (This sudden reversal of capital inflows is what I call ‘Capital Account Whiplash’)

Nevertheless, a situation of financial freefall after currency defaults is by no means certain. The British Pound Sterling’s withdrawal from the European Exchange Rate Mechanism in 1992 for example served to calm markets and boost competitiveness. Furthermore, if the devaluation had not been postponed by Bank of England interventions (which lowered foreign reserves) the result would have been an outright profit on the public account.

Why then did the British example provide such a different result to that of today’s emerging markets, and 1994 Mexico? To my mind, contrasting results (and consequently, a refutation to ‘Reflexivity’ Theory’s proposition that crises are behavioural in nature) can be explained by the way debt markets can reduce or add volatility to growth fundamentals, and thereby create positive or negative feedback loops.

In 1990’s Mexico, borrowing had two fundamental characteristics:
a) It was short-term, needing to be rolled over constantly.
b) It was denominated in foreign currency.

Hence, as Mexican markets stalled and firms were placed under revenue-side constraints, they also felt a sharp stab of pain on the lending side. As the peso devalued, the peso-cost of dollar debt exploded, and the price of avoiding liquidity crises was immense as interest rates soared on the short-term markets. The nature of Mexican leverage and debt indexation thus can be seen to have predictably exacerbated the impact an exogenous shock, as it was inversely correlated to revenues. Debt was automatically indexed so that as revenues expanded, debt costs fell; but when the economy was placed under pressure, debt costs also exploded. Mexican finance, therefore, was mechanically pushed into a positive feed-back loop by the liability managers of the economy.

In Great Britain during the 1990’s by comparison, the story of debt indexation is a very different one. Debt burdens here, were directly correlated to revenues, i.e loans were typically long term with fixed rates, credit was denominated in pounds, and speculators were balanced by institutional ‘vulture’ purchasers that bought against trends. (Sovereign wealth funds etc.) So, as the nation was bogged down by asset revaluations, rising inflation and falling terms of trade, corporations found themselves cushioned by increasing competitiveness, and falling real interest rates. The net result for borrowers pending a fixed exchange withdrawal was thus beneficial.

It is important to note at this point that the Tequila crisis under this framework was neither a result of fundamentals that were papered over, nor irrational exuberance.

So, what are the lessons for current economies facing the prospect of sharp external liquidity contractions in the very near future? Commercial leaders and politicians must reform the national capital structure, and make sure that debt is directly correlated to growth and revenues. If QE is expected to put sudden downward pressure on Emerging Market currencies then, foreign denominated public, and private debt must be replaced by local currency denominations now. Similarly, central banks should strive to reform the liquidity and regulatory environment (get rid of withholding taxes where possible for example) in debt markets so that fixed-rate, long term borrowings are encouraged over variable, short-term borrowings.

Although this is easier said than done. Politically, a project involving re-indexation of debt so that it is long-term and local will imply significantly higher interest rates up-front. Sovereigns will essentially be swapping their lending out of the US financial sector into smaller, less advanced local centres with higher spreads and smaller capacities for dispersing risk. Merely developing a local debt market liquid enough to absorb public borrowing is a huge task for Developing and Emerging markets whose volatile monetary conditions systematically exacerbate inflation and other currency risks for lenders.

But with time, global lenders and investors will recognise the improving capital stability resulting from financial reform. In the meantime Emerging and Developing Market Central Banks should adopt ‘Forward Guidance’ interventions to minimise currency risk expectations, and pray that U.S unemployment warrants continuations of QE for a while longer.