corporate finance

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.

Explaining Slow Growth: Turning Away from the Stale “Lessons from Japan”

For the past 3 years, macroeconomists and central bankers have grappled fiercely over the topic of developed market economic stagnation, pending a true recovery from the financial implosions of 2008. Many influential “macro guys” and financial analysts now see stark similarities with the Japanese post 1990 experience and the current forecasts given for much of the developed world. Paul Krugman in a recent Op—Ed piece in his New York Times Blog for example stated emphatically that “Nowadays, we are all Japan”, whilst Richard Koo’s (highly informative) “The Holy Grail of Macroeconomics: Lessons from Japan” attempted to empirically relate the current financial position of the US to that of Japan during the lost decade. Nevertheless, I see a number of structural differences between the Japanese economy leading up to 1990 and the other indebted developed markets of today.

Essentially, if China’s economic model is a mirror of Japan’s, and thus awaits an equally daunting “Long Landing” as is expected (See Pettis, China Financial Markets), then surely the U.S and Europe who run a functionally obverse economic model shouldn’t intuitively be in the midst of a Japanese styled slump. To my mind, much of the debate amongst the macroeconomists misses this point and is therefore muddled and wonky. To my mind, a viable opponent to the Japanese analysis, is one based upon the international Balance of Payments (BoP).

I have long found it curious and odd, that even at the height of sub-prime lending in the U.S combined with excessively low interest rates after 2001, that the U.S economy remained on its long term average growth path. Surely the asset bubble and leveraging cycle should have propelled growth. Similarly, the 3 rounds of QE in the post-crisis era should have also stimulated growth and investment. (I share the opinion of Richard Koo in the idea that the US financial sector, contrary to popular sentiment is indeed healthy) One explanation for lacklustre growth is that the US economy has lost much of its comparative advantage, and that without constant monetary pump priming growth would be even slower. Another idea is that of Richard Koo and those of the Japan school, who now believe that the U.S economy is caught in a fierce deleveraging cycle that may take decades to resolve. And yet both of these theories, as intuitive as they may be, are muddled by inconsistent empirical evidence and strange contradictions.

What if however, the U.S and European economies were plagued by a very different type of problem? One which monetary pump-priming and asset bubbles could not solve. What if, the U.S and peripheral European demand over the past 20 years had simply been bled out by distortions in the external account? In this case, the US crisis was driven by external trade policies, and not, by a statist investment orgy as in Japan.

This situation at first glance seems to be supported by simple facts and intuition. The persistent current account deficits of developed markets, specifically the US, to my mind have caused both the inflated asset prices leading up to 2008, and also the below trend equilibrium (rather than actual) growth rates experienced since roughly 1997.

The late nineties were indeed a tumultuous period, and can be seen hence, as crucial to the development of instability within the US financial system. In 1997-8 a few things happened:

  1. East-Asian financial markets, stunned by a sequence of currency devaluations, began to run targeted trade surpluses.
  2. The US capital inflows soared (functionally the equivalent of a rising trade deficit that balanced the East-Asian surpluses)
  3. Lending and credit within the US expanded, funnelled largely into real estate.
  4. Housing prices and volumes began their ominous ascent.

The East-Asian surpluses then, can be seen to have (either directly or indirectly) penetrated the American trade account. Consequently, East-Asian markets served to change the composition of the American economy. The U.S tradable sector, due to financial repression and increasing savings in East-Asia, was beaten to a pulp and workers quickly made redundant. With a contracting tradable sector, the only possible way to redeploy labour is through a surge in foreign-financed debt which expands domestic consumption and investment. In addition, when the economy is balancing away from the tradeable sector most investment becomes speculative and in this case was inevitably funnelled towards the increasingly liquid real estate sector.

Therefore, the capital inflows (functionally current account deficits) can be seen to have both slowed equilibrium growth, as productive workers were redeployed and fired, and simultaneously fuelling a speculative binge. (The impending crisis’ magnitude was of course also amplified by the irresponsible lending techniques rampant within US financial markets which increased the probability of insolvency).

Even to this day, East-Asian capital exports have continued to increase, with China probably consuming a mere 35% of production (GDP) in comparison to the US’ 72% and Europe’s 65% (Rough estimates). The effect of such Underconsumption on the national savings rate is immense and if the US is to bear the brunt of the resultant capital inflows and Chinese production overload (As the PBoC reserve account holdings of USD implies it does) then it means the U .S is being bled white through the gaping hole in the external account.

With the financial crisis having largely capped the private sector’s willingness to further leverage-up and accumulate debt, there thus remains only one natural way for the U.S economy to absorb foreign excess capacity- unemployment and slower growth. Of course also there are a few politically unlikely ways too though. The US could become competitive through devaluation, higher VAT tax or equivalent, labour market reforms, tariffs etc. But the point is that China and East-Asia have purposely pushed their surplus savings onto the US. The US must absorb this excess by either more consumption, more investment (both imply less savings) or by intervening in trade and stopping the central bank purchases of so many treasuries (remember for every net $1 of Treasuries that are bought by foreigners, that is by economic law $1 added to the trade deficit). Since debt financed consumption and investment is not really an option without significant fiscal stimulus from the public sector (the private sector seems unwilling to leverage up further) and intervening in trade is politically unlikely the only other way to reduce savings is to reduce production by an amount more than the reduction in consumption. ie unemployment. This is basically an accounting necessity

Spain is an exaggerated version and perhaps a better example to see why. Spain can’t devalue due to it’s Eurozone membership. It also has a very limited capacity to load up on leverage (Look at sovereign bond risk premiums and the imploding banking sector) and so if Germany’s surplus continues to be pushed onto it, what can the Spanish administration do? All it can do is lower domestic savings by jacking up unemployment or try to become competitive and push it’s own savings out onto the rest of the world. (Like a Vampire state, sucking away at foreign demand to keep employment high). Coincidentally, the quickest way to regain competitiveness without intervening in trade is to grind down wages via unemployment. This is referred to the “internal devaluation” mode of recovery.

It is in this context that the anomalous predicament of the U.S and other developed markets is neither surprising nor complex. Unemployment will remain high until the trade interventions in surplus nations are eliminated, and the deficit ones are allowed to compete on an equal basis. In a situation where demand is being haemorrhaged to foreigners, fiscal stimulus will also need to be focused on innovative investments and cannot be allowed to stimulate consumption as is optimal Japan. In this world we must draw very different conclusions from those of the 90s.