The Risk of International Borrowing
The past few months has been a wild ride for Banks, Stock Brokers, Lenders and Borrowers, but the next few months could be even wilder. How can it get any wilder you ask? The unwinding of the international currency trades has really just begun. International borrowing is about to cause the collapse, or near collapse of several nations.
The Carry Trade
One of the surest bets that a large financial institution could make during the past decade of prosperity was to use the Yen Carry Trade to finance the purchase of US Treasury Bonds. Here is how it would work. First, the institution would approach a bank in Japan requesting a large line of credit. In the case of large US financial institutions, investment firms and hedge funds, they would have no trouble getting this line. The line would usually carry an interest rate between 1/2 and 1 percent, essentially free money. Next the firm would use that money to purchase United States Treasure securitys for short periods of tim, usually 30 or 90 day notes. The Treasuries were paying out 3 1/2 to 4 percent, so the spread (difference between interest cost and earned intetrest) ran around 3 percent.
Currency exchange rates on these monsterous trades were very low, or even waived by the exchanges due to the volume of money they were bringing into the various markets. Billions of dollars of trade carried on this way for years, making Japanese Banks and those who used this carry trade extremely wealth. Two or three percent doesn’t sound like much on a passbook savings account, but how much is 3% of $10billion? You get the point. All of this was being paid for by the U.S. Government and the taxpayers because of the voracious appetite for money they had attained.
We all Fall Down
Everything goes along swimingly just so long as those things that we had come to expect continue to be true. The Japanese Government needs to continue to issue money at an interest rate near zero. The U.S. Government needs to continue to pay 3-4 percent on their Treasuries and the exchanges have to be incented to not charge a high exchange rate on thie trades. All of these factors are no longer true.
It Gets Worse
When American and European companies are borrowing Yen to purchase U.S. Treasuries, their are certainly some risks involved, but in general the level of fluctuation we see is small. A percentage point or two. Of course it is in exploiting this percentage point or two difference that a successful carry trade is born. The real key is that in this case all of the currencies are robust, generally stable, world dominating currencies.
The same cannot be said for the “Emerging Markets”. Remote parts of Asia, Arab nations, Latin and South America all have countries who are vying to operate on a world stage. These countries all represent the emerging markets and have all been involved in international borrowing of one type or another over the past decade or more. Herein lies the real trouble for these still developing nations.
My money is worth what!
Imagine that you are a nation that was in need of some infrastructure development to get your industry going. You borrow money from a western bank, begin to improve your infrastructure, promote business and even export your goods to the international audience. Life is moving along in the right direction. Your people begin to have some personal wealth for the very first time and they too want to move forward. Perhaps they build homes or businesses and of course, given the still relative weakness of your countries economy, they too borrow money from western facilities to fund their growth. Servicing the debt is no problem at all as your economy is growing at a rapid clip and things are moving
Suddenly, through no fault of your own, the global economy begins to slow up. Dramatically. No worries you think, we are an energing nation, our people provide cheaper labor, maybe some new jobs will come here! Then reality begins to bear down. The slowdown may bring some jobs to your country, yes, but it also means slower growth worldwide. That slower growth scares investors and suddenly there is less investment money flowing into your country. The world doesn’t need you to grow so fast. The value of your currency, your nations “stock” on the international market, begins to fall relative to the larger western countries. Your money may be worth the same as it always was within the confines of your nation, but abroad? Its worth les, much less.
Not Enough Hard Currency
People and Governments all around the world are finding themselves in this very position as we speak (or write as it may be). Imagine being a Pakistani business man who borrowed $100,00 to grow his business. When you borrowed the money last year, the exchange rate was 60 Pakistani Rupees (PKR) to the dollar. Today the rate stands at 80 PKR to the dollar and rising. This alone represents a 30% increase in burden. Every month your company has to have higher and higher returns just to service the debt because the debt is denominated in dollars, not Rupess and must be repaid as such. There are many, many countries around the world who are suffering as much as a 70% swing in exchange rates within the last year alone.
The biggest problem is when the business owner goes to the local bank to exchange his rupees for dollars and is told that they have no dollars available. The pakistani rupee, as well as hundreds of local currencies, are not concidered “hard money”. There is no large operable international market for them because the country does not have a large export base and accepts other currencies universally. This problem continues up even to the government, where it may not have a total amount of exports available to convert into U.S. Dollars, or Euros, or whatever to pay its debts. This forces the country into a currency crises, even though it has plenty of available input to service its debts. It’s just contained in the wrong form.
The Result is Death
The options for these borrowers, whether individual, corporate or governmental are the same. Borrow More or Bankrupt. Either case will result in death given enough time without change. The real question is this…are western countries immune to the same disease?
