[The rest of this post is also interesting -- mostly details about the structure of sovereign debt and how that matters as much as the gross amount]
http://www.roubini.com/globalmacro-monitor/259275/do_sovereign_debt_ratios_matter_
Jul 21, 2010 10:27AM
Roubini Global Economics Macro Monitor
Do Sovereign Debt Ratios Matter?
Michael Pettis
<snip>
2. The structure of the balance sheet matters, and this may be much
more important than the actual level of debt. In my book [_The
Volatility Machine_, which is self-consciously an attempt to build on
Minsky and Kindleberger] I distinguished between "inverted" debt and
hedged debt. With inverted debt, the value of liabilities is
positively correlated with the value of assets, so that the debt
burden and servicing costs decline in good times (when asset prices
and earnings rise) and rise in bad times. With hedged debt, they are
negatively correlated.
Foreign currency and short-term borrowings are examples of inverted
debt, because the servicing costs decline when confidence and asset
prices rise, and rise when confidence and asset prices decline. This
makes the good times better, and the bad times worse. Long-term
fixed-rate local-currency borrowing is an example of hedged debt.
During an inflation or currency crisis, the cost of servicing the debt
actually declines in real terms, providing the borrower with some
automatic relief, and this relief increases the worse conditions
become.
Inverted debt structures leave a country extremely vulnerable to debt
crises, while hedged debt helps dissipate external shocks. Highly
inverted debt structures are very dangerous because they reinforce
negative shocks and can cause events to spiral out of control, but
unfortunately they are very popular because in good times, when debt
levels typically rise, they magnify positive shocks. I discuss this a
little more below when I talk about virtuous and vicious cycles.
<snip>
Beware virtuous cycles
What does all this tell us about the probability of a country's being
forced into default or restructuring? Perhaps not much except that
tables that rank countries according to their debt ratios are almost
useless in measuring the likelihood of default. This would be true
even if those rankings were accurate, but not surprisingly countries
hide a lot of their real obligations, and the riskier they are the more
likely they are to hide them, so the inaccuracy is always biased in the
wrong direction.
<snip>
In fact some of the recent "star" sovereign performers may very well be
the biggest risks, since their great performance may have been caused
in part by highly inverted balance sheets. These kinds of debt
structures ensure that good times are magnified, but they also ensure
that bad times are exacerbated.
Remember this when someone argues that Country X is doing very well and
has even locked itself into a virtuous cycle, in which a good event
causes other good events that are self-reinforcing. There are few
things as risky as highly virtuous cycles, which are almost always
caused by inverted balance sheets. Many of my Brazilian friends, for
example, wince whenever they hear about virtuous cycles, because they
know first hand how virtuous cycles can quickly collapse into vicious
cycles.
Until 1997, for example, Brazil's biggest credit problem was its huge
fiscal deficit, more than 100% of which was explained by interest
payments on short-term debt. As global conditions improved during the
middle of the decade, Brazil was caught up in a powerful virtuous
cycle. The improving external position caused local interest rates to
decline, which dramatically reduced the projected fiscal deficit, and
so boosted confidence, causing interest rates to decline even more.
Inverted structures are toxic
It was wonderful - and happening very quickly - with real interest
rates dropping from the 30-40% range to the 20-25% range in a matter of
two or three years. But the 1998 crisis set off a devastating reversal
of that process.
A global flight to quality caused Brazilian interest rates to rise.
Rising rates dramatically pushed up the government deficit (the
financial authorities had not bothered to lock in the low rates,
believing that the game would go on until domestic interest rates were
at an "acceptable" rate), which caused confidence to drop. Declining
confidence forced interest rates higher, and so on with the result that
interest rates spiraled out of control as each event reinforced the
other. Brazil was forced into a currency crisis in January 1999.
It was a similar process for the countries participating in the Asian
crisis of 1997. During the early and mid 1990s it seemed obviously
clever to borrow in dollars to fund local operations since dollar
interest rates were much lower than local currency rates, and moreover
the dollar was depreciating in real terms. The more locals borrowed
dollars and converted into local currency, the more local asset markets
boomed and the lower the real cost of the financing (compared to
borrowing in local currency).
It seemed like such an easy way to make money, until it stopped. At
some point the risk caused by the massive currency mismatch (a highly
inverted structure) became unbearable and the market went into
reverse. Suddenly, and just as local asset markets were collapsing
because of capital flight, so did the value of the local currency.
With the collapse of local currency values, all the once-cheap dollar
debt went toxic, soaring in relative terms until one company after
another faced bankruptcy. Of course each company made overall
conditions worse by trying to hedge its dollar debt - buying dollars
simply pushed local currency even lower, and increased the cost of the
dollar debt.
The Asian wreck was magnified by another inverted debt structure:
asset-based loans in the banking sector. When the economy is doing
well, rising asset prices make existing loans seem less risky and
encourage riskier debt structures (i.e. loans whose servicing cannot be
covered out of minimum expected cash flows) because creditworthiness
seems constantly to rise.
But once the crunch comes, asset values and creditworthiness chase each
other in a downward spiral. The fact that this has happened a million
times before, most spectacularly in Japan in the 1980s, never seemed to
affect anyone's evaluation of the risks.
The extent of the carnage in Asia shocked everyone, but it shouldn't
have. We were lulled into overconfidence precisely because balance
sheets were so inverted, and made good times so much better, but the
very fact of the inversion determined the speed and violence of the
balance sheet contraction.
<end excerpts>
Michael