[lbo-talk] Michael Pettis on why virtous circles are vicious

Michael Pollak mpollak at panix.com
Mon Aug 2 17:19:49 PDT 2010


[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



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