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A decade after the subprime bubble burst, a new one seems to be taking its place in the market for corporate collateralized loan obligations. A world economy geared toward increasing the supply of financial assets has hooked market participants and policymakers alike into a global game of Whac-A-Mole.
CAMBRIDGE – Default is back. Sovereign finances weathered a wrenching global recession and a collapse in commodity prices surprisingly well over the past few years. But failed economic models cannot limp along forever, and the slow bleeding of the economies of Puerto Rico and Venezuela have now forced their leaders to say “no mas” to repaying creditors.
Earlier this year, Puerto Rico declared bankruptcy. At the time, the United States commonwealth had about $70 billion in debt and another $50 billion or so in pension liabilities. This made it the largest “municipal” bankruptcy filing in US history.
The debt crisis came after more than a decade of recession (Puerto Rico’s per capita GDP peaked in 2004), declining revenues, and a steady slide in its population. The demographic trends are all the more worrisome because those fleeing Puerto Rico in search of better opportunities on the US mainland are much younger than the population staying behind. And in September, at a time of deepening economic hardship, hurricane Maria dealt the island and its residents an even more devastating blow, the legacy of which will be measured in years, if not decades.
More recently, in mid-November, Venezuela defaulted on its external sovereign debt and debts owed by the state-owned oil company, PDVSA. Default on official domestic debt, either explicitly or through raging hyperinflation, had long preceded this latest manifestation of national bankruptcy.
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CAMBRIDGE – Booms and busts in international capital flows and commodity prices, as well as the vagaries of international interest rates, have long been associated with economic crises, especially – but not exclusively – in emerging markets. The “type” of crisis varies by time and place. Sometimes the “sudden stop” in capital inflows sparks a currency crash, sometimes a banking crisis, and quite often a sovereign default. Twin and triple crises are not uncommon.
Rising international interest rates have usually been bad news for countries where the government and/or the private sector rely on external borrowing. But for many emerging markets, external conditions began to worsen around 2012, when China’s growth slowed, commodity prices plummeted, and capital flows dried up – developments that sparked a spate of currency crashes spanning nearly every region.
In my recent work with Vincent Reinhart and Christoph Trebesch, I show that over the past two centuries, this “double bust” (in commodities and capital flows) has led to a spike in sovereign defaults, usually with a lag of 1-3 years. Yet, since the peak in commodity prices and global capital flows around 2011, the incidence of sovereign defaults worldwide has risen only modestly.
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This time is different are the four most dangerous words any economist or money manager can utter. We learn new things and invent new technologies. Players come and go. But in the big picture, this time is usually not fundamentally different, because fallible humans are still in charge. (Ken Rogoff and Carmen Reinhart wrote an important book called This Time Is Different on the 260-odd times that governments have defaulted on their debts; and on each occasion, up until the moment of collapse, investors kept telling themselves “This time is different.” It never was.)
Nevertheless, I uttered those four words in last week’s letter. I stand by them, too. In the next 20 years, we’re going to see changes that humanity has never seen before, and in some cases never even imagined, and we’re going to have to change. I truly believe this. We have unleashed economic and technological forces we can observe but not entirely control.
I will defend this bold claim at greater length in my forthcoming book, The Age of Transformation.
Today we will zero in on one of those forces, which last week I called “the bubble in government promises,” which I think is arguably the biggest bubble in human history. Elected officials at all levels have promised workers they will receive pension benefits without taking the hard steps necessary to deliver on those promises. This situation will end badly and hurt many people. Unfortunately, massive snafus like this rarely hurt the politicians who made those overly optimistic promises, often years ago.
Earlier this year I called the pension mess “The Crisis We Can’t Muddle Through.” Reflecting since then, I think I was too optimistic. Simply waiting for the floodwaters to drop down to muddle-through depth won’t be enough. We face an entire new ocean, deeper and wider than we can ever cross unaided.
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Spanning a decade (2003-2013), QE0 was the most sustained and uninterrupted surge in central banks’ purchases of Treasuries on record. It is difficult to determine the extent to which the Fed’s QE1 during the crisis owed its success in bringing interest rates down to the fact that it was being reinforced by what foreign central banks worldwide – notably in Asia – were doing simultaneously.
CAMBRIDGE – Between 1913 (when the United States Federal Reserve was founded) and the latter part of the 1980s, it would be fair to say that the Fed was the only game in town when it came to purchases of US Treasury securities by central banks. During that era, the Fed owned anywhere between 12% and 30% of US marketable Treasury securities outstanding (see figure), with the post-World War II peak coming as the Fed tried to prop up the sagging US economy following the first spike in oil prices in 1973.
We no longer live in that US-centric world, where the Fed was the only game in town and changes in its monetary policy powerfully influenced liquidity conditions at home and to a large extent globally. Years before the global financial crisis – and before the term “QE” (quantitative easing) became an established fixture of the financial lexicon – foreign central banks’ ownership of US Treasuries began to catch up with, and then overtake, the Fed’s share.
The purchase of US Treasuries by foreign central banks really took off in 2003, years before the first round of quantitative easing, or “QE1,” was launched in late 2008. The charge of the foreign central banks – let’s call it “QE0” – was led by the People’s Bank of China. By 2006 (the peak of the US housing bubble), foreign official institutions held about one-third of the stock of US Treasuries outstanding, approximately twice the amount held by the Fed. On the eve of the Fed’s QE1, that share stood at around 40%.
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MIAMI – When it comes to sovereign debt, the term “default” is often misunderstood. It almost never entails the complete and permanent repudiation of the entire stock of debt; indeed, even some Czarist-era Russian bonds were eventually (if only partly) repaid after the 1917 revolution. Rather, non-payment – a “default,” according to credit-rating agencies, when it involves private creditors – typically spurs a conversation about debt restructuring, which can involve maturity extensions, coupon-payment cuts, grace periods, or face-value reductions (so-called “haircuts”).
If history is a guide, such conversations may be happening a lot in 2016.
Like so many other features of the global economy, debt accumulation and default tends to occur in cycles. Since 1800, the global economy has endured several such cycles, with the share of independent countries undergoing restructuring during any given year oscillating between zero and 50% (see figure). Whereas one- and two-decade lulls in defaults are not uncommon, each quiet spell has invariably been followed by a new wave of defaults.
The most recent default cycle includes the emerging-market debt crises of the 1980s and 1990s. Most countries resolved their external-debt problems by the mid-1990s, but a substantial share of countries in the lowest-income group remain in chronic arrears with their official creditors.
Like outright default or the restructuring of debts to official creditors, such arrears are often swept under the rug, possibly because they tend to involve low-income debtors and relatively small dollar amounts. But that does not negate their eventual capacity to help spur a new round of crises, when sovereigns who never quite got a handle on their debts are, say, met with unfavorable global conditions.
And, indeed, global economic conditions – such as commodity-price fluctuations and changes in interest rates by major economic powers such as the United States or China – play a major role in precipitating sovereign-debt crises.
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CAMBRIDGE – The global commodity super-cycle is hardly a new phenomenon. Though the details vary, primary commodity exporters tend to act out the same story, and economic outcomes tend to follow recognizable patterns. But the element of predictability in the path of the commodity-price cycle, like that in the course of a roller coaster, does not make its twists and turns any easier to stomach.
Since the late eighteenth century, there have been seven or eight booms in non-oil commodity prices, relative to the price of manufactured goods. (The exact number depends on how peaks and troughs are defined.) The booms typically lasted 7-8 years, though the one that began in 1933 spanned almost two decades. That exception was sustained first by World War II and then by the post-war reconstruction of Europe and Japan, as well as rapid economic growth in the United States. The most recent boom, which began in 2004 and ended in 2011, better fits the norm.
Commodity-price busts – with peak-to-trough declines of more than 30% – have a similar duration, lasting about seven years, on average. The current bust is now in its fourth year, with non-oil commodity prices (relative to the export prices of manufactures) having so far fallen about 25%.
Commodity-price booms are usually associated with rising incomes, stronger fiscal positions, appreciating currencies, declining borrowing costs, and capital inflows. During downturns, these trends are reversed. Indeed, since the current slump began four years ago, economic activity for many commodity exporters has slowed markedly; their currencies have slid, after nearly a decade of relative stability; interest-rate spreads have widened; and capital inflows have dried up.
Just how painful the downturn turns out to be depends largely on how governments and individuals behave during the bonanza.
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As central bankers and finance ministers from around the globe gather for the International Monetary Fund’s annual meetings here in Peru, the emerging world is rife with symptoms of increasing economic vulnerability. Gone are the days when IMF meetings were monopolized by the problems of the advanced economies struggling to recover from the 2008 financial crisis. Now, the discussion has shifted back toward emerging economies, which face the risk of financial crises of their own.
While no two financial crises are identical, all tend to share some telltale symptoms: a significant slowdown in economic growth and exports, the unwinding of asset-price booms, growing current-account and fiscal deficits, rising leverage, and a reduction or outright reversal in capital inflows. To varying degrees, emerging economies are now exhibiting all of them.
The turning point came in 2013, when the expectation of rising interest rates in the United States and falling global commodity prices brought an end to a multi-year capital-inflow bonanza that had been supporting emerging economies’ growth. China’s recent slowdown, by fueling turbulence in global capital markets and weakening commodity prices further, has exacerbated the downturn throughout the emerging world.
These challenges, while difficult to address, are at least discernible. But emerging economies may also be experiencing another common symptom of an impending crisis, one that is much tougher to detect and measure: hidden debts.
Sometimes connected with graft, hidden debts do not usually appear on balance sheets or in standard databases. Their features morph from one crisis to the next, as do the players involved in their creation. As a result, they often go undetected, until it is too late.
Indeed, it was not until after the eruption of the 1994-1995 peso crisis that the world learned that Mexico’s private banks had taken on a significant amount of currency risk through off-balance-sheet borrowing (derivatives).
Read more at https://www.project-syndicate.org/commentary/hidden-debt-burden-emerging-markets-by-carmen-reinhart-2015-10#EU5Q4DVCDEzO1msE.99
CAMBRIDGE – A recurrent topic in the financial press for much of 2018 has been the rising risks in the emerging market (EM) asset class. Emerging economies are, of course, a very diverse group. But the yields on their sovereign bonds have climbed markedly, as capital inflows to these markets have dwindled amid a general perception of deteriorating conditions.
Historically, there has been a tight positive relationship between high-yield US corporate debt instruments and high-yield EM sovereigns. In effect, high-yield US corporate debt is the emerging market that exists within the US economy (let’s call it USEM debt). In the course of this year, however, their paths have diverged (see Figure 1). Notably, US corporate yields have failed to rise in tandem with their EM counterparts.
What’s driving this divergence? Are financial markets overestimating the risks in EM fixed income (EM yields are “too high”)? Or are they underestimating risks in lower-grade US corporates (USEM yields are too low)?
Taking together the current trends and cycles in global factors (US interest rates, the US dollar’s strength, and world commodity prices) plus a variety of adverse country-specific economic and political developments that have recently plagued some of the larger EMs, I am inclined to the second interpretation.
In what is still a low-interest-rate environment globally, the perpetual search for yield has found a comparatively new and attractive source in the guise of collateralized loan obligations (CLOs) within the USEM world.
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