The 2018 Debt Crisis
What do the Turkish lira, the Iranian rial, the Russian ruble, the Indian rupee, the Argentine peso, the Chilean peso, the Chinese yuan and the South African rand all have in common? They’ve all declined steadily this year, and some have depreciated dramatically this summer. But, that is just the latest chapter in a long story.
The truth is that those countries except Iran are sitting on a ticking time bomb of external debt denominated in U.S. dollars. External debt is money that is borrowed from abroad in a foreign currency. For instance, Turkey’s currency is the lira, and when it issues a debt security denominated in a foreign currency, it is increasing its external debt.
External debt comes with all the challenges that debt denominated in a domestic currency does, plus other challenges. In the case of Turkey, if it borrows in liras, then it pays interest and principal back in liras. If the lira depreciates against other currencies, Turkey’s debt doesn’t get more difficult to service. In fact, it gets easier to service, since it owes the same amount of lira, but the currency is worth less. Increasing the money supply lets a country pay back its debt with cheaper currency, effectively inflating its way out of a debt burden. And, while “printing money” carries its own risks, it still leaves the country and its central bank as the masters of its “debt destiny.”
External debt, however, removes this flexibility. Instead, it links the borrower’s ability to repay to the exchange rate between its currency and a foreign currency. And, since the debt must be repaid in a foreign currency, if the local currency depreciates against that foreign currency, then it will take more of the local currency to service the same amount of debt. For example, if Turkey were to borrow $100 million at a 10 percent rate in U.S.-dollar denominated debt, it would owe $10 million per year. If the exchange rate between the lira and the dollar were 2-to-1, then Turkey would owe 20 million liras per year. But, if the lira depreciated relative to the dollar and the exchange rate became 4-to-1, then Turkey would still owe $10 million a year, but that would be equivalent to 40 million liras per year. In effect, the cost of its debt service would double simply because of exchange rate fluctuations. And, though Turkey may have dollar reserves to help alleviate this situation, it cannot print dollars to inflate its way out of this debt as it could with lira-denominated debt.
This is the fundamental problem of external debt; that is, if the borrowing country’s currency were to depreciate, its debt would become costlier to service. In the public sector, this forces the government to allocate more of its budget to debt repayment. In the private sector, it restricts investment capital, since money that could have been used to invest in productive enterprises must instead be diverted to service debt. More money spent on debt service also means less spent on consumption and investment, and, therefore, slower economic growth.
And that’s the essence of the story we see unfolding before us.
It started in the 1990s, when many countries began to accumulate large amounts of debt denominated in U.S. dollars. It was an effective way to kick-start economic activity, and so long as their own currencies remained relatively strong against the dollar, it was fairly low-risk. As a result, from 1990 to 2000, dollar-denominated debt tripled from $642 billion to $2.17 trillion. Since then, dollar-denominated debt has ballooned.
In its latest quarterly report, the Bank of International Settlements found that U.S. denominated debt to non-bank borrowers reached the highest recorded total in its 55 years, at $11.5 trillion in March 2018.
The dollar has strengthened amid a tepid global recovery since the 2008 financial crisis. Meanwhile, the currencies of indebted countries have weakened against the dollar. Therefore, it is becoming harder for some countries to pay their debts. Consequently, this could become a bubble waiting to pop, especially for vulnerable countries that don’t have the monetary policy options to protect themselves.
Such is the case for Turkey, which is particularly susceptible to the vagaries of currency depreciation. The value of the lira had been declining for some time. Then, it dropped dramatically in mid-August.
At nearly $200 billion, almost 50 percent of Turkey’s gross external debt is denominated in dollars, according to the Bank of International Settlements. Meanwhile, Turkey’s own General Directorate of Public Finance puts that figure at nearly 60 percent.
The situation has become progressively more threatening, because of a combination of political uncertainty, unorthodox monetary policy and, most important, U.S. interest rate hikes. Making things worse is the serious “trade push-back” coming from the U.S., triggered by human rights issues. As of August 15, Turkey’s dollar-denominated debt was almost twice as large as its total foreign reserves, putting the country in a very dangerous situation.
However, Turkey isn’t alone. Several other emerging market currencies that were already down year-to-date, nose-dived as the news of the lira’s demise began to circulate. The starkest decline was that of the Argentine peso, whose value against the dollar dropped 9.5 percent in just a week, and the South African rand, which fell roughly 8 percent. Other currencies have been affected too ? the Chilean peso, for example, fell 3.4 percent in the second week of August, while the Indian rupee hit a record low ratio to the dollar during trading on Aug. 14.
What these countries have in common is that they are among the 13 countries that together owe the most on dollar-denominated loans. Turkey is one of the most vulnerable, but there are four other countries facing similar dire challenges: Argentina, Mexico, Chile and Indonesia.
As of this writing, Argentina’s peso is already in free fall. The government recently announced that it would sell $500 million worth of reserves and raise interest rates to stop the peso’s fall.
Then there is Mexico, which, at $271 billion, holds more dollar-denominated debt than any other country on the list except China. This far exceeds Mexico’s official reserves. As with Turkey, dollar-denominated debt is a disproportionately large share of Mexico’s gross external debt, at roughly 60 percent. And since Mexico’s gross external debt to GDP ratio is 39 percent, the dollar’s influence over Mexico is enormous. So far, the Mexican peso has held steady. But the vulnerability of the peso likely played a significant role in Mexico’s decision to enter into a new U. S.-Mexico trade agreement designed to replace NAFTA. It’s aware that political instability surrounding the new president or any other contingency, could quickly put Mexico in a position as bad or worse than Turkey’s.
The situation is similar for Indonesia and Chile. Of the two, Indonesia is in slightly better shape. Its gross external debt is 35 percent of GDP, and 47 percent of that is denominated in dollars. But Indonesia doesn’t have a lot of reserves, and its currency has been showing signs of weakness, down almost 10 percent against the dollar through mid-August. Chile’s percentage of dollar-denominated debt as a proportion of GDP is the highest of all countries ? at a whopping 36 percent. And Chile’s gross external debt-to-GDP ratio is 66 percent. Most concerning, however, is that Chilean reserves totaled just $37 billion in June 2018, equal to about a third of its total dollar-denominated debt of $100 billion.
Though these five countries are the most vulnerable to a strengthening dollar, six others - Brazil, India, South Korea, Malaysia, Russia and South Africa - all face serious problems.
South Africa, for example, isn’t particularly indebted. And, the government insists it won’t intervene to stop the rand’s decline, but that’s only because it doesn’t have nearly enough reserves to cover what debt it has. Its $50.6 billion in reserves could pay off just 28 percent of its gross external debt. This makes it particularly vulnerable, when and if Trump decides to apply pressure, related to deteriorating human rights in South Africa.
The five other countries are in a better position when it comes to reserves. Those countries hold larger amounts of dollar-denominated debt however, they have plenty of reserves. The issue for these countries is larger external debt. A strong U.S. dollar won’t cripple these economies, but it could put enough pressure on them to compel monetary intervention.
The final set of countries on the lists are China and Saudi Arabia. And, while heavily indebted they are particularly well-insulated from the budding currency crisis.
China’s currency has been under pressure this summer, but so far, China has chosen not to let the yuan slide too far. China holds $548 billion in dollar-denominated debt, but that makes up just 4 percent of China’s GDP, and China’s gross external debt to GDP is just 14 percent ? the lowest of the countries on this list. China also has a war chest of $3.2 trillion in foreign reserves that it can deploy, if needed.
Meanwhile, Saudi Arabia also has the benefit of ample foreign reserves. And it will definitely have to use them. The Saudi rial is pegged to the dollar. This offers stability, but it comes at a price: Saudi Arabia has to buy and sell reserves to maintain the peg. And, while Saudi Arabia has more than enough money to play around with, it has less than it once did. Indeed, it’s been burning through its reserves in recent years. For example, it has used $233 billion since 2014 to fund its adventurism abroad and its government deficit. And Riyadh has no shortage of problems it needs to solve. But fortunately, an imminent currency crisis isn’t likely to be one of them.
Given this trend, we offer the following forecast for your consideration.
First, whether this becomes a global financial crisis depends on many factors about which we have limited transparency.
The economies surveyed by the Bank of International Settlements make up just 37 percent of total dollar-denominated debt held worldwide; that means there is another $7.2 trillion in such debt in the global system to account for. And what started in Turkey may well spread to other countries excluded from the Bank of International Settlements report.
Second, Turkey’s economy will get worse before it gets better, but it’s likely to avoid an existential crisis.
This is a clear example of where finance and geopolitical considerations intersect. Even though Turkey is a nominal member of NATO, its Islamist drift, oppression of the Kurds, and cozying up to Russia, have put it at odds with the United States. Meanwhile, western lenders have a big incentive to keep Turkey afloat, because a collapse could trigger the release of millions of Muslim refugees into Europe. Turkey was uniquely susceptible to this sort of thing. The country has low savings rates, high inflation rates and all but refused to make the politically unpopular decision to raise interest rates, before it was too late. Most of the polices that created its economic problems are still in place and Turkey will have to take progressively stronger measures to get on the right track. Moreover, the Turkish central bank’s promise to “pump as much liquidity into the system as necessary” is also keeping investors from pulling the plug on Turkey. Qatar, for one, has already rushed to lend Turkey the money it needs to stay afloat, short-term; this is one way the politically isolated gas giant can win the Turkish support it hopes will offsetting hostility from American and Saudi interests.
Third, the current problem will not develop into a global crisis.
The most important question now is whether the crisis will spread to other vulnerable countries. The most worrying at this point are Argentina, Mexico, Indonesia and Chile. Just as in Turkey, the United States will use this crisis to reshape the world order and further American interests rather than wreak have on the global system. And,
Fourth, the Trump administration will use the debt crisis as bargaining leverage to win concessions from Mexico and others on issues including trade, immigration and drug policy.
Because of its proximity and relative power, the United States has always been in a position to offer Mexico big punishments, as well as big rewards. That is why Mexico was eager to conclude a new trade pact with the United States. Once that’s in place, Mexico is poised to become a leading Latin American success story with U. S. help; but without that help, it’s equally likely to become a failed narco-state. Trump will remind Mexico’s leadership that its relationship with the United States will determine which future awaits it.
1. Geopolitical Futures. August 17, 2018. Jacob L. Shapiro. The Currency Crisis of 2018.
2. Geopolitical Futures. Dec. 14, 2017. George Friedman. Foreign Debt: The Price of Turkey’s Rise to Power.
3. Bloomberg Businessweek. August 15, 2018. Nick Wadhams, Ilya Arkhipov and Peter Martin. Turkey’s Currency Crisis Tests Erdogan’s Gamesmanship.
4. MarketWatch.com. August 15, 2018. Anneken Tappe Strategists see 4 ways out of Turkey’s currency crisis.