A colorful and informative article by John Dizard in the Financial Times on how emerging markets may not have dodged foreign currency exposure risk despite their central banks having very large foreign exchange reserves. It turns out their banks and major companies weren’t so prudent.
Dizard raises a second issue here, one that was discussed at greater length by Brad Setser, how the lack of access to dollar swap lines is causing emerging economies to be hit harder by financial tsuris than their first-world brethren. It is curious that China, with its massive FX reserves, has not stepped into this breach. A few billion here and there would give them enormous sway.
From the Financial Times:
The distressed asset buyer I was chatting with at the IMF/World Bank meetings in Washington pretty well summed up the tone of the buy side people cruising the halls and coffee shops. Cross-border assets were cheap, but on their way to cheaper.
The super rich who had crowded the meetings in past years were almost entirely absent. The scene reminded me of a post-nuclear environment. Many of the survivors, as we expected from science fiction movies, were cockroaches (bureaucrats) and mutants (compliance officers).
The stock market crashes and rich world rescue packages are last week’s chatter. The current topic among the remaining investors in the credit space are the “second-order effects” of reduced access to credit, particularly in emerging markets. The first-order effects of the crisis are so well known that they are even discussed by US presidential candidates.
The principal emerging markets sales desk pitch of recent years has been the expiation of the “original sin” of governments’ borrowing in foreign currencies. The crises of the 1970s and 1980s were all about sovereign borrowers running out of forex. So the sovereign borrowers moved to create effective local markets for government debt and accumulated huge forex reserves. Poof! – no original sin.
Except that the sin was merely transferred to the emerging market banks and companies. According to JPMorgan Chase: “Over the past three years, the sum of syndicated loans and bonds raised by EM corporates exceeded $1,300bn” although that is inflated by rolled-over, short-term facilities. That was no problem, as long as corporations and banks could roll much of those obligations forward as they matured. Oh, and as long as their ability to hedge against risks through derivatives markets was not impaired.
Joyce Chang, JPMorgan Chase’s head of emerging market credit research, says: “All of the emerging market policy people we have spoken to were surprised by how quickly their corporates were impacted by the crisis. Most of them were segmented until early to mid-September, when Lehman hit. That was the catalyst.”
Anecdotally, it seems that Wachovia’s freeze-up and litigious takeover led to a sharp reduction in short-term trade finance lines for Latin America. While I do not have numbers for the bank’s trade line exposure, I am told they were one of the biggest financiers for Latin American companies.
A lot of those companies, particularly in Brazil, managed risks through aggressive hedging of forex and commodities risk. The Brazilian authorities, I am told, estimate their companies had put on at least $25bn in foreign exchange hedges. The more sophisticated emerging market companies were hedging against commodities risks, and they are faced with margin calls on underwater hedges.
Corporate treasurers were listening to people who told them they needed to hedge against the possibility of $200 per barrel oil. Seemed a good idea at the time.
Now, to unwind those positions, they have to find banks or dealers willing to take their counterparty risk. Then they have to come up with the cash to pay the newly increased margins; that’s the cash that was supposed to come from the trade receipts they can’t finance.
The good news is that central banks such as Brazil’s and Mexico’s have big reserves they can commit. But even they have to draw the line somewhere. The interesting question for foreign creditors of the companies is where the line is drawn.
The rich countries don’t have enough cash either, but they have the next best thing: virtually unlimited swap lines with each other. Those have been a principal tool of the Fed to maintain capital flows between the US and Europe. Nobody bothers to consult the Bank of Canada’s forex reserves to see if they have enough dollars, since it could simply swap Canadian dollars for US in whatever quantity they need.
However, swap lines, or bilateral agreements between central banks for short-term, otherwise unsecured, exchanges of currencies, are rather smaller in the emerging market world. Asian countries have swap lines under the Chiang Mai Initiative, but they are tiny in relation to today’s capital flows. For example, Japan has swap arrangements with Korea for $7bn, Thailand for $3bn, Indonesia for $3bn and China for $3bn.
Even the big dog of lenders to the distressed – the International Monetary Fund – has total resources of about $200bn. Some stressed countries are in a better position than others, in part thanks to their past caution and on the part of their lenders. Turkey has proportionately fewer over-borrowed companies.
Russian risks would seem to be the most interesting. Yes, the central bank has more than $500bn in reserves, but which corporate borrowers will it support? There is no clear answer to that, for those outside the Kremlin.
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Any idea what percentage of emerging markets sovereigns are going to default on their debt?
The obvious reason being that the US is going to be far more willing to enter into massive swap agreements with countries that haven’t seen their currency collapse within the last decade or so. Could China provide large scale swaps? Probably, but unlike the US it can’t print Treasuries so it would presumably undermine its reserves by doing so.
Why do I smell another multilateral bailout coming?
Swap lines have traditionally been used to buy currency on the open market to stabilize exchange rates.
it goes a little something like this…
The FED trades USD for some yen from the central Bank of Japan with an agreement to trade it back (with interest) at some later date. The interest is based on exchange rates and might amount to zero. In the meantime, as Japanese investors flee US investments and convert their money to yen, the FED sells yen on the open market to keep the dollar from tanking in relation to the yen. The BoJ likes this because they need a week yen going into the fall because Japan sells a lot of machinery this time of year and if the yen is strong, they can’t export as much.
Also, the FED doesn’t want the USD to lose it’s position as the global trading currency, so it is pumping unlimited amounts of USD into other nations via dollar auctions held at various foreign central banks. How can foreigners buy all our exports if they don’t have any dollars? Exports are the only thing keeping the GDP from sinking like a rock.
The countries that got the unlimited swap lines are the biggest foreign investors/trading partners with the US.
These swap lines carry a lot of risk that is not being talked.
Yves,
Thanks for this.
I live in Mexico and have seen the peso fall by as much as 40% against the dollar in the past few weeks. I knew that the Mexican government had something like $100 billion in forex and has been buying pesos like crazy to try to put some kind of floor under the peso.
I also know that some of Mexico’s largest companies, like Comerical Mexicana, have already declared bankrupcy because they had loans denominated in dollars.
But this explanation greatly helps to fit these occurances into a larger framework that helps to understand what is going on.
Thanks also to Anonymous at 7:27 AM. Your primer on how this works was very helpful.
A question:
The U.S. finance industry has a number of entities that owe it money including:
► Households
Mortgate Debt
Consumer Debt
► Businesses
U.S. owned
Foreign owned
► State and Local Governments
U.S. banks were making loans to foreign businessmen such as Russian oligarch Oleg Deripaska as recently as April of this year. I remember reading in the NY Times just a few days ago that he borrowed $4.5 billion from a syndicate of western banks led by Goldman Sachs and Morgan Stanley to buy a chunk of some Russian mining company in April. The collateral backing up that $4.5 billion loan is now worth only about $2.2 billion (from memory) according to the NY Times.
Also, according to the lead editorial in the NY Times, U.S. businesses are struggling to pay U.S. banks back the money they owe them. Businesses have much more leeway to defer payments than homeowners do, but the thrust of the editorial was that this only postpones the day of rekoning.
Since business debt at $11 trillion is actually slightly greater than household debt (according to FED statistice), doesn’t the potential default on this debt actually pose a greater potential threat than mortgage debt?
According to the NY Times editorial, a recent sampling of $2.6 trillion of that business debt held by U.S. banks showed (and this is from memory) over 13% of it non-performing.
That’s considerably higher than non-performing household debt, isn’t it?
anon @ 7:27 —
brad’s blog over at CFR has an interesting discussion regarding risk on the swap lines. the experts over there seem to think there is little to no risk for reasons similar to what you mentioned.
curious to know why you think there is a lot of risk regarding these swaps.
downsouth: excellent digging, amigo. you just identified another pink elephant in the room.
it’s gonna get ugly.
btw, how is it down in mexico right now? how are people down there reacting to the peso devaluation?
i love that country and it’s been in my thoughts much the last couple weeks.
Matt Dubuque
There is no real reason for the Chinese would to “get in now”.
They already have “enormous sway”. It’s the US that is declining, not China. Why not let that trend accelerate (in their view)?
They are simply biding their time, waiting for things to get far, far worse.
They are interested in game changers, not two-bit handouts.
This is about empire, not about charity.
It’s about the decisive and grand sweep of history. It’s about drama. It’s the new narrative. They are writing history now, not the increasingly irrelevant 12% of the world’s population known as the “Western world”.
The gibberish about “The End of History” is over.
They will do it on their own terms. When they are good and ready.
Matt Dubuque
luther,
The big problem now in Mexico is security. I don’t know if it’s made it into the papers in the U.S. or not, but it’s like a war down here between competing drug traffikers. Many innocent people are getting caught in the crossfire. Kidnappings are also on the increase. The Mexican criminal justice system–police, prosecutors, prisons, judges–is little more than a very well organized, state-sponsored (and with the Merida inititative, a U.S.-sponsored) criminal enterprise.
Layered on top and intertwined with this are the economic problems. Oil exports have dropped from 2 million BOPD in 2004 to 1 million BOPD this year, so that combined with the halving of oil prices in the past few months are leaving a big hole in the federal government’s budget. Tourism is bound to drop due to the troubled U.S. economy combined with the security problems cited above. (The police in Los Cabos beat an American tourist to death a couple months back.) The remesas, or money Mexicans working in the U.S. send back home, have dropped 12% from August 2007 to August 2008. Manufacturing will also be negatively impacted as Mexico’s #1 trade partner, the U.S., experiences more difficulties. So the only segment of the Mexican economy that is booming is the drug trade. America’s appetite for drugs seems to be unlimited and recession-proof.
As far as the man on the street, I don’t think it’s sunk in as to the tidal wave that’s about to hit him. When this wave hits, social unrest will surely escalate. I see a possible revolution in the cards, but almost without doubt a turn to a Chavesque type of government–radical, demogogic populist leftism. I suspect the ruling oligarchy, with the full support and cooperation of the U.S., will attempt 60s and 70s like social control and everything that implies–death squads, “disappearances”, jailing political dissidents, etc. So it could get very ugly. I live each day at a time, but understand I may have to leave here at any time.
In regards to the the U.S. banks, it would be interesting to see a breakdown of that $11 trillion that is owed them by businesses. How much is owed by U.S. businesses and how much by foreign businesses? How much is owed from each country?
luther,
The big problem now in Mexico is security. I don’t know if it’s made it into the papers in the U.S. or not, but it’s like a war down here between competing drug traffikers. Many innocent people are getting caught in the crossfire. Kidnappings are also on the increase. The Mexican criminal justice system–police, prosecutors, prisons, judges–is little more than a very well organized, state-sponsored (and with the Merida inititative, a U.S.-sponsored) criminal enterprise.
Layered on top and intertwined with this are the economic problems. Oil exports have dropped from 2 million BOPD in 2004 to 1 million BOPD this year, so that combined with the halving of oil prices in the past few months are leaving a big hole in the federal government’s budget. Tourism is bound to drop due to the troubled U.S. economy combined with the security problems cited above. (The police in Los Cabos beat an American tourist to death a couple months back.) The remesas, or money Mexicans working in the U.S. send back home, have dropped 12% from August 2007 to August 2008. Manufacturing will also be negatively impacted as Mexico’s #1 trade partner, the U.S., experiences more difficulties. So the only segment of the Mexican economy that is booming is the drug trade. America’s appetite for drugs seems to be unlimited and recession-proof.
As far as the man on the street, I don’t think it’s sunk in as to the tidal wave that’s about to hit him. When this wave hits, social unrest will surely escalate. I see a possible revolution in the cards, but almost without doubt a turn to a Chavesque type of government–radical, demogogic populist leftism. I suspect the ruling oligarchy, with the full support and cooperation of the U.S., will attempt 60s and 70s like social control and everything that implies–death squads, “disappearances”, jailing political dissidents, etc. So it could get very ugly. I live each day at a time, but understand I may have to leave here at any time.
In regards to the the U.S. banks, it would be interesting to see a breakdown of that $11 trillion that is owed them by businesses. How much is owed by U.S. businesses and how much by foreign businesses? How much is owed from each country?
Matt Dubuque,
I agree completely.
We’re talking here about space and about time. Space: The world is bigger than the West. Time: A trader, U.S. corporate chieftan or U.S. politician might think in terms of a day or a week or the next quarter; an investor like Buffet 5 or 10 years; but the leaders of China, Russia and Saudia Arabia think in terms of the next 20, 30 or 50 years.
Also, nine of China’s top ten leaders are engineers. And Putin, although he has a law degree from the University of Lenningrad, in 1997 defended the equivalent of a Ph.D. dissertation at Russia’s St. Petrsburg State Mining Institute.
Meanwhile back on the farm, the United States is led by a bunch of lawyers, financiers and economists.
Although the U.S. may win a skirmish here and there, it doesn’t take a rocket scientist to figure out who’s going to win the war.
downsouth,
thanks for the update. i have friends in Michoacán so i know all about the drug wars…and the corruption…and the machismo playing itself out down there.
from your dire forecast, perhaps the only thing that might save the people from suffering from this for another generation and then some is the fulfillment of the mayan prophecies.
we'll shall see.
btw, very astute of you (and matt) to see this from the perspective of space & time.
in many ways, everything that we are experiencing right now might only be symptoms of a larger battle between these 2 perceptions.
what i wonder is whether there is a 3rd perception that encompasses both, and if so, how might that perception be modeled into reality and its systems (economic, political, social, etc).
Hey downsouth, I think we’ve had an open swap line with Mexico since your peso went nuts in the 90s.
swap line risks-
swap lines usually had short durations (3 months) and were used to buy money. Using my early example, if the FED sold the yen they had swapped for USD with the BoJ, they had to buy the yen back on the open market in time to swap the currencies again at the end of the swap term. This did not always work out so well, but never amounted to much.
When the $620bn swap lines were announced a couple of weeks ago, they had 3 or 4 month durations. That’s a lot of money to sell and then buy back in a short amount of time. They have since made the amounts unlimited which removes the time frame constraints and thereby some risk if they are going to use it for currency stabilization.
I originally thought they came up with the $620bn figure based on their assumptions about how much money was going to flee the US. But I’m not so sure now.
Like I said, swap lines have been used for decades. My guess is that the central banks are just using them now because the regulatory structure was already in place and there was no need to ask anyone (congress) for permission to use them for any reason, or for any amount of money.
Another reason for using the swap lines might be more hocus-pocus accounting illusions. I’m pretty sure both central banks can use the money they got in the swap without showing the deficit on their books. Viola! Unlimited spending on both ends of the swap with no oversight!
I am no expert on swap lines (or anything else). We need somebody in here that knows more about them and how they are actually being used right now.
If there is malfeasance going on, this may be the place to find it. I would check the super secret CPFF, too.
Anonymous @ 10:16 AM:
How do you make these triangle-like shapes? It looks really good.
To make a ► press the Alt key and simultaneously the “1” key and then the “6” key, release the Alt key and it should appear.
If you have the new Windows Vista I don’t think it works.