Debts issued in foreign currencies, some of which are not counted in official statistics, are a rising risk to developing economies as the UK and US get closer to raising rates.
With the Swiss National Bank abandoning the Swiss franc’s peg to the Euro earlier in January and its knock-on consequences for Polish and Hungarian mortgage holders, hard currency debt is once again in the news.
While most debt in a given country is denominated in its own currency, say the renminbi in China or the zloty in Poland, borrowers sometimes borrow in foreign, or hard, currencies (usually of more developed countries, like the US dollar). The borrowers are looking for the lower interest rates that have been in place in developed economies since the 2008 financial crisis.
With the US and UK contemplating raising rates this year, what looked like attractive financing for corporations and governments in the developing world will begin to look less so. In fact, it already is.
The Dollar Index, which tracks the US dollar against six other major currencies, is up nearly 30% since July in response to the end of the Federal Reserve’s quantitative easing program. The interest and principal of debt taken out in US dollars by foreign issuers are now significantly more expensive. As a result, these countries’ balance of payments has deteriorated, which can lead to a cycle of further weakening of currencies and balance of payments.
A similar series of events – taken to the extreme – occurred in the 1997 Asian Financial Crisis, when the economies of Thailand and Indonesia melted down due to currency and balance of payments troubles.
Luckily, the chances of another crisis of that magnitude are low. Across most of the world, hard currency debt is lower than the average since 1995. For a handful of countries, however, there is a real threat posed by strengthening developed country currencies. These are primarily countries with increasing hard currency debt – like Ukraine, Hungary, India, and Poland, but also Brazil and China.
The credit situation in both Brazil and China has deteriorated in the past year. China’s banking system is stressed under the weight of suddenly lagging property prices. Brazil’s economy is no longer a net creditor to the world and growth has stagnated. These worrying trends could be exaggerated by a largely unseen trend in hard currency debt: so-called dark debt.
Dark debt is debt that is not only taken out in a foreign currency but issued in a foreign country as well – for example, a Brazilian company taking out US dollar-denominated debt in the United Kingdom. Because the debt is issued outside of the government or corporation’s home country, dark debt is not usually counted in official statistics. There is concern that this debt is not priced into assets, and that it could cause more stress on developing economies as the US dollar continues to strengthen.
Analysts at Bank of America Merrill Lynch estimate that dark debt accounts for 44% of hard currency debt issued since 2007. Of that, $165 billion was issued to Chinese borrowers and $100 billion was issued to Brazilian borrowers. Adding more complexity to the Brazilian situation is recent Financial Times reporting on its central bank’s creative use of currency swap shorts to maintain its balance of payments, which would amplify the effects of a weaker Brazilian real just like hard currency debt would.
The liabilities of hard currency debt seem benign until they reach the tipping point when all of a sudden defaults spike and central bank intervention becomes increasingly desperate.
Effects of balance of payments crises are already being seen in Venezuela’s widespread product shortages (although not because of hard currency debt). The Hungarian and Polish governments are rushing to minimize the impact of hard currency debts putting their home owners underwater after the Swiss National Bank’s action.
Hard currency debt, with dark debt lurking in the background, could quickly become a threat to both central banks and the real economies of China and Brazil as the Federal Reserve and Bank of England raise interest rates.