from Follow the Money

Emerging market bubble watch - and a word or two on dark matter

December 8, 2005

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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Ecuador is the kind of country that can borrow only when times are really, really good for emerging economies.  It has been and - as far as I can tell - remains politically dysfunctional.   It tends to default on its external debt regularly.  But right now there is - as Desmond Lachman suggests in Paul Blustein's Washington Post article - ""just a huge amount of money sloshing around looking for a place to go." 

I would say looking for a place to go that generates a bit more yield than US Treasuries - the easy money from borrowing short and lending long to the US government is now a distant memory.   But there is still money to be made lending to  a few governments.   "Ecuador's Eurobond issuance is one of my preferred obscure economic indicators.  It seems to correlate well with a bit of froth in emerging market land.

Ecuador last issued a Eurobond (if memory serves) in 1997, a couple of years after doing its Brady deal.  That was the peak of the emerging market boom of the 1990s, more or less.   It defaulted in late 1999, when commodity prices tumbled and capital flows to emerging markets dried up.   I would not be surprised if it defaults in 2007 or 2008.

The scenario that leads Ecuador back into default is not hard to see.   Think of a global slump that leads to a fall in the price of oil, its main export (along with bananas).   Dollarization, in my view will hurt, not help.  If Ecuador's real exchange rate needs to adjust to reflect say $30/ barrel oil, that adjustment will have to come through domestic deflation -- along with shrinking government revenues and severe budget cuts.  Think Argentina under the currency board.   And in those circumstances, I doubt Ecuador will be willing to pay a (substantial) coupon on its external debt.  Just a hunch.

Ecuador's last crisis was triggered, in some sense, by the Asian crisis, which led to a fall in the price of oil, trouble in Russia and a sharp fall in capital flows to all emerging markets. This time the trigger could well be different.  Remember, the recent surge in private capital flows to emerging economies is mostly going to finance a buildup of reserves, not to finance current account deficits.   There have been big changes in most emerging economies since 1997.

Yes, a few emerging economies, mostly in Eastern Europe, do have current account deficits.  But even Turkey's estimated 2006 current account deficit of roughly $25 billion seems rather small in comparison with the United States likely 2006 current account deficit.  Think $900 billion, if not more.   That's why lots of folks who invest in emerging markets are eying the US nervously.

Don't worry, say Ricardo Hausmann and Fredrico Sturzenegger.   Financial dark matter will save the day.  And the US has more of it than anyone else.   See their Financial Times piece.

I quite like Ricardo Hausmann's work, and appreciate his capacity to coin a clever phrase.   He  was the first to call the difficulties many emerging markets (used to?) have borrowing in their own currency  "original sin" for example.   In this case, Dr. Hausmann and Dr. Sturzenegger certainly have found a provocative way of framing two reasonably well known facts:

  1. In 2004, the US earned more on its assets abroad and it paid on its liabilities, even though it had far more liabilities than assets.
  2. That difference stems largely from the fact that Americans got a far higher return on their foreign direct investment outside the US than non-Americans have gotten on their foreign direct investment in the US.   At least if you believe the data reported to the BEA. That is rather puzzling, since most US foreign direct investment is in Europe, not high-risk emerging economies, and most foreign direct investment in the US comes from Europe and Japan.   It is sort of hard to believe that say Toyota's US operations are massively less profitable than GM's European operations.  But that, writ large, is what the US data tells us.   See this CBO report.

Hausmann and Sturzenegger take the United States' $30 billion in net income in 2004, and say, assuming a 5% return, that implies the US has $600 billion in foreign assets - not a foreign debt of $2.5 trillion or so.   The difference: dark matter ...

Four comments in response:

The amount of "dark matter" on the US balance sheet is going to shrink rather rapidly.   The US income balance went into deficit in the second quarter of 2005, and the income deficit (i.e. payments on US debts in excess of what the US earns on its external assets) may well reach $75b or so next year.  Interest on the $800 billion in new debt the US took out in 2005 is part of the reason but also remember ...

US interest rates were very, very, very low in 2002, 2003 and 2004 - unusually so.  That had a thing or two to do with the positive US income balance during those years.   From 2001 to 2003, the interest rate the US had to pay on its bank borrowing from abroad and the US interest rate that the US government had to pay on Treasuries held abroad fell substantially.   That really helped to offset the rise in the US (gross) external debt associated with ongoing current account deficits.   It won't help much longer.    Interest rate differentials are no longer in the United States favor.  Look for the US external interest bill to rise substantially in 2006 on the back of the Fed's tightening cycle.

The same dynamics that have helped the US could also really hurt the US if they ever operated in reverse.  US gross debt far exceeds US net debt.   Gross US external liabilities are around 100% of US GDP.   Big falls in the average cost of servicing all those liabilities have played a big role keeping net US payments down recently. If the US ever lost its ability to borrow from abroad at a very low rate (over the past few years, a falling rate), the overall impact on the US income position could be quite large.    The interest bill on the United States gross debt could potentially go up by a lot.  There is a big difference between say a 4% interest rate on gross debt of a 100% of GDP and a 6 or 7% interest rate on that much debt.  At some point, a potentially very negative dynamic could set in.  That is what worries me.

Finally, generating new dark matter requires investing abroad, and, going forward, it is going to be hard for the US to both borrow to invest abroad and borrow to import so much more than the US exports.  After all, judging from the reported return on foreign investment in the US, investing in the US is NOT the way to make a ton of money.  Better to invest in Europe and try to find the secrets that generate all that dark matter for the US.

One caveat - apologies if my numbers are a bit off here and there.   Fact checking from the road is a bit harder ...

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