Most of you would have heard the old joke about the ethnic minority pointing a gun to his own head on discovering that his wife is adulterous, upon which she starts laughing. His reply, the classic “What are you laughing about? You are next!” is meant to allude to the apparent stupidity of these ethnic minorities in the context of modern Western society. The Americans craft this joke around the Mexicans, the Germans about the Turks and the Australians about the Lebanese.
For a change though, this time around the richer countries in the equation are actually next in line, as the English are proving so adeptly by cratering in response to the largely self-inflicted collapse of Russia. I am however getting ahead of myself.
The collapse of investor confidence in emerging markets can be attributed to a multiplicity of factors; not the least of which is the global economic decline. However, the current situation of money leaving these countries wholesale in favor of dour investments in the developed world such as 0%-yielding three-month US Treasury Bills, can also be attributed to the self-inflicted policy mistakes of these poor countries.
Broadly, the countries having the worst possible set of dynamics – as defined by the inability to secure insurance at any reasonable level – can be further split into three categories: “can’t pay”, “won’t pay” and “both”. There is also a group of countries that are classified as “neither” but in the parlance of Western intelligence agencies, let us just call them “collateral damage” and damn their billion people into the same misery as the billion in the first three categories. I explain briefly the countries that fall into each category, some of which may be surprising to the casual reader.
“Can’t pay” or Iceland cometh
This group comprises countries whose income sources are far surpassed by their near-term obligations; in other words these countries owe a lot of people a lot of money over the next few months and without sufficient external assistance have no ability to meet those obligations. The main countries are those with poor economic bases, dependent excessively on a narrow stream of exports; others have invested way too heavily in the recent past into building up their pipe dreams that would soon come to naught as the world confronts its greatest recession in the past 70 years.
Examples of countries in this group include commodity exporters like Kazakhstan and Ukraine; richer countries with massive gaps between their current cash reserves and near term obligations, such as Iceland, Korea and Dubai; and a last group of poor countries that have simply slipped further due to policy errors that have accelerated the exit of foreign investors – this group includes South Africa, the Philippines and Sri Lanka.
In all of these cases the key issue is a near-term liquidity squeeze that is a result of the global nature of the credit crunch that has helped to divert money away from reasonably creditworthy borrowers to government-backed borrowers from Western countries including the US and those in Europe. Adding to their problems is the host of bad investment decisions made locally, ranging from the overexposure to financial leverage for Iceland and the excessive property bubble in Dubai.
“Won’t pay” or the Chavez trinity
This is the more intriguing group of countries that simply refuse to honor their external obligations. By and large, these countries have faced changes of government or have figured out that bankruptcy in these troubled times isn’t an altogether unacceptable option.
True to the form displayed since the 1980s, when Latin America slipped into a domino pattern of defaulting debt, first off the block this time around was Ecuador, which declared a self-imposed moratorium on servicing its external debt payments as its president declared that the “legality” of these foreign obligations were now in doubt. This was soon followed by the balance of the Chavez trinity (Bolivia and Venezuela) declaring similar doubts about the validity of such debt.
Far from being the opening gambit of a tough negotiating position of the sort that Argentina chose a couple of years ago, the Chavez trinity has attempted to negate debt purely to heap misery on investors at an inopportune time. They perhaps wagered that the wave of upcoming defaults would be so great that no one in particular would remember the actions of the three countries in say 10 years’ time.
In so doing though, the Chavez trinity may have well condemned millions of people in other countries around Latin America, Africa and even Asia to dire poverty as investors become increasingly skittish at the prospects for other countries following suit on the example being set by these charlatans. This law of unintended consequences is the hallmark of anything that Stalinist folks try to do; attempting to reverse an imagined wrong they almost always end up creating significant damage to innocent bystanders.
“Both”, or long sleeve vs short sleeve
The Belgian practice of amputating natives in Congo to keep the population quiet has ever since been taken up with relish by African warlords. The phrase chillingly employed to describe various kinds of amputees is long sleeve (only the hands chopped) versus short sleeve (arm chopped up to the elbow). Applied to the world of credit markets, the phrase refers to countries (or companies) that either promise to repay their creditors much later (long sleeve) or reduce the principal outstanding significantly in order to keep servicing their debt (short sleeve).
Currently, this motley group of emerging markets is represented by various failed states ranging from Zimbabwe to Pakistan (see also The hottest place in the world, Asia Times Online, December 2, 2008); however the group could well expand dramatically if some countries that are currently on the fence such as Bangladesh and Egypt choose to join the fray. In all these cases, the unifying factor is a substantial amount of maturing debt that isn’t covered by either savings as represented in foreign exchange reserves or assets available for disposal such as profitable state companies.
A murky set of fundamentals is only made worse by conflicting geostrategic positions: much as Zimbabwe is precariously balanced between a supportive Africa and a critical Europe, Pakistan is balanced between belligerent democracies such as India and the US against supportive Islamic states such as Saudi Arabia on the other side.
Much of the above should have been clear to most observers in financial markets. The main point of the article here is that it is quite easy to draw parallels between the behavior of countries that are currently in a whole lot of trouble across emerging markets, and their peers in the group of developed and nearly developed countries that constitute the Organization of Economic Cooperation and Development (OECD). The main factor is the degree of tilt, but in every case very similar arguments can be made about the decline seen in emerging markets spreading rather quickly to a similarly afflicted peer in the OECD group.
When I first started over a year ago writing about the problems for Europe, some angry correspondents challenged me to the financial equivalent of a duel – betting for example that the scale of damage in the US would be irreparable while Europe emerged relatively unscathed from the carnage. Most recent data from the continent would suggest that this is a pipedream; if anything Europe appears to be headed for a deeper and longer-term abyss than any other part of the world.
In the “can’t pay” group of OECD, we have countries ranging from the UK to Switzerland (see Europe’s death by guarantee, October 11, 2008), wherein the sheer volume of near-term obligations assumed by the banking sector and thereon by the state could well overwhelm the country’s ability to repay its debt. For the UK, the decline of its banks due to excessive leverage came about last year. Since then, the country’s efforts at securing an economic recovery have been frustrated by, of all sources, Russia.
In cracking down upon the country’s corporate elite, the so-called oligarchs, Russia’s then president and now Prime Minister Vladimir Putin badly miscalculated. The actions have helped to remove foreign investor interest in Russia, creating noxious conditions for its top companies in tapping overseas debt or equity investors. As collateral damage, many Russian oligarchs have seen their net worth vanish overnight as the impact of falling share prices in Russia hurt their borrowings, in turn forcing many of them to pull out their most liquid assets.
Since many Russian oligarchs had a second home in the UK, the net result has been withdrawal of savings from UK banks as well as significant selling pressure on expensive English homes, both of which have served to exacerbate the crisis being faced by Britain. This has pushed confidence in the UK to a recent if not all-time low; with the currency and its stock markets tanking, there doesn’t seem to be anything that the socialist government in the UK can do except perhaps inflict more damage.
Other countries in Europe, including Switzerland, Ireland, Italy and the Netherlands, are facing the collapse of both their banking sectors and large swathes of their corporate sector to boot; making state aid all but impossible to deliver given the scale of the economic calamity.
In the second category, namely “won’t pay”, the principal defaulter is Russia but loosening up the definition would ensnare other countries including France.
In the case of Russia, the country has unilaterally decided to back certain national champions while letting others fail on their international debt obligations. The scale of government involvement in the debt market problems suggests that it is not entirely up to the individual corporate to decide on repaying its foreign creditors; being reclassified as a lower-priority industry automatically means the company is effectively expected to secure a restructuring on its foreign debt that would allow precious foreign exchange to be used instead to repay the obligations of those closer to the Kremlin.
Why France? Typically in a debt restructuring, creditors would gain control of the company and decide on selling assets as merits their intentions to get the maximum repayment. This is, however, difficult to achieve in France, where archaic corporate laws and frequent government intervention mean that the ability of a foreign creditor to enforce collateral pledges remains questionable.
Into this group we must also add countries that are sorely tempted to go back to their socialist roots, ignoring the gains made by opening up to globalization. This motley crew of countries could range from the Balkans to the Baltic States, and within their ambit include various trouble-prone countries (at least politically) such as Greece and Poland. All of these countries can summarily change the nature of their statutes, the pledges made with institutions in the European Union for some and the International Monetary Fund for others. That they are currently rich and want to stay that way would be the only plausible explanation for their actions.
The other common thread uniting these countries is ideological disdain for free markets, as shown by both Putin and French President Nikolas Sarkozy in their criticism of laissez-faire. As all good communists do, these leaders have confused cause with effect in order to build up a self-serving system of patronage in their backyards.
The consequences for Russia are easy to arrive at, namely mounting unemployment, bread and meat queues and increased repression of its people. As for countries like France, the consequences will be a significant spike in unemployment, higher taxes that push out its best brains and entrepreneurs, reduced efficiency and a long-lasting recession. So, no change there.
The last category of “both” is occupied by a heavyweight. This is the country that has more debt than any other, a dysfunctional banking system, a regime change underway, millions of unemployed people, thousands of bust companies and dozens of scam artists. The Land of the Free is now the land of a thousand scams, where everything from the currency to bonds and stocks is mispriced.
Yes ladies and gentlemen, the one country where you have no hope whatsoever of recovering your debt as measured by its current purchasing power is the United States of America. For this is a country that has no source of refinancing except for fresh debt issuance, no industry that it could excel in to generate profits that could prove a succor in the recession and certainly not a lot of confidence-inspiring institutions or even people. Whether it is the parallels to Lehman Brothers or Bernie Madoff, the story for the US is the same – all the world’s smoke and its mirrors cannot conjure up the actual cash flow required for the US to repay its creditors.
The first actions of president-elect Barack Obama have been deeply disappointing, if setting off a dozen alarm bells. Be it the Keynesian spending package announced to build bridges to nowhere (see Honey, I switched the medication, Asia Times Online, December 13, 2008) or the much-vaunted rescue of the automakers that were signed off by President George W Bush apparently with the support of the Obama team, the move towards socialism is unmistakable.
Rather than being a dogmatic gag reflex, my objections are based on cold numbers: reduced corporate efficiency in the United States means there will be a longer recession with more protracted job losses. The destruction of the middle class in the country also means a surge in poverty across the developed world, as purchases of discretionary items and vacations fall off a cliff.
The government is able to finance these expeditions because the rest of the world, including the incredibly dense Asian central bankers, continue to buy into the age-old malarkey of risk-free rates and the US dollar as the reserve currency. An objective longer-term look at the US suggests that the country’s decline is permanent, not cyclical; accelerated as it is by the declining demographic profile.
It took millions of new immigrants from Europe and a world war to pull the US out of its first Great Depression; I shudder to even consider what it would take for the country to get out of this one.
An anecdote related by a corporate leader about the dysfunctional company he joined tells the tale of an “offsite” meeting held in a beach house in California. Feeling the building shudder in the middle of a presentation, everyone in the room screams “earthquake” and starts running out of the house to the beach. As they gather their wits on the waterline, one bright spark points out that if the earthquake had its epicenter underwater, there would soon be a tsunami, which made standing on the beach rather dangerous. So everyone starts running back to the house, now seen as safe.
I leave it to my diligent readers to figure out whether emerging markets are the house or the beach and whether the epicenter of the earthquake now roiling global markets was underwater or subterranean. The point I am making, though independent of all that, is to question whether today’s so-called safe havens merit that badge in any way, shape or form.