Market complacency harms debtor countries as well
When a spoiled child misbehaves, neither the wicked youth nor the misguided parents are innocent. The same is true of spendthrift countries and the indulgent foreign creditors on whom they rely for financial support.
Turkey and Argentina are both currently on the global currency naughty step. The lira and the peso have fallen 16 percent and 25 percent respectively against the dollar since the beginning of 2018. It’s no coincidence that the two countries are the largest cross-border borrowers of any of the world’s big economies, and will this year have to finance current account deficits of more than 5 percent of GDP, according to the IMF. The UK is third on this list, so dependency on the kindness of foreigners is not limited to developing countries.
During good times, financing big trade deficits is a profitable line of business for banks and investors. Companies exporting into the borrowing nation make money, while those nations’ residents live better than they might otherwise.
The long term would be fine too, if everyone were as rational as economic theory sometimes seems to assume. After all, a rational investor would hardly finance an unsustainable boom in consumption, and a rational borrower would not buy a car or finance a factory without good reason to believe that the loans could be repaid.
Sadly, the lure of quick benefits all too often distracts people from rational analysis. The residents and companies in debtor nations find it hard to turn down readily available money, especially when it comes at low interest rates. And while investors and banks may worry about unsustainable financing needs, each one expects to be able to exit before the bubble bursts.
Excessive largesse can be as bad for countries as for children’s character. In Turkey and Argentina, easy access to credit and imported consumer goods have encouraged wasteful spending, discouraged disciplined investment and probably spawned an unmerited sense of entitlement.
And like spoiled children, overindulged countries may take correction badly. In Argentina, President Mauricio Macri is struggling to dismantle policies that are only affordable if foreigners provide most of the money.
Overly generous investors help spawn unhelpful policies. But when political worries emerge, they demand higher returns. This is the antithesis of a long-term solution, because it tends only to compound the problems. High interest rates amplify political discontent and tend to slow down the economic progress needed to pay off existing debts. Debtor countries would be better off without cycles of character-weakening indulgence and economy-weakening austerity.
The most direct cure for this disease is capital controls, but explicit limits on fund flows too often invite cheating and discourage useful foreign investments. The sudden imposition of such curbs might even inflict more damage than the original bad behavior.
Regulatory nudges are a better idea. For example, global banking authorities could discourage ill-advised short-term lending. On the creditor side, that might mean dramatically higher risk weightings on short-term loans into countries with large current account deficits. And the shorter the maturity of the loan, the higher the weighting. In debtor countries, domestic regulators could crack down on long-term domestic loans financed by short-term foreign investments.
Another solution is to require some equity in any foreigner’s investment mix, especially when money is heading for emerging markets. Shares pay variable dividends and do not default, making them more flexible than debt. And unlike loans and lines of credit, equity neither matures nor expires. Investors unwilling to put up some equity capital may not belong in developing economies.
Then there is borrowing in foreign currencies, sometimes known as the original sin in cross-border finance. At first, the loans seem cheap. But if domestic currencies fall, they become stifling. Regulators can make it more expensive to indulge in such financing.
Reform will not be easy, especially with the easy availability of derivatives and other tricks of modern finance that make it easier to skirt around sensible rules. But it is worth a try. Just as children need discipline, wayward cross-border markets need intelligent controls.