In the book “Principles for navigating big debt crisis”, Ray Dalio explains thoroughly the characteristics and the causes of inflationary and deflationary debt crisis. The template of the inflationary debt crisis was created by averaging the twenty-seven worst cases of inflationary cycles. Inflationary debt crises usually occur in developing economies, but developed countries might experience it as well, during the late stages of the economic cycle. This article will cover the six main characteristics of countries that faced inflationary crises, along with examples from the Argentina crisis that splits in three parts:
- Bubble phase between 1995 and 2001
- Recession phase in 2001
- Reflation phase between 2002 and 2012
Inflationary crises are usually seen in countries:
- Whose domestic currency is not considered a reserve currency, thus there is no safe heaven bias towards that currency.
- Where the foreign-exchanges reserves are low. These reserves are part of the Central Bank balance sheet and are used to offset the imbalances in the currency markets.
In the early stages of the cycle, the economy is strong and most of these countries export more than they import, thus the pressure from international markets assure that the demand for the local currency is high. Therefore, the central bank prints money to avoid excessive currency appreciation, which keeps the economy competitive. Subsequently, this newly printed currency is sold for foreign currency, which helps to increase the foreign-exchange reserves and control the excessive currency demand.
When the bubble bursts, there are massive outflows of capital. This simply means that foreign investors are selling assets and exchanging the local currency for their currency. When this happens, there is usually a massive currency devaluation and the central bank has to balance between these two options: let the currency devaluate (it keeps the exports competitive, but savers will lose their savings) or sell the foreign-exchange reserves (it helps to control the devaluation, but foreign-exchange reserves dry up, which increases panic among international investors).
- With a high level of foreign debt. When a bubble emerges, there is usually an appreciation of the currency in relation to other currencies. This incentives irresponsible behavior because economic agents are rewarded for borrowing in the foreign currency, which is expected to depreciate against the local currency, and keep the deposits and revenues in the local currency, without hedging the currency exposure. Moreover, foreign bankers are eager to lend because the country is booming. If there is a lot of external debt, when the local currency appreciates against other currencies, the debt payments decrease, incomes increase, economic agents are more creditworthy, thus they can borrow more. This creates a self-reinforcing cycle that leads to the bubble. However, when the currency weakens the reverse happens: the debt payments increase, and the revenues decrease due to the change in trend of the currency pair. This is problematic during the depression phase because the economic situation contributes to a decrease in the value of the debt collateral below the debt due. Furthermore, it is harder to refinance the debt for longer maturities and hedging costs for the currency exposure increase.
In Argentina there was a huge increase in the total external debt between 1995 and 2001, as shown in the second image.
- With high dependence on foreign capital.
- With large and increasing budget and/or current account deficit. This causes the need to borrow or print money to help fund the deficits. As shown in the last image, during the strong economic expansion before 2001, Argentina had huge deficits.
- With a history of high and uncontrolled inflation, negative real interest rates and lack of trust in the currency value.
To conclude, when investing in a country, through a specific ETF or a fund for example, investors should examine if these characteristics are present, and if the situation is sustainable or not, to decide the weight for that country in a portfolio. When analyzing an individual company in a developing country, investors should also examine if the company has a lot of debt in a weak currency and revenues in a strong currency, how it performs when there is inflation and its exposure to interest rates.
Article published in our February Newsletter
João Ferraz, MSc in Finance