Currency markets - the next tipping point?

Charles Hugh Smith, whom we've met in these pages many times before, highlights a risk area in the international economy to which I may have paid too little attention.

Currencies are in the midst of multi-year revaluations that will destabilize the tottering towers of debt, leverage and risk that have propped up global growth since 2009.

. . .

As a nation's income and asset base decline, there is less national income to pay interest on sovereign bonds, less private income to tax, and a reduced asset base for additional borrowing.

This is especially true if the nation issued debt and/or currency profligately in good times. Recall that debt and currency are one in the same: if someone trades euros for a U.S. Treasury bond, they don't just own a bit of sovereign debt--they own the currency of the nation that issued the bond (in this case, the U.S. dollar).

This is equally true of corporate bonds--all the debt is denominated in a specific currency, and owners of the bonds are not just betting that the interest will be paid and the bond redeemed at maturity, but that the underlying currency will not lose much of its global purchasing power.

. . .

Once participants become aware of the rising risk of holding a depreciating currency, the trickle out of a currency quickly becomes a torrent of fleeing capital.

Once the perceived risk switches from risk-on to risk-off, the only way to prop up the currency is to raise the interest rates that bonds denominated in that currency yield.

But raising interest rates has a brutally negative effect on the domestic economy, as higher rates choke off domestic lending, which then pushes the economy into recession.

It's a no-win double bind, though, for doing nothing and letting one's currency implode drains the nation of capital and makes imports unaffordable. That matters when the imports are energy and/or food.

When those become scarce and unaffordable, social disorder soon follows.

. . .

As emerging market currencies decline, the income streams needed to service all the debt denominated in U.S. dollars declines, a self-reinforcing dynamic: as income and valuations fall, capital flees, pushing the relative value of the currency down even more, which further raises the risk premium that then triggers even more capital flight.

The sums in play are so staggering (an estimated $11 trillion in emerging market debts denominated in other currencies) that even the Fed won't be able to stop the meltdown.

There's more at the link, including some very interesting charts that illustrate his point.  Highly recommended reading.

I've seen this happen in several African economies.  When they had easy, cheap access to loans in hard currency, they took all they could get.  However, when economic hard times arrived, their own currencies declined against the dollar, making it very difficult (if not impossible) to repay those loans in hard currency that suddenly cost much more to buy with local currency.  Inevitably, default was the result;  and if not default, then taking out more and yet more loans with which to pay off the original loans.  That's driven them even deeper into debt, until today they have no more 'wiggle room' left at all.  No-one will lend them any more money, because they're effectively bankrupt.

If the dollar continues to strengthen, we're going to see a currency bloodbath in the Third World.

Peter