Intro: Balance of payments crises are loosely defined by sharp adjustments in imports in response to intense currency depreciation resulting from foreign investors withdrawing assets from a country reliant on overseas borrowing. The difference between a balance of payments crisis and a mere external rebalancing tends to depend on the economic damage caused, which tends to be higher if liabilities are based in foreign currency rather than local currency, are in the form of debt rather than equity, and are concentrated in the public sector.
Persistent current account and net international investment deficits rely on there being foreign investors willing to continue lending to the country. The risk facing countries with large current deficits is the potential for investors to repatriate their assets suddenly (capital flight). This can result in a dramatic reduction in the funds available to import and invest due to a collapsing currency, which in turn causes a recession as domestic companies that rely on imports face an immediate reduction in profitability and it takes time for resources to shift towards more export focused industries.
Currency and balance of payments crises are essentially the same thing, and while there’s no strict definition they are usually associated with countries that have fixed exchange rates and rely on a limited amount of reserves to maintain currency stability. Financial account outflows overwhelm the ability of the central bank to defend the currency with its reserves. The difference between a balance of payments crisis and an external rebalancing tends to depend on the economic damage caused, which tends to be higher if liabilities are based in foreign currencies.
The Importance of Currency Denomination
If a country’s liabilities are predominantly in its own currency, as is usually the case for developed market debtor countries, then a currency devaluation will be a positive for the country’s current account position. The reason being that as the currency weakens, its liabilities do not increase in value, but its assets do, when measured in local currency, meaning there is a natural stabilizer in place.
In contrast, in emerging market debtor countries liabilities are usually denominated in US dollars meaning that as the value of the domestic currency weakens, its ability to repay its debts in dollars deteriorates. This is the cause of almost every EM debt default.
Case Studies: Australia, Mexico, Russia
Australia: Australia has run a large NIIP deficit for several decades but the majority of its liabilities are in local currency terms. This has allowed the currency to act as a shock absorber in times of large scale foreign asset repatriation. As the Australian dollar has weakened in response to foreign outflows, this has kept the amount of liabilities that Australians have had to pay constant, but has increased the value of their assets in AUD terms, cushioning the impact of the negative external shock.
Mexico: Mexico’s external liabilities are largely denominated in US dollars. This means that periods of rapid portfolio outflows, such as the one following the election of Donald Trump as US president, weakness in the Mexican peso causes the NIIP deficit to rise in local currency terms as liabilities (which exceed assets) rise. The implication is that currency weakness can beget further currency weakness, raising the risk of recession and/or default.
Russia: The Russian currency crisis that began in 2014 due to a collapse in oil prices and the imposition of international sanctions was quite unique in that Russia is a large net international creditor (has a large NIIP surplus) with its assets largely denominated in dollars. This means that as the ruble depreciated, Russia’s external balance sheet actually improved as its overseas assets became worth more in local currency terms. This meant that the chances of currency weakness causing a default were negligible.
The Difference Between Debt and Equity Liabilities
As well as the size of assets and liabilities and the currency denomination of them, the form which they take is also crucially important. Liabilities can take the form of FDI, equities, portfolio liabilities, and loans and trade credits. We can break these four categories down into equity liabilities and debt liabilities which is helpful in determining their impact on the economy.
If liabilities are predominantly in the form of equity, meaning that foreign investors effectively have an ownership stake in the country’s corporates, this is a less risky form of liability. The reason being that it is countercyclical. When the domestic economy enters a downturn and equity prices fall, the economy will find that its liabilities are reduced, cushioning the downturn.
In contrast, when liabilities are predominantly in the form of debt, this can actually be procyclical, meaning that in times of economic weakness liabilities can increase and vice versa. The reason is that if a country with a large level of external debt is facing rising default risk, it will have to pay foreign investors a higher yield to borrow from them at the worst possible time.
Case Studies: Brazil, India
Brazil: The terms of trade shock and corruption scandal that undermined the Brazilian real in 2015 was aggravated by the composition of the country’s external liabilities. As a large portion of liabilities were in the form of debt, the increase risk of default caused yields on Brazilian bonds to rise in the midst of the currency weakness, meaning that Brazilian corporates and the government had to pay increasingly punitive rates to borrow from overseas, which exacerbated the country’s economic downturn.
India: In 2011 India went through a currency collapse as foreign investors were concerned over the state of the country’s corporate sector. India’s corporate sector had ‘borrowed’ aggressively from overseas in the form of equity liabilities. As foreign investors lost confidence in the outlook for Indian corporates, they sold Indian shares and the rupee weakened. However, the weakness did not become self-reinforcing as would have been the case if the liabilities had been in the form of debt.
Private Vs Public Sector Liabilities
Another important factor to consider when looking at the potential impact of a country’s external balance sheet on the economy is whether its debt liabilities are held by the public or the private sector. Generally speaking, it is favorable for debt liabilities to be held by the private sector as this reduces the potential for a destabilizing sovereign default, which can in turn trigger corporate sector defaults. Corporate defaults, while also potentially destabilizing, tend not to be of systemic importance, although the presence of state-owned enterprise debt can complicate the situation.
Case Studies: Venezuela, Malaysia
Venezuela: The majority of debt owed by Venezuela is in the form of government bonds, which means that when default risk rises for the government it has contagion effects for the economy as a whole, undermining economic performance and raising the prospect of sovereign default.
Malaysia: In contrast, the majority of Malaysia’s dollar debt liabilities are in the corporate sector and pose little threat to sovereign creditworthiness. While some debt is owed by large state-owned enterprises which have links to the government and therefore may be considered to be continent liabilities to the government, generally speaking there is lower risk of a destabilizing economic shock if the corporate sector defaults compared to if the government defaults.
Other Interesting Comparisons: Greece Vs The US
Greece: Greece managed to build up an extremely unhealthy debt load in terms of size, currency denomination, form, and ownership, which made default a certainty. Greece’s liabilities were in the form of debt, owed by the government, and in a currency that it did not have control over, meaning that a rise in default risk became self-reinforcing and had widespread negative economic implications.
US: While the US also has a large net international investment deficit, which is also in the form of debt, and which is also owed by the government, it has the benefit of the debt being denominated in local currency. This means that the probability of the US defaulting is negligible as is can rely on the Federal Reserve to buy government bonds in the event that demand from foreign investors collapses.
Another positive for the US is that US bond yields tend to fall during times of economic weakness meaning that as the US economy weakens, it has to pay a lower level of interest to foreign investors. Furthermore, the fact that the debts are in US dollar terms means that currency weakness, which tends to be negative for economic performance generally, actually reduces the US’s net external liabilities, giving it the ability to inflate away its debt, in stark contrast to Greece.
