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The risks inherent in overseas borrowing
Moderation is a particularly important central principle for countries that borrow overseas. Borrowing overseas must not only generate cash flow to service the loan; it must do so in the context of a balance of payments sufficiently robust to generate that flow in foreign exchange acceptable to the lender. The United States is in a special position in this regard — despite its persistent balance-of-payments deficits, its dollars and Treasury Bills are still widely acceptable internationally, and frequently comprise the greater part of the foreign-exchange reserves of other countries. No other country is in a position to borrow overseas so readily and so completely in its own currency. Despite the overhang of overseas debt accumulated during decades of heavy overseas borrowing, the great American recession of 2008 did not result from problems in financing overseas borrowing, but from bad debts contracted by an excessively clever finance sector. In this, the United States is a special case; no other country has such ready access to overseas credit, and countries that ape American insouciance regarding overseas borrowing are courting disaster.
Australia has a long history of overseas borrowing, much of which has been win-win in nature — it accelerated economic development to the benefit of domestic consumers and overseas investors alike. However, in the nineteenth century the Australian colonists discovered how easy it was to borrow in London, and the country has been tempted ever since to borrow overseas more than its balance of payments can bear.
Of the forty or fifty economic catastrophes that have occurred over the past three decades in countries with developed financial systems, thirty or forty have taken place in countries that have significant overseas debt. These crises were generated when the country’s creditors came to fear that they might not be repaid on time and in an acceptable currency. Once afflicted by such fears, creditors want their money back quickly. Each crisis has followed its own course, as determined by the economic structure of the borrowing country and the decisions of its policy authorities and its creditors. However, the number of heavily indebted countries that have experienced catastrophe, in the form of a rapid and significant decline in GDP and rise in unemployment, now exceeds the number that have not, and they have provided sufficient combined experience for researchers to generalise from them. The researchers have concluded that excessive overseas borrowing has been a major source of economic breakdown. The second is that, once a crisis begins, it feeds on itself and becomes very hard to arrest.
There are different forms of overseas borrowing, each with its costs and benefits, including direct equity investment, portfolio investment in equities, property investment, interest-bearing loans to private businesses, and fixed-interest loans to financial intermediaries and governments.
The form of overseas borrowing that is least likely, dollar for dollar, to generate economic breakdown is direct equity investment by overseas businesses, usually in the form of subsidiary companies. From the recipient country’s point of view, such equity investment is a form of overseas borrowing, but the equity arrangements take uncertainty into account. The owners monitor the performance of these businesses, and may withdraw their funds if business prospects dim. This is most commonly accomplished by subtle means, such as over-invoicing for inputs from the parent firm of a multinational business, a slow process that may underlie a crisis but is unlikely to be the precipitating factor. Even if disinvestment involves an outright sell-out, the effects are likely to be at the industry or at most regional level, and not a cause of general crisis. Many overseas fixed-interest loans direct to non-financial businesses have similar characteristics, though some are more akin to portfolio investments.
Overseas portfolio investors in equities participate in the alternating capital gains and losses of the share market. Overseas loss of confidence in the market is most likely to occur when a speculative bubble bursts, and can precipitate a crisis as overseas investors sell off and seek to repatriate their money immediately. However, overseas portfolio investors may also have steadier nerves than domestic investors, in which case they may ameliorate the effects of a burst bubble. On the whole, overseas portfolio investment can accentuate crises, but is not particularly likely to precipitate one.
Overseas equity investment differs from portfolio investment in that it is location-specific; it can exacerbate booms and busts in the property market in particular locations. It also interacts with domestic investment in property, much of which is financed from mortgage loans. As with portfolio investment in equities, it can accentuate or dampen domestic price trends; but, unlike portfolio investment in equities, these movements will be multiplied by resulting trends in domestic debt. If overseas property investors lose confidence and decide to exit the market, prices will fall and there will be a multiplier effect as domestic mortgages go bad, with regional and probably national effects.
Overseas fixed-interest loans to governments and financial intermediaries are under constant re-appraisal, not only by individual lenders (whose lending position may be affected by developments in their home market), but by ratings agencies — not that the agencies have proved at all prescient as to impending crisis.3 Reviews of the quality of debt — its probability of repayment on time and in full — are affected by the balance-sheet and cash-flow position of the banks and governments issuing the debt, and also by the balance-sheet and cash-flow position of the country as a whole, particularly by any fall in export revenue (whether due to falling export prices or falling quantities). Falls in export revenue reduce the flow of foreign exchange available for servicing overseas borrowing. Even in the absence of trade shocks, debt may be downgraded simply because the country’s creditors begin to think that it has borrowed too much, or maybe because they perceive similarities to countries that have borrowed too much. There is a long history of countries that have seen their debt downgraded because the hotshots of New York made false comparisons, as when Wall Street downgraded Norway because of defaults in Iceland.
As regards exposure to economic breakdown, the most dangerous form of overseas borrowing is borrowing by the finance sector, in particular by banks. This is because changes in the terms and conditions of overseas borrowing by banks translate directly into the terms and conditions of their domestic lending. Government borrowing is also dangerous in that changes in the interest rates that governments are obliged to pay on their overseas borrowing are likely to translate directly into domestic interest rates.
Whatever the cause of the change in a borrowing country’s credit rating, a banking crisis will ensue if a significant number of foreign investors come to the conclusion that their money is seriously at risk. When the creditors thus change their minds, they demand that their loans be repaid as they fall due. Banks that have borrowed overseas will scramble for foreign exchange with which to repay their debts, an obvious step being to offer higher interest rates to reward overseas lenders for rolling over their loans. This requires an increase in the interest rates charged to the banks’ domestic borrowers, which can have the mild effect of reducing domestic demand for new borrowing and the salutary effect of increasing the proportion of bad debts in the banks’ domestic-lending portfolio.
This, in turn, can generate a vicious cycle. The rise in interest rates plunges the economy into recession. Slack demand increases the default rate on business loans, and rising unemployment increases the default rate on household loans, further weakening bank balance sheets and so worsening the recession by curtailing the supply of credit. The outwards rush of funds also triggers an exchange-rate crisis (that is, a rapid fall in the currency), which feeds on itself by undermining the confidence of other foreign and domestic investors. This not only reinforces the falling exchange rate; it can unleash intense inflationary pressures as capital and labour fight to retain their share of a diminished national income. This fight has the potential to convert recession into Depression.
At the point where the outflow of overseas curre
ncy exhausts the country’s reserves of foreign exchange, it is no longer possible to pay for imports. The country will then suffer further economic disruption, not only because consumers can no longer buy imported goods and services, but because domestic producers are unable to buy the imports that are necessary to their operations. Further, if the banking sector had been active as a transmission mechanism for foreign loans, and has significant foreign liabilities on its balance sheets, the sector’s problems due to bad debts will be greatly exacerbated by the rising domestic-currency value of its overseas borrowings, leading most likely to a banking collapse with further dire consequences for economic activity.
In recent crises in various countries, official reactions to the fall in the exchange rate have included the imposition of international capital controls, sometimes combined with attempts to fix the exchange rate at low levels. Quotas have been imposed on imports by rationing foreign exchange, sometimes with multiple exchange rates for different categories of goods and services. There are precedents for the policy authorities moving to augment the resources available to repay overseas lenders by the compulsory acquisition of residents’ foreign assets, and by large-scale government borrowings from the IMF and/or from consortia of ‘friendly’ countries. The last resort is full or partial default on foreign debts, perhaps including ‘haircuts’ imposed on foreign lenders, with a consequent fall in the country’s credit rating and a reduced access to overseas borrowing.
In recent crises in countries similar in size to Australia, the conditions imposed by creditors have included minimum government surpluses; fixed repayment schedules for foreign debt (especially debts to foreign governments or their agencies incurred during the crisis); imposed structural-reform measures; limits on nominal wage increases; limits on particular types of expenditures, including social security and other safety-net expenditures; and minimum net tax rates on household incomes. All of these measures curtail the power of the government of the indebted country and commit it to prioritising the expectations of its creditors over the needs of its citizens. Since the Global Financial Crisis (known in the United States as the Great Recession), the effectiveness of these measures has been debated, but they remain a risk that indebted countries should take into account.
Financial crises originating in excess overseas borrowing vary in severity. The Asian financial crisis of 1998, though sharp, turned out to be relatively mild. The cessation of borrowing coupled with measures to reduce imports (which diverted foreign-exchange earnings to loan servicing) and fresh international loans (or, in the Malaysian case, a mild rescheduling of repayments) proved sufficient to restore confidence. The regional fall in GDP was limited to 5 to 10 per cent, followed by a quite rapid recovery. Elsewhere, crises have included serious foreign-debt defaults and have generated peak-to-trough falls in GDP in the 20-to-30 per cent range. In recent times, the most extreme example of a country experiencing a severe crisis was Greece, with a 50 per cent fall in its GDP. However, the Greek case was atypical, because Greece is a member of the Eurozone, and its exchange rate is fixed. It is possible that the fall in GDP would have been less had it had its own currency to devalue.
Can economic breakdowns be avoided?
These costs are very large indeed, much greater than the cost of a typical recession. A major, if negative, goal of economic policy must therefore be the avoidance of such economic catastrophes. However, this goal has to be placed in context. In a medium-sized, open economy such as Australia, the threat of catastrophe is inherent in the country’s principal source of prosperity: trading and investment relationships with the rest of the world. The risk of this type of catastrophe can only be completely removed by eliminating overseas borrowing. A more workable choice is to accept that the threat of catastrophe lurks amid the opportunities opened up by international trade and investment, and to try to manage the threat. The need is for moderation in borrowing, and the adoption of a prudent approach to international economic relationships, as indeed there is a need for prudence in domestic economic relationships.
In the light of recent experience, many observers would write off calls for moderation and prudence as no more than pious hopes. Both optimism and pessimism are contagious, and what hope has moderation when faced with a fearlessly buoyant finance sector, or equally when trying to entice the sector out of a blue funk? Who is to keep a level head when all around are losing theirs? Since it is noticeable that busts generally follow booms, pessimism follows optimism, and funk follows elation, the calls for moderation concentrate on restraining over-optimistic behaviour. Once an economic breakdown threatens, and even more when it is under way, the actions required to limit the damage and reconstruct the economy are very challenging indeed. Hence the importance of avoiding crises, if at all possible.
As always, the pursuit of moderation itself requires moderation. It is too much to expect any human person or institution to observe continuous moderation in all things; too much moderation is not only inhuman, but may also suppress the restless spirit of innovation that is an important element in capitalism. However, it may not be too hard to invent institutions that identify and counterbalance threats of serious economic crisis — government and financial institutions that provide shelter from the excitements of everyday market action, and cultural institutions that can stand back from the excitements of the day. The particular challenge is to put in place institutions that can stand their ground, not only when memories of disaster are fresh, but during the following periods of complacency. The post-war experience is relevant: was the increased global incidence of banking crises after 1980 due to fading memories, or was it due to a failure to maintain defensive institutions?
Some of the concerned institutions will be internal to the sectors that are most at risk. As a matter of internal culture, it is important for governments and banks to value moderation and prudence, leaving the response to emerging opportunities to those with a real appetite for risk, and ensuring that these entrepreneurs have access to equity and venture finance. As regards institutions, within government it is the duty of Treasuries to counsel moderation, particularly as regards overseas borrowing. They should oppose borrowing that is unlikely to generate foreign exchange for loan-servicing; they should champion borrowing with good prospects of repayment plus a surplus. Within banks, it is the duty of treasuries to act in the long-term interests of the bank and to identify and oppose risky lending, no matter how juicy the apparent short-term profits.
We will argue that individual bank treasuries cannot do this unaided, particularly as regards loans financed from overseas borrowing. This requires the imposition of a second line of defence — national authorities charged to ensure that risky financial activity is confined to people who know that they are taking a gamble, and is not foisted off, unknown, onto a trusting public. Such prudential authorities, as well as the national Treasury, should be the custodians of the lessons of history and have the power to act, if not to maintain their economy on a precisely even keel, at least to head off catastrophe. They will therefore be attentive to the signs of economic breakdown and be ready with strategies to avoid it, if possible, or at least to minimise its impact. In this task of watching for danger signals, the prudential authorities (and, more broadly, economic analysts and the media) can take advantage of recent experience in countries that have experienced an economic breakdown. In particular, the European Union (EU), has made a concerted effort to learn from recent experiences both within and outside the union.
The European Commission indicators of macroeconomic imbalance
In recent years, much has been written about the dysfunctionality of the European Union, and, as we note in Chapter 8, the British public has voted that they would be better off out of it. This dysfunctionality is highly political, and is not helped by poor institutional design. To its credit, the European Commission (EC) has recognised the need for governments to coordinate economic policy, and is seeking to control the incidence of
bad debts internationally by discouraging both over-lending and over-borrowing. To this end, it has persuaded its members to participate in a ‘macroeconomic imbalance procedure’. Though, in theory, the procedure aims to identify which countries are over-lending as well as those that are over-borrowing, in practice the emphasis has been on the excessive accumulation of debt that results in financial crisis.
In 2011, the commission identified ten statistical indicators that, it argued, provided an early warning of macroeconomic imbalance sufficiently reliable to warrant corrective action being embarked upon, and also gave sufficient warning time to allow such action to be taken.4 The ten indicators are used to identify countries that are at enough risk of crisis to warrant a detailed investigation — following which, use would be made of ‘auxiliary indicators’ to allow a more nuanced assessment of the position. A year later, the commission promoted one of the auxiliary indicators to scoreboard status,5 and three years later it raised the status of three more.6
In the interests of ease of interpretation and statistical accuracy, the number of indicators was initially restricted to ten, with an emphasis on the competitiveness of each economy and on weaknesses that had in the recent past led up to economic catastrophe. The list emphasises indicators of structural weakness in trade and international investment, and that provide warnings of potential catastrophe for the information of the policy authorities in each country and also for each country’s partners in trade and investment. Within the EU, the indicators underpin policy discussions; outside the EU, they have no such formal status, but are still valid as warnings based on recent experience. It remains uncertain whether the indicators will give sufficient early warning to permit corrective action, and even less certain what that corrective action might be, or whether corrective action is politically possible. However, an early warning is at least a beginning.