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How Countries Deal With Debt

By Brent Radcliffe

You’ve heard it before: someone runs into credit card or mortgage payment problems and needs to work out a payment plan to avoid going bankrupt. What does an entire country do when it runs into a similar debt problem? For a number of emerging economies issuing sovereign debt is the only way to raise funds, but things can go sour quickly. How do countries deal with their debt while striving to grow?

Most countries – from those developing their economies to the world’s richest nations – issue debt in order to finance their growth. This is similar to how a business will take out a loan to finance a new project, or how a family might take out a loan to buy a home. The big difference is size; sovereign debt loans will likely cover billions of dollars while personal or business loans can at time be fairly small.

Sovereign Debt

Sovereign debt is a promise by a government to pay those who lend it money. It is the value of bonds issued by that country’s government. The big difference between government debt and sovereign debt is that government debt is issued in the domestic currency, while sovereign debt is issued in a foreign currency. The loan is guaranteed by the country of issue.

Before buying a government’s sovereign debt, investors determine the risk of the investment. The debt of some countries, such as the United States, is generally considered risk free, while the debt of emerging or developing countries carries greater risk. Investors have to consider the government’s stability, how the government plans to repay the debt, and the possibility of the country going into default. In some ways, this risk analysis is similar to that performed with corporate debt, though with sovereign debt investors can sometimes be left significantly more exposed. Because the economic and political risks for sovereign debt outweigh debt from developed countries, the debt is often be given a rating below the safe AAA and AA status, and may be considered below investment grade.

Debt Issued in Foreign Currencies

Investors prefer investments in currencies they know and trust, such as the U.S. dollar and pound sterling. This is why the governments of developed economies are able to issue bonds denominated in their own currencies. The currencies of developing countries tend to have a shorter track record and might not be as stable, meaning that there will be far less demand for debt denominated in their currencies.

Risk and Reputation

Developing countries can be at a disadvantage when it comes to borrowing funds. Like investors with poor credit, developing countries must pay higher interest rates and issue debt in foreign stronger currencies to offset the additional risk assumed by the investor. Most countries, however, don’t run into repayment problems. Problems can arise when inexperienced governments overvalue the projects to be funded by the debt, overestimate the revenue that will be generated by economic growth, structure their debt in such a way as to make payment only feasible in the best of economic circumstances, or if exchange rates make payment in the denominated currency too difficult.

What makes a country issuing sovereign debt want to pay back its loans in the first place? After all, if it can get investors to pour money into its economy, aren’t they taking on the risk? Emerging economies want to repay the debt because it creates a solid reputation that investors can use when evaluating future investment opportunities. Just as teenagers have to build solid credit in order to establish creditworthiness, countries issuing sovereign debt want to repay their debt so that investors can see that they are able to pay off any subsequent loans.

The Impact of Defaulting

Defaulting on sovereign debt can be more complicated than defaults on corporate debt because domestic assets cannot be seized to pay back funds. Rather, the terms of the debt will renegotiated, often leaving the lender in an unfavorable situation, if not an entire loss. The impact of the default can thus be significantly more far-reaching, both in terms of its impact on international markets and of its effect on the country’s population. A government in default can easily become a government in chaos, which can be disastrous for other types of investment in the issuing country.

The Causes of Debt Default

Essentially, default will occur when a country’s debt obligations surpass its capacity to pay. There are several circumstances in which this can happen:

During a currency crisis: The domestic currency loses its convertibility due to rapid changes in the exchange rate. It becomes too expensive to convert the domestic currency to the currency in which the debt is issued.

Changing economic climate: If the country relies heavily on exports, especially in commodities, a significant reduction in foreign demand can shrink GDP and make repayment costly. If a country issues short-term sovereign debt, it is more vulnerable to fluctuations in market sentiment.

Domestic politics: Default risk is often associated with unstable government structure. A new party that seizes power may be reluctant to satisfy the debt obligations accumulated by the previous leaders.

Debt Default Examples

There have been several prominent cases in which emerging economies got in over their heads when it came to their debt.

  • North Korea (1987)
    Post-war North Korea required massive investment in order to jump start economic development. In 1980 it defaulted on most of its newly-restructured foreign debt, and owed nearly $3 billion by 1987. Industrial mismanagement and significant military spending led to a decline in GNP and ability to repay outstanding loans.
  • Russia (1998)
    A large portion of Russian exports came from the sale of commodities, leaving it susceptible to price fluctuations. Russia’s default sent a negative sentiment throughout international markets as many became shocked that an international power can default. This catastrophic event resulted in the well documented collapse of long-term capital management.
  • Argentina (2002)
    Argentina’s economy experienced hyperinflation after it began to grow in the early 1980s, but managed to keep things on an even keel by pegging its currency to the U.S. dollar. A recession in the late 1990s pushed the government to default on its debt in 2002, with foreign investors subsequently ceasing to put more money into the Argentine economy.

Investing in Debt

Global capital markets have become increasingly integrated in recent decades, allowing emerging economies access to a more diverse pool of investors using different debt instruments. This gives emerging economies more flexibility, but also adds uncertainty since debt is spread over so many parties. Each party can have a different goal and tolerance for risk, which makes deciding the best course of action in the face of default a complicated task.

Investors purchasing sovereign debt have to be firm yet flexible. If they push too hard on repayment, they might accelerate the economy’s collapse; if they don’t press hard enough, they might send a signal to other debtor nations that lenders will cave under pressure. If restructuring is required, the goal of the restructure should be to preserve the asset value held by the creditor while helping the issuing country return to economic viability.

Incentives to repay: Countries with unsustainable levels of debt should be given the option of approaching creditors to discuss repayment options without being taken to task. This creates transparency and gives a clear signal that the country wants to continue loan payments.

Providing restructuring alternatives: Before moving to debt restructuring, indebted nations should examine their economic policies to see what sorts of adjustments can be made to allow them to resume loan payments. This can be difficult, if the government is headstrong, since being told what to do can push them over the edge.

Lending prudently: While investors might be on the lookout for diversification into a new country, that doesn’t mean that flooding cash into international securities will always have a positive result. Transparency and corruption are important factors to examine before pouring money into expensive endeavors.

Debt forgiveness: Due to the moral hazard associated with letting debtor countries off the hook, creditors consider wiping a country’s debt clean to be the absolute last thing that they want. However, countries saddled with debt, especially if that debt is owed to an organization such as the World Bank, can seek to have their debt forgiven if it will create economic and political stability. A failed state can have a negative effect on surrounding countries.

Conclusion

The existence of international financial markets makes funding economic growth a possibility for emerging economies, but it can also make debt repayment troublesome by making collective agreements between creditors more complex. With no strict mechanism in place to make the resolution of problems streamlined, it is important for both the sovereign debt issuer and investors to come to a mutual understanding – that everyone is better off coming to an agreement instead of letting the debt go into default.

More from Investopedia: 

A Look At National Debt And Government Bonds

What The National Debt Means To You

How Debt Limits A Country’s Options

Successful Ways That Governments Reduce Federal Debt

Why Country Funds Are So Shaky

Great Company Or Growing Industry?

By Jason Van Bergen

It is no accident that companies within a particular industry move in lock-step with one another. Companies in a single industry are forever bound by the type of product or service that they provide, and they are constantly competing with one another for market share, consumer acceptance and technological leadership in their particular sub-sectors. These competitive and consumer forces shape an industry’s corporations and determine the status of the industry as a whole. These forces have followed roughly the same patterns over time. Here we take a look at these stages and how they affect the companies that follow them.

Initial Growth/Emerging Industries

All companies have to start somewhere, and it takes only a single company or small group of companies to jumpstart an entire industry. Looking back in time, we see that it was not even a company but an individual by the name of Alexander Graham Bell who, with the invention of the telephone, started the entire industry of telecommunications. More recently, companies like Texas Instruments and Fairchild Semiconductor Corporation pioneered the semiconductor industry with the invention of the microchip, the central component of all computers and most high-tech electronics gear.

Companies involved in establishing emerging industries are generally participating in perilous business, as their primary concerns are raising sufficient funds to engage in early-stage research and development. In their developmental stages, which may last months or even years, these companies are likely operating on a shoestring budget, while at the same time presenting to the world a product or service that has yet to be accepted. These pioneering companies might face bankruptcy, development failure and poor consumer acceptance.

Companies in emerging industries are typically recommended to investors with a very high risk tolerance. An adage often used in relation to an initial growth investment is “If you cannot afford to lose your investment in this company, do not make the investment in the first place!”

Individual investors are likely to have access to initial growth companies through private investments, sometimes called “friends-and-family capital”. At such an early stage, investors often know the company founders personally. And they can only hope to make a profit on their investment in the distant future, when the company offers its shares on a secondary trading market, or when the investor can find somebody else to purchase his or her ownership at a premium (which would take place, for example, if another company were to purchase all of the outstanding shares of the company).

Companies in emerging industries are occasionally quoted on major stock exchanges or traded over the counter, and should always be considered in terms of the significant risk they pose. These companies will often be unprofitable, and the large initial start-up costs may result in ongoing negative cash flows. As such, traditional fundamental analysis is often not applicable in emerging industries, and investors must be sophisticated enough to learn or even develop entirely different means of analyzing these stocks. Investing in emerging industries is not for the faint of heart.

Rapid Growth Industries 

Companies in industries that are benefiting from rapid growth have sales and earnings that are expanding at a faster rate than firms in other industries. As such, these companies should display an above average rate of earnings on invested capital for an extended period of time, probably years. Prospects for rapid growth companies should also appear bright for continued sales and earnings growth in ensuing years.

During this period of rapid growth, companies will eventually begin to lower prices in response to competitive pressures and the decline of costs of production, which is often referred to as economies of scale. But costs decrease at a higher rate than prices, so companies entrenched in growth industries often experience growth in profits as their product or service becomes fully accepted in the marketplace. The consumer electronics industry, for example, is characterized by much research and development, followed by significant economies of scale in production. Prices in home electronics inevitably fall, but the costs of production fall faster, thereby ensuring increasing profitability.

Publicly traded companies involved in rapid growth industries, often referred to as growth stocks, are some of the most lucrative investments due to their ability to sustain growth in revenues and profits over long periods of time. Microsoft is an excellent example of a company that became very large in a growth industry (software) over a period of years, increasing its earnings all the while and, most importantly, maintaining its expectations for continued future growth.

Mature Industries

Once an industry has exhausted its period of rapid growth in revenues and earnings, it moves into maturity. Growth in companies in mature industries closely resembles the overall rate of growth of the economy (the GDP). Earnings and cash flow are still likely positive for these companies, but their products and services have become less distinguishable from those of their competitors. Price competition becomes more vicious, taking profit margins along with it, and companies begin to explore other areas for products or services with potentially higher margins. Many of our economy’s most closely watched industries, such as airlines, insurance and utilities, can be categorized as mature industries.

Despite their rather staid position in mature industries, investments in these companies’ stocks can remain very attractive for many years. Share prices within mature industries tend to grow at a relatively stable rate that can often be predicted with some degree of accuracy based on sustainable growth prospects from historical trends. Perhaps even more importantly, companies in mature industries are able to withstand economic downturns and recessions better than growth companies, thanks to their strong financial resources. In troubled times, mature companies can draw from retained earnings for sustenance, and even concentrate on product development in order to capitalize on the economy’s eventual return to growth. Investors in mature industries are those who want to enjoy the potential for growth but also avoid extreme highs and lows.

Declining Industries

Seven Emerging Currencies Challenging The Forex Hierarchy

By Elvis Picardo

In the turbulent world of foreign exchange, the seven most heavily traded currencies occupy a fairly rigid hierarchical order. But though some position shuffling does take place in the top ranks, those moves pale in comparison to the action on the next rung of the forex ladder. In recent years, a number of second-tier currencies have seen a huge increase in their share of global forex turnover, posing a challenge to the established hierarchy. While some of these seven currencies may be obvious, others are less so. Before we delve into learning more about these emerging currencies, let’s take a quick look at the colossal global forex market and the currencies that presently dominate trading in it.

Global Forex Turnover is Soaring

The Bank for International Settlements’ (BIS) triennial survey of forex turnover (or trading volume) is perhaps the most authoritative source of global forex trading data. According to the BIS survey conducted in April 2013, global forex market activity was a staggering $5.3 trillion per day in that month, an increase of 33% from daily turnover of $4 trillion in 2010. Forex turnover has more than quadrupled since 2001, when it was just over $1.2 trillion.

Total forex turnover is estimated to have declined by about $300 billion since the survey period to approximately $5 trillion, which still represents an impressive 25% growth rate from 2010. Expectations of a major shift in Japan’s monetary policy led to exceptional forex trading activity – particularly in the yen – in the run-up to the April 2013 survey.

The Established Forex Hierarchy 

The 2013 BIS survey showed that the U.S. dollar continued to be numero uno by a very wide margin, contrary to occasional speculation about the greenback’s eventual demise. The U.S. dollar accounted for an 87.0% share of average daily forex turnover in April 2013. (Note that since two currencies are involved in each forex transaction, the sum of the percentage shares of individual currencies will total 200% rather than 100%.)

The next three positions were occupied by the euro (33.4% share), Japanese yen (23.0%) and British pound (11.8%). Among the major currencies, trading in the yen surged the most, rising 63% since the 2010 survey for reasons mentioned earlier. These top-four currencies have had the same ranks in the global currency hierarchy in this millennium, although their relative turnover share has fluctuated to a limited extent over the years.

The next three currencies in the April 2013 survey were the Australian dollar, Swiss franc and Canadian dollar. These currencies have swapped places among themselves since 2001. For example, the Australian dollar ranked seventh that year, but it doubled its share of global forex turnover since then to become the fifth-most traded currency in 2013.

Currency Challengers to the Status Quo

Four of the seven leading second-tier currencies are easy to identify, belonging as they do to the biggest emerging economies or BRIC – the Brazilian real, Russian ruble, Indian rupee and Chinese renminbi (or yuan). The other three currencies are less obvious – the Mexican peso, Turkish lira and South African rand. The collective share of average daily forex turnover of these seven currencies has increased from 6.2% in 2010 to 10.8% in 2013 (as mentioned earlier, the sum of individual currency shares totals 200%). Note that all seven currencies belong to emerging market economies (EMEs).

There has been a phenomenal increase in daily turnover for some of these currencies, with the biggest trading surges recorded by the Mexican peso, Chinese renminbi and Russian ruble. Turnover in the Mexican peso increased 171% from 2010 to $135 billion in 2013, giving the currency a 2.5% share of global forex trading and making it No. 8 among the most actively traded currencies. However, the biggest increase in forex trading was recorded by the Chinese renminbi, as daily turnover soared 250% since 2010 to $120 billion in 2013, giving it the No. 9 position among the most-active currencies. The Russian ruble also had a 140% increase in daily forex turnover to $85 billion, enabling it to climb four spots from 2010 to the No. 12 rank in 2013.

The increased share of forex turnover by these emerging currencies has come at the expense of major currencies such as the euro, Swiss franc and Canadian dollar. With the international role of the euro having contracted since the continent’s sovereign debt crisis erupted in 2010, euro forex turnover increased only 15% from 2010 to about $1.8 trillion per day. Although the euro remains the second most traded currency worldwide, its share of global forex turnover declined by almost 6 percentage points to 33.4% in 2013.

Carry Trades and the “Fragile Five”

Leveraged carry trades may partly explain the exponential increase in EME currency trading, but they are far from the only reason. Most of these seven currencies offer high interest rates, making them favored targets for carry traders. For example, as of May 22, 2014, the yield on 10-year government bonds in some of these nations was as follows – Brazil, 11.18%; India, 8.71%; and South Africa, 8.04%. Contrast those yields with the 2.55% yield on the U.S. 10-year Treasury, and it’s easy to see why those interest differentials may be so alluring to savvy traders.

But the high interest rates offered by many EME currencies are there for a reason – rampant inflation. A number of these emerging economies are also beset by structural issues such as growing current-account and budget deficits. In fact, these weak economic fundamentals led Morgan Stanley (MS) last year to identify a group of emerging economies as the “Fragile Five” – Brazil, Indonesia, India, South Africa and Turkey. These five economies have – on average – a budget deficit of 4.0%, current-account deficit of 4.1% and inflation of 7.5%. Concerns that tighter U.S. monetary policy would make it difficult for these nations to attract foreign capital to fund their deficits led to sharp declines in their currencies and stock markets from the summer of 2013 to early 2014.

According to an analysis by BIS staffers, quantitative forex strategies such as carry trades and momentum trades were unlikely to have been the main driver of turnover growth from 2010-13. Over this period, shrinking interest rate differentials due to easier monetary policy by many central banks, the narrow trading range for most major currencies and sudden policy actions – such as those taken by the European Central Bank during the debt crisis – made it an especially challenging time for quant strategies. As a result, quant currency hedge funds had substantial outflows, with assets under management declining from a peak of $35 billion in 2007-08 to just over $10 billion by 2013.

So What is Driving Forex Turnover?

Based on BIS data and findings, three main drivers may account for rapid growth in forex turnover of the emerging-market economies:

  • Exceptional demand for OTC forex derivatives: Forex growth in the EMEs has been led by very strong demand for over-the-counter (OTC) derivatives such as currency forwards, swaps and options. OTC derivatives turnover rose by 41% over the 2010-13 period, from $380 billion to $535 billion, compared with an increase of 17% in spot-forex turnover. This supports the view that hedging demand and speculation by foreign portfolio investors is a primary driver of higher forex turnover.
  • “Internationalization” of emerging-market currenciesOffshore trading – or trading of a currency outside the jurisdiction where it is issued – is a gauge of a currency’s “internationalization.” The offshore component has had the most rapid growth in EME currencies, especially for the Asian currencies such as the renminbi and rupee, with offshore trading contributing as much as 35 percentage points to growth of 41% in the 2010-13 period. The Chinese renminbi is playing an increasingly important role within Asia in this regard, with offshore turnover of $86 billion daily, which amounts to 72% of its global trading volume.
  • “Financialization” of EME currencies: For decades now, the increase in global forex turnover has been magnitudes higher than underlying growth in the global economy or worldwide trade. Growth in EME forex turnover is no exception to this trend, implying that “financialization” of these currencies will continue. That said, part of the forex volume growth can be attributed to higher portfolio flows, with BIS analysis suggesting a positive and statistically highly significant relationship between portfolio inflows and outflows in emerging markets and forex turnover in the respective currencies. For instance, a 10% increase in cross-border fund flows is associated with a 7% increase in global forex turnover for Asian currencies, and a 10% increase for Latin American currencies.

The Table below shows the extent to which forex turnover exceeds GDP and total trade (imports and exports of goods and services) for these seven economies. The ratio of annual forex turnover (calculated on the basis of 250 working days in a year) to GDP ranges from a low of 3.6 for China to a high of 39 for South Africa, compared with an average of 63 for the seven most widely traded currencies. By that measure, the financialization trend of these seven currencies – in particular the BRIC nations – looks unlikely to change.

Rank* Economy 2012 GDP 2012 Trade Daily FX Est. Annual Annual FX Annual FX
(US$ billions) (US$ billions) turnover ($bn) FX T/O ($bn) Turnover  / GDP Turnover  / Trade
2 China 8,227 4,337 120 30,000 3.6 6.9
7 Brazil 2,253 592 59 14,750 6.5 24.9
8 Russia 2,015 1,026 85 21,250 10.5 20.7
10 India 1,859 1,052 53 13,250 7.1 12.6
14 Mexico 1,178 776 135 33,750 28.6 43.5
17 Turkey 789 450 70 17,500 22.2 38.9
28 South Africa 384 211 60 15,000 39.0 71.1
* Global economy rank based on 2012 GDP

The Bottom Line: As these seven economies continue to grow in size and stature in the years ahead, a combination of hedging and speculative demand, internationalization and financialization may lead to them accounting for an increasing share of global forex turnover for the foreseeable future.

More from Investopedia:

Will OIS Replace LIBOR?

The Insiders Who Fix Rates For Gold, Currencies And Libor

How The Forex “Fix” May Be Rigged

For Individual Investors, These May Be The Best Of Times 

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