Today, we’re fortunate to have a guest contribution by Jeffry Frieden, Stanfield Professor of International Peace at Harvard University, and author of the newly published Currency Politics: The Political Economy of Exchange Rate Policy (Princeton University Press, 2015). This post is based upon a portion of that book.
The recent volatility of major currencies reminds us of the close relationship between exchange rate movements and international debt dynamics. While many still think of currency values as important primarily for their impact on the relative prices of domestic and foreign goods, today arguably the principal importance of currency values is their effect on the relative prices of assets and liabilities – including their potential to cause debt crises.
“Twin crises” – linked currency and debt or banking crises – have been common for generations. Inasmuch as domestic firms, or the national government, borrow in foreign currency, large depreciations can massively raise the real cost of foreign-currency liabilities. This was true in the gold-standard era, and the experience has been repeated again and again, from the developing-country debt crisis of early 1980s and Mexico’s “tequila crisis” of 1994, through the 1997-1998 East Asian financial crisis and after.
The debt-currency dynamic has also been central to the Great Financial Crisis that began in 2007. Of course, the inability of countries in the Eurozone to use currency depreciation as a path to adjustment has been central to the continuing problems of Europe’s recovery.
European countries outside the Eurozone were also strongly affected by the connection between currency policy and foreign debt. The Baltic states were pegged to the euro, and in them some 80 percent of bank loans were in foreign currency. Most of this was mortgage debt, which made it politically virtually impossible to contemplate a depreciation, desirable as that might have been. They stayed pegged and suffered a 20-percent collapse of GDP. Meanwhile, Poland had a flexible exchange rate, and the proportion of bank loans in foreign currency was under a third. So the Polish government faced few political barriers to depreciating its currency by 40 percent when the crisis hit – thus avoiding a recession.1
Since 2010, the currency-debt connection has taken several twists and turns. As monetary policy in the G-7 headed toward the zero interest rate lower bound, investors in search of yield poured trillions of dollars into the emerging markets. The search for yield led investors to put money even into the local-currency debt of emerging-market governments. Governments from Peru to Thailand issued debt in their own currencies, in national markets, only to see most of it snapped up by foreigners hungry for the high yields they found there. This was not without problems: as capital poured into Brazil and the real appreciated, the Brazilian government complained that the U.S. was sparking a “currency war” that was impeding the ability of Brazilian firms to compete internationally.
But the main trend was the rapid growth of local-currency borrowing by emerging markets. As Wenxin Du of the Federal Reserve Board and Jesse Schreger of Harvard University show, in 14 major emerging-market economies, the share of government debt in local currency held by foreigners went from 15 percent in 2003 to 60 percent in 2012. The proportions vary: local-currency foreign-owned debt of the Colombian government was 15 percent of the total, while for Thailand the share was 98 percent. But overall, most of these countries’ trillion dollars in sovereign debt owed to foreigners was in local currency. The result was that emerging markets had apparently been absolved of “original sin,” the inability of developing-country governments to borrow long-term in their own currency.
The ability of emerging-market governments to borrow in local currency does not mean that currencies no longer matter for developing-country debt. Liability mismatches persist, but are now mostly in the private sector. While emerging-market governments owe well more than a trillion dollars to foreigners, most of it in local currency, emerging-market private corporations owe over two trillion dollars to foreigners – and 90 percent of this is in foreign currency.
This leaves the typical emerging market acutely exposed to currency movements that can dramatically increase the private-sector’s debt burden. If a government attempts to respond to a negative shock with looser monetary policy, the resultant currency depreciation can bankrupt households or corporations that are heavily indebted (and, as is typical, unhedged) in foreign currency. Brazil now finds itself facing some of these problems, as the real has dropped by more than 20 percent in the last six weeks.
The exchange rate is a powerful instrument of national policy, which can have major effects on the real economy. The use of this instrument is now substantially complicated by the impact of currency movements on the balance sheets of both the public and private sectors. An otherwise desirable depreciation can cause massive financial disruptions, even a descent into debt crisis.
The exchange rate and foreign debt are intricately linked. And they are both extraordinarily political, implicating powerful interests of all sorts. Government attempts to navigate the contemporary international economy find themselves – and will continue to find themselves – torn among conflicting pressures as they attempt to design policy. Currency politics is, and will remain, central to the global economy.
1. Stefanie Walter, Financial Crises and the Politics of Macroeconomic Adjustments (Cambridge: Cambridge University Press, 2013), pages 181-217.
This post written by Jeffry Frieden.