Wall Street Confidential

The Desperate Plight Of The Newly Submerging Nations


October 25,2008

by Edward Jay Epstein


 

Countries may succeed in bailing-out their banks, but who will bail-out these countries? From tiny Iceland (population 320,000), which is still on the verge of bankruptcy, to Pakistan (population 173 million), which is on the verge of running out of money to pay for imports, over a dozen countries are on the watch list for a sovereign debt default. Even some countries with (until recently)thriving economies, such as Brazil, Turkey, Mexico, and Russia, are under review for sovereign credit downgrades.

What helped fuel this crises was a currency arbitrage innocuously called “carry trades.” They work like this. A bank, hedge fund or other kind of arbitrageur sells the currency of a country with a very low-interest rates and then buys the currency of a country paying a higher-rate. By simply holding the currency, the arbitrager collects the "carry," which is the difference in the two interest rates.  As this game was played over the past five years, arbitragers sold short trillions of dollars and yen, since they were the only low-interest currencies that they could safely sell short in such huge volume, and they bought an equivalent amount of currencies in emerging markets in Latin America, Eastern Europe, South Asia and Africa that paid higher interest rates. They required little, if any, capital as collateral to support such carry trades, especially if they were banks.  Their only risk was that the local currencies would lose their value against the dollar and yen. They were willing to assume this risk since they believed it unlikely that Japan, being an exporting economy, would not allow its yen to rise, or that the US dollar would substantially rise.   But then came a near collapse of the global banking system, which, surprise, sent the dollar shooting up. Facing catastrophic losses on their massive carry trades, arbitragers moved to unwind them by selling local currencies at whatever price they could get and buying back the dollars and yen that they were short. This unwinding sent local currencies into a further tail spin–- the Brazilian Real, for example, lost over one-third its value-- while driving the dollar and yen ever higher.  In the panic, these once emerging, and now submerging economies, lost much of the hard currencies that they desperately needed to meet debt commitments.  Will these countries default as Argentina did in 2002 and Russia did in 1998?  The International Monetary Fund can prop up some of these dominoes before they default, but  even its funds are too limited to save them all.

For the prudent investor looking into this abyss of global panic, what stares back, at least for the moment, is the only safe harbor big enough to ride out a gathering storm of sovereign debt defaults,  the US dollar.
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Questions? Email me at edepstein@worldnet.att.net
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