Here’s How “External Dollar Debt” Produces An “Emerging Market Crisis”, by John Rubino

Borrow in dollars and convert them to your home currency and you are essentially short dollars. Which is okay, unless the dollar goes up against your home currency. Then you’re in trouble. From John Rubino at dollarcollapse.com:

Emerging market currencies are collapsing pretty much everywhere these days. But it’s safe to assume that most people don’t understand exactly what’s causing this outbreak, why it’s happening now, or what “external dollar debt” has to do with it. So here’s a quick primer followed by the obligatory apocalyptic prediction:

Prelude: cheap dollar financing
Pretend for a second that you’re Brazil. Your economy is in pretty good shape and your currency – the real – is getting stronger. Because of this, people are willing to lend you money.

Your internal interest rates – that is, what you’d have to pay to borrow real – are around 6%.

But when you look overseas you notice that US dollars – which have been trending down for a while – can be borrowed for around 2%. So you run some numbers and conclude that if you borrow dollars and assume that the real continues to rise against the dollar, you’ll make out two ways, on the spread between what you pay for those dollars and what you earn by investing them, and when you pay back the loans with depreciated dollars. So you borrow dollars, not just a little but a lot because with a lot you make a fortune.

So far so good. For a while the dollar keeps falling versus the real and you earn a nice spread. You feel smart, like you’ve figured out international finance and henceforth will will have a seat at the big table.

US dollar index external dollar debt

The turn
But then the unexpected (for you at least) happens. The dollar stops falling and starts rising.

US dollar index external dollar debt

And suddenly the spread you’re making on your external dollar debt no longer offsets the cost of paying back those ever-more-expensive dollars. That’s bad but manageable as long as the trend (dollar rising versus the real) doesn’t get too extreme. But the financial markets don’t like what they’re seeing and traders start selling real, forcing its value down further. Now you’re looking at massively negative cash flow and a possible death spiral as the markets sell your currency, which makes your dollar loans even more unmanageable and so on, with no end in sight.

To continue reading: Here’s How “External Dollar Debt” Produces An “Emerging Market Crisis”

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