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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