Unintended Consequences: Tempering Interest Rate Increases (Mar 2023)
Risk Commentary
Unintended Consequences: Tempering Interest Rate Increases (Mar 2023)
Announcement: 2022 was a record year for Egan-Jones Ratings. The firm continued to cement its position as the leader in private debt ratings by issuing approximately 2,700 ratings - more than in any prior year. Our performance statistics continue to demonstrate our favorable default experience in 2022. Only one of our rated transactions in 2022 defaulted. It was previously rated CCC+. This was similar to prior years' default experience.
When a problem is too large to be solved, it simply will not be solved. To break inflation, most developed nations have increased interest rates but with inflated debt levels, several countries have little ability to absorb the increased rates. Furthermore, limited foreign currency reserves restrict the ability of central bankers to protect from devaluations. One could argue that several countries are entering into a point of no return. Unfortunately, all three of the four countries we identify are allies of the U.S., thereby presenting the risk that the U.S. will be required to provide some support. Note, the elevated sovereign debt to GDP for many developed countries is likely to temper the inflation-fighting interest rate increases.
There are several conditions that lead to a currency’s devaluation and often simultaneously, its credit quality. Typically, a country’s current account (i.e., generally exports less imports of goods adjusted for investment income) and capital accounts (inflows less outflows of capital) are in crisis. Foreign creditors are unwilling to provide funding because of repayment concerns.
When a country requires foreign capital but has difficulty accessing it, the typical recourse is to request funding via the IMF. Many bemoan the terms typically imposed by the IMF, but unfortunately there rarely is an alternative. The standard playbook for the IMF is currency depreciation (to make exports less expensive and thereby reduce the current account deficit), taxes increases, and government spending reduction. (Supply siders vehemently disagree with these measures, but rarely are their voices heard.) Unfortunately, IMF policies are not popular with the voting population, and a change in government is common. Unfortunately for creditors, devaluation reduce real yields.
For investors, the challenge is to identify devaluation candidates and possibly benefit from likely actions. George Soros was a master at this game and is attributed with “breaking the Bank of England.” As of the early 1990s, UK GDP growth was approximately half than that of Germany [1] perhaps due to the UK’s socialistic policies adopted post World War II and Germany’s unification with East Germany. Germany also developed global leading industries in autos, machine tools, chemicals, and pharmaceuticals whereas the UK’s leading generators of inflows were probably financial services and entertainment, both which were second tier relative to the US. Below is a description from Forbes.
After German reunification, in Soros' view, it was only a matter of time before the European Exchange Rate Mechanism came unglued. … it was clear to just about everyone that some European currencies -- the British pound and Italian lira, for example -- were fundamentally overvalued in relation to stronger ones such as the deutsche mark and French franc. As Britain and Italy struggled to make their currencies attractive, they were forced to maintain high interest rates to attract foreign investment dollars. But this crimped their ability to stimulate their sagging economies. While the British and Italians tried to deal with weak economies, Germany embarked on a policy of trying to restrain its own economy, overstimulated by the spending on eastern Germany.” [2]
Now for the hard part of identifying vulnerable candidates in the current market. As mentioned, we believe there are four leading candidates.
Turkey – stated inflation is near 50% per annum while real inflation is probably near 80%
Japan – sovereign debt to GDP is near 240% and population is in decline
Italy – minimal growth and debt to GDP near 150%
China – massive overhang from failed housing projects, shifts away from China as a manufacturing source, COVID lockdown overhang, likely overstatement of GDP and understatement of debt.
We will provide a more detailed description of possible outcomes in future installments.
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[1] https://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG?locations=GB
https://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG?locations=DE
[2] https://www.forbes.com/sites/steveschaefer/2015/07/07/forbes-flashback-george-soros-british-pound-euro-ecb/?sh=7ff634356131
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