Sunday, January 31, 2010

Restructuring the World's balance sheet

Restructuring a balance sheet is conveniently made possible in the US through a bankruptcy filing. A restructuring is required, usually, when a company's debt load - in terms of interest or principal payments - cannot be supported by cash financing or postponement of any kind.
Now, let's broaden this concept to cover countries. It is common knowledge that in addition to a government's receipts, most of a country's financing is fulfilled by government securities, usually through bonds. These bonds are issued domestically and internationally. Countries have different proportions for both these categories.

If a govt. cannot fulfill its debt obligations towards its own citizens, it can just print money and pay back its creditors. Sounds simple. Of course, this would require disclosure and would generate inflationary pressures. What this would also do is depreciate the home currency.
This is closely related to international behaviour. Let's say that India does not have foreign currency with which to pay off its debt (unless it can manage to get a refinancing), India would be forced to devalue or depreciate its currency so that the forex denomination can be fulfilled. This would be much to the dislike of the foreign counterparty.

Now, a country can issue debt outside of the homeland in any currency it chooses to, as long as it believes that it will have the capability to fulfill the obligation intermittently and at maturity and as long as the issue generates interest. For example, Canada is planning an issue of 1 billion Euro.
The case, as many of us know, is very different for US, where most of its issuances are in the home currency. The de facto trade currency and forex reserve currency is the USD, therefore other countries would love to funnel the same USD back to USA to finance USA (indirectly). And this is what China is *forced* to do.


Now let's see what usually happens in a financial crisis or at times of distress or fear. People prefer taking back their money and if that is not possible, they prefer not refinancing debt of companies.
Could that happen with the US?
Yes.
But this poses a new problem; what would the countries do with the idle USD?
The first mover wins, but the Goliath that is the USD cannot be easily converted without pressurising the USD itself. However, this is an eventuality because US will be forced to print USD sooner rather than later to fulfil its interest payments and debt obligations.
Printing = depreciation = erosion in value of USD
Somewhere that will lead to or be derived from higher yields on long dated treasuries.

The entire issue that makes today nothing like earlier times is that the USD is humongous and countries are trapped. There has to be a deleveraging, the same way that it occurs at times of financial crises. The questions is when and with what fury that will occur.
My bet is that this should happen by the end of 2010.

Let's note again, that inflation is a holistic number.
When we look at inflation in China, real estate prices are up 30%+ in some areas and food prices are up 50%+ for some items. This is the same story, even in India. Even when one speaks to Americans, they will say that prices of vegetables and bread, etc. have risen dramatically.
I have such a sad sinking feeling that the last 20-30 years of global prosperity are prone to a deflation (bubble wise). I see a sort of global freeze. I also think that this is the weakest part of my argument, but one that is not implausible.

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