Friday, September 19, 2008

Currency Crisis A-B-Cs

I got a few emails requesting a little background information on economics and finance as it relates to currency crises. For those familiar with the subject this is a post to skip.

The US, like any other nation is a corporation. A corporation is, literally, an embodiment- for our purposes, a financial embodiment. Like an individual, corporations have balance sheets with assets and liabilities, and as we have been learning recently, when liabilities exceed assets and extra finance is not to be found, they can go bust.

Imagine simple corporation XYZ that makes widgets (that's right out of the textbooks). Its assets are its production plant, any cash or account balances, and uncollected billings (accounts receivable). It's liabilities are unpaid bills (accounts payable), debt and shareholder equity. We'll leave out taxes for fun. Assets and liabilities must be equal, thus the term balance sheet.

The above paragraph is a "stock" (as opposed to flow) analysis.

On the flow side, the corporation (hopefully) is making enough revenues from sales to more than cover its labor costs, maintenance costs, dividends (if applicable) and debt service payments. If so, over time, assuming constant dividends, XYZ's asset side of the balance sheet will grow as cash and account balances rise and by virtue thereof, assuming no other changes, shareholder equity will rise.

Alternatively, if XYZ is not making a profit, and its labor costs, maintenance costs, dividends (if applicable) and debt service payments remain constant, the asset side of the balance sheet will shrink and, assuming no other changes, like a debt increase (we'll get to that next), shareholder equity will shrink, perhaps even becoming negative.

Many corporations, and virtually all start-ups experience negative equity, which is not to be confused with insolvency. Insolvency refers to a corporation's inability to pay its bills and/or service its debt.

If XYZ is running low on cash it can either sell more shares (dilution) or take on more debt, if it can find a source of funds.

The same analysis applies to governments with a few modifications.

There is (except in very unusual situations) no shareholder equity of a nation. Its property, cash and account balances, and unpaid taxes are its assets while its liabilities are unpaid bills and debt.

On the flow side, taxes are its revenues which it spends on, e.g., military, debt service, education or welfare. If taxes are insufficient to cover spending, it either sells property or raises debt.

In a closed (no foreign trade or capital flows) nation, there are no currency crises in the sense of the term we're using. The government can, if mismanaged, become insolvent but it needn't worry about being forced to do anything by foreigners (we'll leave aside complications like war).

In an open nation, currency issues add a bit of complexity.

Open nations have what is called an external or current account- the inflows and outflows of trade and investments. Other things equal, a nation that runs a current account deficit, by, say, importing more than it exports, will increase the supply of its currency held by foreigners, which can be thought of as IOUs on future output. Over time, this tends to lead to a decline in the value of that currency among foreigners (a currency crisis), who may refuse to export to the nation in question more than it gets back in imports. This, in turn, often results in adjustments in the domestic economy (the real sector), reducing imports and/or increasing exports. These adjustments can be inspired by changes in relative prices or by fiat (government decree).

In general, bringing a current account in deficit back to balance and then to surplus (to repay the IOU holders) is unpleasant in much the same way that a family will find it unpleasant to shift from an increasing debt load to paying down that debt.

Sometimes (OK often) a nation will take on foreign currency denominated debt. This usually forces the nation to run a trade surplus to generate sufficient foreign currency receipts to pay debt service (interest and principal). Alternatively, and this is when things get messy, foreigners are, sometimes, willing to lend increasing amounts of money (almost always foreign currency denominated) over time. Under these conditions, the nation can choose to run a trade deficit, using the cash lent by foreigners to pay debt service and balance the trade deficit.

Eventually, though, the external debt load becomes large, the trade balance becomes very negative (I'll leave aside consideration of domestic debt) and the prospects of the nation repaying the debt in the proper currency comes into question.

Wham-O...instant currency crisis.

The inflows of cash become outflows, necessary foreign currency to pay debt service and maintain the trade position cannot be found and the IMF comes knocking.

Unless, of course, you happen to issue the world's reserve currency, which is tomorrow's focus.