The 2018 Debt Crisis

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The 2018 Debt Crisis

What do the Turkish lira, the Iranian rial, the Russian ruble, the Indian rupee, the Argentine peso, the Chilean peso, the Chinese yuan and the South African rand all have in common? They’ve all declined steadily this year, and some have depreciated dramatically this summer. But, that is just the latest chapter in a long story.

The truth is that those countries except Iran are sitting on a ticking time bomb of external debt denominated in U.S. dollars. External debt is money that is borrowed from abroad in a foreign currency. For instance, Turkey’s currency is the lira, and when it issues a debt security denominated in a foreign currency, it is increasing its external debt.

External debt comes with all the challenges that debt denominated in a domestic currency does, plus other challenges. In the case of Turkey, if it borrows in liras, then it pays interest and principal back in liras. If the lira depreciates against other currencies, Turkey’s debt doesn’t get more difficult to service. In fact, it gets easier to service, since it owes the same amount of lira, but the currency is worth less. Increasing the money supply lets a country pay back its debt with cheaper currency, effectively inflating its way out of a debt burden. And, while “printing money” carries its own risks, it still leaves the country and its central bank as the masters of its “debt destiny.”

External debt, however, removes this flexibility. Instead, it links the borrower’s ability to repay to the exchange rate between its currency and a foreign currency. And, since the debt must be repaid in a foreign currency, if the local currency depreciates against that foreign currency, then it will take more of the local currency to service the same amount of debt. For example, if Turkey were to borrow $100 million at a 10 percent rate in U.S.-dollar denominated debt, it would owe $10 million per year. If the exchange rate between the lira and the dollar were 2-to-1, then Turkey would owe 20 million liras per year. But, if the lira depreciated relative to the dollar and the exchange rate became 4-to-1, then Turkey would still owe $10 million a year, but that would be equivalent to 40 million liras per year. In effect, the cost of its debt service would double simply because of exchange rate fluctuations. And, though Turkey may have dollar reserves to help alleviate this situation, it cannot print dollars to inflate its way out of this debt as it could with lira-denominated debt.

This is the fundamental problem of external debt; that is, if the borrowing country’s currency were to depreciate, its debt would become costlier to service...

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