Fool's Eye View

[ September 25, 2000 ]

Debt and Emerging Markets

By Alan Oscroft (TMFAlan)

Liverpool -- The first thing I read this morning when I caught up with my Foolish online reading was this excellent piece from Bill Mann (TMF Otter) of the US Fool. His mention of the part that debt played in Thailand's crash (which was the domino that started the whole chain of Asian disasters) and the approaching similarities with the current US economy brought home some mixed memories of just how good things looked before the Thai crash, and how horrible things have been in the few years since.

Killer Debt

Bill is absolutely right, of course. Thailand had an economy that was easily capable of long-term sustainable growth (in fact, it still has, but that growth has been set back a few years now). But the long-term sustainable rate of economic growth, through experience, seems to come in at just a few percent per year. Thailand's double-figure growth year on year was an anomaly, but many simply saw it as the "Asian phenomenon" as though simply being in a certain part of the world made a difference to long-term economics.

That excessive growth was financed by debt. Amongst other excesses, land was cheap and lots of people saw property development as a sure-fire winner. With the economy growing at more than 10% per year, the demand for condominiums and office blocks was sure to be insatiable. Building them required borrowing sackfuls of money, of course, but 10% growth per year for ever should make it easy to pay off. Today, the Bangkok skyline is crowded with splendid, but often half-empty, high-rise buildings.

It's Worse Than That, Jim

That wasn't all, though. Though a crash of sorts was almost certainly inevitable, it took impressive financial policies on the part of successive governments to bring about the full extent of the horrors that were to come. Those governments did two very bad things. Firstly, they pegged the currency, the Thai Baht, to the US dollar. "The US dollar is a strong and stable currency," went the thought, "so hanging on to its coat tails will be good for us." The second big mistake was setting very high domestic interest rates (which, on its own and with a floating currency, might not have been so bad, but...).

With baht-denominated borrowings costing in the region of 15% per year in interest, dollar-denominated borrowings costing less than half that, and the baht being pegged to the dollar so that repayments were safeguarded, guess what kind of money everyone borrowed? Yep, dollars.

But free lunches of that nature can't go on for ever, and something had to break. What broke was the currency peg, and the baht halved in value as soon as it was allowed to float. Suddenly all those companies that were laden with dollar-denominated debt found their debt burden had effectively doubled. They fell like ninepins, taking the banks and finance companies that had handled the borrowings along with them.

It Couldn't Happen Here, Could It?

In two ways, exactly this kind of disaster can befall private investors here in the West. The first and perhaps most obvious disaster is the one that awaits imprudent investors in "emerging markets". While a country can have a great long-term economic potential (as is very likely the case with Thailand), the short- and medium-term profitability of investments in it can turn far more on governmental mismanagement and short-term greed than on long-term economic potential itself. Governments in emerging countries are relatively inexperienced in running economies, have far less genuine accountability than those of more mature Western countries, and therefore stand a considerably lower chance of helping to turn potential into reality.

So beware. Before trusting your money to an emerging economy find out a bit about the prevailing political and economic conditions and, very importantly, make sure you understand the real debt situation surrounding your chosen companies and countries. If you know about such things, then by all means go for it. But if you don't, you're just gambling. Remember, the only "emerging economy" that has shown reliable long term growth so far has been the American one, and that suffered early mismanagement too.

It's Your Debt

The US debt situation that Bill described isn't as bad as the stuff that the Thai fan was hit with, but that shouldn't make us complacent. While the whole US economy isn't on the brink of bankruptcy (not yet, anyway), the most heavily debt-laden companies just might be. If a company is only just managing to cover its debt right now, think what will happen if interest rates are raised to try to contain an overheating economy, or if the company sees its revenues fall due to lowering demand, or both (a reduction in demand is what raising interest rates is supposed to bring about, after all).

When you buy shares in a company that has lots of debt, it becomes your debt. It's yours in exactly the same way as it would be had you gone to the bank and borrowed the money yourself. And the smaller the margin by which a company manages to service its debt, the riskier is the investment.

Where Next?

American Shares -- How the Recession Will Begin
Value Investing -- How much debt is too much?