We’ve seen a number of foreign debt based crises in the last few years with both Turkey and Argentina suffering from substantial episodes of inflation related to foreign denominated debts. Without getting bogged down in the specifics of these cases I want to touch on a more general question:
Why do countries borrow in foreign currency?
I reached out to an international banker I know for his opinion on why this theme seems to keep occurring. Here’s what he had to say:
Many countries have to borrow dollars for both internal and external purposes. If their currencies are not freely convertible currencies and/or are not accepted by the other party or parties in payment for goods or services, the country has to borrow a more liquid currency (usually USD) to meet such obligations. If the country generates dollars, euros, yen, sterling, swiss francs, etc. from its exports, then it may not need as much in borrowings as those who do not. A good example is virtually any oil based economy. They generate huge amounts of dollars that are then used for infrastructure projects like roads, dams, power plants, housing, etc. These projects are predominantly undertaken by foreign contractors and they want to be paid in dollars or yen, etc. These countries often have to use the foreign contractors because they don’t have the domestic scale or skills to do the work necessary to advance the infrastructure to a more developed technological standard.
At the same time, countries have to have foreign exchange available to meet the demands of their corporate and to a much lesser degree their populations. When a company needs to buy a product or raw materials or pay for services rendered that are priced in dollars, they need to buy that foreign currency from their local banks who in turn, have to buy from the Central Bank or another bank that will buy the local currency against the foreign currency.
Lesser developed economies find themselves in a continual race to advance their technologies to meet first world standards. For instance, as the developed world advances their energy grids lesser developed economies are constantly racing to hire foreign workers who can help them develop the same technologies domestically. This often results in the government or domestic companies getting locked into payment contracts denominated in a foreign currency.
There are other reasons that a country might need to borrow in a foreign currency, but as my friend stated, this is the most common one and probably the simplest to understand. So, when you’re a developing economy there are practical reasons why you might not have enough domestic demand for your bonds. So the country with the most advanced technologies and the strongest reserve currency sets the tone here and all other countries fall in along the spectrum of sovereignty. The most advanced economies have an exorbitant privilege in being able to set the terms of their financial contracts. And everyone else is forced to operate in a relatively less sovereign status often relying on the kindness of strangers by no choice of their own.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.