Sunday, May 08, 2011

Debt restructuring: is it inevitable

The last two weeks has saw increasing interest in gold and silver among various investor classes. Even jewelery traders have climbed onto the bandwagon of ever increasing prices of gold and silver, you have advertisements by jewelers who have started promising customers "that if they book early then they can buy gold on akshaya tritiya at a price which is lower of the booking day price or the price on akshaya tritiya".
If this is not a sign of irrational exuberance then nothing is. It was only expected with increasing liquidity worldwide that the price of some asset classes is going to rise. So what is going to bring this party to an end,
1. Is it slowdown in growth in most emerging countries due increasing inflation/interest rates,
2. Rate hikes by central banks in EU and US,
3. Another shake up due to government defaults,

I believe this phase of rise in commodity prices is going to come to a end due to point 3 more that anything else. We are having a mismatch in inflation rates across the world, economies which remained unscathed by the 2008 financial crisis are facing increasing inflation and economies which have faced the brunt of the crisis are either facing low growth coupled with high employment and/or high government debts. We still have not fully recovered from the financial crisis and that is because we haven't allowed the crisis to reach its conclusions. The belief that infusing more and more money into the economic system is the only way of solving economic slowdowns has to be critically examined. Easy money increases demand in the short term but the costs of this easy money include increasing cyclicality.

Lets take an example of a company, the company has many subsidiaries, each one contributing to the topline. Each of the subsidiaries has certain level of debt. Now in case the subsidiaries revenue slows down and in case of high leverage this would impact the ability of the ability of the company to repay debt. Now the subsidiaries plans to raise more debt to cover the deficit on interest/principal payments to creditors. How ever these subsidiaries have a unique characteristic, the subsidiaries revenue is dependent on the revenue of the other subsidiaries and the expenses of one subsidiary is an income for other subsidiary. So in case of a slowdown, with creditors pressing for repayment or other conditions in one of the subsidiary, that starts to charge more from other subs and starts cutting its expenses. Because of the inter connectivity between the subsidiaries, this only reduces the topline of the stricken subsidiary and further increases pressure on the payments to creditors.

In case the creditor is one of the other subsidiary which has strong cash and its dependency on debtor subsidiary is not high, then is can raise additional debt to cover its expenses. However this is dependent on the creditor subsidiary not having strong dependency on debtor subsidiary.

In case the creditor is a third party and dependency of the subsidiaries is high, then in case debtor subsidiary tries to cut back its expenses and increase its revenue, then is only causes its revenue to fall further to due to the inter dependency among subsidiaries. This resurfaces the problem of debt repayment problem. One of the ways the subsidiary can solve the problem is to reduce dependency among themselves and restructure its debt so that there is not immediate repayment pressure in the short term.

Case 1 is an example of Japan, where the economy has a strong export economy and the government obtains funding internally due to high savings of the population.

Case 2 is an example of Greece, being a part of Euro, they have reduced chances of being an export competitive economy, this makes it even more difficult for it to reduced inter dependency. This makes it even more necessary for debt restructuring to happen. The earlier it happens the better as it reduces the pain.

However a voluntary debt reduction is not going to happen easily and this eventually would lead to a blow up later on.

No comments: