It goes without saying that anybody who is carrying debt is more vulnerable to an economic downturn than someone debt-free. That applies equally to individuals, companies or countries.
When the good times are rolling, everyone cares a lot less about debt. The means to service the debt are growing - individuals have secure incomes, corporations have strong earnings growth and countries have ballooning tax revenues.
Meanwhile, the supply of investment capital is strong, because when times are good, risks appear low, and investors scour the Earth to boost returns in their portfolios.
Such has been the case for the past two years, but with a global slowdown unfolding it is time to consider whether the world is vulnerable to financial crisis.
Indeed, the macroeconomic conditions in place right now are virtually identical to those that prevailed 10 years ago, in 1995-96. The world had boomed in 1994 (like in 2004), rising interest rates had led to a moderation in 1995-96, and all appeared well.
And yet, as it turned out, the Asian crisis was just around the corner, to be followed by the Russian crisis, then a series of crises in Latin America. It is legitimate to ask whether history could repeat itself.
Fact is, the world has changed in the past 15 years. Long-term sovereign emerging market external debt amounts to about $1 trillion, excluding multilateral debt.
Back in the 1980s the stock of sovereign debt was mainly financed by commercial banks. But through the 1990s, as that debtload was restructured, there was a gradual increase in the importance of sovereign bonds in financing that debt. Nowadays, close to 50 per cent of this debt is in the form of bonds.
A global economic slowdown will bring with it lower commodity prices, slower economic growth in emerging markets and less tax revenues, thereby raising risks associated with these borrowers.
There is bound to be some degree of retreat in global capital flows back to the centre - that is, back to the U.S. Treasury market, the traditional safe haven.
It would be very surprising if there was not a widening of emerging market bond spreads against U.S. Treasury bonds during 2007.
But there is reason to think that the system is much less fragile than it was 10 years ago. The strong commodity and bond markets of 2005-06 have allowed a number of well-performing emerging markets to begin to increase their reserves, buy back their external bonds, and then to rely much more on their domestic capital markets for financing.
Some, including Brazil, Mexico, Colombia and Uruguay, have even floated global bonds denominated in their own domestic currencies.
The result is that the biggest debtor risk that prevailed 10-15 years ago - that the local currency would depreciate, inflating the debt-service costs on a U.S. dollar-denominated loan or bond - has been transferred to the creditor, thereby strengthening the system.
The bottom line?
The world economy appears to be much less vulnerable to crisis than it was even 10 years ago.
More exchange rates are flexible, fiscal balances have improved, and debt has shifted into bonds, and local currency bonds at that.
That is no reason for investor complacency, but it is reason to continue to do business in the emerging world.
(Stephen Poloz is a senior vice-president and chief economist for Export Development Canada.
He can be reached at spoloz@edc.ca)
