When it comes to debt, President Donald Trump is remarkably consistent. When he was only a GOP nominee, he said he would renegotiate debt if things get tough for the economy. On Tuesday, President Trump told investors they can "say goodbye" to Puerto Rico's debt, promising: "We're going to have to wipe that out."
In June last year, in an interview with CBS that widely was quoted in the media, the then-nominee said: "I'm the king of debt. I'm great with debt. Nobody knows debt better than me. I've made a fortune by using debt, and if things don't work out I renegotiate the debt. I mean, that's a smart thing, not a stupid thing."
One thing that can be said about President Trump is that he is very good at reading the popular mood and turning it to his personal advantage. Investors should heed his warning and begin planning for a world in which debt forgiveness is no longer a dirty word.
If you need more proof of that, look no further than the recently published International Monetary Fund (IMF) Global Financial Stability Report. It has a whole chapter dedicated to the rise of household debt, warning that even though an increase in the household debt-to-GDP ratio brings higher economic growth and lower unemployment in the short term, it is also associated with a greater probability of banking crises.
In advanced economies, the median household debt-to-GDP ratio increased to 63% in 2016 from 52% in 2008, while for emerging markets, it rose to 21% from 15% over the same period, the report shows.
This means that the negative consequences of rising household debt are likely to be deeper for advanced economies than for developing ones. When recession strikes, the costs of deleveraging will be lower for emerging markets than for advanced ones, because there will be less to deleverage in the first place.
So, as contrarian as that may sound, it seems one thing investors could do to protect themselves from the effects of defaults in case of debt forgiveness would be to diversify by making sure they have some exposure to emerging markets' sovereign debt.
But within that asset class, the foreign currency factor is important, and it is not easy to decide whether to take on local currency-denominated debt of foreign currency bonds. Countries are generally less likely to default on debt issued in their own currency, but they can inflate it away by printing money.
Investors should avoid emerging markets with high household debt, open capital accounts and fixed exchange rates; a bout of capital flight could hit their debt first, because the exchange rate does not act as a cushion in those cases. Another caveat is that countries with less-developed financial systems, low transparency, weak consumer protection and high inequality are generally riskier.
The IMF's report found that increases in the household debt ratio are associated with faster increases in nonperforming loans in a country's banking sector three years later. Fast growth in household debt potentially results in a banking crisis later on.
The European Central Bank launched a consultation on Wednesday on tightening the measures that banks in the eurozone must take to protect against bad loans. This was long in the making, but it is part of the same trend of accepting defaults as normal and learning to deal with them.
For loans that are newly classified as non-performing next year, eurozone banks will be expected to make provisions to cover the full unsecured portion of the non-performing loans (NPL) after two years at the latest, and for the secured portion after seven years from the moment the loan became nonperforming. Previous guidance from the ECB did not set specific timelines for the provisions.
This is likely to slow down new lending in a number of eurozone countries, especially in those with already-high levels of household debt. Among them, besides the "usual suspects" of Greece, Ireland, Italy, Portugal and Spain, are the Netherlands, Finland, Belgium and France, according to Organisation for Economic Cooperation and Development (OECD) data.
With monetary stimulus no longer added and in fact on the brink of being withdrawn all over the developed world, the issue of debt forgiveness will become prominent.
President Trump, with his flair for identifying what will drive public opinion, has delivered a stark warning to fixed-income investors that defaults may be right around the corner. Diversifying and moving away from risky areas are the right response.
