A Template for Understanding Big Debt Crises

by Ray Dalio

At this stage, central banks typically try to defend their currencies by a) filling the balance of payments deficit by spending down reserves and/or b) raising rates. These currency defenses and managed currency declines rarely work because the selling of reserves and/or the raising of interest rates creates more of an opportunity for sellers, while it doesn’t move the currencies and interest rates to the levels that they need to be to bring about sustainable economic conditions. Let’s look at this typical defense and why it fails. There is a critical relationship between a) the interest rate difference and b) the spot/forward currency relationship. The amount the currency is expected to decline is priced into how much less the forward price is below the spot price. For example, if the market expects the currency to fall by 5 percent over a year, it will need that currency to yield a 5 percent higher interest rate. The math is even starker when depreciation is expected over short periods of time. If the market expects a 5 percent depreciation over a month, than it will need that currency to yield a 5 percent higher interest rate over that month—and a 5 percent monthly interest is equivalent to an annual interest rate of about 80 percent10 —a level that’s likely to produce a very severe economic contraction in an already weak economy. Because a small expected currency depreciation (say 5 to 10 percent in a year) would equal a large interest rate premium (5 to 10 percent per...