The coming emerging-market debt squeeze

CONSIDER the following scenario, one that has played out time and again in emerging-market countries. Local banks and firms go on a borrowing binge and pile up dollar-denominated debt - debt that pundits consider perfectly sustainable, as long as the local currency is strong. Suddenly, something (say, an increase in US interest rates, a drop in commodity prices or a domestic political conflict) causes the local currency to drop in value against the dollar. The debt burden, measured in domestic currency, is now much higher. Some borrowers miss interest payments; others are unable to roll over principal. Financial mayhem ensues.

This is how the Latin American debt crisis of the 1980s, the Mexican Tequila crisis of 1994, the Asian debt crisis of 1997, and the Russian crisis of 1998 unfolded. It was also how the financial crisis of 2008-2009 transmitted itself to emerging markets. Every…