Gearing Up for the next Financial Crisis
by Andrew Sheng
In July 2018, the Bank for International Settlements (BIS) asked whether the world was heading towards a perfect financial storm, with the US stock market heading for record highs even as emerging markets like Argentina and Turkey were running into foreign exchange problems. Twenty years after the Asian financial crisis of 1997–98 and the global financial crisis of 2007–08, storm clouds are gathering once again.
Conventional economic models failed to predict the last two crises because the technical definition of financial risk is measured volatility. The global financial crises proved that current models of financial risk, largely used by banks and financial regulators, are totally blind to Black Swan or Grey Rhino events of unmeasurable uncertainty.
This time round, the consensus is that the Grey Rhino (an event with high probability and high impact, but where the trigger is uncertain) is the looming rise in US interest rates in response to a domestic economy that is running at nearly full capacity, with low unemployment levels and signs of creeping inflation. As the BIS has warned, non-financial borrowers outside the United States owe US$11.5 trillion dollars, of which US$3.7 trillion is owed by emerging markets.
Turkey’s recent currency woes are symptoms of domestic policies badly managed, aggravated by the US threat of economic sanctions. Turkey alone has US$467 billion of foreign debt. As global risks rise, capital is flowing back to the booming US stock market and potentially higher interest rate yields. Emerging markets have no alternative but either to allow exchange rate depreciation or defend themselves with higher interest rates that depress their own growth potential. Recently both Indonesia and Hong Kong had to defend their exchange rates through higher interest rates and intervention, respectively.
The tricky thing about US interest rates is that economies with high domestic and foreign debt are vulnerable to tighter liquidity and financial fragility, because their interest rates and credit-risk spreads rise non-linearly. Doomsayers of East Asia’s financial collapse argue that China’s debt of 250 per cent of GDP is the tipping point.
Financial risks are rising not just in China, but globally. Dun and Bradstreet’s Global Risk Matrix, published in May 2018, suggested that US interest rate rises could trigger a fresh debt crisis, sending the global economy into contraction. Echoing this sentiment, the International Monetary Fund’s July 2018 World Economic Outlook argued that rising trade tensions are threatening growth recovery in Europe, Japan and Britain more than predicted. Any overheating in the United States would trigger currency crises for some emerging markets.
In short, we cannot separate financial risks from geopolitical risks. Any unforeseen event arising from a geopolitical miscalculation, climate change disaster, war or cyber-induced disruption could trigger another round of financial crises.
Global financial fragility comes from two structural imbalances. First, the United States is the leading deficit country in terms of trade and debt, owing the world a net US$7.7 trillion, or 39.8 per cent of GDP. This amount is growing because of rising fiscal debt and the low level of national savings. Second, below-par global growth since 2008 has been underwritten almost completely by central bank unconventional monetary policies, which have brought interest rates to an unsustainably low level.
Market fears that the large central banks will withdraw quantitative easing — QExit — threaten to jeopardise the current frail recovery, which is why US President Donald Trump is also against the Federal Reserve raising interest rates.
If geopolitical risks trump financial risks, what could go wrong in the coming months?
Western analysts think that the trigger will be a Chinese debt meltdown. But Chinese debt is internal debt, as China has foreign exchange reserves equivalent to 188 per cent of its foreign debt and still runs a current account surplus. China’s debt problem is an internal debt issue, very much like that of Japan. While Japanese debt is owed largely to Japanese households, Chinese debt is largely owed by state-owned enterprises and local governments to state-owned banks. In such a situation, China is well positioned to rewrite its national balance sheet, a privilege not possible for more privately dominated markets.
A possible Black Swan (a low probability but high impact event) is an unexpected sharp increase in the yen–dollar exchange rate. Japan is the third largest economy after the United States and China and has been increasing its overseas assets since the 1990s. Between 2007 and July 2018, the Bank of Japan has grown its assets the most among the major central banks (to US$4.9 trillion, or just over 100 per cent of GDP). By the end of 2017, Japan’s gross foreign and net assets grew to US$9 trillion and US$2.9 trillion respectively, equivalent to nearly one quarter of US growth in gross foreign liabilities during the same period.
US trade deficits have been sustained by foreign inflows (which had central bank origins) in which Japan is a major player. During the Asian financial crisis, sharp volatility in the yen–dollar exchange rate caused a dramatic withdrawal of Japanese bank loans from Asia, aggravating a regional liquidity crisis that was already spurred by speculative currency attacks.
What complicates today’s financial fragility is Trump’s attempt to control the US trade deficits. He assumes that bilateral negotiations can reverse the unsustainable growth of national debt, which tripled in the last decade and may grow to 100 per cent of GDP in another decade. But tariffs only increase inflation for the consumer, which would trigger higher interest rates and jeopardise the fragile financial stability achieved through unsustainable monetary policies.
The next global crisis will most likely be triggered by geo-political mistakes. In an age when politicians are proving fickle in their decisions, central bankers are perhaps the only professionals who appear able to do something about financial risks. But since Trump does not care much about professional advice, Asian markets worry less about measurable financial volatility than unmeasurable personality risks.
Andrew Sheng is Distinguished Fellow at the Asia Global Institute, University of Hong Kong.
This article appeared in the most recent edition of East Asia Forum Quarterly, ‘Asian crisis, ready or not ’.