The Telegraph – by Ambrose Evans-Pritchard
The world economy is just as vulnerable to a financial crisis as it was in 2007, with the added danger that debt ratios are now far higher and emerging markets have been drawn into the fire as well, the Bank for International Settlements has warned.
Jaime Caruana, head of the Swiss-based financial watchdog, said investors were ignoring the risk of monetary tightening in their voracious hunt for yield.
“Markets seem to be considering only a very narrow spectrum of potential outcomes. They have become convinced that monetary conditions will remain easy for a very long time, and may be taking more assurance than central banks wish to give,” he told The Telegraph.
Mr Caruana said the international system is in many ways more fragile than it was in the build-up to the Lehman crisis. Debt ratios in the developed economies have risen by 20 percentage points to 275pc of GDP since then.
Credit spreads have fallen to to wafer-thin levels. Companies are borrowing heavily to buy back their own shares. The BIS said 40pc of syndicated loans are to sub-investment grade borrowers, a higher ratio than in 2007, with ever fewer protection covenants for creditors.
40pc of syndicated loans are to sub-investment grade borrowers
The disturbing twist in this cycle is that China, Brazil, Turkey and other emerging economies have succumbed to private credit booms of their own, partly as a spill-over from quantitative easing in the West.
Their debt ratios have risen 20 percentage points as well, to 175pc. Average borrowing rates for five-years is 1pc in real terms. This is extemely low, and could reverse suddenly. “We are watching this closely. If we were concerned by excessive leverage in 2007, we cannot be more relaxed today,” he said.
“It may be the case that the debt is better distributed because some highly-indebted countries have deleveraged, like the private sector in the US or Spain, and banks are better capitalized. But there is also now more sensitivity to interest rate movements.”
The BIS warned it is annual report two weeks ago that equity markets had become “euphoric”. Volatility has dropped to an historic low. European equities have risen 15pc in a year despite near zero growth and a 3pc fall in expected earnings. The cyclically-adjusted price earnings ratio of the S&P 500 index in the US reached 25 in May, six points above its half-century average. The Tobin’s Q measure is far more stretched than in 2007.
Volatility has dropped to an historic low
“Overall, it is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments globally,” it said.
Mr Caruana declined to be drawn on when the bubble will burst. “As Keynes said, markets can stay irrational longer than you can stay solvent,” he said.
The BIS says prolonged monetary stimulus in the US, Europe, and Japan has led to a leakage of liquidity, contaminating the rest of the world. The rising powers of Asia are no longer able to act as a firebreak – as they did after the Lehman crash –and may themselves now be a source of risk.
Tobin’s Q shows the difference between an equity’s market value and the cost to replace the firm’s assets.
Emerging markets have racked up $2 trillion in foreign currency debt since 2008. They are a much larger animal than they were during the East Asia crisis of the late 1990s, so any crisis would do more damage. “The ramifications would be particularly serious if China, home to an outsize financial boom, were to falter,” it said.
BIS officials doubt privately the whether China can avoid a ‘hard landing’, fearing that the extreme credit growth over the last five years must lead to a financial reckoning. They also doubt whether the aftermath will in the end be easier to deal with in a state-controlled banking system where the Communist Party controls the credit levers.
The annual report suggested that China’s $4 trillion of reserves are a Maginot Line defence. It noted US was also a large external creditor in the 1920s, as was Japan in the 1980s, before each went into deep crisis. “Time and again, in both advanced and emerging market economies, seemingly strong bank balance sheets have turned out to mask unsuspected vulnerabilities that surface only after the financial boom has given way to bust,” it said.
The BIS is the doyen of world’s financial institutions, created in Basel in 1930 to clean up the mess left by German reparations payments under the Versailles Treaty. It has since evolved into the bank of central banks, and lately the bastion of monetary orthodoxy. It issued a crescendo of warnings in the build-up to the Lehman crisis, implicitly rebuking the US Federal Reserve and others for holding interest rates too low, which in their view robs economic growth from the future.
The BIS was vindicated, though not everybody agrees that it was right for the right reasons. Monetarists argue that the Great Recession was due to over-tightening into the downturn. This caused M3 broad money growth to collapse months before the banking crisis.
The BIS backed QE as an emergency measure in early 2009 to avert a deflationary spiral but has long since called for a return to sound money, and even rate rises. “The predominant risk is that central banks will find themselves behind the curve, exiting too late or too slowly,” it said.
This has earned BIS a reputation for Austrian School ideology , accused of encouraging crude liquidation. The bank denies this, tracing the bank’s doctrines to the pre-Keynesian Swedish economist Knut Wicksell.
Wicksell posited a “natural rate of interest”. Holding rates too low creates a host of problems. While his model looks like the modern “Taylor Rule” used by the Fed and other central banks, it is different in crucial respects.
Confident in its cause, the BIS more or less indicts the central bank establishment of malpractice. “Policy does not lean against the booms but eases aggressively and persistently during busts. This induces a downward bias in interest rates and an upward bias in debt levels, which in turn makes it hard to raise rates without damaging the economy – a debt trap.”
“Systemic financial crises do not become less frequent or intense, private and public debts continue to grow, the economy fails to climb onto a stronger sustainable path, and monetary and fiscal policies run out of ammunition. Over time, policies lose their effectiveness and may end up fostering the very conditions they seek to prevent,” it said.
Basel’s lonely call for discipline pits it against the Fed, the Bank of Japan, the Bank of England, and even Frankfurt these days. It prompted an unusually piquant riposte from London earlier this month. “Has monetary policy aided and abetted risk-taking? I hope so. That’s why we did it,” said the Bank of England’s chief economist Andy Haldane.
“It is good to have the debate,” said Mr Caruana gamely. Yet he refuses to back down. “There is something strange about fighting debt by incentivizing more debt.”
He is now skirmishing on a fresh front, questioning the Fed’s new enthusiasm for macro-prudential curbs as a first line of defence. “On their own there is little evidence that they can constrain financial imbalances. We don’t think macro-pro can serve as a substitute,” he said.
Mr Caruana said the US recovery is not a vindication of monetary stimulus, but evidence that the best answer to “balance sheet recessions” is to clear away the dead wood and unlock resources for new technologies. “The Americans were quite aggressive in forcing recognition of losses and there was a very rapid recapitalisation of the banks. This is why it was successful. The role of quantitative easing is an open question.”
Mr Caruana dismisses the global deflation scare as alarmist, even though Sweden’s Riksbank has just abandoned his camp and slashed rates to near zero to avert a Japanase-style trap. Deflation is very unlikely to happen in the West, he insists. Gently falling prices are typically benign in any case. “We should not exaggerate the role of deflation in history,” he said.
The Great Depression is the exception, not the rule. Welfare systems and unemployment insurance now make such an outcome almost impossible. “In the 1930s the stabilizers were very different,” he said.
Critics are unlikely to accept this assurance since Spain, Greece, Portugal, Ireland, and Latvia have all gone through depressions over the last six years, and Italy, France and Holland are all close to debt-deflation. The concern is what would now happen to parts of Europe if there were a fresh downturn or an external shock. Debt ratios are higher than they were in the 19th Century. The “denominator effect” of deflation is therefore more destructive today.
The International Monetary Fund has hinted that it might be best for the world to chip away its debt mountain with a few years of inflation, as the US did in late 1940s and early 1950s, armed with financial repression.
Asked whether he would support this form of loss recognition for creditors, Mr Caruana came close to choking. “It must be clearly resisted,” he said.