What might cause the next financial crisis?
In the second of three-part series, Ian Fraser evaluates the condition of the global economic market and asks what could trigger the next financial crisis.
Kevin Dowd, Professor of Finance and Economics at Durham University, believes that the flawed policy responses to the 2008 global financial crisis – responses that were far too focused on rescue, and not enough on transformation – mean that another crisis is extremely likely within the next 12 months.
“They may have held the system together in the short term, but that came at the expense of aggravating the underlying problems.
"I’m fairly confident the coming crisis will be worse than the last one: banks are weaker, debt levels are higher, there is more hidden risk in the system and policymakers have less room for manoeuvre.”
In terms of debt levels, the International Monetary Fund (IMF) has pointed out that the median government debt-to-GDP ratio today stands at 52%, up massively from 36% at the time of the last crisis.
The balance sheets of central banks, particularly in advanced economies, are several times larger than they were ahead of the 2008 crisis; and emerging market and developing economies now account for 60% of global GDP, up from 44% in the decade prior to the crisis.
Against this backdrop of increased global indebtedness, rising US interest rates and the unwinding of QE, and a concomitant rising dollar, are widely seen as the sparks that could ignite a global financial conflagration.
Many large corporations have been bingeing on debt, making the most of the tax advantages and lower interest rates to borrow enormous sums to fund share buybacks and huge M&A deals
History repeating itself?
Ann Pettifor, economist and author of The Coming First World Debt Crisis, warns that the global economy is in a very similar position to where it was in 2006.
“It will be the same trigger as the last financial crisis – the current Fed chairman Jerome Powell is doing exactly what Alan Greenspan did: systematically raising interest rates, while failing to place any restraint on the creation of private debt.
"And he’s doing it at a time when there’s clear volatility, when there are very high levels of debt relative to income at the global and national levels.”
The Federal Reserve has been “locked into a process” of steady hikes in interest rates because, Ann believes, it cannot be seen to acquiesce to Trump’s strident calls for rate cuts. This “seems to presage a crisis” she warns.
She also points out that many large corporations have been bingeing on debt, making the most of the tax advantages and lower interest rates to borrow enormous sums to fund share buybacks and huge M&A deals.
Many companies have borrowed so much, often on a so-called “covenant-lite” basis that they have driven their own leverage ratios up to levels that are more commonly seen in “junk” rated borrowers.
However Steve Keen, Professor of Economics at Kingston University London, believes that if US rates rise to 4% it “will cause a recession but not a crisis”.
He says: “A 4% Fed rate means at least a 6% rate for commercial borrowing, which given current debt levels means that something of the order of 10% of GDP would have to go on debt servicing.
That’s unsustainable, so private sector entities will start reducing debt or going bankrupt, which will cause a recession.”
Entering the danger zone
Russell Napier, co-founder of online investment analysis portal ERIC, and a Non-executive Director of the Scottish Investment Trust, is more concerned about an emerging market default.
He says countries that borrow in foreign currencies to fund domestic investment are particularly vulnerable – listing countries like Chile, Hungary, Poland, Romania, Turkey and Uruguay as having foreign currency debt-to-GDP ratios of more than 30%.
According to economists Carmen Reinhart and Kenneth Rogoff, these countries are in the danger zone. Russell says: “The crucial one is Turkey, which is already effectively in default.”
According to a different indebtedness metric favoured by the Bank for International Settlements, Canada, China, Hong Kong, Switzerland, Russia, Turkey, Korea, Norway and Thailand have a two-in-three chance of having a banking crisis within the next three years.
“Turkey is flashing red on both measures,” says Russell. “And China is off the scale on the BIS measure.”
Such a move by China would trigger a wider rout in US Government debt, cause the dollar to plunge and make it harder for the US to finance its massive $20trn debt pile
He warns that, in the event of a domestic credit crisis, China would “start printing money like crazy”.
That would in turn, he says, provoke an exchange-rate crisis for the world, as the value of the Chinese currency the Yuan would plummet. “That would intensify the problem for anyone who’s borrowed lots of dollars. I’ve been predicting this for three years now – I believe it could happen any time.”
Stephany Griffith-Jones, Financial Markets Director at the Initiative for Policy Dialogue at Columbia University, New York, also believes the next crisis will be triggered by China, though for different reasons. She thinks that the People’s Republic could lose patience with Donald Trump, firing a deadly salvo in retaliation to his trade war.
“China holds nearly $1.2trn of US Treasuries,” says Stephany. “They could start buying fewer of these – or even start to dump their holdings.”
Such a move by China would trigger a wider rout in US Government debt, cause the dollar to plunge and make it harder for the US to finance its massive $20trn debt pile. This could lead to a worldwide economic shock.
Another view on the risk from China comes from the Bloomberg columnist Nisha Gopalan, who recently warned that, as the Beijing government clamps down on sources of credit, including peer-to-peer lending, many of China’s private sector firms are effectively broke: “Without access to credit, the average private Chinese business won’t survive.”
[Trump] could precipitate a financial crisis that would make the 2008 crisis seem trivial
President Donald Trump is widely seen as the joker in the pack, and there are fears he could do something particularly stupid that would spark a global crisis.
The author Michael Lewis, whose 2010 bestseller The Big Short chronicled the absurdities of the subprime mortgage market in the US, says Trump may be foolish enough to default on America’s sovereign debt – just as he has frequently walked away from his companies’ debts throughout his business career.
“All of his instincts are to default on debt. To walk away,” he told The Times. “He could precipitate a financial crisis that would make the 2008 crisis seem trivial. And a run on the dollar and all the rest.
"We take it for granted, and we shouldn’t, that the dollar is the world’s reserve currency.
"We have $20trn in debt and he’s jacking up the deficit in ways that we haven’t seen in a long time and he has no compunction about stiffing creditors.”
Other potential shocks that could trigger a global meltdown include bond investors losing faith in the maverick right-wing and populist government in Italy, which must service €2.3trn in government debt, and a no-deal Brexit bringing chaos to European business, trade, supply chains and transport.