Tuesday, July 15, 2014

The Next Crash Cometh

Jaime Caruana, head of the financial watchdog, the Bank for International Settlements, has warned 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. Investors were ignoring the risk of monetary tightening in their voracious hunt for yield.

 “They have become convinced that monetary conditions will remain easy for a very long time” he told The Daily Telegraph.

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. 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 extremely low, and could reverse suddenly. 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 BIS warned it is annual report two weeks ago that equity markets had become "euphoric". European equities have risen 15pc in a year despite near zero growth and a 3pc fall in expected earnings.“Overall, it is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments globally,” it said.

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”.

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.

"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," the BIS said.

Caruana said “There is something strange about fighting debt by incentivizing more debt." 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.

From here

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