Falls at bourses around the world are causing tremors. Not a few voices are alluding to a looming crisis in financial markets. Even statements of leading central bankers sound pretty worryingly when expressing concern as to how world credit markets have been evolving.
A global financial turbulence would be more than a serious matter. It could happen in the financial realm per se, or it could be triggered indirectly by a major shock -as it was the brutal rise in the price of oil several decades ago. Ultimately, a crisis would show up in economic recession/slowing down worldwide and severe pains to firms, industrial and service sectors, to various countries.
History provides illuminating lessons. One famous episode is linked with the Vietnam War. Lax American monetary policy in the 70s, for the sake of financing large budget deficits (the war), resulted in double-digit inflation. The additional liquidity injected in the American economy meant surplus liquidity for the world economy and falling interest rates on world capital markets. Many developing economies were able to finance large external deficits quite cheaply (at even real negative interest rates). Once Paul Volcker took over the helm at the Fed the stance of monetary policy changed radically; his mission was to subdue high inflation ant that goal implied a severe tightening of monetary policy -namely, a sharp rise in interest rates. That rise entailed a tightening of credit conditions on international markets. The S&LAs debacle in the US can be related to that period as well.
Many countries, mostly in Latin America, had borrowed, at floating rates, hugely from North American banks. The turnaround in US monetary policy caught them off guard and not a few of those countries were incapable of honoring their external dues. The Brady bonds are a legacy of that period. This episode shows, quite glaringly, the impact policy turnarounds in the US can have for the rest of the world. US policy moves produce big externalities worldwide. When these externalities are positive almost everybody is happy; instead, when they are negative lots of people are unhappy.
Another "case study" is the crisis in South East Asia in the second half of the past decade. South East Asian economies were prodded by IFIs and international private creditors (major banks) to open their capital account as a means to finance growing consumption and investment needs ?according to the logic of unfettered globalization. That opening was done prematurely (recklessly), at a time when most local currencies were pegged to the USD. The current account deficits surged under the drive of expanding non-governmental credit and over-borrowing became a norm of conduct. Once market sentiment turned sour massive capital flight occurred and financial havoc engulfed the region. Asian economies have recovered after years of pains, by learning that they have to rely more on themselves and create cushions against future trouble by building up considerable reserves. The IMF has seen its reputation severely dented because of the more than controversial pieces of advice it provided during those years.
One observation is to be made regarding Asian economies. As against Latin American countries they have proved much more resilient and infinitely more capable of economic rebound. Arguably, this has been due to much stronger manufacturing capabilities, budget policy discipline and more and diversified export orientation.
Russia's financial meltdown in 1998 is the outcome of extremely high short term borrowing by the government and exchange rate pegging. Ironically, the fall of the ruble (after the crisis erupted) has allowed the economy to recover since then. But clearly, the rise in the price of oil is what boosted, tremendously, the chances for sustained economic growth in the end.
I would add to this series the Long term Credit Management affair, a hedge fund with very high exposure to emerging economies. The fall of this hedge fund (in 1998) scared many people on Wall Street and prompted the Fed to mount a rescue operation, which was done in an indirect, subtle way. The fear of spreading contagion was very big among financiers and damage control was the aim of the intervention.
The above-mentioned episodes and others like them are linked with developments in world financial markets against the backdrop of globalization, of financial liberalization. When imbalances grow and national policies are increasingly less prudent, when lending criteria are loosened excessively, local crises spillover. Are there any signs which would suggest that seeds of another major financial crisis exist?
Some elements should give us food for thought. The pretty large external deficits of the US, during this decade, have involved an increasing amount of US denominated assets bought by foreigners; some of these assets have been acquired for the sake of supporting the value of the USD (in order not to incur big capital losses). Though interest rates have been raised by the Fed and the ECB in the last couple of years significantly there is still excess liquidity in global financial markets. This surplus liquidity has led to a proliferation of asset bubbles around the world. As a matter of fact, the tightening of monetary policy by the Fed and the ECB is to be explained by their fear that excess liquidity will bring about a resurgence of inflation. Ben Bernanke has recently suggested that inflationary pressures may have abated in the US economy, but the ten-year long yields for US bonds (around the critical 5%) indicate a change in long term expectations on inflation. And if that were the case, it would mean that a period of low interest rates has come to an end, that we are entering a different period of time, which asks for tight monetary policies.
And here lies a major policy dilemma for central banks: for higher interest rates would cause pain for those who are overly indebted, with large exposures. Credit expansion has been awesome in recent years and leverage buyouts have become quite customary. Many risky assets, which have been "packaged" by investment banks have been acquired by private equity funds and, to make the matters worse, rating agencies have got into the game of providing exceptionally high valuation to what, normally, should have been seen as junk bonds. Hence the fear that credit conditions tightening would unravel highly intricate relationships and trigger chain reactions, lots of downfalls.
The spread of credit derivatives (of collateralized debt obligations/CDOs) is quite worry-some. These derivatives are highly sophisticated products, frequently poorly understood by those who use them. Several hedge funds (including two managed by the illustrious Bear Stearns) have collapsed miserably lately, which is reminiscent of the LTCM affair.
Tremors in mortgage markets is a very serious issue in the US, in particular (think about the sub-prime market) UK, Spain and other countries. The Chairman of the Fed has sounded quite ominous when he noted that investors are increasingly concerned about other forms of credit (previously he voiced serious concerns about the sub-prime market)
The picture sketched above shows that a bad scenario is not in a fantasy world. If massive capital flight would take place, following a brutal adjustment of risk appetite, many emerging markets would suffer painfully; because investment flows would diminish and credit conditions would worsen. Here I have in mind Central and eastern European countries where high economic growth rates might be badly disrupted ?not least because of very large current account deficits. The Balkan countries might also see their prospects for continuing economic recovery bruised substantially.
To sum up: excess liquidity, over-borrowing, massive leveraging by hedge funds, lack of transparency and poor regulations/ supervision (in, ironically, advanced countries), underestimated risks and improper valuation of investments, lax credit conditions have created the premises for new financial tremors. But there are also grounds to believe that a global crisis can be averted. The biggest external imbalance is caused by the US current account deficit and its financing should be easier since the dollar is a reserve currency (even if it would have to drop further). Many emerging economies have plenty of reserves and their exchange rates are more flexible. Risk diversifications and better risk management techniques would comfort some (though the collapse of several hedge-funds would indicate that this may be more wishful-thinking). The concerns voiced by central bankers and government officials would indicate that they realize the dangers that lie ahead. In the end, however, if a major crisis were to be avoided policy coordination among the main central banks and governments would have to come into play as well.
PS. Governments do not see eye to eye in finding a way to regulate the highly leveraged operations of hedge funds. But hedge funds are not transparent and all the talk about self-regulation seems to lie in the realm of wishful thinking.
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