Is a global crisis in the offing?

27/08/2007

The conditions are ripe for financial turbulence, but skillful policy co-ordination can help avert a severe disruption to the world economy, writes economist and former Romanian Finance Minister Daniel Daianu.

By Daniel Daianu for Southeast European Times in Bucharest – 27/08/07

Financial turbulence has the potential to trigger a global economic recession or slowdown, delivering severe shocks to business, industry and services in numerous countries. [Getty Images]

More than a few voices are saying all is not well in financial markets. Even some leading central bankers have expressed worry. Financial turbulence has the potential to trigger a global economic recession or slowdown, delivering severe shocks to business, industry and services in numerous countries. A crisis could erupt in the financial markets themselves, or it could be triggered indirectly by a major shock – such as the dramatic rise in the price of oil several decades ago.

History provides illuminating lessons. For example, during the Vietnam War, the United States relaxed its monetary policy in order to finance large, war-driven budget deficits. The result was double-digit inflation. The additional liquidity injected into the US economy meant surplus liquidity for the world economy and falling interest rates on world capital markets.

Many developing economies were then able to finance large external deficits cheaply, and even at negative real interest rates. However, once Paul Volcker took over the helm at the Fed, monetary policy changed drastically. His mission was to subdue inflation, and this goal implied a severe tightening of monetary policy – specifically, a sharp rise in interest rates. With that rise came tighter credit conditions on international markets.

Many countries, especially in Latin America, had borrowed at floating rates. The turnaround in US monetary policy caught them off guard, and not a few countries proved incapable of honouring their external debts. Brady bonds are a legacy of that period. In brief, the episode demonstrates the impact policy turnarounds in the United States can have on the rest of the world. US policy moves produce big externalities worldwide. When these externalities are positive, almost everybody is happy; when they are negative, plenty of people are unhappy.

Another case study is the crisis in Southeast Asia during the second half of the past decade. Southeast Asian economies were prodded by international financial institutions and private creditors, such as major banks, to open their capital accounts as a way to finance growing consumption and investment needs. However, this opening was done prematurely, at a time when most local currencies were pegged to the US dollar.

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 learned the hard way that they have to rely more on themselves and build up reserves as a cushion against future trouble. Compared to Latin America, Asia has proved more resilient and capable of economic rebound. Arguably, this has been due to stronger manufacturing capabilities, budget policy discipline and diversified export orientation.

In 1998, another financial meltdown occurred – this time in Russia. The culprit was high short-term borrowing by the government and exchange rate pegging. Ironically, the fall of the ruble has allowed the economy to recover since then. Russia has also benefited from the rise in the price of oil, which has tremendously boosted the chances for sustained economic growth.

In Central and Eastern Europe, economic growth could be badly disrupted, not least because of enormous current account deficits. [File]

Yet another pertinent example is the Long-term Credit Management episode, involving a hedge fund with very high exposure to emerging economies. The fall of this hedge fund (in 1998) alarmed many people on Wall Street and prompted the Fed to mount a discreet, indirect rescue operation.

The above-mentioned cases, and others like them, are linked with specific developments on world financial markets, with globalization as the backdrop. When imbalances grow and national policies become less prudent, when lending criteria are loosened excessively, local crises can become amplified and spill over. Are there any signs that suggest another period of turbulence may be in the offing?

Certainly, some developments provide food for thought. During this decade, the United States has maintained comparatively large external deficits. Foreigners have bought an increasing amount of US-denominated assets, sometimes for the sake of propping up the dollar, in order to avoid large capital losses. Though interest rates have been raised by the Fed and the ECB in the last couple of years, excess liquidity still exists in global financial markets. This surplus liquidity has led to a proliferation of asset bubbles around the world.

In fact, the recent tightening of monetary policy could be attributable to 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 ten year long yields for US bonds (around 5%) indicate a change in long term expectations. This would imply that the period of low interest rates has come to an end.

And here lies a major policy dilemma for central banks. Higher interest rates cause pain for those who are overly indebted, with large exposures. Credit expansion has been impressive in recent years and leverage buyouts have become customary. Many risky assets, "packaged" by investment banks, have been acquired by private equity funds. To make matters worse, rating agencies have got into the game of providing exceptionally high valuation to what normally would have been seen as junk bonds. A tightening of credit conditions has the potential to unravel intricate relationships and trigger chain reactions.

If a massive capital flight were to take place, following a brutal adjustment of risk appetite, many emerging markets would suffer. Investment flows would diminish and credit conditions would worsen. In Central and Eastern Europe, economic growth could be badly disrupted, not least because of enormous 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 supervision (ironically, in advanced countries), underestimated risks, improper valuation of investments and lax credit conditions have brought about the conditions for new financial tremors. However, 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. Many emerging economies have abundant reserves and their exchange rates are more flexible.

The concerns voiced by central bankers and government officials suggest that they realise the dangers that lie ahead. In the end, however, if a major crisis is to be avoided policy co-ordination among the main central banks and governments will have to come into play as well. `