The Financial Express

  Growing signs of stress in the global financial system

Muhammad Mahmood   | Published: March 14, 2020 21:23:56 | Updated: March 15, 2020 22:05:44

Traders work on the floor of the New York Stock Exchange (NYSE) in New York, US on March 12, 2020.              —Photo: Reuters Traders work on the floor of the New York Stock Exchange (NYSE) in New York, US on March 12, 2020.              —Photo: Reuters

There are growing concerns that global financial system is increasingly becoming stressed with coronavirus spreading  around the world causing gloomier growth prospects for the global economy. But it is the plummeting oil price that was the immediate cause of the turmoil in the Tokyo, New York  and other principal stock markets around the world on last Monday (March 09). Rana Faroohar, associate editor of the Financial Times, commented in the paper on last Tuesday and noted that coronavirus was the trigger for, at this point in time,  as a "correction'' in the stock market. It was the worst stock market meltdown since the Global Financial Crisis (GFC) of 2007-2008 creating the conditions for further turmoil in the global financial system.

By Thursday there were further decline in the major global stock market indexes.  The Dow Jones Industrial Average fell 2,352 points or nearly 10 per cent, the biggest one day fall since 1987. The economic fallout of coronavirus drove the stock markets further deeper into the bear market by Thursday.  Now to calm the market, the New York Fed  decided to pump in US$1.5 trillion into short-term funding markets over the next two days.

In effect, factors causing the  stress on the global financial system  go beyond those immediate factors. An independent research arm of the US Treasury Department has found that the financial system still would be in great peril if one or two banks fail, despite reforms enacted since the Global Financial Crisis of 2007-08. The GFC refers to the period of extreme stress in global financial markets and banking system between mid-2007and 2009. During the GFC, a downturn in the US housing market precipitated a financial crisis that spread from the US to the rest of the world through linkages in the global financial system. Many banks incurred heavy losses and had to rely on government bailouts to survive.

The global financial system facilitates international flows for the purposes of investment and trade financing. Multiple cracks are appearing in global financial systems such as soaring private debt composed of credit card debt, housing and car loans, loans for leveraged buyouts and corporate debt. Also rising fiscal deficits in the US and other advanced economies to cope with their spending and reduced bank capital will make banks unable to absorb the losses in the event of an economic downturn. Kenneth Rogoff, economics professor at Harvard University, believes that leading central banks around the world are not well prepared to deal with a new banking crisis.

For all financial crises a number of factors can explain its occurrence and also its severity. These factors include excessive risk taking under a favourable macroeconomic climate, increased borrowing by banks, investors and consumers and regulatory failures.  A decade of extraordinary low interest rates created multiple distortions in the global economy and the financial system. Any one of those or all cumulatively can trigger the crisis. It is quite plausible now that if just one or more big banks fail, that will trigger a chain reaction across the global economy as happed in the GFC of 2007-08 because of the interconnectedness of banks across borders. Also, an unexpected rise in the global real interest rates will seriously cause havoc in high-risk debt market. That can also throw the whole global financial system out of kilter.

In recent years household, corporations and governments have taken advantage of low interest rates.  The combined global debt  composed of borrowing by households, governments and corporations  grew by US$9.0 trillion to US$253 trillion. But that is not the end of the story, according to the Institute of International Finance (IIF), the figure could reach US$257 trillion by the end of first quarter in 2020. A snapshot of total global debt tells us that each inhabitant in our world populated by 7.7 billion people now owes US$32,500, accounting for 322 per cent of global GDP (gross domestic product). 

The US Federal Reserve has kept the interest on hold after three cuts of 0.25 percentage points since July last year and indicated that it has no plans for increases in the foreseeable future. But last week the Federal Reserve further cut interest rates by half a percentage point in an emergency move. Along with interest rate cuts, the Fed resumed quantitative easing (QE)  in July last year as interest rates in the repo (repurchase) market spiralled to 10 per cent from 2.0 per cent in mid-September last year. The repo market is crucial for providing liquidity to the financial system by supplying cash to banks and other financial institutions. The objective of the Fed is to keep the repo rate within its base interest rate target range. The repo market estimated to be at US$ 1.0 trillion and was a contributing factor to the GFC in 2007-08. The Bank of England  also cut its interest rate last Tuesday (March 10) by 50 basic points to 0.25 per cent.

There are massive amounts of unaffordable loans being made to people who can not pay them and such easy availability of loans is leading to asset inflation. Such global asset price inflation (bubbles) is also a major  stress factor which played a crucial role in precipitating the GFC. While after-effects of the GFC are still resonating, the concerns now centre around whether rising global debt levels trigger a new financial crisis. But signs are not encouraging and the health of the real and financial sectors is deteriorating.

If financial crises can be anticipated, then  policy makers can prepare themselves. If the emerging crisis follows the same track as the one before, the response is likely to be the same as before. But no two financial crises are the same and that requires different policy response.  The safety of the financial system depends on the competence of the people who run it.

In the wake of the GFC, policy makers directed much more attention to the  linkages between the financial system and the real economy, known as the transmission mechanism to enable them to gain sound understanding of how the financial markets affect the real economy.

It is generally agreed that the transmission mechanism that flows from  the financial system affects the real economy mainly through four different channels. They are (i) the balance sheet channel which describes how the fall in house and stock prices reduce the value of assets held by households and  businesses, leading to a financial accelerator process reduce or slowdown in consumption and investment; (ii) the bank interest rate channel where rising interest rates lead to a decrease in the present value of financial and real assets due to the negative impact on the price of these assets; (iii) the bank capital channel where different types of risk facing banks can lead them to raise their lending rates to maintain their capital adequacy, solvency, liquidity and profitability can have deleterious effect on both consumption and investment; (iv) the uncertainty channel where increased volatility in financial markets can cause increased levels of precautionary savings  and that can lead to lower consumption and investment.

A decade and more after the GFC, policy makers do claim that they are now better equipped than before to deal with any oncoming crisis - more precisely, the global financial system is much safer now. But the question continues to linger how safe is the system despite all those assurances. The unprecedented pumping of trillions of dollars into the global financial system by the major central banks has failed to bring about any sustained economic growth. The main effect of near zero to below zero interest rates and quantitative easing (QE) has been to push up the price of financial assets like stocks and bonds.

That central banks are pursuing the QE is the manifestation that very low to negative interest rates are failing to stimulate consumption and investment spending. In effect, the QE is blurring the borderline between monetary and fiscal policy as increasingly central banks are purchasing long-term government bonds that are being issued to finance counter cyclical deficit spending. Now in effect, one arm of the state, the government is has increasingly become the seller of debt while another arm, the central bank has become the purchaser.

Bond markets have traditionally been  considered as an arena for risk-free investment but at a low rate of return. But in the second half of the last year a massive amount of bonds, amounting to US$17 trillion, reached negative yield causing a panic in the market. However, the trend has reversed to some extent now. A negative yield signals a financial bubble in an area of financial market which has been considered as stable.

Interest rate cuts and the QE have so far failed to bring about any real expansion of the global economy. Negative interest rates along with monetisation of massive public debt by central banks have created an uncertain economic climate putting the global financial system under serious stress.

Bubbles appearing in the government bonds market, which has always provided a solid foundation to the financial system, now appears to pose a threat to the system itself. All previous financial crises were triggered by "bubbles'' which at some point burst. As Kenneth Rogoff of Harvard University pointed out liquid assets in normal time turn into highly illiquid in a crisis.

Under conditions of increasing international financial turmoil, for developing countries like Bangladesh a few triggers can precipitate the risk of an economic downturn. These triggers include interest rate trends and overall global economic development as manifested in slower growth, ongoing trade tensions and now added to these is the coronavirus effect.

With an ever-expanding global financial system with global debt expected to reach US$257 trillion by the first quarter of this year, the possibility of a synchronised global economic slowdown which is now further exacerbated by coronavirus mean that the next major financial crisis may not be too far off.

Muhammad Mahmood is an independent economic and political analyst.




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