On July 3, Bloomberg an international business news agency, reported that the Bank of America (BoA), the second largest by assets in the US, sees the situation on financial markets today as signs of many parallels with what happened just before the Asian financial crisis of 1997-1998. This news is worth paying attention to for two reasons. Firstly, financial companies, especially world leaders in this sector, typically avoid talking directly about any possible crisis. Even if they see one coming, they normally won’t broadcast their concerns as they prefer to make money on it themselves, quietly adjusting the necessary investment decisions. Secondly, the Bloomberg comment was picked up by several Ukrainian publications and roused avid discussion among local economists. It’s clear that Ukraine risks having a new crisis and plenty of ink has been spilt on the subject, but so far there hasn’t been anything much about a possible global crisis. The Ukrainian Week decided to look in-depth at the biggest risks that might lead to it.
The world economy is seeing destructive processes of global significance nearly every day. The migration crisis in Europe, Brexit, currency and trade wars, America’s exit from the Iran deal North Korea’s nuclear bravado—all of these developments affect economic process well beyond the borders of the countries involved. Still, such processes extremely rarely lead to a large-scale economic crisis: if the global economy is in good shape, it adjusts to the new conditions fairly easily. So, in order to analyze the risks of a new global crisis, these events need to be largely ignored.
What, then, could lead to a new global economic crisis? The answer comes from a surprising corner: classical 19thcentury economists: crises arise in the foundations of the economic system itself, caused by its structure and becoming negative in response specific tendencies.
The US weighs in
A number of such trends can be seen today, the main one being the ever-tighter monetary policy of the US Federal Reserve, which has two components. One is raising the prime rate: at the end of 2015, the Fed raised the rate 0.25% for the first time in more than seven years, signaling that the impact of 2008-2009 had been overcome and the American economy was in decent shape. Then there was a one-year break, after which the Fed began raising the prime rate every quarter or two. It seems that the conditions for these steps are in place: inflation is rising in the US, having gone up to 2.9% in June, the highest it’s been since early 2012, while unemployment was at 3.8% in May, similar to the low point in 2000 registered right after the Asian crisis and the peak of the dotcom bubble—although it rose to 4.0% again in June. Indeed, based on inflation and unemployment rates, the US economy is on the verge of overheating and the main instrument to cool it down today is raising the prime rate, just as the Fed is doing.
But this particular instrument has a number of side effects. Firstly, yields on T-bills tend to rise (see Attractive Debt). A few weeks ago it broke 3% on 10-year bonds, although it did not stay at that level long. Under these conditions, these bonds are competitive on international markets with Italy at 2.68%, Poland at 3.20%, Hungary at 3.50%, Thailand at 2.61%, and many more countries. Understandably, US bonds win the competition because the risks on American papers are so much lower than those of other countries. And so as the Fed raises its rate, capital will gradually move over to the United States, while developing countries will feel a shortage. This will negatively impact their balance of payments and their macroeconomic indicators.
The second side-effect is because yields on US T-bills are generally perceived as risk-free, that is, they are the basic rate on which eurobonds in most countries are oriented. And so, if the cost of US debt keeps rising, it automatically rises for many other countries that borrow abroad. For instance, in the middle of September last year, Ukraine placed 15-year sovereign eurobonds at 7.375% and a few weeks ago, yields on these papers had grown to 9.5%: in short, they had jumped more than 2pp in less than a year. One of the reasons was the growing cost of capital in the US.
In recent months, a sharp rise in eurobond yields in many developing countries has become a steady trend. If these yields pass a certain threshold, such as 10% or 15%, those countries will have a very hard time borrowing any sum on external markets, even a relatively small one. If this happens at an inconvenient time, such as during an election campaign or when major external debt servicing comes due, this can lead to a balance of payments crisis, with the resulting negative impact on the domestic currency and the overall economy.
For instance, when the Fed began to sharply raise the prime rate from 3% to 6% over 1994-1995, the global financial system began to accumulate imbalances. Barely two years later, this turned into the Asian crisis in late 1997 and then Russia’s default in 1998. The entire crisis affected many countries, in fact and many of them, like Ukraine, had to restructure their public debt. The parallel between events now and those two decades ago is pretty clear. Then, of course, it took two years for things to reach crisis point. How long it might take today is hard to say.
Reverse quantitative easing
The second component of the Fed’s tight monetary policy is reducing its own balance. After the 2008-2009 crisis, the US central bank went for quantitative easing, that is, redeeming securities on the market using newly-printed money, in order to stimulate the economy. This blew up the Fed’s balance to US $4.5tn. Last year, a decision was made that, starting in QIV 2017, the Federal Reserve would begin to gradually liquidate the securities on its balance sheet. The pace of this shedding will go from US $10bn per month in QIV 2017 to US $50bn per month by the end of 2018.
This step is probably even more dangerous for markets than raising the prime rate, because the money the Fed removes from circulation will be coming from everywhere, but mostly from the weakest assets. In other words, if high yields on US government bonds, in and of themselves, cause capital to flee emerging markets, the reduction of the Fed’s balance sheet will only strengthen this trend. This establishes a long-term fundamental condition for a collapse on global financial markets.
This trend can already be seen on stock markets (see When There’s Not Enough Air): the reduction of the Fed’s balance began in October 2017 and, by January 2018, most markets reached their peak and entered a substantial, simultaneous adjustment. In short, they fell. Whereas American stock indices were down only about 5.4% at the beginning of July compared to January’s peak, Chinese stock markets lost more than 22%, while the MSCI EM, an emerging markets index involving stocks from 24 countries, was down nearly 17%. This is a clear indication that stocks from these countries are not favored among investors right now. This makes an outflow of capital impossible and problems with the balance of payments that, in some cases, is likely to grow into a full-blown crisis.
It’s important to note that the concept of quantitative easing did not exist in the 1990s, so it could not be curtailed, either. And that’s what makes the current situation much more complicated. Reducing the Fed’s balance will likely reinforce and accelerate all the current trends on global markets. The problem is that the pace of this decline is only likely to keep rising until at least the end of 2018, which means the pressure on markets will keep growing. Altogether, the Fed has announced that it plans to reduce its balance by US $420bn, and this number will increase to US $600bn over 2019-2020. For comparison, the IMF reports that all emerging markets put together received around US $500bn in direct and portfolio investments in 2017. The numbers speak for themselves.
America’s fiscal bazooka
The other important trend is the US government’s soft fiscal policy. At the end of 2017, the Trump Administration initiated tax reforms that were passed by the Congress. It introduced a series of innovations, but the biggest change was a reduction in corporate profit tax from 35% to 21%. The key result of this reform is that the US budget deficit will go up US $1.5 trillion over the next 10 years. This is the basic figure that was calculated. Economists say that the spur to economic growth that this reform should lead to will ensure greater budget revenues, so that, according to various calculations, the actual deficit will only go up $0.5-1.3tn over the next decade, or about US $40-100mn a year.
Economic theory says that monetary policy needs to always be independent of fiscal policy. In practice, coordinating them can lead to much better results, but, more than anything, it helps avoid having them at cross purposes. This is the situation in the US today, if we look at both policies in the context of economic growth. On one hand, we have US monetary policy that is clearly intended to slow down inflation and limit growth while the unemployment rate remains low. On the other, we have US fiscal policy that is clearly intended to stimulate growth. Yet the Trump Administration has been quite consistent in its inconsistency: It keeps doing things to attract business to the States, not only by reducing corporate taxes, but also by instituting protectionist measures, including higher import tariffs, directed at stimulating domestic manufacturing. The problem is that these measures all work well when there is enough of a labor force on the domestic market. But when joblessness is low and immigration is being blocked in every way possible, this kind of fiscal policy—and not just the fiscal aspect—only speeds up the overheating of the economy and the negative consequences will last a very long time.
For financial markets, however, this is not the main point. What matters more is that, as the deficit grows, the US will be issuing US $40-100mn more government bonds every year. With interest rates on T-bills very attractive to global capital, any new issues will be grabbed up like hot pies at a Saturday market—at the cost of the same volume of capital not going to emerging markets. That will only increase the negative trends that can already be seen there. In the end, the US is likely to win: more money will flow into the country, which will nicely stimulate domestic demand and partly ensure additional economic growth, while the other share of aggregate demand growth will go into rising prices. But the rest of the world will feel a serious shortfall of capital that could prove critical to some of them—including Ukraine.
Unhappy prospects for EMs
In short, today two powerful global trends are in swing: shrinking liquidity in the global financial and economic system, and an outflow of money from emerging markets to developed ones, especially the US, which is more profitable and less risky. The overall impact of these forces will be negative for developing economies. What’s more, it’s been evident since the beginning of 2018: after the January-February collapse on stock markets, yields on the government bonds of countries like Brazil, Argentina and Turkey went up several percentage points. In other countries, securities reacted less strongly, but nearly all markets felt some outflow of capital.
This, in turn, is putting pressure on balances of payment and downward pressure on national currencies. The MSCI EM Currency Index fell 6.3% from its peak in March to the beginning of July. The DXY strengthened almost the same amount, the dollar index that aggregates the rate of the greenback against the currencies of a basket of developed economies. What’s more, all of this echoes trends from 20 years ago, because the DXY grew over 1995-1997 by almost 25%, creating many problems for countries with large foreign debts. For some, the burden proved more than they could bear.
What the ultimate impact of these two trends will be on the US is an open question. If more EM capital flows to US stock and bond markets than the Fed is prepared to swallow, a new investment boom will take place. All the necessary conditions are in place, given that the technology giants for whom an abbreviation has even been invented—FAANG for Apple, Amazon, Netflix, Google—are all showing miraculously steep growth. It’s possible that what we are looking at is a dotcom bubble 2.0, but this will happen only if the US has a constant net positive inflow of capital. If there should be a capital shortfall even on the US market, we will likely see a simultaneous collapse across all or nearly all stock markets in the world. If that happens, it won’t be possible to avoid devastating consequences on a global scale.
Right now, it’s probably early to talk about a crisis, but the first harbingers are already there. A few weeks ago, Argentina turned to the IMF for financial support because it was unable to handle the pressure on its balance of payments and the Argentinean peso lost nearly a third of its value just in the last two months. Of course, the financial systems of developing countries are far more stable than they were 20 or even 10 years ago, so a large scale crisis is unlikely to emerge tomorrow, next month or even next quarter. All the more so that financial market processes tend to move in waves and most recently the situation appears to have improved a tiny bit.
However, the basic trends that led to the recent decline in EM stocks have not gone away. The imbalances will continue to accumulate and will sooner or later make themselves felt with new force. Perhaps it’s just a matter of time. But the worst thing for Ukraine is that it will suffer along with everyone else, and possibly even more. It could be that the next wave of capital flight from developing countries will happen at the same time as Ukraine’s domestic problems grow more acute, what with the disruption of IMF cooperation and substantial debt payments that loom over 2018-2019. This could lead to some of the worst losses in the world for Ukraine and Ukrainians—in which case the BoA’s parallels with the 1990s will look unfortunately prescient.