Why the next global financial crisis may dwarf the one in 2008
- Big risks today include the nonbank financial sector and high corporate debt. There are more ‘zombie companies’ now than at any time during the 2008 crisis, while huge dollar liabilities in banks outside the US and emerging market indebtedness add to the dangers
Recent turmoil in money markets that forced the US Federal Reserve to make huge injections of liquidity into the financial system was almost certainly a portent of more alarming things to come. And, while financial crises come and go with increasing frequency nowadays, the next one could prove to be the “mother” of them all.
The financial system has been strengthened by regulatory reforms since the 2008 global financial crisis but these reforms are unlikely to cope with the structural changes that have taken place since then. Money market upheavals this month reflect these unseen but very significant changes.
The danger of further squeezes in short-term markets that are vital to the functioning of the financial system is growing as so-called nonbank financial institutions rely increasingly on short-term markets to borrow against the security of corporate and government debt.
And this is but one symptom of a much wider malaise in the global financial system, according to research by Hung Tran, a former executive managing director at the Institute of International Finance. “It’s not easy to determine when a financial crisis is about to materialise and take action to forestall it,” says Tran, now a non-resident senior fellow at the Atlantic Council in Washington.
This is especially true if the next crisis comes in a new guise, as is likely to be the case.
Banks were at the centre of the 2008 crisis because of their excess liquidity and their consequent involvement with dicey debt obligations such as subprime mortgages and other collateralised debt obligations. They have since been brought under control but the big risks have migrated elsewhere in the system.
Banks have been “disintermediated” to a quite alarming extent by nonbank financial institutions, such as mutual funds, insurance companies, pension funds and sovereign wealth funds, which now hold assets estimated by a 2018 McKinsey Global Institute report to be US$135 trillion, versus US$127 trillion by banks.
These nonbank financial institutions have increasingly replaced banks by lending to businesses via the leveraged loan market and by buying corporate bonds. (A leveraged loan is one that is extended to companies or individuals that already have considerable amounts of debt or a poor credit history.)
Since the 2008 crisis, the global non-financial corporate sector has stepped up its borrowing sharply, boosting outstanding debt to US$73 trillion (or 92 per cent of world gross domestic product), according to the Institute of International Finance. At the same time, the quality of the corporate bond market has deteriorated.
If a recession comes or when interest rates rise, a multitude of such companies will be severely distressed and face bankruptcy. If enough fail, that will constitute a major shock to the financial system, similar to the US savings and loans crisis in the 1980s, Tran believes.
There are far more “zombie companies” now than at the time during the global financial crisis, partly because central banks have accumulated US$19.4 trillion of financial assets, including corporate securities. This has unleashed what Tran calls a “powerful search for yield”, leading to excessive risk-taking and overvaluation of securities – particularly corporate debt.
It has kept zombie companies (those not profitable enough to pay interest) alive, and the dynamism of the economy has been sapped.
In an already illiquid corporate bond market, a sharp downward price movement from current historically high levels and in disorderly market conditions will have significant contagion effects by intensifying investor risk aversion, Tran says.
Threats to the financial system do not end there. Banks outside the US have built up dollar liabilities estimated at up to US$15 trillion, according to the Bank for International Settlements. They have relied on short-term interbank and currency swap markets to fund dollar loans and are vulnerable to changes in market sentiment and risk appetite.
“When they run into funding distress, they don’t have recourse to a lender of last resort to provide emergency dollar liquidity on a sufficient scale,” Tran fears. “If a global financial crisis breaks out, huge dollar funding distress by non-US banks will put us in uncharted waters.”
Again, the problems do not stop there. Emerging market indebtedness has reached a record US$69 trillion, or 216 per cent of overall GDP, according to the Institute of International Finance. Borrowing by emerging market non-financial corporations has soared to US$30 trillion and China’s non-financial corporate debt has hit US$15.4 trillion.
Against this, many emerging-market countries have accumulated foreign exchange reserves totalling around US$7.2 trillion since the 1997 Asian financial crisis, of which China accounts for about US$3 trillion. China thus seems well placed to provide emergency support in the event of any new crisis.
Even so, Chinese reserves and those available through arrangement, such as Asia’s Chiang Mai Initiative Multilateralised Agreement, are only capable of dealing with balance-of-payment crises of one or a small group of countries.
Of key importance are the currency swap agreements among major central banks, led by the US Fed. But as Tran says, “given the dysfunctional international political environment, it is unclear whether currency swaps on a sufficient scale can be counted on”.
It may be much more difficult to stabilise the next global liquidity crisis.
Anthony Rowley is a veteran journalist specialising in Asian economic and financial affairs